The valuation allowance for deferred tax assets and stock price crash risk

Abstract

Using a large sample of U.S. firms from 1994 to 2023, we provide strong and robust evidence that the reporting of a valuation allowance for deferred tax assets is negatively associated with future stock price crash risk. This finding suggests that the valuation allowance conveys a timely signal of a firm’s deteriorating expected future performance. Additionally, the negative association is more pronounced for firms in opaque information environments, where the valuation allowance is perceived as more credible. In contrast, the effect is weaker for firms facing higher tax-related uncertainty, as their valuation allowance adjustments may reflect aggressive tax strategies that could increase future firm-specific risk. Overall, our results are consistent with the notion that valuation allowances provide a valuable, timely signal of a firm’s expected future underperformance, which, in turn, reduces stock price crash risk.