This study utilizes a sample comprised of Fortune 500 firms to examine earnings management via changes in the deferred tax asset valuation allowance. The study extends existing research in three ways. First, we document that the earnings effect of a valuation allowance change often cannot be determined from financial statement disclosures. Based on an analysis of sample firms' income tax footnotes, we offer suggestions to improve disclosure policy. Second, prior research uses the net change in the valuation allowance account as a proxy for the earnings effect of valuation allowance changes. We argue that the amount reported in the effective tax rate reconciliation is a better measure of the income statement effect and document certain significant differences between the measures. Third, prior research employs cross-sectional regression models in an effort to make generalizations about earnings management behavior. In contrast, we use a contextual approach to assess whether observed valuation allowance changes are consistent with different motivations for earnings manipulation. The contextual analyses are based on identifying firms in the position to engage in various forms of earnings management and examining the earnings effect of valuation allowance changes made by firm managers. Cross-sectional tests find virtually no evidence in support of earnings management. Of particular note, we find that the incidence of “big bath” behavior may be exaggerated. In contrast, a contextual approach identifies specific instances in which earnings management may exist. Thus, the analysis of valuation allowance changes is contextual and requires careful consideration of activity in the allowance account. This point underscores the deficiency in income tax reporting and the need for increased disclosure in this area.

If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service information about how to choose which publication to write for and submission guidelines are available for all. Please visit www.emeraldinsight.com/authors for more information. About Emerald www.emeraldinsight.comEmerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online products and additional customer resources and services.Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation. AbstractPurpose -The purpose of this study is to re-examine the relation between changes in profit margin (⌬PM) and changes in return on net operating assets (⌬RNOA) by partitioning on the direction of the change in PM. DuPont analysis provides a means of disaggregating a firm's return on net operating assets (RNOA) into asset turnover (ATO) and profit margin (PM) components to gain insights into the underlying drivers of operating profitability. Prior research finds that changes in ATO are informative about one-year-ahead changes in RNOA, while changes in PM are not. Design/methodology/approach -Consistent with prior research, regression analysis is used to develop a predictive model for one-year-ahead changes in RNOA. Results based on in-sample parameter estimates are used to examine the out-of-sample forecasting accuracy of alternative model specifications.Findings -The results are consistent with significant forecast improvement resulting from considering the impact on future RNOA of the direction of the ⌬PM. Originality/value -The study contributes to the literature on the determinants of profitability ratios by providing further guidance on how financial statement information can be utilized to improve forecasts of firm performance.

This paper reports the results of a study of the financial reporting effects of off-balance-sheet activities concealed by the equity method of accounting. The study examines footnote disclosures relating to equity method investees, offers suggestions for improving the usefulness of those disclosures, and estimates the valuation effects of information in the disclosures. An important empirical finding is that the market places significant negative values on investor-guaranteed off-balance-sheet obligations.

One role of stock options in executive compensation packages is to counterbalance the inherently short-term orientation of base salary and annual bonuses. Managerial compensation plans frequently include stock options in order to better align the interests of managers and outside shareholders and reduce agency problems. However, since option values are sensitive to fluctuations in stock prices, and investors reward firms that meet or exceed earnings expectations, executives of firms with sizable option components in their compensation plans have increased incentives to report earnings that meet or exceed analysts' forecasts. We show that the propensity to meet or exceed analysts' quarterly earnings forecasts is positively related to the use of options in top executives' compensation plans. Further, firms that employ relatively more options in their compensation plans more frequently report earnings surprises that exceed analysts' forecast by small amounts (between 0 and 1 cent per share). These results suggest that the use of stock-based compensation intensifies top executives' focus on financial analysts' short-term earnings forecasts. Copyright Springer Science + Business Media, Inc. 2006

Under current accounting rules, U.S. multinationals are not required to record liabilities for future taxes on earnings of foreign subsidiaries, as long as those earnings are deemed to be indefinitely reinvested in those subsidiaries. These rules allow considerable flexibility in the designation of earnings deemed permanently reinvested and the reporting of expected repatriation taxes thereon. Some firms disclose amounts for unrecorded taxes on permanently reinvested earnings, but most do not. We show that while estimated repatriation taxes are relevant in explaining share prices of non-disclosing firms, they are less relevant than firm-disclosed amounts are in explaining share prices of disclosing firms. This result is due to estimated repatriation tax amounts exhibiting downward bias, and less accuracy for actual repatriation tax effects, relative to firm-disclosed repatriation tax amounts. We propose new disclosures designed to improve the relevance of estimated repatriation tax amounts.