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Background Advanced Chemical Industries (ACI) is a leading pharmaceutical compan

Background Advanced Chemical Industries (ACI) is a leading pharmaceutical company. ACI only operates in the US. Excluding the deferred tax asset ACI total assets are $3.5 million. ACI was a profitable company. In 2018 ACI began reporting a net loss (both book and tax loss) which has been primarily attributable to significant research and development costs. Now it is 2020. The following table presents the loss figures for ACI. ACIs relevant statutory tax rate is 21% and the company did not have any permanent book-tax differences during 2018 2019 or 2020. ACI did not establish a valuation allowance to offset the deferred tax asset in 2018 or 2019. 2018 2019 2020 Pretax book loss $ (900 000) $(1 890 000) $(775 000) Net temporary differences (210 000) (60 000) (110 000) Taxable loss (1 110 000) (1 950 000) (885 000) Statutory tax rate 21% 21% 21% Impact on the deferred tax asset balance 233 100 409 500 185 850 Net loss (after tax)* $(666 900) $(1 480 500) $(589 150) Deferred tax asset balance $233 100 $642 600 $828 450 Valuation allowance* “ “ ? ACI is assessing the need to record a valuation allowance to offset the deferred tax asset balance created by the net operating loss carryforward. While the company has reported losses in the past three years management anticipates positive income in the future. The executives of ACI do not anticipate any fundamental shift in its business operations in the future. The company is currently in the final research and development stage of a new drug that has tremendous market opportunity. Management believes that this drug will be on the market within three years based on the companys past experience. The income projections for the next five years prepared by the CFO are presented below. The CFO determined that while NOL can be carried forward indefinitely predicting numbers beyond the 5- year period was impractical. However the CFO does anticipate positive taxable income in 2026 and beyond because the new drug can bring long-term profit and there lacks of any known competing drugs. The CFO has been with ACI for his entire career and has been extremely competent in terms of preparing income projections and meeting forecasts. The income effect of the new drug is based on information gathered when its most recent significant drug was released. There have been no actual or expected changes in tax laws indicating a potential change in the statutory tax rate. The projections provided have been shared with analysts and investors. The CFO obtained a schedule for the existing taxable temporary differences relating to the gross deferred tax liability at December 31 2020. This schedule was reviewed by the tax director. The schedule indicated that there would be no reversals scheduled in the foreseeable future. 2021 2022 2023 2024 2025 Pretax book loss excluding new drug $(750 000) $(600 000) $ (525 000) $ (490 000) $ (350 000) Income effect of new drug 2 000 000 3 500 000 3 750 000 Pretax book (loss) income (750 000) (600 000) 1 475 000 3 010 000 3 400 000 Net temporary differences (110 000) (110 000) (110 000) (110 000) (150 000) Future taxable (loss) income (860 000) (710 000) 1 365 000 2 900 000 3 250 000 Limitation on carryforwards 80% 80% 80% Future taxable income available to offset carryforward 1 092 000 2 320 000 2 600 000* Statutory tax rate 21% 21% 21% 21% 21% Impact on deferred tax asset balance 180 600 149 100 (229 320) (487 ) (441 630)* Beginning of year deferred tax asset balance 828 450 1 009 050 1 158 150 928 830 441 630 End of year deferred tax asset balance $1 009 050 $1 158 150 $ 928 830 $ 441 630 $ “ *For 2025 there is only $441 630 left in the deferred tax asset account balance As the junior accountant the CFO has asked you to provide him with an analysis of the need for a valuation allowance account for the deferred tax asset. The CFO has informed you that the tax director has said that ACI does not have any available tax-planning strategies to realize the deferred tax asset. The CFO has suggested that beyond looking at ASC 740 for guidance on this determination she also recommends that you read paragraphs 99 through 103 in the Basis for Conclusions in SFAS No. 109. Required For December 31 2020 using your judgment perform an analysis of the need for a valuation allowance to offset part or all of the deferred tax asset created by the net operating loss carryforward. Document your judgment in a draft memorandum format that you will provide to the CFO (not to exceed 2-3 pages double space 12 font size). Always include references to the applicable guidance. Upon completing your documentation make certain that you are able to address the following considerations: “ Is the documentation sufficient to support your judgment? Specially regarding the size of the valuation allowance why possible alternatives were not selected? “ Can another professional possibly outside of the accounting field understand what you are trying to say as well as how you reached your conclusion?

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