Information Content and Earnings Management Implication of Changes in the Valuation Allowance for Deferred Tax Assets

Abstract

The valuation allowance for deferred tax assets is an estimate of the portion of deferred tax assets that is not realizable because of insufficient future taxable income. A change in the valuation allowance might contain the manager's private forward-looking information that helps users of financial statements assess the firm's future income. The inclusion of changes in the valuation allowance in income from continuing operations, however, creates opportunities for earnings management because the valuation allowance amount is based primarily on the manager's unverifiable judgment. This study provides evidence of both benefits (incremental information content) and costs (earnings management implication) of disclosing the valuation allowance for deferred tax assets. Changes in the valuation allowance contain incremental information content, in addition to publicly available information, in predicting one- and two-year-ahead income. However, changes in the valuation allowance for firms that likely manage earnings through their valuation allowance accounts are less associated with future income than for non-earnings management firms, implying that managers manipulate the valuation allowance to manage earnings.