For December 31, 2020, does Asbat need to record a valuation allowance?
Asbat Pharmaceuticals (Asbat) is a leading pharmaceutical company that has been in existence for 22 years. Asbat has a calendar year-end and is audited annually. Asbat only operates in the US and is not subject to state or local income taxation. Its total assets, exclusive of the deferred tax asset, are $3.5 million.
In the early years, Asbat operated at a net loss. After its fifth year of business, upon the release of its first drug, Asbat began reporting annual net profits. These profits continued until two years ago, when, in 20, Asbat once again began reporting a net loss, which has been primarily attributable to significant research and development costs.
The following table presents the loss figures for Asbat. Asbat’s relevant statutory tax rate is 21% and the company did not have any permanent book-tax differences during 2018, 2019 or 2020. Asbat did not establish a valuation allowance to offset the deferred tax asset in 2018 or 2019.
|Pretax book loss||$ (900,000)||$(1,890,000)||$(775,000)|
|Net temporary differences||(210,000)||(60,000)||(110,000)|
|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|
|Net deferred tax asset balance*||$233,100||$642,600||$828,450|
*Prior to determining the need for a valuation allowance in 2020.
Asbat has 100,000 common shares outstanding with no dilutive securities. Thus, its pretax loss per share for 2020 is $7.75. The current consensus analyst forecast for net loss per share (after tax) is $7.
Asbat 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, management anticipates positive income in the future. The executives of Asbat do not anticipate any fundamental shift in its business in the future. However, 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 company’s past R&D experience with its most recent prior drug release. The income projections for the next five years prepared by the CFO are presented below. The CFO determined that, while a carryforward has an indefinite time period to consider, looking out at a period beyond 5 years was too unpredictable. However, the CFO does anticipate continued future taxable income in 2026 and beyond based on the potential long-term impact of the new drug and lack of any known competition. The CFO has been with Asbat for her entire career and has been extremely competent in terms of preparing income projections and meeting forecasts. The pretax income projections that exclude the impact of the new drug are based on reliable historical data on income and trends. The income effect of the new drug is based on information gathered and modified from the boost to income that Asbat experienced 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 are the same that have been shared with analysts and investors.
The CFO obtained a reversal schedule for the existing taxable temporary differences relating to the gross deferred tax liability as of December 31, 2020, prepared and clerically tested by the junior tax accountant. This schedule was reviewed by the tax director. The schedule indicated that there would be no reversals scheduled in the foreseeable future.
|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)||(487,200)||(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, possible offset would be $546,000, but there is only $441,630 left in the deferred tax asset account balance.
The CFO has informed you that the tax director has said that Asbat does not have any available tax-planning strategies to realize the deferred tax asset.
For December 31, 2020, does Asbat need to record a valuation allowance? If so, does the company need to record a full valuation allowance or partial (provide the amount)?