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

43 Pages Posted: 14 Sep 2000

See all articles by Christine C. Bauman

Christine C. Bauman

University of Northern Iowa - College of Business Administration

Mark P. Bauman

University of Northern Iowa

Robert F. Halsey

Babson College - Accounting and Law Division

Date Written: August 2000

Abstract

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.

JEL Classification: M41, M43, M44, K22

Suggested Citation

Bauman, Christine C. and Bauman, Mark P. and Halsey, Robert F., Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings? (August 2000). Available at SSRN: https://ssrn.com/abstract=239054 or http://dx.doi.org/10.2139/ssrn.239054

Christine C. Bauman

University of Northern Iowa - College of Business Administration ( email )

Cedar Falls, IA 50614-0124
United States
319-273-2968 (Phone)
319-273-2922 (Fax)

Mark P. Bauman (Contact Author)

University of Northern Iowa ( email )

Cedar Falls, IA 50614
United States
319-273-4323 (Phone)

Robert F. Halsey

Babson College - Accounting and Law Division ( email )

Babson Park, MA 02157
United States
781-239-4347 (Phone)
781-239-5230 (Fax)

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