Valuation Allowance for Deferred Tax Assets

US GAAP recognizes a deferred tax asset in full but reduces it by a valuation allowance if it is very likely that some or the entire deferred tax asset will not be realized.

Valuation Allowance

Deferred tax assets should be assessed on every balance sheet date. If there is doubt that the deferral will be recovered, then the carrying amount should be reduced to the expected recoverable amount. The reduction may, however, be reversed if the situation changes and projects the possibility of the recovery of the deferral in future.

Deferred tax assets are reduced, under US GAAP, by creating a valuation allowance. The creation of the valuation allowance reduces the deferred tax asset and income in the period in which the allowance is established.

If circumstances change to the extent that a deferred tax asset valuation allowance may be reduced, the reversal will increase the deferred tax asset and operating income.

Question 1

The creation of a valuation allowance:

1. Always reduces the deferred tax asset during the period in which the allowance is established.
2. Always increases the deferred tax asset during the period in which the allowance is established.
3. May reduce or increase the deferred tax asset during the period in which the allowance is established.

Solution

The correct answer is A.

A valuation allowance will reduce the deferred tax asset during the period in which the allowance is established if it is very likely that some or the entire deferred tax asset will not be realized.

Question 2

Amir Co. reports under IFRS whereas Hamed Ltd. reports under US GAAP. Both companies reported tax assets on their financial statements. If the recoverability of the tax assets of both companies becomes susceptible, how would that affect their financial statements?

1. Both companies would report a valuation allowance.
2. Amir Co. would report a valuation allowance and Hamed Ltd. would decrease the asset by the susceptible amount.
3. Hamed Ltd. would report a valuation allowance and Amir Co. would decrease the asset by the susceptible amount.

Solution

The correct answer is C.

Regarding the recoverability of deferred tax assets, US GAAP requires the creation of a valuation allowance while IFRS requires the devaluation of the deferred tax asset.