Discretion in the Deferred Tax Valuation Allowance and Its Impact on Firms' Dividend Payouts

Prior studies document that firms manage earnings by exercising discretion in valuing deferred tax assets. Drawing from a hand-collected sample of more than 10,000 firm-year observations of Japanese listed firms, we extend the literature by focusing on dividend policy as a motive to manage earnings. If reported earnings are central to determining dividends, managers have incentives to manage earnings upward to avoid dividend cuts. Therefore, we test whether and how firms exercise discretion in valuation allowance account for deferred tax assets in order to manage earnings. We find that discretionary changes in the valuation allowance are related to dividends, particularly among firms that favor increased and stable dividends. We also find that firms likely establish lower valuation allowance when pre-managed earnings and distributable profits fall short of levels needed to maintain dividends. We provide new evidence of dividend-based earnings management and the economic consequences of using managerial estimates as measurement inputs.