The valuation allowance for deferred tax assets and earnings management

In this study, I hypothesize that managers use the valuation allowance for deferred tax assets (1) to take a "big bath" when they report "core" net income below the previous year's, (2) to increase reported income to loosen the debt covenant restrictions, or (3) to meet analysts' earnings forecasts. Regression analyses were performed on a sample of firms with "core" net income below the previous year's between 1994 and 1996. Results indicate the following: (1) Managers in the sample firms used the valuation allowance for deferred tax assets to accentuate current declines in "core" net income to make it easier to improve reported earnings in the future years. (2) Managers of more leveraged firms adjusted the valuation allowance to increase reported earnings, perhaps to reduce the probability of violating restrictive debt covenants. (3) Managers used valuation allowance accounts to mitigate the difference between the firms' actual earnings per share and the analysts' forecasts.; The results are also consistent with the notion that managers use the valuation allowance to signal their expectation of a firm's future profitability. Further investigation on whether managers increase core net income by reversing the valuation allowance in future years helps to confirm the results on the "big bath" hypothesis.; The results of this study are of interest for several reasons. First, the results may have implications for accounting policy setting. FASB believes that the asset-liability approach in SFAS No. 109 produces more useful and understandable information than any other method of accounting for income taxes. On the other hand, if the subjectivity in the measurement process provides managers an opportunity for earnings management, the cross-sectional comparability of the information disclosed under the SFAS No. 109 may be compromised. Second, the results are useful to those who are concerned that the valuation allowance may be used to distort a company's financial status. Third, this study improves the understanding of how managers determine the valuation allowance.