According to ASC 740-10 (formerly SFAS No. 109), deferred tax assets and liabilities are recognized for the estimated future tax effects of events that have been recognized differently in a firm’s financial statements than in its tax returns. Specifically, deferred tax liabilities (DTL) are recognized for temporary differences between book value and tax basis of assets and liabilities, which will result in taxable amounts in future years. Deferred tax assets (DTA) are recognized for temporary differences that will result in tax deductible amounts in future years as well as for tax loss and tax credit carryforwards. Hence, deferred taxes are supposed to inform about future tax payments. Yet, it is not clear to what extent recognized deferred tax balances are actually related to future tax payments.
Critics argue that the informative value of deferred taxes is only low due to highly uncertain cash flow implications. Specifically, it is argued that the major part of deferred taxes is not expected to be realized in the near future as a consequence of arising from operating and, therefore, periodically recurring activities, which results in an effectively permanent deferral of the associated tax cash flow.59 Lacking relevance of deferred tax information as a consequence of lacking cash flow implications would challenge the usefulness of deferred tax accounting, which is routinely named by accountants as one of the most complex and costly provisions to comply with.60
Although the tax cash flow implications of deferred taxes are crucial for the value and decision relevance of deferred taxes, research directly addressing the cash flow implications of deferred taxes is scarce. Instead, research focuses on whether financial statement users consider deferred taxes in their decision making process, thereby implicitly deducing (by financial statement users presumed) cash flow relevance from decision relevance. Regarding analysts and lenders, empirical as well as anecdotal evidence concludes that these do not consider deferred tax information in their decision making process (see Chen and Schoderbek 2000, Amir and Sougiannis 1999, and Chattopadhyay et al. 1997 for empirical and Beechy 2007, Carnahan and Novack 2002, and Cheung et al. 1997 for anecdotal evidence), which implies no relevant (information about) deferred tax cash flows.
59 See Beechy (2007), Colley et al. (2009), or Johnson (2010).
60 The relatively high costs arise due to the fact that accounting for deferred taxes is complex and requires a high level of coordination. It is necessary, for instance, to prepare the tax report within a narrow time frame and to assess the future realizability of deferred tax assets. The latter includes, among other things, estimating future taxable income. Moreover, it is necessary to determine the expected manner of recovery/settlement if the manner of recovery/settlement affects the applicable tax rate. Accordingly, accountants name deferred tax allocation as one of the most complex and costly provisions to comply with, so that there is an ongoing controversy about whether there is adequate benefit that justifies the high accounting costs involved.
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With respect to deferred tax consideration by investors (value relevance studies), empirical results are mixed. While early studies, based on the first fiscal years after implementation of SFAS No. 109, find significant valuation coefficients of deferred taxes (Amir et al. 1997 and Ayers 1998), more recent studies based on US GAAP-data (Raedy et al.
2011) as well as studies based on non-US GAAP-data (Citron 2001, Chang et al. 2009, and Chludek 2011) find no consistent evidence for value relevance.
Research directly addressing the relation of deferred taxes and future tax payments is scarce, however, so that there is hardly any evidence on (a) the actual relation of deferred taxes and tax cash flow and (b) whether the required method of accounting for deferred taxes is informative about future tax cash flows. Cheung et al. (1997) report that deferred tax information improves the prediction of one-period-ahead tax payments by decreasing the mean absolute percentage error (MAPE) of their forecasts by roughly 2.78 percent. Moreover, they report that deferred tax information reduces average forecast error of forecasting operating cash flow for 16 of 30 industries. Yet, the study has several shortcomings concerning data, estimation method, and variables.61
Using the actual U.S. tax liability as it is reported on the corporate tax return Form 1120, Lisowsky (2009) finds that deferred tax expense is not related to the actual U.S. tax liability.
In contrast to these two studies, which basically analyze the relation of deferred tax expense and tax payments, Legoria and Sellers (2005) focus in cross-sectional regression analyses on the effect of deferred taxes on operating cash flow of up to four periods ahead.
Inclusion of deferred tax balance information increases the explanatory power of their model, as measured by adjusted R-squared, by 0.49 to 1.42 percentage points. They report a significantly positive (negative) relation of deferred tax assets (the valuation allowance for deferred tax assets) and future operating cash flow. The effect of the valuation allowance, however, is dominating. Moreover, deferred tax liabilities show an unexpectedly significantly positive coefficient estimate in their basic model specification, which becomes insignificant
61 First, by using data of years 1975 to 1994, their sample covers a period when a total of three different accounting standards on deferred taxes were in force – APB No. 11, SFAS No. 96, and SFAS No. 109 –, which might cause some inconsistency in the data. Second, Cheung et al. (1997) do not comment at all on the estimation method used to estimate their dynamic panel models, for which estimation issues might arise easily, possibly biasing their results. Third, by including either deferred tax expense or the annual change in noncurrent deferred tax liabilities in their models, they only take into account changes in deferred tax balances, thus ignoring significant parts of deferred tax information. Because of the high degree of aggregation in their deferred tax variables, they can neither distinguish between deferred tax expense due to reversing versus growing accounts, nor between possible asymmetric effects of deferred tax assets versus deferred tax liabilities, nor do they investigate the long-term information embedded in deferred tax balances, which should be of most interest
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as soon as other financial statement information is controlled for. Hence, their findings rather suggest a future performance indicating effect of deferred taxes (this is, deferred taxes anticipating future firm performance via underlying assets and recognition constraints), than a tax cash flow effect.62
This study, by contrast, has the advantage that it uses a direct measure, to assess the relation of deferred taxes on future tax payments, by focusing on the implications of recognized deferred tax balances for (future) cash taxes paid. Furthermore, I am able to analyze a considerably longer time-period than most prior studies. Time-series data of up to 16 observation years allow to estimate models by firm, which is very important, since deferred tax composition, reversal behavior and, therefore, translation into tax cash flow may be very firm-specific. Moreover, the long time-series enable to assess whether deferred tax balances contain long-term information about future tax payments.
62 A significant relation between deferred taxes and future operating cash flow does not necessarily have to stem from tax cash flow. Instead, deferred taxes may be related to future cash flow via underlying assets and recognition constraints. On the one hand, deferred taxes increase in their underlying assets. To the extent that growing operating assets produce higher operating cash flow, deferred taxes are positively related to future operating cash flow via the underlying assets, if other factors are not controlled for. In line, Legoria and Sellers (2005) report a significantly positive coefficient estimate also for deferred tax liabilities, which contradicts the tax effect and which becomes insignificant as soon as other financial statement information is controlled for.
On the other hand, deferred tax assets are reduced by a valuation allowance to the amount that is more likely than not to be realized. Thus, a ceteris paribus larger deferred tax asset balance (larger valuation allowance) suggests management expectations of higher (lower) taxable income, so that deferred tax assets (the valuation allowance) may be positively (negatively) related to future operating cash flow because of anticipating improved (decreased) future firm performance, instead of being related via lower (higher) tax payments. In particular the finding of a dominating influence of the valuation allowance by Legoria and Sellers (2005) may be a hint that their model rather captures performance indicating effects than tax cash flow effects of deferred taxes. Empirical results by Gordon and Joos (2004), showing that basically only changes in unrecognized deferred taxes are significantly related to future firm performance, while changes in recognized deferred taxes are largely insignificant, suggest a dominance of the performance over the tax effect on total cash flow.
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