Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets?

Overview:

This paper investigates whether managers use the deferred tax asset valuation allowance account (VAA) to manage earnings around three earnings targets: to report a positive profit, to report an earnings increase, and to meet or beat the mean analyst forecast. Early research on the VAA found little evidence of earnings management via the VAA. However, using firms narrowly defined on their ability or incentive to manage earnings, Schrand and Wong (2002) and Burgstahler, Elliott, and Hanlon (2002) conclude that certain firms use the VAA to manage earnings around certain earnings targets. Nonetheless, sample selection and research design issues limit the generalizability of these studies. Using SFAS No. 109 to model the VAA, this paper extends prior VAA research by examining changes in the VAA for all manufacturing firms for all years since SFAS No. 109's inception. We find substantial evidence that when premanaged earnings are below the mean analyst forecast, managers use the VAA to manage earnings upward, and when premanaged earnings are sufficiently above the mean analyst forecast, managers use the VAA to smooth earnings downward. We find mixed evidence that firms manage earnings via the VAA around the positive net income and prior year's net income earnings targets. Using a broad sample, this paper finds the most comprehensive evidence to date that managers take advantage of the discretion associated with setting the VAA in order to manage earnings.

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