Earnings Management and its Pricing Implications : Evidence from Banks' Adjustments to the Valuation Allowance for Deferred Tax Assets Under SFAS 109

SFAS 109, Accounting for income taxes, was criticized for allowing firms to set arbitrarily high valuation allowances against deferred tax assets at adoption as quot;hidden reservesquot; that firms could use in future periods to manage earnings. Consistent with these claims, bank managers make discretionary decreases in the valuation allowance, which represents an increase in earnings, when earnings before adjustment are below the consensus analyst forecast. The magnitude of the discretionary adjustment increases in the deviation from forecast. Abnormal returns around the 10-K filing date suggest that the market attributes value to these discretionary earnings even though they presumably have no direct cash flow implications. However, additional tests indicate that the association between returns and discretionary changes in the valuation allowance are related to reductions in earnings volatility which provide indirect, but real, cash flow benefits in the regulated banking industry