Valuation Allowance for Deferred Tax Assets

Introduction

US GAAP recognizes a deferred tax asset in full but then reduces it by a valuation allowance if it is very likely that some or all of the 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 be reversed however if the situation changes and suggests that the future will lead to recovery of the deferral.

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:

A. always increases the deferred tax asset during the period in which the allowance is established

B. always reduces the deferred tax asset during the period in which the allowance is established

C. may reduce or increase the deferred tax asset during the period in which the allowance is established

Solution

The correct answer is B.

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 all of the 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?

A. Amir Co. would report a valuation allowance and Hamed Ltd. would decrease the asset by the susceptible amount.

B. Amir Co. would report a valuation allowance and Hamed Ltd. would decrease the asset by the susceptible amount.

C. Both companies would report a valuation allowance.

Solution

The correct answer is B.

Regarding the recoverability of deferred tax assets, US GAAP requires creating a valuation allowance while IFRS requires the deferred tax asset to be devalued.

 

Reading 30 LOS 30g:

Describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements

 

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