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    Deferred Income Tax

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    You have just been promoted to assistant controller of Doncast company. One of your responsibilities is to calculate income tax expense and any deferred tax assets or liabilities.

    The company took a lot of debt five years ago to finance a major expansion, and the recent rise in interest rates, along with a decline in sales, has resulted in a large operating loss for the current year. Unfortunately, the decline in sales is likely to continue until the economy improves. Economists are not predicting an upturn for several years. In the meantime, the interest payments have tripled, and the company is scheduled to begin repaying the principal on the loan next year. There has been talk of layoffs and even bankruptcy.

    You have computed the current year's loss and the refunds due as a result of the loss carryback to the two previous years. The remaining loss will be reported as a loss carryforward and a deferred tax asset.

    You are concerned that the company may not have any future earnings and have computed a valuation allowance for the deferred tax asset that reduces it substantially.

    You take your calculations and journal entries to your boss, the controller, and she's pleased about the refunds the company will get. However, when she sees the journal entry for the valuation allowance, she refuses to approve it. "The company needs every asset it can report," she says. "Besides, these numbers are just your estimates. No one knows for sure what will happen in the future, so there's no good reason to make this entry."

    Based on your analysis of the information provided, respond to the following questions:
    •How a loss carryback can arise?
    •What is the timeframe for using a loss carryback?
    •Why would a valuation allowance be used?
    •Is one warranted in this situation?
    •What would happen if the company did become profitable and could use the entire loss carryback?
    •What is your evaluation of the ethical issues that would arise as result of your boss refusing to approve the valuation allowance?
    •What is your analysis of the stakeholders involved, and how will they be affected?

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    Solution Preview

    Step 1
    A loss carry-back arises when a company applies net operating losses to preceding year's income. The large operating loss that the company has suffered can be applied to previous year's income to reduce tax liabilities in previous years. The loss carry-back occurs when a tax loss is carried back against taxable income. Usually, a refund of taxes paid should be received by Doncast Company.

    Step 2
    According to GAAP a loss carry-back can be applied only to the three years preceding the loss. This loss carry-back should be applied in accordance with the applicable income tax laws. For example, some income tax laws allow carry-back to be applied only for the preceding two years.

    Step 3
    A valuation allowance is a balance sheet item that offsets all or a portion of the value of a company's deferred tax benefits because the company does not expect it will be able to realize it. A deferred tax asset will be created for carrying forward net operating loss. However, if the firm does not expect ...

    Solution Summary

    This solution explains the reason why valuation allowance should be created. The sources used are also included in the solution.