Acme Inc presents financial statements in accordance with US GAAP.In 2014, Acme discloses a DTA=100 & valuation allowance =10. In 2013, Acme discloses a valuation allowance =15 & DTA=95.
The change in valuation allowance most likely indicates
a. Deferred tax liabilities were reduced in 2014
b. expectation of future earnings power has increased.
c. expectation of future earnings power has decreased.
A valuation allowance ist made when the future earnings power decreases so that the DTA is not expected to be recovered fully. (DTA = you have paid taxes in the past you expect to recover in the future based on temporary differences in GAAP and tax laws.)
In this case the valuation allowance was decreased by 5 indicating that the company is expecting to better recover the DTA because of an increased earnings expectation. So B should be correct.
Note that due to the decrease in the valuation allowance and subsequent increase in DTA income taxes will decrease as the following equation holds true:
The valuation allowance is actually not calculated but derived from management estimations. In case the probability to recover certain DTA’s is below 50% a valuation allowance must be established. For example this might be the case when the management believes that future profitability will be not sufficient to recover all of the deferred tax assets.