Is management's assessment of the adequacy of the valuation allowance is appropriate?

Case 2016-04 SafeAccess Inc. SafeAccess Inc. (SAI) is a public company that develops customized encoded card-reading applications for security and access control devices. For the year ended December 31, 2013, SFI has $18 million of deferred tax assets (net of $2 million valuation allowance), which primarily consist of net operating loss and income tax credit carryforwards. The following table summarizes the deferred tax assets by category, as of December 31, 2013, and indicates the years over which the future tax benefits will expire if not used. Deferred Tax Assets: Federal net operating loss carryforwards Federal and state income tax credits Research and development credits Subtotal Less: Valuation allowance Total deferred tax assets (in millions) $ 15.0 3.0 2.0 $ 20.0 (2.0) $ 18.0 Expiration Period 2014- 2023 2014- 2019 2014- 2016 Additional information regarding the Company's income taxes: SFI does not have any significant deferred tax liabilities SFI is not permitted by tax law to carryback operating losses to income in prior years SFI is not permitted to carryback income tax credits to recover taxes paid in prior years SFI has historically utilized its net operating loss and income tax credit carryforwards prior to those benefits expiring unused The effective tax rate for the Company is 40% As the independent auditor, you are starting the review of the income tax provision workpapers for the year ended December 31, 2013, and specifically to consider the adequacy of the valuation allowance related to the recognition of the deferred tax assets as of December 31, 2013. Case 2016-04 Page 1 The income tax workpapers include two documents important to your review: a five-year summary of Selected Historical Consolidated Financial Information (Handout 1) a memorandum prepared by the Controller of SFI, Jennifer Chu, supporting management's assessment of the adequacy of the $2 million valuation allowance for the year ended December 31, 2013 (Handout 2) Case Analysis: You are the auditors for SafeAccess Inc. Audit management's assessment of the $2 million valuation allowance and determine the appropriateness of the assessment for the year ended December 31, 2013. Prepare a summary report on your research, analysis and conclusion on the valuation allowance. Your report should address two alternatives: (1) Management's assessment of the adequacy of the valuation allowance is appropriate. (2) Management's assessment of the adequacy of the valuation allowance is not appropriate. Your conclusion should include the amount and calculation of your estimate of the allowance based on the case facts (which may or may not be the same amount and calculation as management has provided in their memo). Your calculation should be presented in an appendix to your memo (as an additional page). Case 2016-04 Page 2 Case 2016-04 - HANDOUT 1 SafeAccess Inc. Selected Historical Consolidated Financial Information Years Ended December 31 INCOME STATEMENT DATA (in millions) Net revenue Cost of goods sold Inventory write-off Gross Margin Operating Expenses: Selling and marketing Research and development Mergers and restructurings Intangible asset amortization Acquired in-process R&D Total Operating Expenses Pretax income (loss) (a) $ (b) 2009 149.2 103.4 45.8 $ 38.2 5.5 43.7 (c) (d) (e) $ 2.1 2010 155.4 106.7 48.7 $ 39.7 5.7 45.4 $ 3.3 2011 197.4 134.4 63.0 $ 52.2 5.0 1.7 1.2 60.1 $ 2.9 $ 2012 246.7 171.7 75.0 $ 2013 305.3 213.5 4.3 87.5 Cumulative 3 Years $ 749.4 519.6 4.3 225.5 67.1 5.6 3.8 1.5 2.1 80.1 84.3 3.9 2.6 90.8 (5.1) $ (3.3) $ (a) The increase in revenues from 2011 to 2013 is the result of acquisitions completed during each of the years ended December 31, 2011 and 2012, and the introduction of EYE-Trak, a newly developed technology, during 2013. (b) The $4.3 million represents inventory scrapped in connection with the introduction of EYE-Trak. (c) Represents merger and restructuring charges incurred in connection with the acquisitions made during 2011 and 2012. Those charges primarily consist of the elimination of management, workforce, and facility redundancies. (d) Represents amortization of intangible assets (e.g., technology and non-compete agreements) acquired during 2011 and 2012. (e) The $2.1 million represents in-process research and development with no alternative future use acquired in 2012 and immediately written-off. Case 2016-04 Page 3 203.6 14.5 5.5 5.3 2.1 231.0 (5.5) Case 2016-04 - HANDOUT 2 SafeAccess Inc. Memo to Files Prepared by: Date: Jennifer Chu, Controller January 20, 2014 Subject: Year End 2013 Valuation Allowance for Deferred Tax Assets This memo summarizes SafeAccess Inc.'s assessment of the $2 million valuation allowance recorded against deferred tax assets of $20 million as of December 31, 2013. Historical Earnings The five-year historical operating results, presented in the Selected Historical Consolidated Financial Information (Handout 1), indicate that a cumulative pretax loss of $5.5 million exists (calculated as the current year pretax loss plus the pretax income/loss of the immediate two preceding years). However, management believes the cumulative pretax loss is the result of certain events that occurred during those periods and are not representative of the Company's ability to generate future taxable income (in order to utilize the future tax benefits). Those events are described in (b) - (e) in the Selected Historical Consolidated Financial Information (Handout 1). Except for the intangible asset amortization, management believes each of the events are nonrecurring and an aberration, rather than a continuing condition. Accordingly, we believe those nonrecurring events should be excluded from the analysis of historical earnings when making an assessment of the adequacy of the valuation allowance. An analysis of the historical earnings adjusted for the removal of these nonrecurring events is presented at the end of this memo. The analysis indicates that SafeAccess Inc. will generate approximately $21.0 million ($2.1 million annual adjusted pretax income multiplied by 10 years) in pretax income on a historical basis over the period that the future tax benefits expire. We also note that the Company has a history of utilizing all net operating loss and income tax credit carryforwards prior to their expiration as a result of sufficient taxable income. TargetCo Acquisition On January 15, 2014, SafeAccess Inc. announced it had signed a letter of intent to acquire TargetCo in a purchase business combination to be completed by April 30, 2014. Case 2016-04 Page 4 TargetCo recently introduced Prints-Plus, a state-of-the-art security system activated by unique fingerprint scans. Prints-Plus has been well received in the market, and TargetCo has a portfolio of firm purchase commitments established with major distributors in the industry that management believes will ensure future revenues and taxable income. Based on the audited financial statements of TargetCo for the years ended December 31, 2011, 2012, and 2013, we expect TargetCo to contribute, on an annual basis, approximately $80.0 million and $1.7 million in revenues and pretax income respectively (calculated as the average of the three years ended December 31, 2013). Accordingly, we believe the acquisition will provide additional pretax income of approximately $17.0 million ($1.7 million projected pretax income multiplied by 10 years) over the period that the future tax benefits expire. See Adjusted Historical Earnings below. Future Earnings Forecast Future revenues are projected to increase by 12% annually over the next five years (exclusive of the acquisition of TargetCo) primarily as the result of increased sales volume from the introduction of EYE-Trak during 2013. Operating costs are projected to decrease by 5% over the same period primarily due to reduced fixed costs from the restructuring programs implemented during the 2011 to 2013 time frame. Pretax income from continuing operations for the year ended December 31, 2014, is projected to be $3.3 million increasing to approximately $4.5 million for the year ended December 31, 2018. Accordingly, we believe SafeAccess Inc. will generate an additional $12.0 million [($3.3 million projected pretax income less $2.1 adjusted historical pretax income) multiplied by 10 years] in pretax income over the period which the future tax benefits expire. See Adjusted Historical Earnings below. Adjusted Historical Earnings The following analysis presents the historical operating results adjusted for the nonrecurring events from 2011 to 2013 and management's estimates of future income from the items discussed above. The analysis then reconciles management's estimate of future taxable income that will be generated over the 10-year period to the amount of future tax benefits from net operating loss and income tax credit carryforwards expiring during the same period. Case 2016-04 Page 5 As noted in the conclusion below, the $2 million valuation allowance represents the amount of research and development credits that management believes will expire unused. In order to utilize the net operating loss and income tax credit carryforwards, management believes SafeAccess Inc. must generate $45 million [($18.0 million deferred tax assets from net operating loss and income tax credit carryforwards) divided by 40% tax rate] of future taxable income over the period that those benefits expire. ADJUSTED HISTORICAL EARNINGS INCOME STATEMENT DATA (in millions) Pretax income (loss) $ Nonrecurring items not indicative of future operations: Inventory write-off Mergers and restructurings Acquired in-process R&D write-off Adjusted pretax income (loss) $ Years Ended December 31 Cumulative 2011 2012 2013 3 Years 2.9 $ (5.1) $ (3.3) $ (5.5) 1.7 4.6 3.8 2.1 0.8 4.3 1.0 $ 4.3 5.5 2.1 6.4 Average annual adjusted pretax income (loss) $ 2.1 SOURCES OF FUTURE TAXABLE INCOME Adjusted historical pretax income [$2.1m x 10 years*] $ 21.0 $ $ Projected annual pretax income from Target Co acquisition [$1.7m x 10 years*] 17.0 Projected annual increase in pretax income from operations [$1.2m x 10 years*] 12.0 Total estimated future taxable income Less: Deferred tax benefits as of 12/31/13, expiring 2014-2023 [($15.0m NOLs + $3.0m Tax Credits) / 40% tax rate] 50.0 Excess future taxable income (45.0) $ 5.0 * Represents the number of years over which the future tax benefits expire (2014 - 2023). Conclusion The amount of valuation allowance generally represents our actual experience of the amount of tax benefits that have expired unused. Historically, this amount consists of research and development credits, or similar credits, with expiration periods of three years or less and limited deductibility under tax law. Consistent with prior years, the $2 million valuation allowance represents the amount of Case 2016-04 Page 6 research and development credits that management believes will expire unused. Based on the Adjusted Historical Earnings and the supporting basis for conclusions described above, it is management's conclusion that it is more likely than not that the future tax benefits related to the net operating loss and income tax credit carryforwards will be realized. The analysis indicates an excess $5 million of future taxable income over the amount of future tax benefits from net operating loss and income tax credit carryforwards expiring during the same period. Accordingly, we believe the $2 million valuation allowance appropriately reduces deferred tax assets as of December 31, 2013 to the amount more likely than not to be realized. Case 2016-04 Page 7