Creating a Bigger Bath Using the Deferred Tax Valuation Allowance

Abstract

Abstract: The provisions of SFAS No. 109 allow US companies to make an earnings big bath even bigger through the establishment of a deferred tax valuation allowance. At the time a firm recognizes a non‐cash charge, it also recognizes a deferred tax asset to represent the future tax benefits of the charge. Recognition of the deferred tax asset partially mitigates the negative earnings impact of the special charge. However, if the firm does not expect to have sufficient future taxable income to utilize the future tax benefits of the charge, SFAS No. 109 requires the firm to establish a deferred tax valuation allowance, effectively eliminating the recognized deferred tax asset. Thus, the establishment of the valuation allowance amplifies the negative earnings impact of the non‐cash charge. We use a valuation allowance prediction model to identify firms that create a larger‐than‐expected valuation allowance; these firms may be creating a large valuation allowance as a reserve to be used to manage earnings in a subsequent period. We find that the vast majority of these larger‐than‐expected valuation allowances apparently reflect informed management pessimism about the future in that these firms actually do have poorer operating performance in subsequent periods. We do not find any evidence that subsequent reversals of valuation allowances are used to turn a loss into a profit. However, we do find a very small number of firms that appear to have used a valuation allowance reversal to meet or beat the mean analyst forecast.