Analysts' Interpretation and Investors' Valuation of Tax Carryforwards*


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    Accepted by Dan Thornton. This paper was presented at the 1997 Contemporary Accounting Research Conference, generously supported by: the CGA-Canada Research Foundation, the Canadian Institute of Chartered Accountants, CGA-Ontario, the Society of Management Accountants of Ontario, and the Ernst & Young Foundation. We are grateful to International Brokers Estimate System (IBES) for providing analysts' earnings forecasts. We thank two anonymous reviewers, Robert Freeman. Tom Lys, Dan Thornton, and seminar participants at Harvard University. University of Michigan. University of Pennsylvania (Wharton), Washington University at St. Louis, the 1997 Contemporary Accounting Research (CAR) Conference (Toronto), and the Eighth Annual Conference on Financial Economics and Accounting (Buffalo) for helpful comments.


We examine how financial analysts and equity investors incorporate information on deferred taxes from carryforwards into earnings forecasts and share prices. We focus on carryforwards because, in providing this information each period, management must use their private information about the firm's profitability prospects. Thus, accounting measurement of tax carryforwards is another way of providing a management earnings forecast. In analyzing the role of carryforwards in valuation, we distinguish between two conflicting effects. First, deferred taxes from carryforwards represent future tax savings; hence, they should be valued positively as assets. In contrast, the existence of tax carryforwards may signal a higher likelihood of future losses, which would have a negative effect on expected earnings and share prices. We find that analysts consider earnings of firms with carryforwards to be less persistent because of the increased likelihood of future losses. We also find that analysts tend to be less precise and more optimistic (biased) in forecasting earnings of firms with carryforwards. This higher optimism and lower precision are more pronounced just after firms adopt Statement of Financial Accounting Standards (SPAS) 109 and are almost entirely corrected over time. An analysis of investors' valuation indicates a strong positive relation between deferred taxes from carryforwards and share prices, suggesting that these carryforwards are valued as assets. Also, earnings and book values of equity are valued less in firms that have carryforwards than in firms without carryforwards. Finally, the valuation allowance required under SFAS 109 assists equity investors in valuing a firm's earnings and net assets. The combined findings on analysts' interpretation and investors' valuation suggest that analysts fail to fully capture the implication of carryforwards on future earnings within their forecasting horizon.