The valuation allowance for deferred tax assets and earnings management

This dissertation extends earnings management literature by examining three situations in which managers are likely to have strong incentives to use the valuation allowance for deferred tax assets for earnings management: (1) to avoid reporting a loss, (2) to avoid reporting a decrease in earnings per share, and (3) to create earnings reserves in particularly profitable years. Because considerable judgment is required to set the valuation allowance and because decreases (increases) in the allowance can increase (decrease) reported earnings, there is concern that managers will use the account for earnings management. The findings provide limited evidence that managers use the account to manage earnings. For firms making income-increasing discretionary accruals to avoid reporting a loss, larger pre-managed losses are associated with larger reductions in the valuation allowance. This association is related to several firm attributes: relatively high or low P/E ratios, reported positive earnings per share that are very close to zero, and large valuation allowances as a percentage of deferred tax assets. There is little evidence that managers use the valuation allowance to avoid reporting a decrease in earnings. There is no evidence that managers use the valuation allowance to create earnings reserves in particularly profitable years. In each situation, the evidence suggests that managers take into consideration the guidelines provided in. Statement of Financial Accounting Standard No. 109 for setting the valuation allowance.