Earnings Management Using the Valuation Allowance for Deferred Tax Assets under SFAS No. 109*

TLDR

SFAS 109 permits firms to set discretionary valuation allowances on deferred tax assets, which can later be used as hidden reserves to manage earnings. Our study finds that most banks record valuation allowances in line with SFAS 109 rather than for earnings management; however, well‑capitalized banks raise allowances with capital and subsequently adjust them to smooth earnings, with adjustment size linked to deviations between unadjusted earnings and forecasts.

Abstract

109) allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS No. 109. However, if the bank is sufficiently well capitalized to absorb the current‐period impact on capital, then the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.