DelRio Western Wear, which is in the business of manufacturing western wear, has been operating for approximately 10 years and had grown until it was generating approximately $10,000,000 in sales and approximately $600,000-$700,000 in pre-tax taxable income in recent years. Due to a strike that began early in 2015, the company incurred a taxable loss of $3,100,000 in 2015.
Due to negotiations, the strike ended in early 2016 with the company having agreed to some wage increases. Currently it is mid-March 2016 and the company has not yet issued it financial statements for 2015. Now that the strike has ended, Mr. Houston, the company? CEO, strongly believes that the company will return to profitability in 2016. However, even if the company achieves profitability in 2016, it is likely to be at a somewhat reduced level, since it will take a while to get the business operating again at its normal capacity and to lure back former customers that have been purchasing their merchandise from other suppliers due to lack of company merchandise. The company has certain bank notes payable that are maturing in 2016 and the company wants to be able to refinance these notes without much difficulty. Because of the anticipated refinancing, Mr. Houston would like to keep the net loss reported in the 2015 financial statements to a minimum. That is, he would like to reflect in the 2015 income statement any tax benefits related to the NOL carrybacks or carryforwards arising from the 2015 taxable loss to the greatest extent allowable under GAAP.
Since the financial statements for 2015 have not yet been issued, Mr. Houston has asked you, the company controller, for your best professional opinion on what amount of valuation allowance, if any, the company will have to record in its 2015 financial statements associated with any deferred tax asset that may arise from the 2015 taxable loss. Assume for tax purposes, the company always chooses to carry back a net operating loss (NOL) if it can do so, prior to carrying any unused amounts forward. In the years prior to the strike the company had taxable income of $700,000 in 2012, $650,000 in 2013, and $600,000 in 2014. The declining income in recent years reflected increased competition, as the company attempted to retain customers by reducing prices on its merchandise. At the end of 2015, DelRio Western Wear has a deferred tax liability related to using accelerated depreciation for tax purposes of $70,000. Assume a tax rate of 35% was in effect in the past and is the enacted income tax rate for 2015 and future years.
The company has followed the LIFO inventory method for all the years it has been in business and there is a remaining $250,000 LIFO reserve that reflects the extent to which the inventory?s current costs exceed its LIFO-based costs (hence, appreciated assets which if liquidated would generate taxable income). Although the company?s CEO has indicated he would be somewhat reluctant to do so, he would consider switching from LIFO in the future if that would provide future taxable income for the purposes of permitting the company to have a lower valuation allowance in 2015.
In preparation for further discussion of this issue with Mr. Houston, you should prepare a memo in which you:
(a) Explain the facts, i.e., describe the circumstances in which the company finds itself regarding the net operating loss (NOL).
(b) Generally explain 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)
(c) Provide your conclusion on whether a valuation allowance is needed on any deferred tax asset that may be recorded at the end of 2015 related to the 2015 net operating loss. The discussion should include all possible sources of taxable income that could be used to recover the NOL and include a discussion of whether and how these sources of recovery may be applied in the company?s situation. YOU MUST DISCUSS HOW THE CODIFICATION GUIDANCE SHOULD BE APPLIED TO THIS SITUATION TO RECEIVE FULL CREDIT.
(d) In regard to (c) above
(i) Please provide your estimate of the amount of any receivable due from the IRS arising from the loss in 2015 and the amount of any deferred tax asset that will be recorded in 2015 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).
(ii) 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).
(e) Discuss whether the fact that company management believes that it is probable that the company will return to profitability in 2016 is enough evidence to justify not setting up any allowance on any deferred tax asset related to the NOL carryforward at the end of 2015.
The memo should be in plain English to the extent possible 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 2-4 pages long, exclusive of the citations from the FASB Accounting Standards Codification. You should be sure to give the full 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.
 Note: this is the deferred tax liability not the amount of the taxable temporary differences. The 2015 deferred tax liability is expected to reverse out over the next 3-4 years.
 Prior to the strike, the company had a policy of maintaining only a relatively small finished goods inventory. Thus even though its finished goods inventory was depleted during the strike, its raw materials remained at pre-strike levels since production stopped.
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