Changes in Unrecognised Deferred Tax Accruals from Carry‐Forward Losses: Earnings Management or Signalling?

Abstract

Abstract: This paper examines how managers elect to use their discretion over the amount of unrecognised tax assets from carry‐forward losses that is available under the income statement method specified in AASB1020 ‘Accounting for Income Taxes’. Specifically, we consider whether changes in the amount of unrecognised deferred tax assets from carry‐forward losses, reflect managers’ incentives to opportunistically manage earnings, or communicate private information about future profitability (i.e., signalling). Using data from firms listed on the Australian Stock Exchange during the period 1999 to 2005, we find evidence consistent with income‐increasing earnings management when pre‐tax earnings are below the median analyst forecast. Interestingly, we find that the potential existence of earnings management does not reduce the capacity of changes in unrecognised deferred tax assets from carry‐forward losses to predict one‐year‐ahead performance, and to a much lesser extent, three‐year ahead performance. This result highlights the complexity of managers’ incentives in trading‐off between managing earnings toward a desired target and communicating useful information to market participants.