Does the Deferred Tax Asset Valuation Allowance Signal Firm Creditworthiness

Recent years have seen a dramatic decline in the creditworthiness of firms and increasing concern regarding the reliability of credit estimates provided by rating agencies. In this paper, I find evidence that a particular account, 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 they expect 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 deferred tax asset 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 positive (negative) association between increases in the valuation allowance and the future cost of debt (contemporaneous and future credit ratings), evidence that is consistent with increases in the valuation allowance signaling a decline in firms' creditworthiness.