LOL (the Company), an SEC registrant with a calendar year-end, is a manufacturer and distributor of sports equipment. The Company was created in 1989 and is headquartered in Southern California. The Company has manufacturing operations and numerous sales and administrative locations in the United States. LOL files a consolidated U.S. federal tax return. (This case will not consider the evaluation of the state jurisdictions; it will only consider the federal jurisdiction.)

As LOLs auditors, you are now performing the Companys year-end audit for the fiscal year ended December 31, 2010, and have the following information available to you:

LOL draft income statement and excerpt from tax footnote as of December 31, 2010 (Handout 1).

A deferred tax asset realization analysis showing pre-tax book income projections (Handout 2).

The projected income schedule (realization analysis above) projects organic growth beginning in 2012 after stemming the decrease in pre-tax book income.

LOL does not have the ability to carry back any losses to prior periods. A significant customer declared bankruptcy in 2010; therefore, the Company wrote off all accounts receivable from this customer. The Company is considering the exclusion of such expense when evaluating whether future income is objectively verifiable.

The Company does not have a history of operating losses or tax credit carryforwards expiring unused.

The Company has identified the following possible tax-planning strategies: o Selling and leasing back manufacturing equipment that would result in a taxable gain of $20 million. o Selling the primary manufacturing facility at a gain to offset existing capital loss carryforwards.

Required:

Question 1 What are the four possible sources of taxable income according to ASC 740?

Question 2 How much of the reversing taxable temporary differences may be considered in estimating future taxable income?

. Question 3a In evaluating the income that LOL is projecting related to future operations, is LOL in a cumulative loss position (assuming LOL considers three years as the period over which to evaluate pretax accounting income or loss from continuing operations for cumulative losses)?

Question 3b In evaluating the income that LOL is projecting related to future operations, may LOL exclude the impact of the impairment of the nondeductible goodwill when estimating future taxable income?

Question 3c In evaluating the income that LOL is projecting related to future operations, may LOL exclude the expense from writing off the accounts receivable from the customer who declared bankruptcy when evaluating the projections of future income?

Question 3d In evaluating the income that LOL is projecting related to future operations, the Company has projected growth in its future projections. Does the evidence of historic losses affect our ability to accept the Companys estimate of future growth?

Question 3e In evaluating the income that LOL is projecting related to future operations, in an effort to satisfy your appropriate professional skepticism, what evidence might you ask for to support the Companys projections?

Question 4 Would the tax-planning strategy to sell and lease back manufacturing equipment be a tax-planning strategy that is considered prudent and feasible? Why or why not?

Question 5 Would the tax-planning strategy to sell but not lease back the primary manufacturing facility be a tax-planning strategy that is prudent and feasible? Why or why not?

Additional Facts Intraperiod Allocation Consideration Assume that a valuation allowance of $105 million is recorded as of December 31, 2010 ($150 million deferred tax asset (DTA) less $45 million reversing deferred tax liabilities (DTL)). Further assume that during 2010, the Company recognized a loss of $50 million in accumulated other comprehensive income (AOCI) related to a pension adjustment from a loss in investment value. The Companys effective tax rate, without the recognition of a valuation allowance, is 37 percent.

Required:

Question 6 Calculate the tax effect on the loss of $50 million recognized in AOCI in 2010.

Additional Facts Assume that a valuation allowance of $105 million is recorded as of December 31, 2010 ($150 million DTA less $45 million reversing DTLs). Further assume that the Companys projection for 2011 pre-tax book income of $0 is accurate, but the Company sells a component of the business and recognizes the component as a discontinued operation. The discontinued operations earn $20 million before tax, and the continuing operations lose $20 million before tax for a net pre-tax book income of $0. As described above, the Company has a full valuation allowance.

Required:

Question 7a Is there a tax benefit on the loss of $20 million from continuing operations?

Question 7b Is there a tax provision on the $20 million of income from discontinued operations?

Additional Facts Interim Reporting Assume that a valuation allowance of $105 million is recorded as of December 31, 2010 ($150 million DTA less $45 million reversing DTLs). Further assume that the actual 2011 net income before tax was $0 as projected at the end of 2010. In calculating the 2012 annual effective tax rate (AETR) at the beginning of the year, the Company projected income before taxes of $40 million ($10 million per quarter). Using the effective tax rate of 37 percent, the $40 million of income would result in a tax provision of $14.8 million during 2012 ($3.7 million per quarter) before considering the release of the valuation allowance. In addition, assume that the net operating loss carryforward will be used as income is generated during the year, resulting in annual estimated tax of $0 and an annual estimated effective tax rate of 0 percent. In the absence of a release of the valuation allowance during 2012 from a change in estimate, the year-end valuation allowance would be $90.2 million ($105 million less $14.8 million) as a result of the income earned in 2012. In the second quarter of 2012, LOL determined that there was sufficient evidence of future taxable income to satisfy the valuation assertion of the DTA.

Required: Question 8 Calculate the tax provision (benefit) that would be recognized in the second quarter of 2012.

Handout 1 - LOL Draft Income Statement and Excerpt From Tax Footnote as of December 31, 2018 LOL Corporation Consolidated Statement of Operations Years ended December 31, 2018, 2017, and 2016 (in thousands) 2017 2018 2016 Revenues, net 2,000,0001,900,0001,800,000 Cost of goods sold 1,400,000 1,250,000 ,200,000 Gross profit 600,000 650,000 600,000 Selling, general, and administrative 500,000 500,000 400,000 expense Goodwill impairment 750,000 Operating income (loss) (650,000) 150,000 200,000 50,000 50,000 Interest expense, net 50,000 Income (loss) before provision for (700.000) 100,000 150,000 income taxes 36,00054000 Provision (benefit) for income taxes Net (loss) income 64,000 96,000 LOL Corporation Inventory of Deferred Tax Balances The components of net deferred income taxes are as follows: 2018 2017 Year ended December 31 (in thousands) Deferred income tax assets: Allowance for doubtful accounts 30,000 25,000 Tax loss carryforwards (pre-2018) 100,000 100,000 20,000 Accruals and other 25,000 150,000 150,000 Deferred income tax liabilities: (15,000) (20,000) Depreciation Indefinite lived intangible assets (trademark) (50,000) (50,000) (35,000 (20,000) (100,000) (90,000) Prepaid expenses Net deferred income taxes 60,000 50,000 Valuation allowance Net deferred tax asset (liability) 2??260,000 As of December 31, 2018, LOL had $475 million of net operating loss carryforwards. Of these, $25 million are capital losses and will expire in 2019, and the remaining $450 million are operating losses and will expire in 2033 Handout 2- LOL Deferred Tax Asset Realization Analysis Showing Pretax Book Income Projections LOL Corporation Deferred Tax Asset Realization Analysis in thousands) The documentation below was provided to auditors as part of their audit. Adjusted Pretax Book Goodwill Pretax Book Year Income (Loss) Impairment*Income (Loss Actual Results 2016 150,000 150,000 2017 100,000 100,000 2018 700,000 750,000 50,000 Projections 2019 2020 40,000 2021 80,000 85,000 90,000 2022 2023 2024 2025 95,000 100,000 2026 105,000 110,000 2027 2028 115,000 2029 120,000 The goodwill impaired is nondeductible. There was no basis in the goodwill for tax purposes, therefore, the impairment had no direct impact on the tax provision. In other words, the impairment of the goodwill for book purposes does not result in a corresponding deduction for tax purposes in any period. The book expense, therefore, does not affect the resulting taxes payable, and it results in an effective tax rate that differs (unfavorably) from the statutory tax rate