Investors’ Sophistication in Identifying the Earnings Management Using the Valuation Allowance for Deferred Tax Assets

A valuation allowance for deferred tax assets (VA) must be disclosed if managers expect that future taxable income will be insufficient for the realization of deferred tax assets. Prior studies find that VA conveys timely new information relevant to stock prices, but it can be manipulated to manage earnings. Consistent with prior studies, investors quickly response to disclosures of VA. However, value-relevant information in VA for non-earnings management firms significantly links to the market before the disclosures. Therefore,investors do not significantly respond to the VA changes of non-earnings management firms. On the other hand, investors mechanically respond to VA changes of likely earnings management firms. These empirical results suggest that investors are not sophisticated enough to recognize earnings management implications of VA. However, investors are likely to adjust the earnings management implications through VA changes of earnings management firms in recent years. These findings of this study provide accounting setters and regulators with insight into how managers use the flexibility in financial reporting when generating forwardlooking information and how investors use such information.