How Firms Avoid Losses: Evidence of Use of the Net Deferred Tax Asset Account
David Burgstahler* University of Washington Gerhard G. Mueller Endowed Professor in Accounting

W. Brooke Elliott University of Washington Michelle Hanlon University of Michigan Business School
November 26, 2002

_________________________________________________________________________________ ABSTRACT: This paper investigates whether firms use discretion in accounting for deferred taxes to increase earnings and avoid reporting a loss. We find that firm-years with small scaled profits reduce (relative to the prior year) the proportion of the gross deferred tax asset reserved by the valuation allowance more than firm-years with small scaled losses. We find no evidence that the firm-years that have seemingly moved from having a small scaled loss to a small scaled profit using changes in the net deferred tax asset have greater expected future taxable income to support this change under SFAS 109. Our results also suggest that firms that increase earnings through the net deferred tax asset have relatively lower costs to managing earnings to avoid a loss, that is, these firms have a smaller pre-managed loss. ______________________________________________________________________________

*Corresponding author: David Burgstahler, (206) 543-6316, dburg@u.washington.edu.
We are grateful for helpful comments from Bob Bowen, Frank Hodge, Kathryn Kadous, Shiva Rajgopal and Terry Shevlin and workshop participants at the University of Washington and the 2002 UBCOW conference. We would also like to thank Corey Murata for his assistance in the data collection process.

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Introduction Since its introduction in 1992, Statement of Financial Accounting Standard No. 109

Accounting for Income Taxes (SFAS 109) has been controversial. Unlike previous statements, e.g., SFAS No. 96 and Accounting