How Do Auditors Learn to Forecast? Evidence from the Predictive Power of the Deferred Tax Asset Valuation Allowance

Abstract

This paper investigates auditor influence on the association between discretionary changes in the deferred tax asset valuation allowance (VA) and changes in future pretax earnings. Investors should be able to infer changes in future earnings from changes in the VA because the VA estimation depends on management’s forecast of future taxable earnings. Our study finds discretionary VA changes are significant and persistent predictors of future earnings changes. We focus on the effects of auditor expertise on the relationship between VA changes and future earnings changes, with expertise stemming from industry knowledge (measured by local market share) and firm-specific knowledge (measured by substantial auditor-provided tax services (APTS). We find that both types of knowledge build valuable expertise. However, when we examine a high judgment setting (i.e., VA releases despite ongoing losses), we find that VA predictive value improves with substantial APTS but diminishes with auditor industry expertise.