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CFA Level I · CFA Level I Exam · Analysis of Income Taxes

Under US GAAP, a company reports a deferred tax asset of $500,000 and concludes that it is more likely than not that $120,000 of it will not be realized. The most likely effect of recording the valuation allowance is that:

Recording the $120,000 valuation allowance reduces the net deferred tax asset to $380,000 and increases income tax expense by $120,000, lowering net income. The allowance is a contra-asset charged to tax expense, so the asset carrying amount falls and expense rises.

  1. Anet deferred tax assets fall to $380,000 and income tax expense increases by $120,000Correct
  2. Bnet deferred tax assets fall to $380,000 and income tax expense decreases by $120,000
  3. Cnet deferred tax assets stay at $500,000 and income tax expense increases by $120,000

Explanation

The allowance reduces the net deferred tax asset by $120,000 to $380,000 (500,000 - 120,000). The offsetting entry is a debit to income tax expense, so expense rises and net income falls. Option B reverses the sign of the expense effect; option C ignores that the allowance reduces the asset.

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