The Deferred Tax Asset Valuation Allowance and Earnings Quality

Abstract

Extant research examining the determinants of deferred tax asset valuation allowances finds that the evidence provisions outlined in SFAS 109 explain a significant portion of both levels of and changes in recorded valuation allowances. In addition, there is evidence of a stock price reaction around the time of announcements of valuation allowance information. The present study extends existing research in two ways. First, extant research on determinants of valuation allowance changes does not incorporate the asymmetry in the evidence provisions of SFAS 109. Accordingly, we separately examine the determinants of increases versus decreases in valuation allowances and find that the evidence provisions of SFAS 109 explain a much greater portion of valuation allowance increases than decreases. Second, we examine the association between annual stock returns and reported earnings resulting from valuation allowance changes. While the earnings effect of valuation allowance changes is found to be significant in the expected direction, the stock price reactions do not occur in the period the earnings effect is reported. This is consistent with low earnings “quality” under SFAS 109.