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LOS g: Discuss the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements.

Which of the following situations will most likely require a company to record a valuation allowance on its balance sheet?

A)	A firm is unlikely to have future taxable income that would enable it to take advantage of deferred tax assets.

B)	To report depreciation, a firm uses the double-declining balance method for tax purposes and the straight-line method for financial reporting purposes.

C)	A firm has differences between taxable and pretax income that are never expected to reverse.

A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. If a firm is unlikely to have future taxable income, it would be unlikely to ever use its deferred tax assets, and therefore must record a valuation allowance.

Which of the following statements best justifies analyst scrutiny of valuation allowances?

A)	Changes in valuation allowances can be used to manage reported net income.

B)	If differences in taxable and pretax incomes are never expected to reverse, a company’s equity may be understated.

C)	Increases in valuation allowances may be a signal that management expects earnings to improve in the future.

A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. Changes in the valuation allowance have a direct impact on reported income. Because management has discretion with regard to the amount and timing of a valuation allowance, changes in the valuation allowance give management significant opportunity to manage earnings.

Which of the following statements best describes the impact of a valuation allowance on the financial statements? A valuation allowance:

A)	reduces reported income, increases liabilities, and reduces equity.

B)	reduces reported income, reduces assets, and reduces equity.

C)	increases reported income, reduces assets, and reduces equity.

A valuation allowance is a contra account (offset) against deferred tax assets that reflects the likelihood that the deferred tax assets will never be realized. The establishment of a valuation allowance reduces reported income, offsets (reduces) assets, and reduces equity.