Comprehensive versus partial deferred tax liabilities and equity market values
We acknowledge the helpful comments and suggestions from an anonymous reviewer, Steven Cahan, Andrew Christie, Dan Dhaliwal, David Emanuel, Debra Jeter, Phil Shane, Alan Teixeira and participants at the 2009 Auckland Regional Accounting Conference. We also thank Jennifer Ho for her research assistance.
Abstract
This study investigates the value relevance of the deferred tax liability recognized using comprehensive versus partial allocation. Our research examines New Zealand firms who, prior to the introduction of International Financial Reporting Standards, were free to choose between comprehensive and partial allocation. We test the joint hypothesis that the partial, as opposed to comprehensive, deferred tax liability is relevant for equity valuation and is sufficiently reliable to be reflected in investors’ valuation assessments. Our results are consistent with this prediction.
1. Introduction
The method for recognizing the deferred tax liability (DTL) has been subject to much debate in the accounting literature. The debate is whether the DTL should be recognized using comprehensive allocation, where the tax effect of all timing differences is recognized, or partial allocation, where the tax effect of timing differences that reverse in the relatively short run is recognized. The matching argument, where the income tax expense is matched against revenues, is used to justify comprehensive allocation on the grounds that this principle requires a complete matching of expenses and revenues. The argument against comprehensive allocation is that all timing differences do not reverse and their tax effect does not result in a payment of the DTL. As a result, comprehensive allocation does not report a DTL that reflects the future cash outflows to the tax authority. On the other hand, partial allocation would recognize only that portion or part of the comprehensive tax liability that results in future cash outflows to the tax authority.
This study investigates the vexing issue of the recognition and value relevance of the DTL. Studies that track the long-term behaviour of companies’ deferred tax liabilities indicate that a sizeable portion of these liabilities does not result in future tax payments (Davidson, 1958; Davidson et al., 1977; Wise, 1980, 1986; Beechy, 1983). Davidson (1958, p. 180) attributes this to the growing investment in fixed assets where ‘the firm can look forward to an ever-increasing annual tax saving continuing year after year’. Similarly, Livingstone (1967) indicates that a long-term trend of fixed asset expenditures would prevent repayment of the DTL. A growing investment in fixed assets generates recurring depreciation timing differences such that the related DTL is not settled in the foreseeable future. Commentators have argued that reporting the DTL under such circumstances would be inconsistent with the notion of a liability (Chaney and Jeter, 1989; Wolk et al., 2001).
In spite of these concerns, most countries require firms to recognize the tax effect of all timing differences in their DTL, that is, a prescription to adopt the comprehensive allocation procedure. However, some countries do not have this single method prescription. Prior to their adoption of International Financial Reporting Standards (IFRS) that prescribe the comprehensive allocation procedure, accounting standard setters in the United Kingdom required partial allocation only (Gordon and Joos, 2004), while New Zealand firms had a choice between comprehensive and partial allocation (Wong, 2005).
In comparing the two procedures, comprehensive allocation recognizes the tax effect of all timing differences, while partial allocation recognizes the tax effect of only those timing differences that will result in a future tax payment in the foreseeable future. The former method generally reduces earnings and increases the DTL,1 while the latter method increases earnings and reduces the DTL. For the partial allocation method, the tax effect of the unrecognized timing differences and the associated unrecognized deferred tax liability (DTLU) are disclosed in the notes to the financial statements. This disclosure enables a reader to convert the partial deferred tax liability (DTLP) to the comprehensive deferred tax liability (DTLC) by adding the DTLU disclosed in the notes to the DTLP recognized on the balance sheet.
Capital market studies by Beaver and Dukes (1972) and Ayers (1998) indicate the value relevance of deferred tax liabilities without distinguishing between comprehensive and partial deferred tax liabilities. This distinction was first explored by Chaney and Jeter (1989) who report a weaker negative association between security returns and the deferred tax component of earnings for larger amounts of recurring differences in the deferred tax make-up. They conclude (p. 11) that the result is ‘consistent with the theory that deferred taxes which arise from predictably recurring items provide little or no information to the market’. Givoly and Hayn (1992) provide evidence consistent with Chaney and Jeter (1989) that investors discount deferred tax liabilities according to the timing and likelihood of their settlement. They conclude that ‘For accounting rule-making bodies, the results indicate that deferred taxes, arising from comprehensive interperiod tax allocation, are being transformed by investors into a value that appears to be consistent with the notion of partial allocation’ (Givoly and Hayn, 1992, p. 406).
The UK Accounting Standards Board’s (1985) SSAP No. 15 Accounting for Deferred Taxation prescription for partial allocation provided a setting for Citron (2001) and Lynn et al. (2008) to test the value relevance of the recognized DTLP and the unrecognized note-disclosed DTLU. Citron (2001) uses data from 1989 to 1991 and finds value relevance only for the recognized DTLP, thereby supporting partial allocation, while Lynn et al. (2008) use data from 1993 to 1998 and find both components of the DTL, the recognized DTLP and the unrecognized note-disclosed DTLU, value relevant, thereby supporting comprehensive allocation.
A recent Australian study by Chang et al. (2009) indicates that deferred tax liabilities arising from recurring timing differences ‘are not viewed as liabilities by market participants’ (p. 666). Using a more powerful test for ‘loss-making, tax-consolidating firms’ (p. 666), which proxy for the increased likelihood of paying the deferred tax liabilities, the market perceives such deferred tax liabilities as financial liabilities because they are likely to reverse in the future.
Our study extends the aforementioned research by examining the market’s response to comprehensive versus partial deferred tax liabilities of New Zealand firms who could report comprehensive or partial deferred tax liabilities, thereby giving us cleaner data to examine the market’s perception of deferred tax liabilities. Our study is over the 2000 to 2004 period, which is prior to the adoption of IFRS when New Zealand GAAP under SSAP-12 (Revised) Accounting for Interperiod Allocation of Income Tax allowed firms to choose either comprehensive or partial tax allocation (Wong, 2005). This setting provides an ideal opportunity to investigate whether investors value the DTL under comprehensive or partial allocation.
The approach in our study contrasts with (i) Givoly and Hayn (1992) who infer the market’s preference for partial allocation from US firms’ use of comprehensive allocation, (ii) Citron (2001) and Lynn et al. (2008) who examine value relevance in the UK partial allocation regime and (iii) Chang et al. (2009) who use a subsample of ‘loss-making and tax consolidating firms’ (p. 666) to proxy for nonrecurring deferred tax liabilities. Our study looks at the comprehensive versus partial choice available to New Zealand companies up to 2005, so we are able to stack comprehensive against partial allocation to see which is more closely related to equity values. Given that the partial allocation procedure recognizes only a liability that is associated with future cash outflows, we hypothesise that the market value of the firm’s equity is more closely related to DTLP than DTLC. We evaluate this proposition by investigating the value relevance of the recognized DTLC for firms employing the comprehensive tax allocation procedure and the value relevance of the recognized DTLP and note-disclosed DTLU for firms adopting the partial tax allocation procedure.
We also conduct further tests to provide additional confidence in our results. First, we examine the relationship between changes in the deferred tax liabilities and contemporaneous share returns to investigate the timeliness of the deferred tax expense. Second, given the relationship between growing investments in fixed assets and the nonpayment of deferred taxes (Davidson, 1958; Livingstone, 1967), all comprehensive and partial firms are ranked on the basis of the growth in the depreciable asset base, deciles are then formed, and separate regressions are performed of the market value of equity (MVE) on comprehensive and partial deferred tax liabilities to test the sensitivity of the relation for varying deciles of growth in the depreciable asset base. Neither Citron (2001) nor Lynn et al. (2008) conduct these tests. While Chang et al. (2009) attempt to do this by using loss-making firms to proxy for limited growth to probe the value relevance of the deferred tax liabilities, their test lacks power relative to ours that partitions growth in deciles.
Our results indicate that DTLC is not value relevant or sufficiently reliable to be reflected in share prices. In contrast, our findings suggest that the market finds the recognized DTLP more relevant and sufficiently reliable to be reflected in equity values. We find similar results by examining the relationship between annual changes in deferred tax liabilities and contemporaneous annual share returns: share returns are not significantly related to annual changes in DTLC, but they are negatively and significantly related to annual changes in DTLP.
Additional tests show that DTLC is value relevant for a subset of low asset growth firms whose DTLC is most likely to represent future tax payments. However, this is not so for high asset growth firms whose DTLC is unlikely to represent future tax payments. Conversely, our significant findings for the recognized DTLP are being driven by a subset of high asset growth firms, whose recognized DTLP is most likely to represent future tax payments. Overall, our results suggest that partial dominates comprehensive allocation in terms of value relevance, and the low/high asset growth results are consistent with this finding.
Our study contributes to the literature in two ways. First, it supports previous findings in the United States (Chaney and Jeter, 1989; Givoly and Hayn, 1992) and Australia (Chang et al., 2009) that part of DTLC is not a ‘real and imminent liability’ (Givoly and Hayn, 1992, p. 395) and that the market discounts DTLC to reflect the ‘likelihood and timing of its settlement’ (Givoly and Hayn, 1992, p. 406). The evidence from the UK indicates that DTLP and the resultant DTLU convey relevant information about the future profitability of the firm (Gordon and Joos, 2004). Overall, these studies point to the usefulness of the partial tax allocation procedure.
Second, the results of our study shed light on the usefulness of an accounting procedure for valuation, even though that procedure may be prone to opportunistic behaviour. Opportunistic contracting incentives (Watts and Zimmerman, 1986) would predict the use of partial allocation to increase managers’ bonus payments and assist in avoiding debt covenant infringement (Gupta, 1995; Gordon and Joos, 2004), but our results indicate that, in spite of the possibility for such behaviour, investors find the partial procedure relevant and reliable in their valuation of the firm’s equity. Hence, it adds to the finding in Wong (2005, p. 1172)– that the partial allocation method is contracting efficient for some New Zealand firms – in that partial allocation has a useful role in equity valuation.2
The study is structured as follows. The next section outlines our research design. Section 3 reports the descriptive statistics and presents our findings. Section 4 discusses the results of our additional tests. We summarize and conclude the study in Section 5.
2. Research design
2.1. Sample selection
The sample employed in our analyses consists of New Zealand publicly listed firms that (i) operated during the period 2000–2004, (ii) have annual report coverage for the sample period on the NZX Annual Reports database, (iii) disclosed sufficient data to construct the variables employed in our empirical model and (iv) provided a clear indication of whether they employed comprehensive or partial allocation to recognize their DTL.3 This selection procedure resulted in a final sample of 411 firm-year observations. Of these, 319 firm-year observations employed comprehensive allocation (referred to as the comprehensive group), while the remaining 92 firm-year observations used partial allocation (referred to as the partial group).
Industry classifications of the sample firms are reported in Table 1. Industry classification has been hypothesized to be related to accounting choices. Sunder (1973) and Eggleton et al. (1976) indicate that LIFO change firms are not uniformly distributed across industries, while Gosman (1973) and Holthausen (1981) do not find evidence of an association between accounting changes and industry classification. Even if there were an association, industry could be proxying for the economic determinants of accounting choices (Watts and Zimmerman, 1986). Bowen et al. (1999) investigate this possibility and conclude that economic determinants explain a substantial portion of industry clustering of accounting methods, and they also provide explanations that are not captured by industry clustering.
| Industry | Total sample | Comprehensive sample | Partial sample | |||
|---|---|---|---|---|---|---|
| n | % | n | % | n | % | |
| Agriculture and fishing | 12 | 2.92 | 12 | 3.76 | 0 | 0.00 |
| Building materials and construction | 15 | 3.65 | 15 | 4.70 | 0 | 0.00 |
| Consumer | 63 | 15.33 | 52 | 16.30 | 11 | 11.96 |
| Energy | 26 | 6.33 | 20 | 6.27 | 6 | 6.52 |
| Finance and other services | 36 | 8.76 | 21 | 6.58 | 15 | 16.30 |
| Food and beverages | 6 | 1.46 | 6 | 1.88 | 0 | 0.00 |
| Forestry and forest products | 8 | 1.95 | 0 | 0.00 | 8 | 8.70 |
| Intermediate and durables | 37 | 9.00 | 36 | 11.29 | 1 | 1.09 |
| Investment | 49 | 11.92 | 49 | 15.36 | 0 | 0.00 |
| Leisure and tourism | 20 | 4.87 | 20 | 6.27 | 0 | 0.00 |
| Media and telecommunications | 16 | 3.89 | 14 | 4.39 | 2 | 2.17 |
| Mining | 9 | 2.19 | 9 | 2.82 | 0 | 0.00 |
| NZAX* | 24 | 5.84 | 24 | 7.52 | 0 | 0.00 |
| Ports | 25 | 6.08 | 20 | 6.27 | 5 | 5.43 |
| Property | 45 | 10.95 | 5 | 1.57 | 40 | 43.48 |
| Textiles and apparel | 9 | 2.19 | 6 | 1.88 | 3 | 3.26 |
| Transport | 11 | 2.68 | 10 | 3.13 | 1 | 1.09 |
| 411 | 100.00 | 319 | 100.00 | 92 | 100.00 | |
- *Represents small high-growth stocks who may be operating in different industries.
For our sample of firms, Table 1 indicates an uneven distribution across industries and the accounting choices. Noticeable instances of industry concentration are in (i) the consumer, intermediate and durables and investment industries where firms prefer the comprehensive method and (ii) the property industry where firms prefer the partial method. Compared with the former group, the latter group is more capital intensive. Capital intensive firms have larger depreciation timing differences that give rise to larger deferred tax liabilities and hence are more likely to use the partial allocation to report liabilities that result in future cash outflows. Other than cross-sectional industry differences in the DTL, which is the test variable in this study (see section 2.2), firm size is also likely to vary across industries and this, too, is included as a test variable [the book value of equity (BVE)] in our study.
2.2. Empirical models
Our objective is to assess whether the DTL under comprehensive or partial allocation is associated with share prices. We hypothesise that share prices are more closely related to DTLP because it reflects future tax payments, whereas DTLC is not necessarily linked to the future tax payments. Finding that DTLP is relevant for the equity valuation is supportive of the efficiency explanation for this accounting choice and that the estimated liability is sufficiently reliable to be reflected in share prices. Because our priors are that DTLP is relevant to investors, failure to find a significant negative relationship with share prices could be due to measurement error, given that the reversing timing differences and the related future tax payments depend on management’s forecasts ‘in the foreseeable future’ of future profitability, ‘growth, estimate of asset useful lives, asset impairments, and plans for plant closures’ (Gordon and Joos, 2004, p. 100).
()
()
()2.2.1. Value relevance of DTLC
()2.2.2. Value relevance of DTLP
()3. Results
3.1. Descriptive statistics
Panel A of Table 2 reports descriptive statistics on the variables employed in the study for the comprehensive and partial groups, as well as results from parametric (nonparametric) tests of the difference in the mean (median) values across the two groups. A parametric test reveals that the mean share price of the comprehensive group (2.474) is significantly larger than the corresponding mean of the partial group (1.484) at the 1 per cent level. Next, a nonparametric test indicates that the median book equity per share of the comprehensive group (0.731) is significantly smaller, at the 1 per cent level, than the median book equity per share of the partial group (0.974). While both groups operate profitably during the sample period, there is no significant difference between their profitability. Both the mean and median DTL of the comprehensive group are significantly smaller, at the 1 per cent level, than the mean and median total DTL (i.e., recognized plus note-disclosed DTL) of the partial group. Finally, the mean (median) DTL that is unrecognized but disclosed in the notes for the partial group is 0.093 (0.049). Results from a paired t-test (not tabulated) reveal that there is a significant difference between the mean recognized DTL and note-disclosed DTL of the partial group (at the 1 per cent level). These results could suggest the possibility of the partial group acting opportunistically to reduce total recognized liabilities by opting to disclose a significant portion of their total DTL in the notes to the financial statements instead of recognizing them in the balance sheet. However, these results could also reflect exactly why the partial group chose the method that it did: these companies have large and growing deferred tax liabilities and the partial method presents a more accurate estimate of their firms’ future tax payments.
| Variable | Comprehensive group† (n = 319) | Partial group† (n = 92) | Test of differences | |||||
|---|---|---|---|---|---|---|---|---|
| Mean | Median | Std. dev. | Mean | Median | Std. dev. | t-statistic | Wilcoxon Z | |
| Panel A: Variable descriptive statistics | ||||||||
| MVE | 2.474 | 1.400 | 3.272 | 1.484 | 1.000 | 1.365 | 2.83*** | 1.44 |
| BV | 1.339 | 0.731 | 2.018 | 1.177 | 0.974 | 0.717 | 0.76 | −2.89*** |
| NI | 0.138 | 0.082 | 0.298 | 0.096 | 0.087 | 0.105 | 1.32 | −0.61 |
| DTLC | 0.003 | 0.000 | 0.069 | 0.096 | 0.049 | 0.145 | −8.62*** | −9.62*** |
| DTLP | 0.003 | 0.000 | 0.031 | |||||
| DTLU | 0.093 | 0.049 | 0.146 | |||||
| Panel B: Unscaled descriptive statistics | ||||||||
| Market capitalization ($000) | 305,154 | 67,476 | 1,040,821 | 720,530 | 149,853 | 1,843,657 | ||
| Book value of equity ($000) | 128,039 | 38,385 | 244,489 | 524,150 | 144,868 | 1,014,978 | ||
| Net income from cont. operations ($000) | 12,290 | 3,547 | 48,271 | 36,342 | 11,993 | 90,056 | ||
| Total deferred tax liability ($000) | 1,102 | 0 | 12,823 | 26,423 | 8,215 | 54,314 | ||
| Recognized deferred tax liability ($000) | 763 | 0 | 21,905 | |||||
| Disclosed deferred tax liability ($000) | 25,660 | 7,091 | 53,606 | |||||
- Variable definitions: DTLCit, the total of deferred tax liability that is recognized on the balance sheet and that is disclosed in the notes to the financial statements scaled by the number of shares outstanding of firm i at the end of year t; DTLPit, the deferred tax liability recognized on the balance sheet scaled by the number of shares outstanding of firm i at the end of year t; and DTLUit, the deferred tax liability not recognized on the balance sheet but disclosed in the notes to the financial statements scaled by the number of shares outstanding of firm i at the end of year t; BVit, the book value of equity (after adjusting for DTLPit) scaled by the number of shares outstanding of firm i at the end of year t; MVEit, the share price of firm i at the end of year t; NIit, the net income from continuing operations scaled by the number of shares outstanding of firm i at the end of year t. ***Denotes significance at the 0.01 level. †Comprehensive group consists of firms that employ comprehensive allocation to account for deferred tax liabilities. Partial group consists of firm-year observations that recognize deferred tax liabilities using partial allocation.
At the empirical level, if investors consider the note-disclosed DTLU to be value relevant, then our regression analysis for the partial group should reveal a significant relationship between share prices and both the recognized DTLP and note-disclosed DTLU. Alternatively, if investors have strong confidence in the firms’ decision to adopt the partial allocation method, on the basis that the note-disclosed DTLU is unlikely to materialize, then we should find a significant relationship between share prices and DTLP but not the note-disclosed DTLU.
Panel B of Table 2 reports summary statistics on unscaled equity, NI and deferred tax. We find that the mean (median) value of the unscaled total DTL for the partial group is more than $25 ($8) million. Moreover, on average, partial firms opt to disclose more than $25 million of their deferred tax in the notes to the financial statements and recognize only $763,000 in the balance sheet. In contrast, firms in the comprehensive group have a lower mean total DTL, all of which is recognized in the balance sheet, amounting to $1.102 million.
3.2. Regression analysis
Panel A of Table 3 reports the results from the estimation of Equation (4) using the comprehensive group. Consistent with expectations, the coefficients on the book value of equity, BV, and NI, are positive as predicted and significant at the 1 per cent level. However, the coefficient on DTLC does not take the predicted negative sign and it is indistinguishable from zero. This result indicates that DTLC of the comprehensive firms is not related to share prices, so DTLC lacks relevance and reliability. One interpretation for this finding is that some firms in the comprehensive group are incorrectly accounting for deferred tax and that partial allocation may be the more appropriate procedure. Later in Section 4 of our study, we undertake an additional test to investigate this possible explanation.
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| Panel A: Results for comprehensive group† | ||||
| BV | + | 0.837 | 12.000 | 0.000*** |
| NI | + | 4.583 | 9.480 | 0.000*** |
| DTLC | − | 0.839 | 0.640 | 0.261 |
| Year indicators | Included | |||
| Adjusted R2 | 0.784 | |||
| No. of obs. | 319 | |||
| Panel B: Results for partial group† | ||||
| BV | + | 0.491 | 3.100 | 0.002*** |
| NI | + | 7.924 | 7.330 | 0.000*** |
| DTLC | − | −0.832 | −1.120 | 0.267 |
| Year indicators | Included | |||
| Adjusted R2 | 0.457 | |||
| No. of obs. | 92 | |||
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test). †Comprehensive group consists of firms that employ comprehensive allocation to account for deferred tax liabilities. Partial group consists of firm-year observations that recognize deferred tax liabilities using partial allocation.
The results from the estimation of Equation (4) using the partial group, reported in panel B of Table 3, also indicate that share prices are positively and significantly related to the book value of equity, BV, and NI, at the 1 per cent level, but insignificantly related to the partial companies’ total DTL, DTLC, comprising DTLP recognized on the balance sheet and DTLU disclosed in the notes to the financial statements. It is possible that while investors do not value the information provided by the total DTL, DTLC, they may react significantly to information provided by its two separate components – the DTLP recognized on the balance sheet and the DTLU disclosed in the notes to the financial statements.4
Table 4 reports the results from the estimation of Equation (5) for the partial group, which evaluates the separate effects of the recognized DTLP and note-disclosed DTLU on share prices. As predicted, the coefficients on the book value of equity, BV, and NI, are positive as predicted and significant at the 1 per cent level. In striking contrast to the previous results, the coefficient on DTLP, is negative as predicted and significant at the 1 per cent level. There is an insignificant relationship between share prices and the note-disclosed DTLU. Hence, while our results reported in panel B of Table 3 indicate that investors do not consider the total DTL, DTLC, of the partial group as being value relevant and reliable, they react negatively to DTLP, recognized for those timing differences that are likely to result in future tax payments. Further, despite the large magnitude of DTLU disclosed in the notes to the financial statements by the partial group, investors do not consider DTLU to be value relevant. This is consistent with the notion that the note-disclosed DTLU represents timing differences that are unlikely to reverse. While it is management that assesses that some timing differences are unlikely to reverse and hence do not recognize their related DTL on the balance sheet, the results here suggest that investors also do not reflect DTLU in their valuation assessments.
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| BV | + | 0.426 | 2.690 | 0.005*** |
| NI | + | 8.815 | 7.780 | 0.000*** |
| DTLP | − | −8.476 | −2.380 | 0.010*** |
| DTLU | − | −0.563 | −0.760 | 0.224 |
| Year indicators | Included | |||
| Adjusted R2 | 0.486 | |||
| No. of obs. | 92 |
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test).
Together, the insignificance of the coefficient of DTLC (α3) for the comprehensive firms in Equation (4) and the significance of the coefficient of DTLP (β3) and the insignificance of DTLU (β4) for the partial firms in Equation (5) rule out the mechanistic view that investors respond to reported earnings without understanding the underlying economics behind the reported numbers. To summarize, the analyses reported earlier indicate that DTLC and DTLU are not significantly associated with share prices. In contrast, DTLP is negatively and significantly associated with share prices, so we find evidence that DTLP is relevant to investors and it is measured with sufficient reliability to be reflected in their valuation assessments. This finding indicates that investors find partial allocation useful for valuation.
4. Additional tests
4.1. Alternative model specification
()
()The returns (changes) specification mitigates potential omitted variable bias (Christie, 1987; Kothari and Zimmerman, 1995) and also enables us to investigate the timeliness of the deferred tax expense. Timely means that the deferred tax expense for a year reflects changes in the DTL during the year. If the DTL captures valuation-relevant information, but is not timely, we would observe a significant relation in the price specification but not in the returns specification. Consistent with our earlier approach, we estimate Equation (6) separately for both the comprehensive and partial groups, while Equation (7) is applied to the partial group only.
The results in Table 5 from the estimation of Equation (6), for both the comprehensive and partial groups, indicate that share returns are not significantly related to the annual change in DTLC. However, the results in Table 6 for Equation (7) reveal that the share returns of firms in the partial group are negatively and significantly related to the annual change in the recognized DTLP at the 5 per cent level and unrelated to the annual change in the note-disclosed DTLU. These results from the estimation of Equations (6) and (7) are consistent with our main results and provide further support for the notion that investors only consider DTLP and ADTLP to be value relevant.
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| Panel A: Results for comprehensive group† | ||||
| NI | + | −0.112 | −0.280 | 0.392 |
| ΔNI | + | 0.152 | 0.290 | 0.387 |
| ΔDTLC | − | 0.086 | 0.040 | 0.484 |
| Year indicators | Included | |||
| Adjusted R2 | 0.013 | |||
| No. of obs. | 230 | |||
| Panel B: Results for partial group† | ||||
| NI | + | 0.119 | 0.200 | 0.419 |
| ΔNI | + | 0.888 | 1.770 | 0.041** |
| ΔDTLC | − | 0.223 | 0.960 | 0.170 |
| Year indicators | Included | |||
| Adjusted R2 | 0.103 | |||
| No. of obs. | 69 | |||
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test).
- †Comprehensive group consists of firms that employ comprehensive allocation to account for deferred tax liabilities. Partial group consists of firm-year observations that recognize deferred tax liabilities using partial allocation.
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| NI | + | −0.048 | −0.080 | 0.467 |
| ΔNI | + | 1.467 | 2.520 | 0.007*** |
| ΔDTLP | − | −7.054 | −1.940 | 0.028** |
| ΔDTLU | − | 0.222 | 0.980 | 0.165 |
| Year indicators | Included | |||
| Adjusted R2 | 0.153 | |||
| No. of obs. | 69 |
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test).
4.2.Impact of firm growth
As discussed earlier, the insignificant relationship between share prices and DTLC for the comprehensive group may be due to garbled data. For some firms in the comprehensive group, DTLC may be an accurate reflection of their future tax payments because all their timing differences will reverse and the DTL will crystallize, while this may not be so for other firms with timing differences that are expected to grow rather than reverse. For the former subset of firms within the comprehensive group, their choice of comprehensive allocation is tantamount to partial allocation because they recognize all timing differences in the DTL that will result in a tax payment in the foreseeable future. Such firms are likely to experience smaller growth in their depreciable asset base in comparison with other firms in the comprehensive and partial groups.
To investigate this, we begin by comparing the mean and median growth in the depreciable assets of the comprehensive and partial groups. Untabulated descriptive statistics reveal that the mean (median) growth rate in the depreciable assets of firms in the comprehensive group over the sample period is 31.61 per cent (9.86 per cent), while the comparable mean (median) for firms in the partial group is 40.52 per cent (8.59 per cent). Parametric and nonparametric tests fail to reject the null hypothesis that there is no difference between the mean and median growth rate in the depreciable assets of the two groups. Hence, we find no support for the view that firms in the comprehensive group experience smaller growth in their asset base. This finding adds further support to the view that the use of comprehensive allocation may be inappropriate for some firms within the comprehensive group, resulting in the recognition of deferred tax liabilities with questionable relevance and reliability.
In light of the aforesaid, if comprehensive allocation is more appropriate for firms with smaller growth in their asset base, then we should find a negative relationship between share prices and DTLC if we re-estimated Equation (4) for firms in our comprehensive group with smaller growth in their asset base. To conduct this analysis, we assign all our sample firms into deciles based on their mean depreciable asset base growth rate during the sample period. We find that of the 124 firm-year observations from firms assigned to the three most bottom deciles for mean asset base growth, 108 observations are from the comprehensive group.5 Panel A of Table 7 reports the results from the estimation of Equation (4) based on these 108 observations.
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| Panel A: Results for low growth firms in the comprehensive group† | ||||
| BV | + | 1.020 | 8.190 | 0.000*** |
| NI | + | 4.310 | 4.950 | 0.000*** |
| DTLC | − | −7.223 | −2.320 | 0.011** |
| Year indicators | Included | |||
| Adjusted R2 | 0.852 | |||
| No. of obs. | 108 | |||
| Panel B: Results for remaining (non–low growth) firms in the comprehensive group† | ||||
| BV | + | 0.787 | 8.650 | 0.000*** |
| NI | + | 5.015 | 8.860 | 0.000*** |
| DTLC | − | 3.923 | 2.900 | 0.002*** |
| Year indicators | Included | |||
| Adjusted R2 | 0.635 | |||
| No. of obs. | 211 | |||
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test). †Low growth firms in the comprehensive group are firms in the comprehensive group that are assigned to the three most bottom deciles for mean depreciable asset base growth during the sample period.
In contrast to our results from Table 3, the results in Panel A of Table 7 indicate that there is a negative relationship, which is significant at the 5 per cent level, between share prices and DTLC. Hence, for firms with low asset growth, a characteristic associated with reversing timing differences and future tax payments, we find evidence of a significant negative relationship between share prices and DTLC; the coefficients on the book value of equity, BV, and NI, continue to be positive (as predicted) and significant at the 1 per cent level. The results from the estimation of Equation (4) for the remaining 211 comprehensive group observations with high asset growth, a characteristic associated with nonreversing timing differences and the noncrystallization of the DTL, are reported in Panel B of Table 7. In comparison with the results reported in Panel A, the coefficient for DTLC is significant at the 1 per cent level but it is positive. Upon closer examination, we find that this result is driven by the subsample of observations that are from firms assigned to the three highest deciles for mean asset base growth, so one interpretation of the positive coefficient is that investors view the DTL as part of equity (Jeter and Chaney, 1988) – the related deferred tax expense and liability should not have been recognized given the remoteness of the future tax payment. In line with our reasoning thus far, the use of comprehensive allocation is inappropriate for these firms and partial allocation would have been more suitable.
To further validate our reasoning based on the depreciable asset growth rate, we undertake a similar exercise for the partial group. More specifically, given that partial allocation is most appropriate for firms with high asset growth, it is possible that the significant negative relationship between share prices and DTLP reported in Table 4 is driven by firms with high growth in depreciable assets. Accordingly, Panel A of Table 8 reports the replication of our analysis from Equation (5) using observations from firms in the partial group with mean asset base growth that place them in the three highest deciles for asset growth (n = 43).6
| Variable | Predicted sign | Coefficient est. | t-statistic | p-value |
|---|---|---|---|---|
| Panel A: Results for high growth firms in the partial group† | ||||
| BV | + | 0.138 | 0.900 | 0.186 |
| NI | + | 7.340 | 4.220 | 0.000*** |
| DTLP | − | −4.715 | −2.180 | 0.018** |
| DTLU | − | −0.083 | −0.110 | 0.455 |
| Year indicators | Included | |||
| Adjusted R2 | 0.569 | |||
| No. of obs. | 43 | |||
| Panel B: Results for remaining (non–high growth) firms in the partial group† | ||||
| BV | + | 0.582 | 2.230 | 0.016** |
| NI | + | 9.485 | 5.770 | 0.000*** |
| DTLP | − | −3.995 | −1.190 | 0.121 |
| DTLU | − | −1.064 | −0.960 | 0.172 |
| Year indicators | Included | |||
| Adjusted R2 | 0.490 | |||
| No. of obs. | 49 | |||
- See Table 2 for variable definitions. ***Denotes significance at the 0.01 level (one-tailed test). †High growth firms in the partial group are firms in the partial group that are assigned to the three highest deciles for mean depreciable asset base growth during the sample period.
In line with our expectations, for high growth firms from the partial group, we find a negative (as predicted) relationship, which is significant at the 5 per cent level, between share prices and DTLP. The coefficient on the note-disclosed DTLU remains insignificant. For this regression, the coefficients on the book value of equity, BV, is surprisingly insignificant, while the coefficient on NI, continues to be positive (as predicted) and significant at the 1 per cent level. The results using the remaining firms from the partial group, reported in the Panel B of Table 8, indicate that both DTLP and DTLU are insignificantly related to share prices, while the coefficients on the book value of equity, BV, and NI, are positive and significant at the 5 and 1 per cent levels, respectively.
Overall, our findings from Tables 7 and 8 indicate that investors price deferred tax liabilities that are likely to result in future tax payments. Specifically, we find:
- •
For comprehensive firms with low asset growth, a characteristic associated with reversing timing differences and future tax payments, DTLC is value relevant and sufficiently reliable to be reflected in share prices. However, for comprehensive firms with high asset growth, a characteristic associated with nonreversing timing differences and the noncrystallization of the DTL, DTLC is not value relevant nor is it sufficiently reliable to be reflected in share prices.
- •
For partial firms with high asset growth, a characteristic associated with nonreversing timing differences and the noncrystallization of the DTL, DTLP which is an estimate of the DTL that will result in cash outflows, is value relevant and sufficiently reliable to be reflected in share prices. For partial firms with low asset growth, a characteristic associated with reversing timing differences and future tax payments, the relevance and reliability of DTLP loses significance, and it is statistically significant at the 10 per cent level.
5. Summary and conclusion
This study investigates whether DTLC or DTLP most closely reflects the information that investors assess when they value the firm’s equity. Our tests are based on New Zealand firms that, prior to the introduction of IFRS, were free to choose between comprehensive and partial allocation, and we test the joint hypothesis that DTLP is relevant for equity valuation and is sufficiently reliable to be reflected in investors’ valuation assessments.
We conduct a number of tests to provide additional confidence in our results. First, we provide evidence that DTLC is not value relevant or sufficiently reliable to be reflected in share prices. Second, we provide evidence that DTLP is value relevant and sufficiently reliable to be reflected in share prices.
Third, we take a subset of low asset growth firms from the sample of comprehensive firms, whose DTLC is most likely to represent future tax payments, and we find evidence that DTLC for this particular set of firms is value relevant and sufficiently reliable to be reflected in share prices. In comparison, for the comprehensive firms with high asset growth, whose DTLC is unlikely to represent future tax payments, we find that DTLC is not value relevant or sufficiently reliable to be reflected in share prices.
Fourth, we take a subset of high asset growth firms from the sample of partial firms whose recognized DTLP is most likely to represent future tax payments, and we find evidence that the recognized DTLP is value relevant and sufficiently reliable to be reflected in share prices. For the partial firms with low asset growth, we find that the DTLP is bordering on relevance and reliability with significance at the 10 per cent level.
Finally, we examine the value relevance of deferred tax liabilities by investigating the association between annual changes in deferred tax liabilities and contemporaneous annual share returns. A returns specification investigates the timeliness of changes in deferred tax liabilities, whereby timely means that the change in deferred tax liabilities from one year to the next reflects changes in the value of the firm’s deferred tax liabilities during the year. We find that share returns are not significantly related to annual changes in DTLC, but they are negatively and significantly related to annual changes in DTLP.
Taken together, our results are robust and consistent across various tests, thereby giving us confidence that partial deferred tax liabilities are value relevant and sufficiently reliable to be reflected in investors’ valuation assessments. The implication of this finding for accounting standard setters is echoed in Givoly and Hayn (1992, p. 406): ‘For accounting rule-making bodies, the results indicate that deferred taxes, arising from comprehensive interperiod tax allocation, are being transformed by investors into a value that appears to be consistent with the notion of partial allocation’. Our evidence indicates that investors’ preference for partial allocation still stands. In light of these findings, accounting standard setters like the International Accounting Standards Board may wish to reconsider partial allocation as an alternative to the prescribed comprehensive allocation.
