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

ABSTRACT 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, 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.

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

Journal of the American Taxation Association ◽

10.2308/jata.2006.28.1.43 ◽

2006 ◽

Vol 28 (1) ◽

pp. 43-65 ◽

Cited By ~ 84

Author(s):

Mary Margaret Frank ◽

Sonja Olhoft Rego

Keyword(s):

Earnings Management ◽

Capital Market ◽

Analyst Forecast ◽

Asset Valuation ◽

Homogeneous Sample ◽

Valuation Allowance ◽

Time Period ◽

Earnings Targets ◽

Deferred Tax ◽

Reported Earnings

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.

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

Journal of the American Taxation Association ◽

10.2308/jata.2001.23.s-1.27 ◽

2001 ◽

Vol 23 (s-1) ◽

pp. 27-48 ◽

Cited By ~ 45

Author(s):

Christine C. Bauman ◽

Mark P. Bauman ◽

Robert F. Halsey

Keyword(s):

Earnings Management ◽

Income Tax ◽

Careful Consideration ◽

Contextual Approach ◽

Asset Valuation ◽

Effective Tax Rate ◽

Cross Sectional ◽

Tax Rate ◽

Valuation Allowance ◽

Deferred Tax

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.

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