The Deferred Tax Asset Valuation Allowance and Firm Creditworthiness

Edwards (2018) studies how the valuation allowance for deferred tax assets predicts evaluations of firm credit risk. The valuation allowance is a contra-asset account to deferred tax assets. The valuation allowance therefore reduces the book value of deferred tax assets that have a more-likely-than-not chance of not being realized. Since managers determine the amount of the valuation allowance (subject to external audit), the valuation allowance reflects management's expectation that there is a more-likely-than-not probability that the firm will lack future taxable income that would be offset by the deferred tax assets; therefore, its deferred tax assets will not be usable. In this way, the valuation allowance contains information about management's expectations of future taxable income, or lack thereof. To the extent that taxable income contains information about future economic income, the valuation allowance may be an informative signal to debt market participants. Specifically, Edwards (2018) predicts that increases in the...