Graphic. Inc. Financial Case Analysis - Article Example

If it is more likely than not that more than 50% of the deferred tax assets will not be realized, this should form the basis for release of the valuation allowance. Graphic, Inc. needs to complete its annual report for filing with the SEC using Form 10-K for the year ended December 31, 2005. In order to do this, there is need to identify the positive and negative evidence to be considered to evaluate the need to record a valuation allowance against the Company's deferred tax assets. Based on the analysis of positive and negative evidence, it would be possible to determine which evidence should have more weight assigned than others; how much valuation allowance, whether full, none or partial, should be recorded at December 31, 2005; and if a full or partial valuation allowance is used, what criteria should be met before the entire valuation allowance is released (Deloitt 2003).

Graphic, Inc. has five years of cumulative losses at December 31, 2005. Based on the company's substantial net operating loss carry forward, no income tax provision has been reflected in the 2005 interim income statements. At December 31, 2005, the deferred tax asset was $51,073 after application to reduce 2005 taxable income but before valuation allowance. A company can recognize the tax benefit produced by a carry back of tax losses or credits. According to GAAP, a loss carry back can be applied to the three years preceding the loss (Investopedia 2008).

The carry back results in a refund based on events that have already occurred (Kwan-Hyun 1992). On the other hand, carry forwards represent potential tax savings based on past events but certain limitations must be overcome in the future before the company can realize potential benefits. The realization of future benefit is inherently speculative because they cannot be predicted with certainty. The asset is then limited by requiring a valuation allowance if realization is sufficiently in doubt, under the ''more likely than not'' standard (Kwan-Hyun 1992).

Positive and negative evidences therefore, need to be considered in judging the likelihood of realizing a tax benefit. For Graphic, Inc. negative evidences include its history of expired tax carry forward, its history of continuous losses for the past decade, as well as the fact that the company operates in a cyclical industry. Positive evidences include the growing success of its new product G-1000 which has generated net income for the last two years and very favorable negotiations with The Sports Magazine for a recurring $20 million annual contract.

In the preliminary tax provision for 2005, Graphic, Inc. applied $12,400 to tax loss carry forwards expiring in 2005. $25,000 of capital loss carry forwards and $2,600 of NOL carry forwards expired in 2005. Therefore, the decrease in operating loss carry forwards of $40,000, from $173,700 at December 31, 2004 to $133,700 at December 31, 2005 is comprised of $12,400 of NOLs applied to reduce 2005 taxable income, expiration of $2,600 of NOL carry forwards, and expiration of $25,000 of capital loss carry forwards (Deloitt 2003).

The company's evaluation is to determine deferred tax assets for net