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

Abstract

Phillips et al. (2004) (hereafter PPRW) investigate whether changes in eight components of net deferred tax liabilities can be used to identify firms that manage earnings to avoid earnings declines. PPRW extend existing literature that examines whether deferred tax expense can be used to detect earnings management by collecting detailed information about accounts that affect the net deferred tax liability (and deferred tax expense) to identify specific components of the net deferred tax liability that predict whether firms manage earnings. The paper investigates this issue by estimating a system of equations that simultaneously determines a firm’s earnings management classification and eight components of the net deferred tax liability. The eight components include changes in deferred tax assets and liabilities related to: (1) revenue and expense accruals and reserves, (2) compensation, (3) depreciation of tangible assets, (4) other asset valuations, (5) miscellaneous items, (6) tax carryforwards, (7) unrealized gains and losses, and (8) the deferred tax asset valuation allowance account (VAA). For the full sample, only two components, changes in revenue and expense accruals and reserves and other asset valuations, are predictive of earnings management. For firmyears with positive changes in the net deferred tax liability, the probability that a firm manages earnings is positively related to changes in revenue and expense accruals and reserves and negatively related to changes in the VAA. For firm-years with negative changes in the net deferred tax liability, the probability that a firm manages earnings is positively related to changes in revenue and expense accruals and reserves and other asset valuations. The paper addresses an important topic, and I think the analysis of the components of the deferred tax liability provides useful information to academics and financial statement users about how firms manage earnings. However, the empirical analysis in this study presents some challenges. In this discussion, I first summarize the paper’s contribution to the literature and then I detail my concerns about the empirical analysis.