Decomposing Changes in Deferred Tax Assets and Liabilities to Isolate Earnings Management Activities

Abstract

This paper provides evidence on the types of accounts that reveal earnings management activities. We build on Burgstahler and Dichev's (1997) evidence of earnings management to avoid an earnings decline and Phillips et al.'s (2003) findings that deferred tax expense can be used to detect such earnings management. In particular, we investigate the relation between changes in annual earnings and changes in deferred tax asset and liability components using firms' income tax footnote disclosures. We establish the incremental usefulness of the change in net deferred tax liabilities (DTLs) in detecting earnings management to avoid an earnings decline, and then decompose the total change in net DTLs into eight components to determine which types of accounts are associated with earnings management activities. Our evidence indicates that firms use revenue and expense accruals and reserves and other asset valuation accruals to manage earnings upwards. In addition, we build on Joos et al.'s (2003) results and partition our sample into firm-years with positive and negative changes in net DTLs and repeat our analyses. We find that both sub-samples manage revenue and expense accruals and reserves to report earnings increases; however, only firm-years with a positive change in net DTL also reflect the use of the deferred tax asset valuation allowance account to manage earnings upward, and only firm-years with a negative change in net DTL also manage earnings upward using other asset valuation accruals.