Discussion Memorandum #1
Net Operating Losses
The Dam Tubing Company has been in business for approximately 15 years operating a tubing business along the Guadalupe River near a local dam. By 2010, the business had been growing steadily was generating approximately $1,300,000 in sales and $200,000 of taxable income each year. The pattern changed in 2011 when, due to a two year drought, the company saw its taxable income reduced and then turn into a taxable loss in 2012. In 2013, because there was more rainfall, the company experienced something of a recovery resulting in taxable income for 2013. Unfortunately calendar year 2014 was another record dry year and the company experienced a large taxable loss due to the severity of the drought and to incurring certain extra drought-related safety measures the company implemented in that year. The pattern of taxable income and loss is shown below:
years prior to 2011- $200,000
2011- 110,000
2012- (150,000)
2013- 130,000
2014- (300,000)
As company controller, you have already explained to Mr. Floater, the company's owner and CEO, that the company will likely choose to carryback part of the 2014 loss to prior years to obtain a quick recovery of taxes previously paid the IRS. Besides any receivable from the IRS that may be recorded, Mr. Floater would like to see no allowance recorded on any deferred tax asset that may be recognized related to any unused 2014 net operating loss (NOL) that is carried forward. He wants to see an improvement in the company's financial position in preparation for borrowing funds to do additional maintenance on the tubing facilities due to damage caused by the rains in 2013 followed by drought in 2014. Mr. Floater has informed you that in his opinion it is not only probable but highly likely that the company will return to profitability soon allowing the company to fully use the NOL carryforward, especially since the weather forecasters are predicting El Niño conditions that are expected to result in periodic heavy rains for 2015.
The company has some excess property located near its tubing business currently used for storage that could be sold to generate approximately $30,000 of net gains. Assume the company would be able to treat the gains as ordinary income taxable at 30% for tax purposes should the property be sold. Although the company does not want to sell the property because it may need it to expand the business, the company would sell the property, if necessary, to avoid losing a tax benefit from the NOL's.
The owner has asked you as the controller for The Dam Tubing Company, if you could do some research on whether the company will be able to show a tax benefit from the NOLs generated in 2014, either by routine loss carrybacks or carryforwards or through other means, if necessary. For the purposes of the analysis, at the end of 2014 the company has $18,000 of deferred tax liabilities (related to depreciation) classified as noncurrent liabilities which are expected to reverse out over approximately the next five years and the currently enacted tax rate is 30% and is the same for all past and future years.
In preparation for further discussion of this issue, you should prepare a memo that:
Explains the facts, i.e., describe the circumstances that The Dam Tubing Company finds itself in regarding the valuation allowance and why there is a valuation allowance for certain deferred tax assets the beginning of 2014.
Generally explains the accounting guidance that applies to this type of situation. You should cite the appropriate paragraphs of the codification in your memo and include the text of such paragraphs in the memo near where you are discussing how the guidance would be applied. Only include the relevant passages, that is, the codification guidance included in the discussion should be only those passages relevant to the point being discussed. (You must include the full code topic, subtopic, section, and paragraph numbers, for example, 320-10-25-1.(See sample DM)
Provides your conclusion on whether and how much of a tax benefit the company will be able to recognize in 2014 from the NOL arising in 2014. The discussion should include all possible sources of taxable income that could be used to recognize a tax benefit fromthe NOL (taxable income in carryback years, future taxable income, etc., and discuss whether any valuation allowance is necessary for any deferred tax asset that may be recorded with respect to any NOL carryforward.
In regard to (c) above
Please provide your estimate of the amount of any receivable due from the IRS arising from the loss in 2014 and the amount of any deferred tax asset that will be recorded in 2014 related to any unused operating loss carryforward and then give your estimate of the amount of the valuation allowance, if any, that will be required on that deferred tax asset based on the guidance in the FASB's Accounting Standards Codification. (You may attach a handwritten sheet showing your computations).
You should discuss how you applied the codification guidance to this situation. The discussion should include all possible sources of taxable income that could be used to recover the deferred tax asset and whether and how these sources of recovery are being applied in this case. TO RECEIVE FULL CREDIT, YOU MUST INCLUDE THIS DISCUSSION. (A discussion is more than one sentence).
Discuss whether Mr. Floater's belief that it is likely that the company will soon return to profitability is sufficient to avoid setting up an allowance on a deferred tax asset related to NOL carryforwards or other tax-book differences?
The memo should be in plain English to the extent possible (except for quotes from the codification) since as company controller you will have to explain the situation and conclusions in the memo to the company's owner and ultimately to the audit committee. The discussion memo should be from 2-5 pages long, exclusive of the citations from the FASB Accounting Standards Codification. You should be sure to give the section numbers for the Codification and to the extent you utilize other sources you should include footnotes referencing such sources, whether you use a direct quote or paraphrase. PLEASE DRAFT THIS AS A MEMO AND NOT AS RESPONSES TO ITEMS A-E ABOVE.
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