On pg. 443 of the Financial Statement Analysis book, there is an example with Apple Computer. In the example: “Apple Computer had recorded a significant valuation allowance against its deferred tax assets due to losses in the mid-1990’s” “net income was inflated by the valuation allowance reductions. To eliminate these distortions, analysis should be based on net income excluding changes in the valuation allowance.” My question is how do valuation allowance reductions inflate net income? My line of thought is that deferred tax assets reduce taxable income, and valuation allowances are supposed to counteract that because it may be improbable that those assets will reverse. So in effect, valuation allowances increase taxable income. So why would valuation allowance reductions inflate net income? Thanks!
valuation allowance reduces your DTA. and because DTA reduction means a reduction in the Tax Expense. Tax Payable + Delta DTL - Delta DTA = Tax Expense. Delta DTA reduces, so Tax Expense reduces. This means a NI increase.
CPK123: According to your equation, Reduced DTA will lead to an increase in Tax expense.