Question

Kleckner Company started operations in 2013. Although it has grown steadily, the company reported accumulated operating losses of \(450,000 in its first four years in business. In the most recent year (2017), Kleckner appears to have turned the corner and reported modest taxable income of \)30,000. In addition to a deferred tax asset related to its net operating loss, Kleckner has recorded a deferred tax asset related to product warranties and a deferred tax liability related to accelerated depreciation.

Given its past operating results, Kleckner has established a full valuation allowance for its deferred tax assets. However, given its improved performance, Kleckner management wonders whether the company can now reduce or eliminate the valuation allowance. They would like you to conduct some research on the accounting for its valuation allowance.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

1. Briefly explain to Kleckner management the importance of future taxable income as it relates to the valuation allowance for deferred tax assets.
2. What are the sources of income that may be relied upon to remove the need for a valuation allowance?
3. What are tax-planning strategies? From the information provided, does it appear that Kleckner could employ a tax planning strategy to support reducing its valuation allowance?

Short answer

1. The carry-forward of unused tax losses must be recorded as a deferred tax asset.
2. When assessing profitability, an entity must consider taxable profits, unused tax losses, tax planning opportunities, and other criteria.
3. Tax planning is an objective to create or increase taxable income.

Step-by-step solution

Meaning of Income-tax

A business's tax responsibility to the government in which it operates is known as "income tax payable." A business's profits will determine the amount owed over a given period and the tax rates imposed. Tax payable is a debt that must be paid within the next 12 months. Thus, it is not considered a long-term responsibility but rather a current one.

(a) Explaining the importance of future taxable income.

IAS 12, paragraph 34, "A deferred tax asset shall be recorded for unused tax losses and unused tax credits to the extent future taxable profits will probably be available against which the unused tax losses and unused tax credits can be applied." Therefore, future taxable income is essential for boosting the amount recognized in the deferred tax asset.

(b) Explaining the sources of income that may be relied upon to remove the need for a valuation allowance.

This question is about the material in paragraph 36, which says, "An entity considers the following elements in determining the likelihood that taxable profit would be available against which the unused tax losses or unused tax credits can be applied."

1. It would be prudent for the entity to ensure that it has sufficient temporary differences with the same tax authority and the taxable entity that will generate taxable amounts against which unused tax losses or unused tax credits can be used before they expire;
2. When the unused tax loss or credit is likely to be eliminated by the company before generating a taxable profit.
3. Unused tax losses stem from identifiable and unlikely to repeat reasons.

The deferred tax asset is not recognized since it is improbable that taxable earnings would be available to offset the utilized tax losses or tax credits.

(c) Explaining the tax-planning strategies.

“Tax planning opportunities are measures that will materially provide for creating or increasing assessable income over a specified period or assessing credit carry forwards.”In some jurisdictions, for example, taxable profit can be made or raised by:

1. Deciding whether interest income is taxed as received or as receivable
2. Delaying the claim for certain taxable profit deductions;
3. selling and maybe leasing back assets that have increased in value but whose tax base has not been modified to reflect this; and
4. Selling a non-taxable asset (such as a government bond in some countries) to fund the acquisition of a taxable asset