Changes in Unrecognised Deferred Tax Accruals from Carry‐Forward Losses: Earnings Management or Signalling?

Abstract

This paper examines how managers elect to use their discretion over the amount of unrecognised tax assets from carry-forward losses that is available under the income statement method specified in "AASB1020" 'Accounting for Income Taxes'. Specifically, we consider whether changes in the amount of unrecognised deferred tax assets from carry-forward losses, reflect managers' incentives to opportunistically manage earnings, or communicate private information about future profitability (i.e., signalling). Using data from firms listed on the Australian Stock Exchange during the period 1999 to 2005, we find evidence consistent with income-increasing earnings management when pre-tax earnings are below the median analyst forecast. Interestingly, we find that the potential existence of earnings management does not reduce the capacity of changes in unrecognised deferred tax assets from carry-forward losses to predict one-year-ahead performance, and to a much lesser extent, three-year ahead performance. This result highlights the complexity of managers' incentives in trading-off between managing earnings toward a desired target and communicating useful information to market participants. Copyright (c) 2010 Blackwell Publishing Ltd.

Market's perception of deferred tax accruals

“…This is consistent with the findings ofHerbohn et al (2008). They find that managers use unrecognized deferred tax assets due to losses to manage earnings upward when pretax earnings are below the median analyst forecast and historical earnings levels.…”

The Market Response to Beating After‐tax Earnings Targets Revisited using Analysts’ Pre‐tax Earnings Forecasts and Concurrent Tax Note Disclosures

“…Using the rationale of Laux (2013), these tax deferrals are likely to be informative since they are included in GAAP income prior to taxable income. In particular, recognition of these assets may convey information about the quality of reported earnings (Herbohn et al, 2010), 7 or provide a signal of future profitability to the market (Amir and Sougiannis, 1999;De Waegenaere et al, 2003;Zeng, 2003;Chang et al, 2009).…”

“…12 The "achieve pre-tax" firms provide market participants with mixed signals about future profitability. They achieve before-tax earnings forecasts, but fail to achieve 11 Illustrating the duality of deferred tax accruals from carry-forward tax losses, Herbohn et al (2010) find that the opportunistic management of unrecognised deferred tax assets (losses) to achieve analysts' after-tax earnings forecasts, does not impact the ability of managers to signal expectations about future profitability. 12 It should be noted that Graham et al (2012) caution against accepting evidence on the pricing of deferred tax accruals drawn from price-level studies because of potential methodological issues highlighted in Holthausen and Watts (2001). after-tax earnings forecasts which may be interpreted as symptomatic of hidden issues within these firms (Graham et al, 2005).…”

“…Thus, managers were able to exercise judgement in applying this criterion. There is evidence that the recognition criteria of AASB1020 are not meaningfully different in practice from the recognition criterion of AASB112 (Herbohn et al., ).…”

“…Illustrating the duality of deferred tax accruals from carry‐forward tax losses, Herbohn et al. () find that the opportunistic management of unrecognised deferred tax assets (losses) to achieve analysts’ after‐tax earnings forecasts, does not impact the ability of managers to signal expectations about future profitability.…”