Background

Asbat Pharmaceuticals (Asbat) is a leading US 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 2018, 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. Asbats 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.

	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*
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 $7.00.

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 in the past three years, 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 companys past R&D experience with its most recent prior drug release. The income projections for the next five years prepared by the CFO are

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 his entire career and has been extremely competent in terms of preparing income projections and meeting analyst 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 at December 31, 2020 prepared and clerically tested by the tax accountant. 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)	(487,200)	(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.

As the junior accountant, the CFO has asked you to provide him with an analysis of the need for a valuation allowance account to offset the deferred tax asset. The CFO has informed you that the tax director is looking into 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. In a meeting, the CFO mentioned that the company was potentially looking into a Series D financing or a SPAC-based acquisition and that the financials needed to look top-notch earnings growth-wise to potential investors.

Required

1. With respect to valuation allowance, what is the primary decision that the CFO needs to make in this case? What is the dollar range of possible values for the valuation allowance?

2. Research the guidance in ASC 740 and SFAS No. 109.

1. Briefly state the information and/or list the factors that the junior accountant would need to know to make a professional judgment about the dollar amount of the valuation allowance needed, if any.

2. What changes were made for the accounting of net operating losses in the 2017 Tax Cuts and Jobs Act?

1. What changes were made for the accounting of net operating losses in the Coronavirus Aid Relief and Economic Security Act 2020?