| Under SFAS 109, a valuation allowance for deferred tax assets (deferred tax allowance) must be disclosed if managers expect that future taxable income will be insufficient for the realization of deferred tax assets. This study contributes to the literature as follows: First, it investigates whether deferred tax allowance changes are useful in predicting future earnings and cash flows; Second, it examines whether managers manipulate deferred tax allowances to smooth earnings, avoid reporting losses or earnings declines, and enhance an earnings "big bath;" Third, this study examines how much new information the deferred tax allowance conveys to the market compared to the information summarized by it that is already available to the market via timely media before the deferred tax allowance announcements; Finally, this study tests whether investors, in pricing securities, are sophisticated enough to filter out the value-relevant component of deferred tax allowances from the component that arises from earnings management.; The empirical results are as follows: First, deferred tax allowance changes are associated with one- and two-year-ahead income and one-year ahead cash flows (after controlling for certain publicly-available information reflected in deferred tax allowance changes), which indicates that it contains useful information (e.g., managers' private forward-looking information); Second, this study confirms prior studies' evidence of earnings management through the deferred tax allowance to smooth earnings, avoid losses, and avoid earnings-declines, and it provides evidence that deferred tax assets are used to enhance an earnings big bath; Third, this study finds that deferred tax allowance changes do not provide timely new information for firms that do not manage earnings, but the market reacts mechanistically to deferred tax allowances for firms that manage earnings. This finding is inconsistent with prior research, which finds that deferred tax allowance changes provide timely new information to financial markets, perhaps because such research has not taken into account the earnings management implications of deferred tax allowances. |
