Download this Paper Open PDF in Browser

The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

52 Pages Posted: 16 May 2017 Last revised: 17 Jun 2017

Alexander Edwards

University of Toronto - Rotman School of Management

Date Written: May 5, 2017

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, 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.

Keywords: Deferred Tax Assets, Valuation Allowance, Credit Ratings

JEL Classification: G29, H25, M41

Suggested Citation

Edwards, Alexander, The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness (May 5, 2017). Available at SSRN: https://ssrn.com/abstract=2968463

Alexander Edwards (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Paper statistics

Downloads
127
Rank
193,126
Abstract Views
401