Deferred Tax Asset Valuation Allowance Research Articles

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

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.

The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

ABSTRACTIn this study, I provide evidence that the valuation allowance for deferred tax assets helps predict the future creditworthiness of a firm. Under the provisions of SFAS No. 109, a firm records a deferred tax asset provided it expects to generate sufficient taxable income to realize the asset in the form of tax savings in the future. If a firm does not expect to generate sufficient taxable income to realize the asset, then a valuation allowance is created to reduce the balance. As a result, the valuation allowance indicates management's expectation of future taxable income, which could be informative in predicting the ability of the firm to make future interest and principal payments on debt. Alternatively, the valuation allowance may not be informative regarding creditworthiness if it is a result of overly conservative accounting practices or if it is used as an earnings management tool. I document a negative association between material increases in the valuation allowance and contemporaneous and future changes in credit ratings, evidence that is consistent with the valuation allowance providing a summary measure of a decline in firms' creditworthiness.JEL Classifications: G29; H25; M41.Data Availability: Data are available from sources identified in the paper.

The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

In this study, I provide evidence that the valuation allowance for deferred tax assets helps predict the future creditworthiness of a firm. Under the provisions of SFAS No. 109, a firm records a deferred tax asset provided it expects to generate sufficient taxable income to realize the asset in the form of tax savings in the future. If a firm does not expect to generate sufficient taxable income to realize the asset, a valuation allowance is created to reduce the balance. As a result, the valuation allowance indicates management’s expectation of future taxable income, which could be informative in predicting the ability of the firm to make future interest and principal payments on debt. Alternatively, the valuation allowance may not be informative regarding creditworthiness if it is a result of overly conservative accounting practices or if it is used as an earnings management tool. I document a negative association between material increases in the valuation allowance and contemporaneous and future changes in credit ratings, evidence that is consistent with the valuation allowance providing a summary measure of a decline in firms’ creditworthiness.

EVIDENCE OF EARNINGS MANAGEMENT FROM THE MEASUREMENT OF THE DEFERRED TAX ALLOWANCE ACCOUNT

Positive accounting literature has provided empirical evidence regarding firms' characteristics that cause their managers to make particular accounting decisions. The purpose of this study is to extend this line of research to the area of accounting for income taxes. The research is designed to identify accounting choice variables that influence managers' decisions to change the level of the deferred tax asset valuation allowance under SFAS No. 109. Specifically, the study presents an empirical examination of whether managerial discretion over the valuation allowance appears to be used for earnings management purposes. Evidence of earnings management motivations can provide insights into whether it is an appropriate accounting policy to give management considerable discretion to choose the level of the valuation allowance.

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

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.

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

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.

Do Managers Use the Valuation Allowance Account to Manage Earnings around Certain Earnings Targets?

This paper provides additional evidence on earnings management via the deferred tax asset valuation allowance account (VAA). Earlier publications that do not find evidence of earnings management via the VAA examine contractual incentives using broad samples. A more recent publication finds evidence consistent with earnings management via the VAA but examines capital-market-based incentives using a homogeneous sample. To bridge the gap between these studies, we exploit a heterogeneous sample over an extended time period but examine capital-market-based incentives to manage earnings. The results provide substantial evidence that firms use the VAA to smooth earnings toward the mean analyst forecast. However, the results do not provide evidence that firms use the VAA to smooth earnings toward positive or prior year's reported earnings targets or engage in “big bath” behavior for any of the earnings targets.

Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets?

This paper provides additional evidence on earnings management via the deferred tax asset valuation allowance account (VAA). Earlier publications that do not find evidence of earnings management via the VAA examine contractual incentives using broad samples. A more recent publication finds evidence consistent with earnings management via the VAA but examines capital market-based incentives using a homogeneous sample. To bridge the gap between these studies, we exploit a heterogeneous sample over an extended time period but examine capital market-based incentives to manage earnings. The results provide substantial evidence that firms use the VAA to smooth earnings toward the mean analyst forecast. However, the results do not provide evidence that firms use the VAA to smooth earnings toward positive or prior year's reported earnings targets or engage in big bath behavior for any of the earnings targets.

The Deferred Tax Asset Valuation Allowance and Earnings Quality

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.

Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings?

This study utilizes a sample comprised of Fortune 500 firms to examine earnings management via changes in the deferred tax asset valuation allowance. The study extends existing research in three ways. First, we document that the earnings effect of a valuation allowance change often cannot be determined from financial statement disclosures. Based on an analysis of sample firms' income tax footnotes, we offer suggestions to improve disclosure policy. Second, prior research uses the net change in the valuation allowance account as a proxy for the earnings effect of valuation allowance changes. We argue that the amount reported in the effective tax rate reconciliation is a better measure of the income statement effect and document certain significant differences between the measures. Third, prior research employs cross-sectional regression models in an effort to make generalizations about earnings management behavior. In contrast, we use a contextual approach to assess whether observed valuation allowance changes are consistent with different motivations for earnings manipulation. The contextual analyses are based on identifying firms in the position to engage in various forms of earnings management and examining the earnings effect of valuation allowance changes made by firm managers. Cross-sectional tests find virtually no evidence in support of earnings management. Of particular note, we find that the incidence of “big bath” behavior may be exaggerated. In contrast, a contextual approach identifies specific instances in which earnings management may exist. Thus, the analysis of valuation allowance changes is contextual and requires careful consideration of activity in the allowance account. This point underscores the deficiency in income tax reporting and the need for increased disclosure in this area.

Discussion of Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings?

Discussion of Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings?

Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings?

This study utilizes a sample of Fortune 500 firms to examine earnings management via changes in the deferred tax asset valuation allowance. The study extends existing research in three ways. First, we document that the earnings effect of a valuation allowance change often cannot be determined from financial statement disclosures. Based on an analysis of sample firms' income tax footnotes, we offer suggestions to improve disclosure policy. Second, prior research uses the net change in the valuation allowance account as a proxy for the earnings effect of valuation allowance changes. We argue that the amount reported in the effective tax rate reconciliation is a better measure of the income statement effect and document certain significant differences between the measures. Third, prior research employs cross-sectional regression models in an effort to make generalizations about earnings management behavior. In contrast, we use a contextual approach to assess whether observed valuation allowance changes are consistent with different motivations for earnings manipulation. Cross-sectional tests find virtually no evidence in support of earnings management. Of particular note, we find that the incidence of big bath behavior may be exaggerated. In contrast, a contextual approach identifies specific instances in which earnings management may exist. Thus, the analysis of valuation allowance changes is contextual and requires careful consideration of activity in the allowance account. This point underscores the deficiency in current deferred tax reporting and the need for increased disclosure in this area.