IFRS and US GAAP follow the liability view by classifying deferred tax liabilities (deferred tax assets) as liabilities (assets).30 According to IAS 12.5, deferred tax liabilities (deferred tax assets) account for the amounts of income taxes payable (recoverable) in future periods that arise from temporary book-tax differences, i.e., differences between the book value of an asset or a liability and its tax base that will result in taxable (tax deductible) amounts when the book value of the liability (asset) is settled (recovered).31 Deferred tax liabilities arise, for example, from accelerated tax depreciation or from financially recorded income that has not yet been taxed. Deferred tax assets are recognized for the probably realizable tax benefits of tax loss carryforwards and arise, for example, from provisions for warranty costs or bad debts, which are already expensed for book purposes, but which are not tax deductible until the provision is utilized.
Critics of the liability view argue that, for one thing, 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, so that single reversing temporary differences are offset by newly created temporary differences in the same fiscal year, in sum deferring the reversal of the aggregate temporary differences and the associated tax cash flow indefinitely.
For another thing, uncertainty does not only exist concerning the timing of the associated tax cash flow, but also concerning the realizability of implied tax payments and tax benefits, since realization of these cash flows depends on the firm’s development and future operations.32 Particularly, if large parts of temporary differences reverse due to ceasing recurring operating
30 Deferred tax accounting is very similar under IFRS/IAS (IAS 12) and under US GAAP (SFAS No. 109).
Differences concern, for instance, reporting requirements like the disclosure of the valuation allowance and the extent to which deferred taxes are allowed to be included in other positions on the balance sheet.
31 Deferred tax accounting is an outcome of the matching principle, aiming at recognizing the tax consequences of an item reported within the financial statements in the same accounting period as the item itself.
32 This applies primarily to deferred tax liabilities, since deferred tax assets are only recognized to the extent that their associated benefits are “probable” (IAS 12.24, 12.27) to be realized. Yet, “probable” amounts can only be estimates, therefore containing uncertainty per definitionem. Besides, firms have an incentive to defer a downwards adjustment of their deferred tax assets in case of decreasing realization probability because such an
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activities, the firm will most likely be in severe financial difficulties, with the consequence that accruing tax benefits (tax liabilities) cannot be used (paid) because of lacking taxable income (cash inflow), such that deferred tax cash flow will not be realized even in case of reversing temporary differences. For these reasons, proponents of the equity view argue that deferred taxes account principally for distant and – in several dimensions – uncertain cash flows, being of no or only little relevance for the amount of tax payments in the next years, the associated cash flows having a present value that is close to zero. Therefore, deferred taxes are effectively part of equity according to this view.
Empirical evidence on whether financial statement users take deferred tax information into account is rather inconclusive. Using similar data,33 Amir et al. (1997) and Ayers (1998) provide evidence consistent with the liability view and the market discounting deferred tax components according to their expected time and likelihood of reversal, while Chang et al.
(2009), using Australian data, find only deferred tax assets to be value relevant. By contrast, Chandra and Ro (1997) provide evidence consistent with the equity view by showing that deferred taxes and stock risk are related negatively. Chen and Schoderbek (2000) report that deferred tax adjustments as a consequence of a change in the corporate tax rate were reflected in share prices at the same rate as recurring earnings, despite their different implications for future cash flows.34 Apparently, investors did not expect the income effects due to tax rate change-induced deferred tax adjustments, which suggests either that investors are not familiar with deferred tax accounting rules, the concept of deferred taxes, or that they ignore deferred taxes altogether.35 Consistent with the latter, Lev and Nissim (2004) find no significant relation between deferred tax expense and annual returns, which suggests that investors do not consider deferred taxes to be relevant.
Regarding other financial statement users, Amir and Sougiannis (1999) and Chen and Schoderbek (2000) report empirical evidence of financial analysts not including deferred tax information in their earnings forecasts. Likewise, several empirical studies report that deferred
33 Amir et al. (1997) use data of Fortune 500 companies, years 1992 to 1994, and Ayers (1998) uses data of NYSE and AMEX firms, years 1992 and 1993.
34 Deferred taxes are calculated by multiplying the temporary difference (the difference between book value and tax base) with the tax rate that is expected to apply at the time of its reversal. Since future tax rates are not known, current tax rates are used with the consequence that deferred tax balances have to be adjusted as soon as changes in income tax rates are enacted (IAS 12.47–49 and SFAS No. 109, para. 27). To the extent that the recognition of these deferred taxes was included in net income, the adjustments flow through income, too.
35 Amir et al. (1997), as well as Weber (2009), suggest that lacking consideration of disclosed (deferred) tax information may be due to its complexity. In line with Plumlee’s (2003) finding of market participants being less likely to incorporate complex information due to either inability or cost-benefit considerations, Chen and Schoderbek (2000) attribute their finding to investors possibly rationally deciding to not become informed of specific accounting rules based on cost-benefit considerations and/or considering estimation of the tax adjustments not cost-beneficial.
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taxes are not reflected in bond ratings (see Huss and Zhao 1991, Chattopadhyay et al. 1997).
In line, a German survey study by Haller et al. (2008) reports that the vast majority of their interviewees (59 employees of 32 credit institutions, who work in the area of credit analysis and scoring of medium-sized enterprises) declared to add deferred tax assets back to equity because of doubtful value.36
Reviewing the literature reveals that empirical evidence concerning the use and interpretation of disclosed deferred tax information is rather inconclusive. While some studies focusing on investors find evidence supportive of the liability view, others do not. Moreover, some of these studies have econometric issues, not properly controlling for serial correlation and possible correlated omitted variable bias, as indicated by unexpectedly high deferred tax coefficients. Furthermore, these studies are largely based on similar data, such that significant findings might be driven by observations of the implementation year of SFAS No. 109, 1992.37 Studies examining the use of deferred tax information by other financial statement users – lenders, bond raters, and financial analysts – suggest that those typically ignore deferred taxes in their decision-making process and eventually reverse out the inter-period tax allocation by adding deferred taxes back to equity and earnings, respectively.
36 See also Chaney and Jeter (1989), Carnahan and Novack (2002), and Beechy (2007), who report anecdotal evidence suggesting that banks and other lenders, as well as credit and financial analysts, routinely reverse out the impact of inter-period tax allocation, adding deferred tax expense back to net income and treating deferred tax balances as equity.
37 Besides, many companies include under U.S. GAAP at least part of their deferred taxes in other balance sheet positions like other (current) assets, other (current) liabilities, accrued liabilities, or even in income taxes payable. If investors do not check the notes for deferred tax information, deferred taxes might be included automatically in firm value, although they are not deliberately considered by investors as future tax benefits and
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