CFA Level I · CFA Level I Exam · Analysis of Income Taxes
A company previously recorded a valuation allowance against its tax loss carryforward. After three consecutive profitable years and strong order books, management concludes the carryforward is now more likely than not to be realized. The most likely result of reversing the allowance is:
Reversing a valuation allowance raises the net deferred tax asset and reduces income tax expense in the period of reversal, so reported net income is higher. Cash taxes paid do not change, but earnings quality is affected because the gain is non-operating.
- Aa decrease in the deferred tax asset and lower reported net income
- Bno change in reported net income because the cash taxes paid are unchanged
- Ca higher reported net income through lower income tax expense in the period of reversalCorrect
Explanation
Reversing an allowance increases the net deferred tax asset and creates a credit to income tax expense, raising net income in the period of reversal. Cash taxes are unaffected, but reported earnings are, so option B is wrong. Option A has the direction reversed.
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