How Do Hedge Fund Activists Use and Affect Tax Reporting? Evidence from the Valuation Allowance for Deferred Tax Assets

Abstract

This study uses the valuation allowance (VA) for deferred tax assets (DTAs) to examine whether hedge fund activists (HFAs) use and affect tax reporting. Specifically, we investigate whether HFAs target firms with VAs and whether target firms are more likely to release VAs postintervention. We find that the existence, magnitude, and increases in the VA are positively associated with interventions. We also find that interventions are positively associated with releases of VAs in the intervention year and for the subsequent two years. VA releases appear to stem from implemented tax avoidance strategies and changes in tax reporting rather than real changes in operating performance or earnings management. Overall, HFAs appear to understand the interplay between tax planning and tax reporting and use both to unlock value in target firms.

Keywords: Accounting for Income Taxes, ASC 740, Deferred Tax Assets, Hedge Fund Activists, Valuation Allowance JEL Codes: G23, G32, H26, M41