Academic journal article Academy of Accounting and Financial Studies Journal

Predictive Ability of the Valuation Allowance for Deferred Tax Assets

Academic journal article Academy of Accounting and Financial Studies Journal

Predictive Ability of the Valuation Allowance for Deferred Tax Assets

Article excerpt

ABSTRACT

The valuation allowance for deferred tax assets is an estimate of the portion of deferred tax assets that is not realizable because of insufficient future taxable income. The valuation allowance account might contain forward-looking information on the management's estimates of a firm's future income. This study finds that a change in the valuation allowance provides incremental information beyond publicly available information in predicting one- and two-year-ahead income and cash flows. The predictive ability of the valuation allowance suggests that recognition of forward-looking information in financial statements has the potential to make these statements more informative.

INTRODUCTION

The primary objective of financial accounting is to provide external users with information about the financial health and profitability of the firm in a format that facilitates their decision-making (FASB, 1978). There is a demand for forward-looking information on the firm's future earnings and cash flows from users of financial reports, whose decisions depend primarily on estimates of the future. In December, 2002. the AICPA Board of Directors approved a new committee to explore how to enhance the delivery and content of business-related information. The committee argues that the current model does serve as an effective foundation from which business reporting should start; however, it focuses on the lagging indicators (i.e., information on past transactions) and lacks leading indicators (i.e., forward-looking information). Accounting standard-setters are, however, wary of permitting firms to use estimates or projections in generating their financial statement numbers because they may be unreliable. Inclusion of unverifiable numbers in the financial statements may provide opportunities to managers for managing earnings thereby reducing the value of financial statements to investors (Lang and Warfield, 1997).

Consequently, most forward-looking information used by firms in their internal decision-making is not reported in the financial statements (AICPA, 2002). One exception to this occurs when firms are required by SFAS 109 to disclose the valuation allowance for deferred tax assets on their balance sheets from 1992 onwards. The valuation allowance is an estimate of the portion of deferred tax assets that is not realizable because of insufficient future taxable income. If a manager receives positive information about future income, (s)he should decrease the valuation allowance for deferred tax assets because a greater portion of the future tax benefits is likely to be realized. If a manager receives negative information about future income, (s)he should increase the valuation allowance because a smaller portion of the future tax benefits is likely to be realized due to lower taxable income in future years. Hence, the valuation allowance account might contain forward-looking information on managers' estimates of a firm's future income; a higher (lower) the valuation allowance would represent the manager's expectation of lower (higher) future income for a given level of deferred tax assets.

On the other hand, SFAS 109 requires changes in the valuation allowance for deferred tax assets to be included (as part of income tax expense or benefit) in income from continuing operations, which is used to measure the persistent component of earnings by many investors and financial analysts. Thus, the valuation allowance that is based on managers' unverifiable forecasts offers opportunities for earnings management. As an example of the effect of changes in the valuation allowance on earnings, consider the following from PR Newswire on November 10, 2003: "EZCORP, Inc. (Nasdaq: EZPW) announced today results for its fiscal fourth quarter and 2003 fiscal year, which ended September 30, 2003. For the quarter ended September 30, 2003, EZCORP is reporting net income of $4,563,000 ($0.36 per share) compared to net income of $251,000 ($0. …

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