The Information Content of the Deferred Tax Valuation Allowance: Evidence from Venture Capital Backed IPO Firms

Abstract

This study examines the deferred tax disclosures of a sample of venture capital backed IPOs with net operating loss (NOL) carryforwards. I find that 82 percent of these firms record an allowance that reduces the associated deferred tax asset to zero. I show that the size of a firm’s NOL, and proxies for its expectation of future taxable income, have significant predictive power for the magnitude of the valuation allowance, and that the allowance sends a strong negative signal about future book income. Both of these results indicate that the valuation allowance does provide information about an IPO firm’s economic fundamentals. I propose a new explanation for the presence of the allowance: the ownership change limitation, which can cause firms to record an allowance independent of their expectations about future earnings. I find firms take this limitation into account when recording the allowance, and that controlling for it can enhance the allowance’s signal regarding future income.

Keywords: Deferred tax valuation allowance, ownership change limitation, taxation

JEL Classification: M40, H20