When a liability is written down by $100, which statement best describes the income statement effect?

• A. There is a gain on the income statement of $100, increasing PTI; NI up $80 after tax
• B. There is a loss on the income statement of $100
• C. No effect on the income statement
• D. The write-down reduces revenue

Answer: (A)

This scenario tests how reducing a liability affects the income statement. When you write down a liability by 100, you’re relieving an obligation, which is recorded as a gain on the income statement. So pretax income increases by 100. The tax effect then reduces net income by the tax amount on that gain. With a 20% tax rate, tax on the 100 gain is 20, leaving net income up by 80. So the income statement shows a 100 gain before tax and an 80 increase in net income after tax. It’s not a loss, not no effect, and not a change to revenue—the impact is a gain from reducing the liability.