Valluation Allowance

The Information Content of the Deferred Tax Valuation Allowance
Author(s): Krishna R. Kumar and Gnanakumar Visvanathan

Source: The Accounting Review, Vol. 78, No. 2 (Apr., 2003), pp. 471-490
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 78, No. 2
2003
pp. 471-490
The Information Content of the Deferred

Tax Valuation Allowance
Krishna R. Kumar
The George WashingtonUniversity
Gnanakumar Visvanathan
George Mason University
ABSTRACT: An event study demonstrates that disclosures of changes in deferred tax
valuation allowances (VA) provide information beyond contemporaneous earnings re-
ports. Prior research shows that, in setting VA, managers consider the extent that
taxable income is available from various sources for the realization of deferred tax
assets (DTA).Our evidence supports a characterization where investors use VA disclo-
sures to infer management's expectations about DTA,its realizability,and future taxable
income available for realization. These findings are more generally relevant for assess-
ing the consequences of reporting standards that require or permit management judg-
ment, especially about future outcomes. In particular, they support the view that dis-
cretion can be a vehicle for management to communicate expectations to the benefit
of investors.
Keywords: deferred taxes; valuation allowance; information content; event study; future
profits.
Data Availability: Data are available from sources identified in the paper.
I. INTRODUCTION
-D _ eferred tax assets (DTA) represent future tax benefits from deductible temporary
differences, tax losses, and tax credits.' Realization of DTA is contingent upon the
availability of taxable income of appropriate nature in periods in which deductible
Deductibletemporarydifferencestypically arise when taxableincome (expense)leads (lags) pretaxfinancial

income (expense)or when the tax bases of assets increase(liabilitiesdecrease)relativeto theirbalancesheet
values.
We are gratefulto Bill Baber,LindaBamber,ChrisJones,FredLindahl,Jim Patton,Renee Price, and two anon-

ymousreviewersfor theircommentson the currentandpreviousversionsof the manuscript.We also acknowledge
helpful commentsfrom workshopparticipantsat AmericanUniversity,Universityof Cincinnati,GeorgeMason
University,The George WashingtonUniversity,RutgersUniversityat Camden,RutgersUniversityat Newark,
TempleUniversity,the 23rd AnnualCongressof the EuropeanAccountingAssociationat Munich,Germany,and
the 2002 AmericanAccountingAssociationAnnualMeeting.We also thankMithuDey for herresearchassistance.
Finally,we gratefullyacknowledgethe contributionof I/B/E/S InternationalInc. in providingearningsforecast
data,availablevia the InstitutionalBrokerageEstimateSystem.These datahave been providedas partof a broad
academicprogramto encourageearningsexpectationsresearch.
Editor'snote: This paperwas acceptedby TerryShevlin,SeniorEditor.
Submitted March 2000
Accepted November 2002
471

472 Kumarand Visvanathan
temporarydifferencesres verse, or before tax losses or tax creditsexpire. The availabilityof

such income is not assured,and thereforeStatementof FinancialAccountingStandardsNo.
109 (SFAS No. 109, Financial Accounting Standards Board [FASB] 1992) requires a val-
uation allowance (VA) to reduce DTA when it is "more likely than not" that such assets
will expire before they can be realized. Taxableincome for the realizationof DTA can
come from futureoperations,past operaions, or futurereversalsof taxabletemporarydif-
ferences.Thus, unanticipateddisclosuresof VA revisionspotentiallyinforminvestorsabout
DTA, the likelihood of its realization, and about the nature and amount of future taxable
income.
For VA change disclosures to be informative,however, managersmust use private
value-relevant information and expectations when making VA changes. By endorsing the
"applicationof judgment"(ratherthan providinga rigid set of standards)in determining
VA under SFAS No. 109, the FASB apparently both expects and encourages the use of
such private information.2 If managers have little relevant private information, or are un-
willing to use private information in setting VA, or if VA disclosures are pre-empted by
other information sources, then VA revisions are likely not informative.
Prior research suggests that managers follow SFAS No. 109 in setting VA, and that VA
assessments are associated with firm value. In particular, Miller and Skinner (1998) (here-
after MS) find that managers consider the nature of DTA and the extent that DTA are likely
to be realized in setting VA. Valuation studies typically indicate negative relations between
VA balances and security prices (Amir et al. 1997; Ayers 1998; Amir and Sougiannis 1999).
While these studies show how VA is determined and demonstrate value-relevance, they do
not investigate whether disclosures of VA provide significant and timely new information
to investors-information that is unavailable from other sources, and can influence investor
expectations and move security prices.
The present study addresses this question by using an event-study approach to examine
security price responses to news media disclosures of VA revisions.3 Such disclosures are
typically made concurrently with quarterly earnings. We consider news disclosures-rather
than SEC-mandated 10-K disclosures-for three reasons. First, we expect managers to make
such disclosures when they judge VA changes to be material. Second, unlike 10-K filings
where large and diverse sets of other information are disclosed, VA news disclosures are
usually accompanied by quarterly earnings announcements only. Third, except for filings
on EDGAR, filing dates for SEC filings are difficult to identify precisely (Easton and
Zmijewski 1993).4 In contrast, news announcements can be dated quite accurately. Thus,
compared to SEC filings, news disclosures are relatively uncontaminated sources of VA
information and have precisely identified event dates.
Our sample consists of 136 1994 to 1998 news releases. Using standard event-study
methodology and OLS regression models, we document negative associations between VA
changes and security returns over three-day disclosure event windows. We then consider
the nature of information conveyed in the disclosures. In light of the MS findings that
2
SFAS No. 109 provides guidelines for the application of such judgment.
3 Although we are unaware of other event studies that consider the informativeness of VA disclosures, event
studies as well as association studies have previously been used to consider the value-relevance of deferred
taxes. For example, Beaver and Dukes (1972) use associations with security returns over annual windows to
demonstrate the value-relevance of tax deferrals. Givoly and Hayn (1992) demonstrate the value-relevance of
deferred tax liabilities by examining security return responses to events leading up to the passage of the Tax
Reform Act of 1986.
4 Effective May 6, 1996, with few exceptions, SEC registrants are required to file on EDGAR. Our study period
focuses on the years 1994 through 1998.
The Accounting Review, April 2003

InformationContentof DeferredTax ValuationAllowance 473
managers set VA based on their DTA expectations and the extent that DTA will be realized,
we examine whether event-window security returns are associated with revisions in inves-
tors' expectations about DTA realizability and future taxable income available to realize
DTA. More specifically, the objective is to examine whether VA disclosures cause investors
to revise expectations about yet unreported underlying determinants of VA. Results support
a characterization where investors use the disclosures to infer managers' expectations and
revise their assessments of current year DTA and the likelihood of its realization. Further-
more, investors also revise expectations of earnings for the year following the disclosure.5
The investigation of investor interpretations of VA changes incorporates three features
designed to address concerns that the observed security price responses are attributable to
other contemporaneous disclosures, rather than to VA changes. First, we include measures
of unexpected earnings for the current quarter to control for contemporaneous earnings
disclosures. Second, we eliminate observations with disclosures other than VA changes and
earnings during a five-day period around the disclosure. Third, we use a control group of
quarterly earnings announcements without concurrent VA change disclosures. Results show
that investor reassessments of future profit expectations and DTA realizability are more
substantial during quarterly earnings announcements with VA disclosures than during other
quarterly earnings announcements.
We also consider the possibility that security price effects are attributable to opportun-
istic use of VA to manage earnings. Tests using proxies for earnings management incentives
as additional explanatory variables indicate that our findings are not driven by earnings
management.6
This study has implications for investors, standard setters, and researchers. In particular,
the evidence indicates that VA disclosures-at least those made in news announce-
ments-provide new information to investors. Moreover, the evidence suggests that market
participants are relatively sophisticated in their interpretation of this information. Results
also indicate that allowing discretion in reporting choices, and thereby eliciting management
judgment, can be useful. At least in the context of SFAS No. 109, investors appear to
understand the judgment process and effectively use disclosures to assess the underlying
expectations of managers. However, caution is recommended. First, the evidence is from a
single accounting standard, and therefore, it should be considered preliminary. Second, this
evidence is based on a sample of firms that make disclosures through the media, prior to
10-K filings. Thus, these results may not generalize to firms that do not use the media to
disclose VA changes.
This study also contributes to the literature, which suggests that discretionary accruals
can inform investors about future profitability (e.g., Subramanyam 1996). The study shows
how a single accrual-the valuation allowance-can inform investors about future profit
performance. The ability to communicate future profitability distinguishes VA changes from
other accruals, which typically relate to individual financial statement items. Thus, VA
5 Note that by providing direct evidence of investor reassessments of factors underlying VA changes, the present
study goes beyond the work of MS (1998). Their study, while identifying factors that determine VA, does not
provide evidence on whether investors revise their expectations of these factors based on VA disclosures. Investor
reassessments following disclosures occur only to the extent that investors do not fully anticipate the changes.
6 These findings should not be construed as evidence that VA changes are not used for earnings management in
other instances. Firms may be less inclined to use VA changes to manage earnings when they make media
disclosures. Thus, our tests are designed as controls for, rather than as direct tests of, earnings management (see
Guay et al. [1996] and Phillips et al. [2002] for tests of earnings management). One study that directly focuses
on the role of VA changes in earnings management (in the banking industry) is by Schrand and Wong (2001).
TheAccountingReview,April 2003

disclosures are more directly informative than other accruals, and as such, they are poten-
tially more relevantto investors.
The following section discusses provisionsof SFAS No. 109 and explanationsfor the
security price effects of valuation allowance disclosures. Section III discusses sample se-
lection. The research design and empirical specifications are presented in Section IV. Sec-
tion V discusses results of analysis, and Section VI presentsthe summary.
II. BACKGROUNDAND SECURITY PRICE IMPLICATIONSOF

VALUATIONALLOWANCE
A feature that distinguishesSFAS No. 109 from prior standardson accounting for
deferredtaxesis that SFAS No. 109 requiresthe recognitionof DTA for all deductible
temporarydifferences,tax loss carryforwards,and tax credits.7The underlyingrationaleis
that "the critical (asset) recognitionevent is the (historical)event that gives rise to de-
ductibletemporarydifferencesand carryforwards" (FASB 1992, para.85). Since realization
of these assets is contingent on the availability of taxable income of appropriate character,
the standard also requires firms to record a valuation allowance to reduce DTA to the extent
that such assets are "morelikely than not" to expire unrealized.
Assessments of whether, and in what amount, DTA are realized involve judgments
about the amount, timing, and sources of future taxable income. SFAS No. 109 guides such
judgments by identifying four income sources that can be used to realize DTA: (1) future
reversals of existing temporary differences, (2) future taxable income exclusive of reversing
temporary differences, (3) taxable income in prior carryback years if carryback is permitted,
and (4) tax-planning strategies.8 The standard also identifies examples of evidence, both
positive and negative, to be considered when estimating future income. Positive evidence,
which reduces the need for a VA, includes existing sales contracts and order backlogs,
strong historical earnings, and assets with fair values well in excess of book values. Negative
evidence, which suggests establishing or increasing the VA, includes current loss carryfor-
wards, a history of expired loss carryforwards, and expected future losses.
The standard encourages managers to use private information to set VA. If managers
do so, then VA disclosures can cause investors to revise assessments of the amount and
composition of DTA, the extent it is likely to be realized, and about future earnings available
for such realization. Security price reactions to VA change disclosures reflect any such
revised assessments. On the other hand, managers may lack relevant private information or
may be reluctant to use private information if doing so risks higher costs of capital, loss
of competitive advantage, or litigation. In such cases, VA disclosures are not informative,
and thus, security prices do not respond.
III. SAMPLE SELECTION

We search LEXIS/NEXIS for news releases from 1994 through 1998 that include the
keywords "valuation allowance," and report changes in deferred tax VA. When several
reports provide identical information for a firm-quarter,we select the first disclosure. This
procedure yields 181 VA change disclosures. Of these, we discard eight that do not specify
magnitudes and 33 where either necessary quarterly earnings data on the 1999 Standard &
Poor's Compustat databases or daily stock returns on the Center for Research on Security
7
Accounting Principles Board Opinion No. 11 (APB No. 11, APB 1967) did not permit recognition of DTA for
tax-credit carryforwardsand severely limited recognition of tax-loss carryforwards. SFAS No. 96 was even more
restrictive, permitting recognition only when realization was assured by the availability of tax-loss carrybacks.
8
Tax-planning strategies refer to actions taken by managers-for example, investing in taxable instead of tax-
exempt securities-to prevent the unrealized expiration of DTA.

Prices (CRSP) databases are not available. We drop four additional observations with po-
tentially confounding news announcements (other than earnings) during the five-day period
centered on the news release date. These procedures yield 136 observations where VA
changes are disclosed with quarterly earnings announcements (see Table 1, Panel A). One
hundred six (106) firms enter the sample once-that is, for only one quarter in the five-
year period-and 13 firms appear twice or more. We use this sample, after excluding four
outliers, to study aggregate security price reactions to VA disclosures.9
Investigations of associations of event-period security price reactions with VA change
determinants use a smaller sample because these analyses require additional data, such as
changes in DTA and DTL, that are reported annually, but not quarterly, and earnings for
eight quarters following the VA disclosures. For nine firms that report VA changes twice
in the same fiscal year, analysis using annual data raises concerns that observations are not
independent. For these firms, we retain only the earlier o the two disclosures in the sample.
Next, we omit three observations that lack required additional data. The remaining 120
observations, representing 113 firms, comprise the sample for the study of the nature of
information conveyed in VA disclosures.
The majority of VA changes in the sample (89 of 136) are negative; 69 of 136 disclo-
sures occur in the fourth quarter with the remaining distributed fairly evenly across the
other three quarters. Industry distributions, displayed in Table 1, Panel B, follow the clas-
sification scheme advanced by Ali and Kumar (1994). As in previous studies (e.g., Amir
et al. 1997), manufacturers comprise a relatively large proportion of the sample.
IV. MODEL DEVELOPMENT AND EMPIRICAL SPECIFICATIONS

Are VA Disclosures Informative?
We investigate whether VA disclosures are informative by regressing three-day cumu-
lative market-model residual returns, centered on the disclosure date, on unexpected changes
in VA for disclosure quarter t.10We control for contemporaneous quarterly earnings releases
by including unexpected earnings as an explanatory variable. The empirical specification
is:
CARt = aO + a, AVA,/P_ + a2AEt,/Ph + a3 E,_lIPP + a4 Ret1OO,+ f,t (1)
where all variables are as defined in Exhibit 1; ao-a4 = estimated parameters; and firm
subscripts are suppressed.
In Expression (1), we specify AVA, as the proxy for unexpected disclosure quarter
change in VA, based on MS's (1998, 229) finding that valuation allowances typically do
not change from year to year. If this finding applies to quarterly VA changes, then expected
AVAtis zero.'1
We include variables AE, and AE,t_ in Expression (1) so as to reflect unexpected earn-
ings per share (EPS) under Foster's (1977) first-order autoregressive model of quarterly
9 We use Belsley et al.'s (1980) dffitsstatisticsto identifyoutliers.

10 Resultsare similarwhen cumulative
residualreturns(CARe)are computedover five-daywindowsbeginningon
day -2, whereday 0 is the announcementdate.
11 Since firmsare not requiredto reportquarterlyVA changes,we are unableto documentthe statisticalproperties
of such changes.However,we investigateannualVA changesby estimatinga cross-sectionalregressionof price-
deflatedannualper-shareVA changes(AVAT/PT_1) on theirfirstlags (AVAT-l PT-_) for the observationsin our
sample.Estimatedinterceptsandslopes arenot reliablydifferentfromzeroat conventionallevels, thussupporting
a simplerandomwalk characterization and the assumptionof zero beginning-of-period
expectationsfor annual
VA changes.

476 Kumar and Visvanathan
TABLE 1
Sample Selection and Distribution
Panel A: Sample Selection

News disclosures'b in 1994 through 1998 reported on LEXIS/NEXIS that include the 181
phrase "valuation allowance" and report a deferred tax valuation allowance (VA) change
Less news disclosures (events) that do not report the magnitude of the change in VA (8)
Less events relating to firms that lack necessary earnings and stock returns data on the (33)
Compustat and CRSP databasesc
Less events excluded because of confounding news disclosures in the five days from day (4)
-2 through day +2, where day 0 is the news release date
Sample for the investigation of security price responses to VA change disclosuresd 136
Less events excluded from the investigation of the nature of information in VA change
disclosures:
(i) because they are not the first VA change disclosures for the fiscal year; (9)
(ii) because of the lack of necessary financial data needed to compute explanatory (3)
variables; and
(iii) as outliers identified using Belsley et al. (1980) diagnostics (4)
Sample for the investigation of the nature of information in VA disclosures' 120
Panel B: Industry Distribution

Observations Used in Security Observations Used in Investigation
Industrye Price Response Analysis of Nature of Information
Basic 8 8
CapitalGoods 43 38
Construction 7 6
ConsumerGoods 57 49
Energy 3 3
FinancialServices 15 14
Transportation 0 0
Utilities 3 2
Total 136 120
a
All news disclosures of VA changes in our sample are made contemporaneouslywith quarterlyearnings
announcements.
b We includeone news disclosure
c per firm-quarter-theearliestfor the quarter.
Earningsdataare neededto computevariablesthatcontrolfor the effects of contemporaneous quarterlyearnings
disclosures.
d 47 (40) of 136 (120) disclosuresreportpositiveVA changes. 17 (16) disclosuresoccurin the firstfiscal quarter,
17 (16) in the second quarter,33 (25) in the thirdquarter,and the remaining69 (63) in the fourthquarter.
eIndustrydesignationsare a variationof Sharpe(1982) and follow Ali and Kumar(1994). SIC codes in each
industryare:
Basic Industries: 1000-1299, 1400-1499, 2600-2699, 2800-2829, 2870-2899, 3300-3399;
CapitalGoods: 3400-3419, 3440-3599, 3620-3629, 3670-3699, 3800-3849, 5080-5089, 5100-5129,
5160-5169, 7300-7399;
Construction: 1500-1999, 2400-2499, 3220-3299, 3430-3439, 5200-5219;
ConsumerGoods: 0000-0999, 2000-2399, 2500-2599, 2700-2799, 2830-2869, 3000-3219, 3420-3429,
3600-3619, 3630-3669, 3700-3719, 3850-3899, 3900-3999, 4830-4899, 5000-5079,
5090-5099, 5130-5159, 5180-5199, 5220-5999, 7000-7299, 7400-9999;
Energy: 1300-1399, 2900-2999, 5170-5179;
Finance: 6000-6999;
Transportation:3720-3799, 4000-4799;
Utilities: 4800-4829, 4900-4999.

Information Content of Deferred Tax Valuation Allowance 477
earnings changes.'2 Foster's model specifies unexpected quarterly earnings as AE, - KAE,
where K is a constant. Thus, a3 includes K.13 Following Christie (1987), we scale all
financial variables by P,, the price per share at the beginning of the disclosure window
(the end of day -2).
Our variablesmeasure VA change and EPS expectationswith errorfor at least two
reasons. First, forecast dates typically precede the disclosure windows by several weeks,
and expectations on forecast dates can differ substantially from beginning-of-event-window
expectations. Second, estimated forecasts may not accurately reflect unobservable market
expectationson forecast dates. Such measurementerrorcan bias estimatedcoefficients.
We addressthis measurementerrorin three ways. First,following Brown et al. (1987),
Collins et al. (1994), Lys and Sivaramakrishnan (1988), and others, we include cumulative
returnsleading up to the event-window (RetlOO0)as a proxy for measurementerror in
expectedearningsand VA changes.The objectiveis to mitigatecoefficientbias by including
as an explanatory variable a proxy for expectation revisions between the forecast date and
the beginning of the disclosure window.)4 Second, we address concerns that Foster's (1977)
model does not accurately represent earnings expectations on forecast dates by considering
alternative time-series forecasts as well as analysts' forecasts (see footnote 13). Third, we
estimate Expression (1) using measurement error proxies starting from alternative forecast
dates, specifically 80 and 60 trading days prior to the beginning of the event window and
the prior quarter earnings announcement date. We report results only with RetlOO0as they
are similar for other measurement error specifications.
Unanticipated VA decreases (increases) signal increases (decreases) in the amounts of
DTA likely to be realized and thus provide good (bad) news; therefore, we predict al < 0.
A substantial
quantial tity of literature on earnings response coefficients predicts a positive
12
We estimatecurrentquarterEPS (E) before VA changes as reportedEPS minus VA change per share.This
assumesthat all VA changes flow throughearningsinto stockholders'equity.However,SFAS No. 109 (para.
36) identifiesseveraltransactionsfor which tax effects (andrelatedVA changes)flow directlyinto stockholders'
equity.If materialamountsof VA changesrelateto such transactions,thenEPS beforeVA changesaremeasured
with error(see Hanlon and Shevlin [2002] for evidence that such effects can be materialin the context of
employee stock option-relatedtax benefits)and coefficienta2 of AE, can be biased.We are unableto address
such measurementerrorbecause the details of transactionswhose tax effects flow directlyinto stockholders'
equityare typicallynot disclosedin quarterlyearningsannouncementsor even in quarterlyreports.
13 Resultsare similarwhen we use the IMA(1,1)or SRW models to specify unexpectedearnings.The IMA(l,l)
processprovidesa parsimoniousspecificationfor unexpectedearningsin termsof earningslevels andchanges,
while allowingfor transitoryunexpectedearnings(see Ali andZarowin1992). AmirandLev (1996) andWahlen
(1994) use the levels and changesspecificationfor unexpectedquarterlyearnings,thus assumingthatquarterly
earningsfollow an IMA(1,1) process in four lags. Results are also similarwhen we use consensusanalysts'
forecastsfrom I/B/E/S as earningsexpectationproxies.These forecastshave at least two shortcomingsin our
context.First,they arenot availablefor well overhalf of our samplefirms.Second,it is unclearwhetheranalysts'
earningsforecastsincludeor exclude VA changes.
14 We follow Brownet al. (1987) in using Retl00, as a specificationfor the measurement-error proxy.The under-
lying assumption-thatbeginning-of-quarter time-seriesforecastsreflectexpectations100 dayspriorto the event
window-appears reasonableconsideringthat (1) a quarterhas about 90 calendardays and about 60 to 70
tradingdays, and(2) expectationsreflectedin beginning-of-quarter forecastscan be anticipatedby securityprices
even before the priorquarterearningsannouncement.Estimatingthe measurementerrorproxy over a window
of pre-specified(100-day) duration,ratherthan from actualpriorquarterearningsannouncementdates to the
beginningof the announcementwindowhas the addedadvantagethatobservationsare not lost when the earlier
announcementdates are unavailable.

EXHIBIT 1
Variable Definitions
Price and return data are from the CRSP Daily Returns files. Valuation allowance changes (AVA,)
and event quarter earnings per share (Et) are obtained from news disclosures on the WIRES section
of LEXIS/NEXIS. Deferred tax assets (DTA), including DTA due to loss carry-forwards and tax
credits, and deferred tax liabilities (DTL) are from footnote disclosures in annual report/10-K
filings. All other data are from Compustat. Compustat data item numbers are provided in
parentheses where applicable.
CARt = the three-day cumulative, value-weighted, market-model residual

return for days -1 through day + 1 where day 0 is the VA change
disclosure date for quarter t and market-model parameters are
estimated over 250 days preceding the event window;
AVAt = the reported per share change in VA for quarter t (VAt - VAt_l);
AEt = (E, - Et_4) where E, is earnings per share (EPS) before VA change
in quarter t and Et-i is EPS for quarter t-i (E, is Compustat quarterly
item # 19);
AEBT(t+l,+4) [AEBT(t+5t+8)] = the cumulativeactualpretaxEPS for quarterst+ 1 throught+4
[quarters t+5 through t+8] minus cumulative actual pretax EPS for
quarters t- through t-4 [Pretax EPS = Quarterly pretax earnings/
split-adjusted common shares outstanding (Compustat quarterly item
#23/(item#15 x item#17)];
ANetDTAT= the per share change in DTA (exclusive of those related to loss
carryforwards and tax credits) net of DTL for fiscal year T, which
includes event quarter t; that is, NetDTAT - NetDTAT_, where
NetDTATis DTA minus DTL for year T, and DTA are gross amounts
before subtracting VA;
ANOLT= the per share change in DTA due to loss carry-forwards and tax
credits for fiscal year T;
RetlOOt= the cumulative raw return over 100 trading days ending on day -2;
RetNonEvt, = the cumulative raw return over the period from the beginning of the
fourth month of fiscal year T to the end of the third month of the
following fiscal year but excluding the three-day event window;
FutRet4t (FutRet8t) = the cumulative raw return for the period from the end of the event
window until 45 calendar days after the end of quarter t+4 (t+8);
and
Pw = the closing price per share for day -2.
coefficient a2 on AEl/P..15 We expect RetlOO to vary directly with the measurement error
in unexpected earnings and inversely with the error in unexpected VA change. If measure-
ment errors are material, we anticipate a4 < 0.16
areconstantacrosssamplefirms.
15 EstimatingExpression(1) cross-sectionallyassumesthatall modelparameters
Such assumptionscharacterizemost cross-sectionalsecurityreturnstudies,includingAmirandLev (1996) and
Wahlen(1994, 474). An alternativeapproachthatestimatesunexpectedearningsusingforecastparameters from
firm-specificearningstime-series-that is, assumingtime-invariant forecastmodel parameters-canserve as a
check for robustness.We do not pursuethis option since the procedureresultsin a substantialloss of obser-
vations.However,note thatfindingsarerobustto the use of analysts'forecastsandacrossa rangeof time-series
forecastmodels.
16 We expect thatrevisionsin earnings(VA change)expectationsare associatedpositively(negatively)with return
responses.Thus, correlationsbetweenRetlO0,and measurementerrorin earnings(VA change)expectationsare
positive (negative).Since these correlationsigns coincide with predictedcoefficientsigns on the respective
explanatoryvariablesin Expression(1), the coefficienton RetlO0,in Expression(1) is predictedto be negative
(Brownet al. 1987).

What Do Investors Learn from VA Disclosures?

As we note in Section II, VA disclosures potentially communicate value-relevant in-
formation about underlying changes in the extent and nature of DTA, its likelihood of being
realized and about the availability of future taxable profits for such realization.'7 We in-
vestigate evidence of such information by examining associations between event-window
stock returns and measures of investor expectation revisions about DTA realizability, in-
cluding revisions about pretax income for two years following the disclosure quarter. The
empirical specification, Expression (2) below, is derived primarily by substituting for AVA,
in Expression (1) with proxies for expectation revisions about DTA, the likelihood of its
realization, and the availability of future profits for realization (see MS 1998). Firm sub-
scripts are suppressed.
CARo= bo
b,+ A+4)/P,
AEBT(t+l, + b2 AEBT(t+5,t+8P, + b3 ANetDTATIPw
+ b4 ANOLT/IP, + b6 AE,/Pw + b7,AEt,/P
b ANOLTIP
+ b8 RetNonEvtt + bg FutRet4, + b,l FutRet8, + b1l RetlOOt + Ebt, (2)
where all variables are as defined in Exhibit 1; and bo-bl = estimated parameters.
The disadvantage of restricting the horizon to two yearss that reversals
eveof deductible
temporary differences can occur after two years, and earnings beyond two years are relevant
for asessing the realizability of the related DTA. On the other hand, earnings for later time
periods have a declining influence on VA revisions if reversals or earnings predictability
decline as the horizon extends. If so, then the power of statistical tests to detect future
earnings' effects declines. Furthermore, sample attrition increases as the horizon is extended.
Thus, the two-year horizon is a compromise that trades off a more complete specification
with concerns about the consequences of decreasing sample size and statistical power.'8
Using Foster's (1977) model, we obtain (AEBT(t+lt+4) - K'AE, ) [(AEBT(t+5,t+8)
- K"'AEt_)]as the expression for unexpected pretax earnings for quarters t+ through t+4
[t+5 through t+8] relative to the forecast date at the beginning of quarter t.19We use these
expressions as proxies for event-window expectation revisions for quarter t+ 1 through t+4
(t+5 through t+8) pretax earnings. Thus, we include AEBT(t+t+4)hAEBT(t+5,t+s and AEt-
(scaled by beginning of event-window price Pj) as independent variables in Expression (2).
Measurement error in using the above expressions as proxies for event-window expec-
tation revisions has two components-(1) expectation revisions from the forecast date in
quarter t through the beginning of the event-window, and (2) expectation revisions from
the end of t event-window through the disclosure of quarter t+4 (t+8) pretax EPS. We
thed
17 Managerscan also make VA changesin responseto changesin income from priorperiodsavailableto realize
loss-carryback-related DTA. Such VA changeswill be uninformativesince past earningsare "old news."Thus,
we do not considerloss-carrybacks in ourreturnspecification.We also do not considerincomefromtax-planning
strategiesbecause such actions are limited in scope and their effects are difficult to predict (MS 1998).
Visvanathan(1998) finds that very few firms acknowledgethe use of such strategiesand none in his sample
reportan income effect.
18 Findingsreportedin the following section, that only one-year-ahead earningsare associatedwith VA changes,
supportthis researchdesignchoice. Ourspecificationof futureearningsalso assumesthatmanagersuse forecast
horizonsthat roll forwardby one quarterevery quarter.An alternativeis to assume that managersconsider
futureearningsoverfiscal year periods.To this end, we also use earningsover the remainingquartersof the
event fiscal year and the two following fiscal years as futureearnings.Results (not reported)are qualitatively
similarto those from Expression(2).
19 Note that
quartert earningsarenot availableat the beginningof the announcementwindow.HenceEPS changes
are measuredrelativeto quarterst-1 throught-4.

use raw returns leading up to the event-window (RetO100)to consider the former, and
cumulative returns from the end of the event-window until 45 calendar days after the end
of quarter t+4 (t+8) following event quarter t (FutRet4, or FutRet8,) to proxy for the latter.
In computing FutRet4N(FutRet8t) we go beyond the end of quarter t+4 (t+8) in order to
accommodate that quarter's 10-Q release date.
DTA and DTL are reported annually only; therefore, we use the actual change in DTA
net of DTL for fiscal year T (encompassing event quarter t) as the proxy for event-window
expectation revisions regarding DTA and the likelihood of its realization through future
reversals of taxable temporary differences. Netting DTA and DTL assumes that each dollar
of DTL helps realize, and in turn, offsets a dollar of DTA, and that investors are concerned
only with the net balance (see MS 1998).
We also follow MS (1998) in distinguishing DTA related to net operating loss credits
and carryforwards. The reasoning is that the likelihood of realization of DTA related to
loss and credit carryforwards can be lower due to jurisdictional restrictions on income
available to realize DTA. Thus,ANetDTAT proxies for event-window expectation revisions
about DTA excluding that from net operating loss carryforwards and credits, and the like-
lihood of its realization through reversals of taxable temporary differences. ANOLTconsid-
ers DTA from loss carryforwards and credits.
The use of annual changes (ANetDTATand ANOLT) as expectation-revision proxies
assumes that NetDTATand NOLT follow random walk processes. Based on cross-sectional
regressions, we document significant positive associations for ANOLT(scaled by beginning-
of-event-window stock price PJ) with ANOLTZ_,but no associations between ANetDTAT
andANetDTAT_ . Thus, the data support the random walk assumption for ANetDTATbut
favor a first-order autoregressive process to represent the time-series behavior of ANOLT.
As such, we specify the proxy for event-window revisions in investor expectations for the
realization of NOLT as ANOLT- ko - k, ANOLT_,1 where ko and k, are parameters of the
ANOLT time-series process.20 We use cumulative raw returns from the end of the third
month following the beginning of fiscal year T until the end of the third month following
the end of fiscal year T but excluding the three-day event-window, defined as RetNonEvtt,
as proxies for measurement error in both ANetDTATand ANOLT.This assumes that annual
reports are released by the end of the third month following the end of the fiscal year.
As in Expression (1), we include current and prior period earnings changes AE, and
AE,t_ to consider event-window expectation revisions for current quarter t earnings, and
RetlOO to proxy for measurement error that results from using these measures to capture
event-window expectation revisions.
Security price responses to revisions in expectations about future earnings for quarters
t+l through t+4 (t+5 through t+8) following event quarter t are indicated by coefficients
b, and b2 in Expression (2). If investors use VA changes to revise expectations about future
profits, then, given the evidence that earnings and returns vary directly, we expect b, > 0
and b2 > 0. Coefficients b3 and b4 on ANetDTATIPWand ANOLTIPW, respectively, reflect
responses to expectation revisions regarding DTA and its realization through DTL. Predic-
tions about the signs of these coefficients are predicated on MS's findings that VA changes
vary positively with both contemporaneous changes in DTA net of DTL (exclusive of DTA
20
That is, we assume ANOLT = ko + k1 ANOLT_ + ?k. Thus, unexpected annual ANOLTis specified as ek
= ANOLT- -
ko k, ANOLT_ .

from NOL) and NOL-related DTA.21 These findings suggest that VA increases (decreases)
signal reduced (increased) likelihood of DTA recovery for the year, both for DTA from
NOL and from other sources. Such expectation revisions for DTA have security price
consequences of opposite sign. Therefore, coefficients b3 and b4 on ANetDTATlPWand
ANOLT/Pware predictedto be negative.We predictcoefficientb6 on AE,/Pwto be positive.
To the extent that variables are measured with error, coefficients b8 through b11 on the
measurement-error control variables RetNonEvtt, FutRet4N,FutRet8, and RetlOO0,respec-
tively, are expected to be negative.
Two featuresof the researchdesign underlyingExpression(2) provide assurancethat
documented security-return associations with DTA changes and future profitability are at-
tributable to VA disclosures. First, we use a short (three-day) event-window, thus limiting
the potential impact of news outside the event-window. Second, we exclude observations
with confoundingnews disclosuresother than the quarterlyearningsannouncement.Even
so, in order to addressany remainingconcerns about spuriouseffects attributableto un-
specified information releases other than VA changes or earnings that might accompany
quarterly earnings releases, we conduct additional tests using a control sample of quarterly
earnings announcements without VA disclosures. Quarterly earnings announcements by our
sample firms that occur in the same fiscal years as the VA disclosures but have no contem-
poraneous VA disclosures represent a natural control sample because they are drawn from
the same set of firm-years as the experimental sample. If revisions of investor expectations
of future profits and DTA realization are more substantial for quarters in which VA disclo-
sures occur than for other quarters,then is unlikely that such revisions are attributable
to factors other than the VA disclosures.
In orderto compareexpectationrevisions about DTA/DTL changes and futureprofit-
ability during quarterly earnings announcements across firm-quarters with and without VA
disclosures, we estimate Expression (3) for a pooled set of observations comprising both
the experimental (with VA disclosure) and control (without VA disclosure) groups. A
dummy variable Dt, coded 1 for observations with VA disclosures, and 0 otherwise, distin-
guishes the two groups. Other variables in Expression (3) are as in Expression (2).
CARt = co + co Dt + cl AEBT(t+lt+4)/IPW+ c;(AEBT(t+1,+4)/Pw) X Dt

+ C2 AEBT(t+s5t+8)/P, + c'2 (AEBT(t+5,t+8)1Pw) X Dt + c3 NetDTATIPw
+ c3 (ANetDTAT/PW)X Dt + c4 ANOLT/PW+ c4 (ANOLr/P,) X D,
E/P
cc5 NOLT+ ANOLT_ ( L P ) XD D +c P ++ c7 AEt-_/P
+ c8 RetNonEvt, + cg FutRet4, + CioFutRet8, + cl RetlO0, + ec,. (3)
Coefficientsums (ca + cl) [(c2 + c')] reflect marketresponsesto expectationrevisions

about future earnings in quarters t+1 through t+4 [t+5 through t+8] for experimental
sample observations. Similarly, coefficient sums (c3 + c3) and (c4 + c4) indicate responses
to expectationrevisions about DTA and its realizabilityfor this sample. Coefficients cl,
c2, c3, and c' indicate differencesin returnresponsesbetween the experimentaland control
samples.
21
We verify thatassociationsbetweenannualVA changesand annualchangesin DTA (net of DTL andexcluding
NOL-relatedDTA),annualchangesin NOL-relatedDTA,andchangesin futureprofitability(relativeto the most
recentfour quarters)are consistentwith those documentedin MS (1998).

V. RESULTS
Descriptive Statistics
Table 2 provides descriptivestatistics.The ratio IAVA,/E,Iindicates that VA changes
have a materialimpact on reportedearningsfor the disclosure quartert. This is not sur-
prisinggiven that firmsconsiderthese VA changes large enough to warrantspecific disclo-
sure. Disclosure quarterVA changes representabout 70 percentof the VA change for the
year (not reportedin the table), and are thereforealso substantialrelative to changes for
the remainingquarters.Median (mean) VA changes are about equal (more than twice) in
magnitudeto quarterlyearnings before valuation allowance changes. A majorityof VA
changes (89 of 136) are negative,indicatingexpectationsthat smalleramountsof DTA will
go unrealized.
Mean and median event-windowcumulativeresidualreturns(CAR) are -1.5 percent
and -0.8 percent, respectively. Both mean and median price-scaled event-quarter EPS
changes (AE,/Pw) relative to quarter t-4 are negative. Sample firms appear to be experi-
encing deteriorating earning performance and this decline perhaps partly explains the neg-
ative event-window returns. Mean price-scaled earnings level (E,IPt ) is also negative, al-
though the median is positive. Almost one-half of sample firms experience losses in the
event quarter.22
Mean price-scaled change in net DTA other than due to NOL carryforwards(ANetDTA./
P,) is positive, indicating increasing DTA (net of DTL) on average. Median change is
marginally negative, indicating that over one-half of the sample report reductions in
NetDTAT in the event year T. Both mean and median changes in DTA relating to NOL
carryforwards (ANOLTIPW)are positive. These increases in NOL carryforwards are consis-
tent with the relatively poor financial performance of the sample firms. Median levels of
future quarter earnings for both quarters t+ through t+4 (EBT(t+1,+4)IPJ)and quarters
t+5 through t+8 following the event quarter t (EBT(t+5,t+8,IP) are positive, but changes
relative to the most recent four quarters (AEBT(,+l,+4)1IPw,AEBT(t+5,+8),/P) are negative.
As such, the majority of sample firms are profitable but experience declining performance
after the event quarter. However, mean future earnings levels and changes over both time
frames are negative, indicating that a few firms have poor and deteriorating post-event-
quarter performance.
Median (mean) market value of equity (MVE) (not reported in Table 2) is $49 ($554)
million. Although a majority of the sample firms are relatively small, the skewed MVE
distribution indicates the presence of large firms.23 Overall, earnings-announcement dis-
closers of VA changes are typically smaller than the cross-section of U.S. firms.
Are VA Changes Informative?

Regression results for Expression (1) are in Table 3. Coefficient a, on VA changes
(-0.309) is reliably negative (p < 0.01, one-tailed) in Model 1 (which corresponds to
Expression (1)). Thus, increases (decreases) in VA lead to value-relevant downward (up-
ward) revisions in investor expectations regarding the extent that DTA are realized. Coef-
ficients are also reliably less than 1 (p < 0.01, one-tailed) (results not reported). If VA
changes cause investors to reassess DTA realizability dollar-for-dollar, and if book values
of DTA and DTL reflect market values (Guenther and Sansing 2000), then VA change
22
Mean price-scaled event-period EPS (E,IP,) falls at the 33rd percentile of the Compustat population for 1994
through 1998. Mean change in price-scaled EPS (AE,/P,) is at the 31st percentile; so sample firms have both
lower and declining performance relative to the median Compustat firm.
23
Median MVE for our sample is at the 31st percentile of the Compustat population for 1994 through 1998.

TABLE 2
Descriptive Statistics
25th 75th
Variablesa N Mean Median percentile percentile
Three-dayevent-windowreturns
CAR, 136 -0 .015 -0.008 -0.078 0.034
Measuresof valuationallowancechanges
AVA,/P, 136 0.017 -0.007 -0.021 0.025
IAVAt/E,I 136 2.250 1.059 0.322 2.306
Measuresof contemporaneouslydisclosed quarterlyearnings
E,IP, 136 -0.031 0.004 -0.043 0.017
AE,I/P 136 -0.096 -0.008 -0.068 0.005
Explanatoryvariablesfor securityprice effects of vw
aluationallowancechanges
ANetDTATIPw 120 0.007 -0.001 -0.008 0.010
ANOLT/PW 120 0.017 0.002 -0.001 0.019
AEBT(,+ ,t+4)/Pw 120 -0.024 -0.005 -0.077 0.034
EBT(t+l t+4)lIPw 120 -0.041 0.017 -0.099 0.081
AEBT(t+5,t+8)/Pw 120 -0.040 -0.011 -0.091 0.051
EBT(t+5^t+8)lPw 120 -0.058 0.005 -0.036 0.069
Othercontrolvariables
RetlOOt 136 -0.006 -0.050 -0.245 0.163
RetNonEvt, 120 0.093 -0.033 -0.351 0.438
FutRet4, 120 0.265 -0.032 -0.305 0.298
FutRet8, 120 0.540 -0.158 -0.555 0.786
a
Variable
definitions
arein Exhibit1.
coefficients are 1. Such coefficients can be less than 1, however, (1) if assets and liabilities
underlying DTA are recorded at greater than market value (Guenther and Sansing 2000),
or (2) if investors discount managers' assessments of VA. They can also be less than 1 to
the extent that VA changes reflect reassessments of DTL available for DTA realization,
because market values of DTL are, in many instances, discounted relative to book value
(Sansing 1998). Coefficients can be biased if there is residual measurement error in the
unexpected VA change measure, or if variables correlated with VA changes are omitted.
Coefficient a2 on AEt/Pw (0.224), representing event-window return responses to un-
expected quarter t earnings, is positive and significant (p < 0.05, one-tailed). Thus, con-
sistent with numerous prior studies, contemporaneously reported quarterly earnings are also
informative. Finally, coefficient a4 on RetlO0, is not statistically significant. As such, error
in the expectations measures does not appear to be serious.
Tests (not reported) comparing coefficients a, on VA changes and a2 on unex-
pected earnings indicate no significant differences. Stock prices respond similarly to un-
expected changes in earnings due to VA changes and other sources such as current oper-
ations. For the analyst, this suggests that earnings due to VA changes are as important as
earnings from operations.
Next, we distinguish between VA increases and decreases in Expression (1) by includ-
a
ing dummy variable D,, coded 1 for VA increases, and 0 otherwise. Dt appears both as a
main effect and in interaction with AVAt/Pw (Model 1A in Table 3). Return responses to

TABLE 3
of
Regressions Three-Day Quarterly Earnings AnnouncementWindow Return Residuals on
Measures of Unexpected Earnings and Unexpected Valuation Allowance (n = 132a)
Model 1: CAR, = ao + a, AVA,tP, + a2 AE,/Pw + a3 AEt,_/Pw + a4 RetlO0, + Eat
Model IA: CAR = aO + a' D, + a' AVA,/P, + a;(AVA,/IP) x D, + a' AEt,/P

+ a3 AEt,_I/P + a4 RetlOO, + eat
Predicted
Coefficient Model 1 Model 1A
Variablesb[Coefficients] Signs Value t-statisticc Value t-statisticc
Intercept[ao, a'] ? -0.002 -0.24 -0.022 -1.57
D, [ag] -~- - 0.029 1.06
AVA,/Pw [a,, al] -0.309 -3.37*** -0.725 -3.43***
(AVA,/P,)x D, [a'] - ~- 0.497 1.98**
AE,IP, [a2, a2] + 0.224 2.03** 0.299 2.62**
AE,_,/Pw [a3, a3] 9 -0.058 -2.28** -0.049 -1.90*
RetlO0, [a4, a4] 0.041 1.25 0.048 1.34
AdjustedR2 0.25 0.27
Coefficientsums Value t-statisticc
AVA,IP,, (AVA,IPw) -0.228 -1.82**
x D, [a,+al] d
***, **, * indicatesignificanceat the 1 percent,5 percent,and 10 percentlevels, respectively,for one-tailedtests

wherecoefficientsigns are predictedand for two-tailedtests otherwise.
a Results are
reportedafterexcludingfour observationsidentifiedas influentialusing the dffitsstatisticproposed
by Belsley et al. (1980).
b D, is coded 1 for observationswith positive VAQ,and 0 otherwise.All remainingvariablesare as defined in
Exhibit1.
c All t-statisticsare based on White's(1980) heteroscedasticity-consistent
standarderrors.
d The coefficientsum AVA,/IP,
(AVA,/Pw)x D, [al+a'] in Model 1A is the coefficientof AVA,for the 43 (of 132)
observationswith positiveAVA,.
both VA increases (-0.228; p < 0.05, one-tailed), indicated by a1 + a', and VA decreases
(-0.725; p < 0.01, one-tailed), indicated by a,, are reliably negative. The difference be-
tween the two (0.497; p < 0.05, two-tailed), indicated by a', is reliably positive and shows
that return responses are stronger for VA decreases. The smaller responses to VA increases
(which are income-decreasing) are consistent with prior research findings that earnings
decreases (bad news) are more timely-that is, anticipated to a greater degree-and less
persistent than earnings increases (Basu 1997).
As noted in Table 1, over one-half (69 of 136) of the VA change disclosures are made
in the fourth quarter. We investigate differences between return responses to fourth quarter
and other quarter VA disclosures by including a dummy variable to distinguish fourth
quarter disclosures in a specification similar to Model 1A in Table 3. Results (not reported)
indicate no significant differences.24
24
Additionaltests (not reported),using dummyvariablesto indicatethreeof the four disclosurequarters,do not
detect significantdifferencesin securityprice responsesbased on the quarterof VA changedisclosure.

Results are robust to the use of alternativeunexpectedearningsproxies, winsorizing

all independent variables or replacing independent variables with their ranks. In sum, we
find that VA change news disclosures provide new value-relevant information comparable
in importance-as measured by security price impact-to contemporaneous earnings
disclosures.
Tests of the Nature of Information in VA Disclosures
Results for the analysis of factors underlyingsecurity price responses to VA change
disclosures are in Table 4. Panel A presents results for Expression (2). Model 2 (which
corresponds to Expression (2)) is estimated for 120 VA disclosures with available data.
Coefficient b, on AEBT(t+,,t+4)/P (0.093) is positive and significant (p < 0.05, one-tailed),
but coefficient b2 on AEBT(t+5,+8)/Pw (-0.008) is not significant.25Thus, investorsappear
to use VA change disclosures for quartert to revise their assessments of earnings for
quarters t+l through t+4, but not for quarters t+5 through t+8 (the second year). Two
explanationscome to mind-that managers(on average) do not consider two-year-ahead
earningsexpectationsin setting VA changes, or that investorsfully anticipatesuch expec-
tations. Given the evidence from coefficient bo that investorsdo not fully anticipateone-
year aheadearnings,it seems unlikely that they fully anticipateearningsfartherout in the
future. Thus, it appears more likely that the first explanation, and not the second, holds.
Coefficientsb3 (-0.626; p < 0.01, one-tailed) and b4 (-0.482; p < 0.01, one-tailed) on
ANetDTATIPWand ANOLTIPW,respectively, are both significantly less than zero. Thus,
investors also use VA disclosures to materially revise expectations about DTA for the year
and the likelihood of its realization via DTL.
As in Table 3, coefficient b6 on AE,/P, (unexpected current quarter earnings) is positive
and significant. The coefficient on RetNonEvt, is negative and significant (p < 0.01, one-
tailed) but coefficients on RetlOO,, FutRet4t, and FutRet8, are not. Thus, at least in one
instance,the inclusion of a measurementerrorproxy appearsto be useful.
Results for Expression (3) are in Table 4, Panel B. Coefficient c' (0.081) on
(AEBT(t+,lt+4),PW) x Dt is positive and significant (p < 0.05, one-tailed), and indicates that
return responses to reassessments of future-profit expectations for quarters t+ through
t+4 are significantly greater for the VA disclosure sample than for the non-VA disclosure
sample. Coefficientc' on (AEBT(t+,t+8)/Pw) x D, is not statisticallysignificant,consistent
with the absenceof evidence in Model 2 (Table4, Panel A) of expectationrevisionsrelating
to quarter t+5 through t+8 earnings. Coefficients c3 (-0.427) and c4 (-0.317) on
(ANetDTAt/Pw) x Dt and (ANOLt,IP) x D,, respectively, are both negative and significant
(p < 0.05, one-tailed).As a result, reassessmentsof DTA and the extent of its realization
through DTL are also more substantial for the VA disclosure sample. Coefficient sums
cl + cl (0.106), C3+ c3 (-0.615), and c4 + c4 (-0.520) estimate return response coefficients
onAEBT(t+l,t+4)/Pw, ANetDTAtIPw,and ANOL,/Pwfor VA disclosersand are all statistically
significant(p < 0.01). These resultsconfirmfindingsreportedin Panel A for the respective
variables.Finally, the coefficient on Dt is not significant,indicatingthat a "VA announce-
ment" effect does not appearto distinguishreturnresponsesfor the two samples.Overall,
25
Note thatfutureearningsare measuredbeforetaxes.Therefore,coefficientsof unexpectedfuturequarterearnings
(i.e., b, or b2) shouldbe dividedby (1 - T), where T is the marginaltax rate, when makingany comparisons
with coefficientsof unexpectedcurrentearnings(i.e., b6).

486 486
~~~~~~~~~~~~~~~Kumar
and Visvanathan
TABLE 4
Regressions of Three-Day Quarterly Earnings Announcement Window Return Residuals on
Measures of Unexpected Earnings and Valuation Allowance Change Determinants
Panel A: Quarterly Earnings Announcements with VA Disclosures (experimental group) (n = 120)

Model 2: CARt bo + b, AEB1(t+l,f+4)lIP.,+ b2 AEBI(t+5,t+8)/PW, + b3 ANetDTAT/P,,
+ b4 ANOLT/PW, + b5 ANOLT- 1/Pw + b6 AEt/Pw+ b7 AJEtI/Pm + b8RetNonEvt,
+ b9 Fi'utReNt4+ bl0 FutRet8t + bl1 RetJ00t + -6bt
Predicted
Coefficient
Variables"[Coefficients] Signs Value
Intercept[b0] 0.021 1.87*
0.093 2.04**
AEBT(t+5,t+8),pw [b2] -0.008 -0.34
ANetDTAT/PW,, [b3] -0.626
ANOLT/PWv [b4] -0.482
ANOLT 1IP,, [b5] -0.050 -0.19
/P,, [b6]
,AEt + 0.191 1.50*
-0.005 -0.06
RetNonEvtt [b8] -0.074 -353***
FutReNt4[b9] -0.006 -0.98
FutRet8t [b10] -0.003 -0.49
RetJ00t [bl1] 0.059 1.71
AdjustedR2 0.26
Panel B: Pooled Sample (n = 443c)
Model 3: CARE= co+ C'oDt +CIAEB1(t+l,t+4) IPW + CI'(AEBT(t+l,t+4) IP.) X Dt

+ C2AB(t+5,t+8)IP. + C2'(AEBT(t5t8l,, NtTTP,
t+C AetTTP
w XD+
+c2+ZNeBDTA
c
(ANetTATPW) x Dt + C4 t5,+)NOL
NOT/pw + C4'(ANOLTr/P,) X Dt
+ c5 ANOLT- I/Pv + C5'(ANOLT- 1/ w) x Dt ? c6 AEt/Pw + c7 AEt1/P,,
+ c8 RetNonEvtt + c9 FutReNt4? c1I0 FutRet8t + c11 RetJOO1,
+ sct
Predicted
Variables' [Coeffiicients] CoefficientSigns Value t-si;tatistiCb
Intercept[co] 0.017 2.75***
D, [cs]l -0.003 -0.24
0.025 0.94
(AEBT(t?l,t+4)IPW) >( D, [C'] + 0.081 1.70**
IP. [C2]
AEBT(,+5,t+8) 0.035 1.36
(AEBT(t+5,t+8)IPW) X Dt[c'] + -0.047 -1.33
A.NetDTATIPW
[C3] -0.188 -1.67*
(ANetDTATIP,,) > Dt [c'] -0.427 1.98**
ANOLTIPw [C4] -0.203 -1.95**
(ANOLTI/Pw)x D, [c'] -0.3 17 -1.81**
(continued on next page)

TABLE 4 (continued)
Predicted
Variablesd [Coefficients] Coefficient Signs Value t-statisticb
ANOLT_i/P [c5] ? 0.010 0.07
(ANOLT_ /Pw) x D, [c5] ? -0.054 -0.18
AE/,P, [c6] + 0.131 1.91**
AE,_/Pw [c7] ? 0.052 1.15
- -0.037 3.65***
RetNonEvt, [c8]
FutRet4, [c] - 0.001 0.03
FutRet8, [c0] - -0.001 -0.22
Retl00, [c1] - 0.023 1.56
Adjusted R2 0.13
Coefficient Sumse Predicted Signs Value t-statisticb
(AEBT(t+,t+4)/Pw) x D, [c, + c']
AEBT(t+,,,+4)/P,, + 0.106 2.54***
AEBT(t+5t+8)/Pw,(AEBT(t+5t+8)/Pw) x D, [c2+cC] + -0.012 -0.58
ANetDTAT/Pw, (ANetDTAT/P) x D, [c3+c3] - -0.615 -3.03***
ANOLT/Pw, (ANOLT/Pw) D, [c4+C4] - -0.520 -3.27***
***, **, * indicatesignificanceat the 1%,5% and 10%levels, respectively,for one-tailedtests wherecoefficient
signs are predicted,and for two-tailedtests otherwise.
a Variablesare as definedin Exhibit 1.
b
All t-statisticsare based on White's(1980) heteroscedasticity-consistent
standarderrors.
c The
pooled sampleconsistsof the 120 VA changedisclosureswith concurrentquarterlyearningsannouncements
in 1994 through1998 (the experimentalgroup),and 323 quarterlyearningsannouncementswith no concurrent
VA changedisclosures(the controlgroup).Nondisclosureobservationsare selected by identifyingfor each ob-
servationin the disclosuresample,the threequarterlyearningsannouncements in the same fiscal yearthatdo not
have a concurrentVA changedisclosure.Thirty-sevenof the maximumpossible 360 nondisclosureobservations
are lost for lack of data.
d D, is coded 1 for the 120 observations for which a changein valuationallowanceis reportedconcurrentlywith
the quarterlyearningsannouncement,and 0 otherwise.All othervariablesare as definedin Exhibit 1. For each
variable,the coefficientson interactionswith D, indicatedifferencesbetweenthe coefficientson thatvariablefor
the experimentaland controlgroups.
e
EBT(t+l,+4)/Pw, (AEBT(,+,,+4)/1P) x D, indicates the sum of the coefficients on AEBT(,+ ,,+4)/Pw and
(AEBT(,+l,+4,)1P) X D, [c1+cl], and estimatesthe coefficienton unexpectedcumulativeEPS beforetaxes over
quarterst+ 1 throught+4 followingeventquartert for the experimentalsample.The coefficientsumAEBT(,,,,,+8
Pw,(AEBT(,+5,+8)IPw)x D, [c2+c2]estimatesthe coefficienton unexpectedt+5 throught+8 cumulativepretax
EPS for the experimental sample. The coefficient sums ANetDTATIPw,(ANetDTAT/Pw)X D, [c3+c3] and ANOL7l
Pw,(ANOLT/P) x D, [c4+C4] estimatecoefficientson unexpectedchangesin net deferredtax assets otherthan
due to NOLs and unexpectedchanges in deferredtax assets due to NOLs, respectively,for the experimental
sample.
these results indicate that investor reassessments of DTA, the likelihood of its realization,
and the availability of future profits for such realization occur through VA disclosures rather
than other unspecified contemporaneous information releases.26
26
As an additionaltest of whetherreturnresponsesto DTA and futureprofitabilityexpectationrevisions are
attributableto VA disclosures,we re-estimateExpression(2) afterincludingAVA,/Pwas an explanatoryvariable.
We find that coefficientson VA changes(AVAI/Pw) are negativeand significant(p < 0.05) but those on future
profitabilityandDTA changemeasuresare not (resultsnot reported).Thus,thereappearsto be little information
aboutDTAandprofitsavailablefor its realizationdisclosedduringthe announcement windowthatis incremental
to the VA disclosure.Thus, announcement-window expectationrevisions about futureprofitabilityand DTA
realizabilitydocumentedin Table4, PanelA appearto be primarilydrivenby VA disclosures.

Robustness Tests to Consider Earnings Management Effects as Alternative

Explanations
Khalaf (1993) and others suggest that managerscan use the discretion available in
setting VA to manage reportedearnings. Incentives for earningsmanagementarise from
effortsto transferwealth among the firm's stakeholders.If VA changes are used to manage
earnings,then securityprice responsesto disclosuresof VA changes can be attributableto
such wealth transfersand not to the informationeffects suggestedin this paper.We address
such concerns(resultsnot reported)by includingin Expression(2) firmcharacteristicsthat
proxyfor earningsmanagementincentives.Priorresearch(see WattsandZimmerman1986)
shows that firms with higher leverage (higherlevels of political visibility) have incentives
to report higher (lower) income. Compensation contracts can provide incentives to manage
earnings upward (downward) in periods of poor (good) performance. To control for such
incentives, we include measures in Expression (2) of firm size, leverage, and a dummy
variable DSMOOTH that is coded 1 when VA changes reduce the volatility of earnings.27
All findings remain robust to including these variables.
VI. SUMMARY AND CONCLUSIONS

SFAS No. 109 brought about a significant change in the accounting for income taxes
by adopting the asset-liability approach. Two key features of the standard are a more liberal
position on the recognition of DTA, and the use of a VA to reduce DTA to the extent that
realization of DTA is uncertain. Although the standardprovides guidance, the determination
of valuation allowances involves considerable managerial judgment. Consequently, the
question arises whether and how VA disclosures are useful to investors. Disclosures can be
useful if managers use value-relevant, non-public information in setting VA allowances and
if such information does not become public prior to the VA disclosures.
This study addresses these questions by examining security price responses to news
disclosures of VA changes. The primary result is that, after considering contemporaneous
earnings announcements, security price reactions to the news reports are negatively asso-
ciated with changes in VA. Thus, public disclosures of VA changes are informative.
Further analysis of the nature of information communicated in such disclosures indi-
cates that market participants revise expectations about DTA, its realizability, and about
future earnings, for up to four quarters following the event quarter.Security price responses
to disclosures suggest that investors understand how managers determine VA under SFAS
No. 109 and objectively value deferred tax VA changes.
The findings of the study indicate, quite convincingly, that VA disclosures provide new
information to investors. Evidence from prior research with respect to this issue is mixed,
and thus inconclusive. By using an event-study approach, the present study offers more
powerful tests and thus stronger evidence than previous studies about the informativeness
of valuation allowances. More generally, the findings are potentially useful for standard-
setting agencies in considering accounting policies and disclosures that rely on the judgment
and discretion of management.
27 Increasesin VA are income-decreasingand potentiallyreduce volatility when earningsbefore VA changes

increase.Decreases in VA are income-increasingand reduce volatility when earningsbefore VA decrease.
DSMOOTHis coded 1 when VA increases(decreases)coincide with earningsincreases(decreases)relativeto
four prior quarters.Firm size is measuredas the naturallog of the marketvalue of equity and leverage is
measuredas the ratio of the book value of total debt to the marketvalue of equity,both at the beginningof
year T.

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The Information Content of the Deferred Tax Valuation Allowance

Author(s): Krishna R. Kumar and Gnanakumar Visvanathan

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The Information Content of the Deferred

Deductibletemporarydifferencestypically arise when taxableincome (expense)leads (lags) pretaxfinancial

We are gratefulto Bill Baber,LindaBamber,ChrisJones,FredLindahl,Jim Patton,Renee Price, and two anon-

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temporarydifferencesres verse, or before tax losses or tax creditsexpire. The availabilityof

The Accounting Review, April 2003

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II. BACKGROUNDAND SECURITY PRICE IMPLICATIONSOF

III. SAMPLE SELECTION

The Accounting Review, April 2003

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IV. MODEL DEVELOPMENT AND EMPIRICAL SPECIFICATIONS

CARt = aO + a, AVA,/P_ + a2AEt,/Ph + a3 E,_lIPP + a4 Ret1OO,+ f,t (1)

9 We use Belsley et al.'s (1980) dffitsstatisticsto identifyoutliers.

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Panel A: Sample Selection

Panel B: Industry Distribution

The Accounting Review, April 2003

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The Accounting Review, April 2003

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CARt = the three-day cumulative, value-weighted, market-model residual

The Accounting Review, April 2003

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What Do Investors Learn from VA Disclosures?

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The Accounting Review, April 2003

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CARt = co + co Dt + cl AEBT(t+lt+4)/IPW+ c;(AEBT(t+1,+4)/Pw) X Dt

Coefficientsums (ca + cl) [(c2 + c')] reflect marketresponsesto expectationrevisions

The Accounting Review, April 2003

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Are VA Changes Informative?

The Accounting Review, April 2003

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The Accounting Review, April 2003

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Model 1: CAR, = ao + a, AVA,tP, + a2 AE,/Pw + a3 AEt,_/Pw + a4 RetlO0, + Eat

Model IA: CAR = aO + a' D, + a' AVA,/P, + a;(AVA,/IP) x D, + a' AEt,/P

***, **, * indicatesignificanceat the 1 percent,5 percent,and 10 percentlevels, respectively,for one-tailedtests

The Accounting Review, April 2003

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Results are robust to the use of alternativeunexpectedearningsproxies, winsorizing

The Accounting Review, April 2003

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Panel A: Quarterly Earnings Announcements with VA Disclosures (experimental group) (n = 120)

Model 3: CARE= co+ C'oDt +CIAEB1(t+l,t+4) IPW + CI'(AEBT(t+l,t+4) IP.) X Dt

(continued on next page)

The Accounting Review, April 2003

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The Accounting Review, April 2003

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Robustness Tests to Consider Earnings Management Effects as Alternative

VI. SUMMARY AND CONCLUSIONS

, , indicatesignificanceat the 1 percent,5 percent,and 10 percentlevels, respectively,for one-tailedtests