How Firms Avoid Losses-Use of Net DTA

Topics: Taxation, Progressive tax, Taxation in the United States Pages: 83 (10337 words) Published: December 7, 2013
How Firms Avoid Losses:
Evidence of Use of the Net Deferred Tax Asset Account
David Burgstahler*
University of Washington
Gerhard G. Mueller Endowed Professor in Accounting

W. Brooke Elliott
University of Washington
Michelle Hanlon
University of Michigan Business School
November 26, 2002

_________________________________________________________________________________ ABSTRACT: This paper investigates whether firms use discretion in accounting for deferred taxes to increase earnings and avoid reporting a loss. We find that firm-years with small scaled profits reduce (relative to the prior year) the proportion of the gross deferred tax asset reserved by the valuation allowance more than firm-years with small scaled losses. We find no evidence that the firm-years that have seemingly moved from having a small scaled loss to a small scaled profit using changes in the net deferred tax asset have greater expected future taxable income to support this change under SFAS 109. Our results also suggest that firms that increase earnings through the net deferred tax asset have relatively lower costs to managing earnings to avoid a loss, that is, these firms have a smaller pre-managed loss.


*Corresponding author: David Burgstahler, (206) 543-6316, We are grateful for helpful comments from Bob Bowen, Frank Hodge, Kathryn Kadous, Shiva Rajgopal and Terry Shevlin and workshop participants at the University of Washington and the 2002 UBCOW conference. We would also like to thank Corey Murata for his assistance in the data collection process.


Since its introduction in 1992, Statement of Financial Accounting Standard No. 109

Accounting for Income Taxes (SFAS 109) has been controversial. Unlike previous statements, e.g., SFAS No. 96 and Accounting Principles Board (APB) No. 11, SFAS 109 requires managers to value and record deferred tax assets to the extent that they are “more likely than not” to be realized. Any portion that does not meet the “more likely than not” criteria is reserved using a valuation allowance against the gross deferred tax asset. Petree et al. (1995) claim that recognizing the net deferred tax asset is the most complex and subjective area of SFAS 109.1 Because the "more likely than not" criteria is subjective, managers have substantial discretion in determining the size of the valuation allowance and therefore also reported earnings.2 This paper investigates whether firms manage the net deferred tax asset to avoid reporting a loss. An example of possible earnings management is found in Network Appliance’s 1996 annual report. During a year when the gross deferred tax asset declined slightly from $3.2 million to $2.8 million, Network Appliance reduced its valuation allowance from 100% of the $3.2 million gross asset to approximately 25% of the $2.8 million gross asset, or $0.67 million. If Network Appliances had maintained the allowance at 100%, they would have reported a loss instead of showing a small positive earnings number for 1996.3


For example, see Khalaf (1993), Peavey and Nurnberg (1993), and Petree (1995). Also see Miller and Skinner (1998) which outlines the following reasons to expect earnings management: (1) no well-established guidelines for determining the appropriate level of the allowance; (2) appropriate level of the allowance depends on managers' expectations about future earnings; and (3) the provision is large enough to allow managers to make material adjustments to accounting earnings.

Adjustments to the valuation allowance in many cases flow directly to after-tax income from continuing operations through the provision for deferred taxes (tax expense). As discussed in Bauman, Bauman and Halsey (2000) and Hanlon and Shevlin (2001), adjustments to the valuation allowance do not always affect reported net income. This issue is discussed in greater...

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