Market Perception

Accounting and Finance 49 (2009) 645–673

Market’s perception of deferred tax accruals

Cheryl Chang, Kathleen Herbohn, Irene Tutticci
UQ Business School, University of Queensland, St Lucia, 4072, Australia

Abstract

This study investigates the value relevance and incremental information content
of deferred tax accruals reported under the ‘income statement method’ (AASB
1020 Accounting for Income Taxes) over the period 2001–2004. Our findings sug-
gest that deferred tax accruals are viewed as assets and liabilities. We document
a positive relation between recognized deferred tax assets and firm value using
the levels model, while the results from the returns model suggest that deferred
tax liabilities reflect future tax payments. The balance of unrecognized deferred
tax assets provides a negative signal to the market about future profitability,
particularly for companies from the materials and energy sectors and loss-makers.

Key words: Deferred tax asset; Deferred tax liability; Income statement method;
Value relevance

JEL classification: G14, M41

doi: 10.1111/j.1467-629X.2009.00307.x

1. Introduction

In many countries, accounting for deferred taxes is a controversial issue and
Australia has proven to be no exception. Possibly the most contentious issue
has been the replacement of the income statement method prescribed by the
Australian Accounting Standards Board (AASB) in 1020, Accounting for
Income Taxes (1989), with the balance sheet method prescribed in AASB 112,

We would like to thank participants of seminars at the Australian National University,
University of Technology, Sydney, the University of Southern Queensland and Queens-
land University of Technology as well as attendees of the 2006 Accounting & Finance
Association of Australia and New Zealand conference in Wellington, New Zealand.
In particular, we would like to recognize the insightful comments of Allen Craswell,
Jane Hamilton, Steve Huddart and Peter Wells. The research assistance of Laurel Yu and
Akihiro Omura is also gratefully acknowledged.
Received 24 September 2007; accepted 17 March 2009 by Robert Faff (Editor).

Ó The Authors
Journal compilation Ó 2009 AFAANZ

646 C. Chang et al./Accounting and Finance 49 (2009) 645–673

Income Taxes.1 Such change was first flagged in the mid-1990s as a way to
make accounting for tax consistent with the Australian conceptual framework.2
Tax assets and liabilities recognized under the income statement method were
argued to be ‘hypothetical’ in comparison with the ‘real’ assets and liabilities
recognized under the balance sheet method. However, critics questioned
whether the tax deferrals recognized under the balance sheet method would be
any more ‘real’ (e.g. Sidhu, 1996).
The conceptual debate remained unresolved and ultimately the balance sheet
method was introduced as part of the AASB’s policy of adopting Australian
equivalents of International Financial Reporting Standards (AIFRS). The
unresolved nature of the debate is of concern because it is important to under-
stand the consequences of adopting AIFRS. One such consequence may well be
the potential loss of information provided by tax deferrals recognized using the
income statement approach. Consequently, in the present paper we examine the
market’s perception of the relevance of deferred tax assets and liabilities reported
by Australian companies under the income statement method specified by AASB
1020. As part of this investigation, we consider whether current period tax accruals
have incremental information content to reported earnings. Finally, we extend
our analysis to an investigation of the relevance of the unrecognized tax assets
disclosed in the notes to the accounts. These are the items that fail to meet the
recognition criteria specified in AASB 1020. Assets arising from timing differences
are required to meet the criterion of ‘beyond reasonable doubt’ while assets from
tax losses must be ‘virtually certain’ to be offset in the future.3
Overall, our study is important because there has been no direct investigation
of the relevance of deferred tax assets recognized using the income statement
method since the US standard APB Opinion no. 11 required firms to disclose

1
AASB 112 is the Australian equivalent of IAS 12 and superseded AASB 1020 from
January 2005.
2
The balance sheet method was first raised in Discussion Paper no. 22 Accounting for
Income Tax issued by the Australian Accounting Research Foundation. AASB 1020 was
subsequently reissued in December 1999 to prescribe the balance sheet method. Voluntary
adoption of the balance sheet method was proposed prior to the implementation of the
international standards. As few firms took up this method, we excluded firms using the
balance sheet method from our sample.
3
Recognition of deferred tax losses under the income statement method of AASB 1020
required firms to be ‘virtually certain’ there would be sufficient future taxable income to
offset the benefit carried forward. This requirement is stringent compared with other juris-
dictions. For example, the recognition requirement of UK standard FRS 19 Deferred Tax
for deferred tax assets was that they must be ‘recoverable’ and did not distinguish between
carry forward losses and other timing differences. ‘Recoverable’ was defined as ‘more
likely than not’. The International Accounting Standard IAS12 Income Taxes requires
recognition of deferred tax assets and losses when the associated benefits are ‘probable’ to
arise. The US requirements of SFAS no. 109 recognize deferred tax assets if the realization
of benefits is ‘more likely than not’ to occur.

Ó The Authors

C. Chang et al./Accounting and Finance 49 (2009) 645–673 647

net deferred tax liabilities without separate disclosure of deferred tax assets.
Evidence on the value of deferred tax assets instead comes from settings which
use the balance sheet method. Subtle differences in the Australian institutional
setting relative to other jurisdictions allow us to examine deferred tax assets
and deferred tax liabilities separately.
There have only been two published Australian studies of tax accounting;
these are by Sidhu and Whittred (1993, 2003). The first examined the introduction
of deferred tax accounting in Australia in the early 1970s, and the second the
role of political costs in the deferred tax policy choices of Australian firms. Our
study is the first Australian study to consider the value relevance of tax accruals
and provides a more recent and comprehensive assessment of the consequences
of discontinuing the income statement approach.4 As such, we provide a starting
point for future investigation of the relevance of deferred tax accruals in Australia
since accruals recognized under the income statement method represent a subset
of accruals that will arise under the balance sheet approach now required by
AASB 112.5 In fact, the more restrictive requirements of the income statement
method provide a base value for items which if found value relevant during the
period of our study should translate to the new setting.6
Evidence from US research suggests that deferred taxes provide value-relevant
information under the income statement method in APB Opinion no. 11 (Givoly
and Hayn, 1992; Chaney and Jeter, 1994) and more recently, the balance sheet
method in SFAS no. 109 (Amir et al., 1997; Ayres, 1998; Amir and Sougiannis,
1999). In general, evidence suggests that deferred tax liabilities are viewed by
the market as comparable to other reported liabilities, although the relation may
be tempered by recurring items that have little likelihood of reversal. Similarly,
prior research suggests that reported deferred tax assets represent future tax
savings, although the relation may be diminished because recognition of deferred

4
At the time this study was conducted insufficient time had lapsed since the implementation of
AASB 112 to allow the collection of a reasonably sized sample which would afford a compari-
son of the balance sheet and income statement methods.
5
The income statement method recognizes timing differences between taxable income or
loss and accounting profit or loss as deferred tax assets or liabilities. The balance sheet
method of tax accounting recognizes temporary differences between the carrying amount
of an asset or a liability and its tax base as deferred tax accruals. Consequently, the
balance sheet method results in an increase in items giving rise to deferred tax assets and
liabilities.
6
For example, AASB 112 (para. 34) allows the recognition of a deferred tax asset for the
carry-forward of unused tax losses to the extent that it is ‘probable’ that future taxable
income will be available against which the losses can be used. In contrast, AASB 1020 spec-
ifies that a deferred tax asset is to be recognized when there is assurance ‘beyond any
reasonable doubt’ that sufficient benefits will be earned in the future to offset this asset.
Furthermore, when a deferred tax asset arises from a tax loss carried forward, the asset can
only be recognized if it is ‘virtually certain’ that sufficient taxable income will be earned.

Ó The Authors


tax assets due to losses could be interpreted as a signal of future losses. Researchers
have not considered the market’s perception of unrecognized tax assets carried
forward. Therefore, the nature of the relation is undecided. In contrast, the balances
could be perceived as representing future tax savings. This is particularly the
case given that the stringent recognition criterion for losses does not reflect
Australian tax legislation which allows losses to be carried forward indefinitely.
On the other hand, the balance of unrecognized deferred tax assets may be negatively
interpreted as a signal of future losses.
Prior research findings on the incremental information content of current
period tax accruals have been mixed. There is some evidence that these deferrals
represent increases and decreases in balance sheet assets and liabilities which
reflect future tax savings or payments (Amir et al., 1997; Chaney and Jeter, 1994).
As such, research suggests that the market will value increases in deferred tax
liabilities negatively and increases in deferred tax assets positively. In an Austra-
lian context, we particularly expect this relation to hold for deferred tax assets
from losses because of AASB 1020’s strict recognition criterion of tax benefits
being ‘virtually certain’. However, there is other evidence that current period
accruals convey information signals to the market about current and future
profitability (Givoly and Hayn, 1992; Chaney and Jeter, 1994). Of particular
importance are the components of the tax accruals since there is evidence that the
market discounts the value of deferred tax liabilities based on their likelihood of
settlement. This results in recurring items such as depreciation having no value
relevance for a growing firm.
Limitations on the required disclosures for the income statement method do
not allow us to identify the components contributing to current period accruals.
Instead, by reconstruction we identify the net change in current period deferred
tax assets (distinguishing between timing differences and carry forward tax
losses), and deferred tax liabilities. We also include any current period change
to the unrecognized tax assets disclosed in the accounts.
A random sample of 300 firms is selected from the top 1000 companies (by
market capitalization) listed on the Australian Stock Exchange in 2002. Data
are collected for the 2002, 2003 and 2004 financial years. These years represent
the period just prior to the implementation of the balance sheet method (AASB
112). The sample period also overlaps with tax consolidation. In 2002, the starting
point for our study, Australian accounting standards did not allow the netting of
deferred tax assets and liabilities at the group level as taxable income was
determined at the individual firm level. However, changes to the tax legislation
allowed firms to elect consolidation for tax purposes for financial periods ending
30 June 2003. Less than half of our sample firms took up this option in the latter
2 years of the sample period (i.e. 2003 and 2004). As a result, we are able to
examine deferred tax assets and deferred tax liabilities separately for firms and
years in which there was no tax consolidation and then compare this analysis
with the net tax assets and liabilities reported by tax consolidators in the latter
part of our sample period.

Ó The Authors


We use both levels and returns models to test our expectations. The models
distinguish between profit-making and loss-making years on the basis that
expectations of coefficients on the financial variables in these models differ
depending on whether firms are making a profit or loss. The rationale for this is
that losses are not expected to persist (Hayn, 1995).
Using the levels model, we find that the balance of deferred tax assets is
positively and significantly associated with firm value which indicates that the
market perceives these items as assets of the firm. This result holds for all firms,
irrespective of whether they are profit-making or loss-making, or whether they
elected to adopt tax consolidation. The result is consistent with prior research
and our expectation that deferred tax assets are perceived to represent future
tax savings. The results for deferred tax liabilities are generally insignificant, indi-
cating that the market views the deferred tax liabilities as having little relation-
ship to future tax payments. Based on prior research, we infer from this result
that the market expects the major sources of the deferred tax liabilities to be recur-
ring timing differences. The one exception is the significant and negative associa-
tion we document between deferred tax liabilities and price for loss-making tax
consolidators. Typically, these firms have poor financial performance and, hence,
are limited in their capacity for growth. The market may perceive that the deferred
tax liabilities for these firms are therefore more likely to reverse in the future and
so values them as financial liabilities, unlike the remaining firms in our sample.
We document a negative relation between market value and the balance of
unrecognized deferred tax assets disclosed in the notes to the accounts. This result
is consistent with our expectations that failure to meet the recognition criteria
sends a negative signal to the market about the future prospects of the firm.
There is an industry effect apparent using the levels model which has not
been documented in prior research. When we limit the sample to companies
from the materials and energy sectors, deferred tax liabilities are found to be
significantly negatively associated with price. This is consistent with the market
perceiving the deferred tax liability to be due to non-recurring items, thus making
future tax payments probable. In contrast, there is no result for deferred tax assets
and unrecognized deferred tax assets are negatively associated with firm value.
When taken together, this suggests that market participants have reservations
that these firms will ever benefit from either their recognized or unrecognized
deferred tax assets.
The results from the returns model provide a slightly different perspective.
The most persistent result here is found on the incremental value relevance of
the change in the balance of deferred tax liabilities. A net increase in deferred
tax liabilities is negatively associated with a firm’s return indicating that the
market expects lower cash flows in the future. These results are consistent with
prior research and with the levels model results for loss firms or firms from the
materials and energy sectors. For deferred tax assets, our results suggest that
the source of the deferred tax asset is an important factor. That is, we find no
relation between returns and changes in recognized deferred tax assets from

Ó The Authors


timing differences. However, an increase in recognized deferred tax assets from
carry-forward losses is found to be positively associated with returns. The latter
result on recognized deferred tax assets due to losses is consistent with prior
research and the levels model results. On balance, it seems that the market perceives
deferred tax assets as representing likely future tax savings.
Finally, our results on the market’s perception of changes in unrecognized
deferred tax assets are mixed. However, when viewed collectively, it appears
that the market views adjustments to these amounts as a negative signal about
the future profitability of the firm. We find that this signal is particularly strong
where firms are more likely to make losses as is the case for the materials and
energy sectors.
Overall, our results suggest that the income statement method did indeed
provide market participants with information relevant to market value. Therefore,
the discontinuation of this method has not been without cost. Also, deferred tax
assets from losses as defined by the criteria of the income statement method
appear to provide signals to the market about future value that are particularly
relevant to the materials and energy sectors. Future research will be able to consider
the usefulness of the additional disclosure provided by the balance sheet method
regarding the components giving rise to deferred tax assets and liabilities.7
The remainder of this paper is organized as follows. Section 2 outlines the hypothe-
ses development, the methodology and sample are described in Section 3, and
the results are presented in Section 4. Concluding comments follow in Section 5.

2. Market perception of deferred tax accruals

We investigate the market’s perception of deferred tax assets and liabilities as
well as the information content of current deferrals. A summary of our testable
propositions is presented in Table 1 and subsequently discussed in Sections 2.1
and 2.2.

2.1. Value relevance of deferred tax assets and liabilities

2.1.1. Deferred tax liabilities

Under the income statement method outlined in the 1989 version of
AASB 1020, a deferred tax liability, labelled a ‘provision for deferred income

7
For example, AASB 112 (para. 79) requires disclosure of the major components of tax
expense for the period including the amount of any deferred tax expense (income) relating
to the origination and reversal of temporary differences (para. 80(c)) and the amount of
benefit arising from a previously unrecognized tax loss that is used to reduce deferred tax
expense (para. 80(e)). In contrast, these types of disclosures were not required by the
superseded standard AASB 1020. To illustrate, very few of the sample firms in this study
separately disclosed the changes in deferred tax assets due to timing differences.

Ó The Authors


Table 1
Summary of hypotheses and research expectations

Hypotheses and Expected
research expectations relation Discussion

Levels model
Hypothesis 1: – Market views as financial liabilities, although the relation may
Deferred tax be tempered by recurring items (e.g. depreciation) with little
liabilities chance of reversal
Hypothesis 2: + Market views as assets representing future tax savings
Deferred tax assets (measurement perspective), although the relation may be
tempered because the recognition of deferred tax assets due
to losses may be interpreted as a signal of future losses
Hypothesis 3: ? The relation has not been considered in prior research. Ex ante
Unrecognized analysis suggests two possibilities, focusing on unrecognized
deferred tax assets deferred tax assets due to losses:
Positive relation:
Market views as assets representing future tax savings because
tax losses can be carried forward indefinitely under
Australian income tax legislation
Negative relation:
Market views as a signal of future losses, particularly if the
balance is increasing over time
Returns model
Current deferrals of ? Prior research has identified two possibilities:
deferred tax liabilities Negative relation:
Market views as financial liabilities with increases valued
negatively and decreases valued positively
No specified relation:
Market determines the value relevance from individual
components of the adjustment. For example, the market
discounts the value relevance of deferred tax liabilities based
on the likelihood of their settlement (e.g. recurring items such
as depreciation are not value relevant in a growing firm)
Current deferrals of + Market views as assets representing future tax savings
deferred tax assets with increases valued positively and decreases valued
negatively. This is expected to be the case particularly
for adjustments to deferred tax assets from losses because
of AASB 1020’s strict recognition criterion of tax benefits
being ‘virtually certain
Change in unrecognised ? The relation has not been considered in prior research. Ex ante
deferred tax assets analysis suggests two possibilities:
Negative relation:
Market views increases as signalling low expectations for
future profitability and decreases as signalling high
expectations for future profitability
Positive relation:
Market views the accounting recognition rule for deferred tax
assets as restrictive and values changes in unrecognized
balances as it would an asset of the firm

Ó The Authors


tax’, is recognized when income tax expense exceeds income tax payable. This
difference can arise from two sources – revenues recognized in profit before tax
in an earlier reporting period than they are included in taxable income; or
expenses that are deductible for tax purposes in one period but deferred for
accounting purposes until later periods. The deferred tax liability is recognized
when it is probable.8
There is disagreement as to the market’s perception of deferred tax liabilities.
Some claim that the reliability of deferred tax liabilities is minimal because the
liabilities bear little relationship to future tax payments (Lasman and Weil,
1978; Chaney and Jeter, 1988, 1989; Defliese, 1991). In the case of recurring
timing differences (e.g. deferred taxes resulting from depreciation) the liability
recognized will likely not involve a probable future sacrifice of economic benefits.
As long as a company is growing or at least maintaining its operating capacity,
reversing differences are generally offset by equal or larger originating differences,
with the result that the liability is not likely to be settled in the foreseeable
future (Chaney and Jeter, 1988, 1989). Therefore, large deferred tax liabilities,
a significant portion of which are unlikely to lead to future tax payments, would
not be expected to be considered liabilities of the firm or be relevant to a firm’s
value.9
However, empirical evidence from US studies suggests otherwise. The studies
show that deferred tax liabilities are in fact regarded as financial liabilities by the
market (Beaver and Dukes, 1972; Givoly and Hayn, 1992; Amir et al.,
1997; Ayres, 1998).10 A negative association has been documented between
security returns and net deferred tax liabilities and changes therein that are
recognized under the income statement method (APB Opinion no. 11) (Beaver
and Dukes, 1972; Givoly and Hayn, 1992).11 Therefore, it appears that deferred

8
The term probable means that the chance of the future sacrifices of economic benefits
when the timing difference reverses is more likely rather than less likely to occur.
9
In fact, there is evidence from Australia, the USA and New Zealand that companies, on
average, disclose deferred tax liabilities with positive long-term growth trends which sug-
gests that permanent deferral of taxes is more likely to occur than their realization (Wise,
1986; Bartholomew, 1987).
10
The studies by Amir et al. (1997) and Ayres (1998) investigate deferred tax liabilities under
the balance sheet method (SFAS 109). In both studies, the results were consistent with inves-
tors valuing deferred tax liabilities in a way similar to other balance sheet liabilities.
11
Specifically, Beaver and Dukes (1972) found that unexpected stock returns are more
highly correlated with unexpected earnings measures that include tax deferrals than with
unexpected earnings measures that do not. Adopting a different perspective, Givoly and
Hayn (1992) identified a positive association between stock returns and the reduction in
the deferred tax liability implied by the change in tax rate around the 1986 Tax Reform
Act. More recently, Chaney and Jeter (1994) documented a negative association between
net deferred tax liabilities and security returns.

Ó The Authors


tax liabilities are perceived in the same way as other liabilities recognized on
firms’ balance sheets.
We hypothesize that the Australian financial market also treats deferred tax
liabilities reported under the income statement method as ‘real’ liabilities (refer
to Table 1). Specifically we predict that deferred tax liabilities are negatively
associated with firm value. Hypothesis 1 stated in the alternate form is:

H1: Deferred tax liabilities determined under the income statement method are
negatively associated with firm market value.

2.1.2. Deferred tax assets

A deferred tax asset, referred to as a ‘future income tax benefit’, is recognized
under the income statement method when income tax payable exceeds income
tax expense. This difference may arise from two sources – revenues included in
taxable income in an earlier reporting period than they are recognized in profit
before tax, or expenses recognized in the current period in profit before tax but not
deducted for tax purposes until a later period. The deferred tax asset is recognized
as an asset when there is assurance ‘beyond any reasonable doubt’ that sufficient
benefits will be earned in the future to offset this asset. Furthermore, when a deferred
tax asset arises from a tax loss carried forward, the asset can only be recognized
if it is ‘virtually certain’ that sufficient taxable income will be earned.
We draw upon indirect evidence from US studies of deferred tax assets recognized
under SFAS no. 109 (balance sheet method) to inform our study. The main con-
straint in doing so is the more stringent asset recognition rules applied by the
income statement method relative to the balance sheet method. We return to this
issue prior to stating the second hypothesis.
The evidence from the US relates largely to tax assets arising from tax losses
carried forward. There are two conflicting effects that influence the relation
between market values and deferred taxes from tax losses carried forward (Amir
and Sougiannis, 1999). First, from a measurement perspective, it is argued that
losses carried forward are perceived as an asset because they represent future tax
savings. Therefore, they are valued positively by investors (Amir and Sougiannis,
1999; De Waegenaere et al., 2003). Alternatively, from an information perspective
investors may interpret deferred tax losses as signals of future tax losses rather
than as expected tax savings. Since firms with tax losses carried forward have
already experienced losses in the past, they are more likely to experience losses
in the future (Amir et al., 1997). Therefore, markets value deferred tax assets
negatively because they signal probable future losses.
Empirical evidence largely supports the measurement perspective. Evidence
from Canadian markets suggests that tax losses carried forward enhance firm
market value (Zeng, 2003). Similarly, the US study of Amir and Sougiannis
(1999, p. 6) found ‘a strong positive relation between deferred taxes from carry
forwards and share prices, suggesting that these carry forwards are valued as

Ó The Authors


assets.’ However, Amir and Sougiannis (1999) also found evidence of the informa-
tion effect since investors valued earnings and book values of firms with tax
losses carried forward less than firms without tax losses carried forward.12
We argue that the measurement perspective will dominate Australian markets.
The income statement method (AASB 1020, 1989 version) only allows deferred
tax assets from tax losses to be recognized when it is ‘virtually certain’ that
sufficient taxable income will be earned. Therefore, on balance we expect that
deferred tax assets reliably communicate the likelihood of future tax savings.
Similar reasoning can be applied to deferred tax assets arising from timing dif-
ferences that may only be recognized if their realization is considered ‘beyond
any reasonable doubt’.
We hypothesize that under the income statement method (AASB 1020, 1989)
investors in Australian financial markets will adopt a measurement perspective
and treat deferred tax assets as assets that represent future tax savings. Specifically,
we predict that deferred tax assets are positively associated with firm value (see
Table 1). Hypothesis 2 stated in the alternate form is:

H2: Recognized deferred tax assets determined under the income statement method
are positively associated with firm market value.

2.1.3. Unrecognized carried forward tax assets

As we have discussed, the test for recognition of deferred tax assets is more
stringent under Australian accounting standards than the recognition criteria for
deferred tax liabilities. This means that in some instances companies will disclose
unrecognized deferred tax assets which do not meet the recognition criteria.
The market’s perception of unrecognized tax assets has not previously been
investigated. We consider the nature of this relation in our study. On the one hand,
the unrecognized portion of the deferred tax assets may be considered by the
market to be an asset of the firm. A substantial proportion of these unrecognized
deferred tax assets arise from tax losses. The accounting recognition criterion is
particularly stringent in relation to deferred tax losses, whereas Australian
income tax legislation allows tax losses to be carried forward indefinitely.
Therefore, the market may view the unrecognized portion of the deferred tax
losses to be an asset of the firm when it returns to profit, despite its accounting
treatment under AASB 1020. On the other hand, it is possible that the inability
to meet the recognition criterion sends a negative signal to the market about the

12
An earlier study by Amir et al. (1997), found that deferred tax accruals from losses were
negatively associated with stock prices, consistent with the information perspective. How-
ever, the results of this study were called into question by Amir and Sougiannis (1999)
who argued that Amir et al. (1997) did not distinguish between the measurement and
information effects of carry-forwards on share prices, thereby resulting in a mis-specified
valuation model and biased results.

Ó The Authors


firm’s ability to generate future profits. Furthermore, this signal is likely reinforced
if unrecognized deferred tax assets are increasing over time. Hence, we could
expect the balance of unrecognized deferred tax assets, disclosed in the notes to
the accounts, to be negatively associated with the market value of the firm.
There is only indirect empirical evidence on this issue from Amir et al. (1997).
They find a negative (but insignificant) association between deferred tax losses
recognized by US firms and share price. They interpret this finding as evidence
that the market does not expect these losses to be utilized.
Given the unresolved nature of the relation between unrecognized tax assets
and firm value, our hypothesis is non-directional (see Table 1). Therefore,
Hypothesis 3, stated in the alternate form, predicts an association between
unrecognized tax assets and firm value.

H3: Unrecognized deferred tax assets determined under the income statement
method are associated with firm market value.

2.2. Information content of current deferrals

A number of different views have been adopted in prior research to make predic-
tions about current period deferrals. In general, these views can be categorized
around two themes which we consider in this study. The first view applies the spirit
of the accounting standards and expects that these deferrals represent increases
and decreases in balance sheet assets and liabilities which reflect future tax savings
or payments. This is consistent with the measurement perspective previously
discussed. The second view is that current period accruals convey information
relevant to the sustainability of current period earnings. Chaney and Jeter (1994)
contend that if firms choose the most advantageous methods and rates available
for tax purposes, then deferred taxes will reflect information about the underlying
accounting choices made by firms. Hereafter, we refer to this as the additional
information view. We discuss the expectations that arise from both of these
perspectives but do not formally state hypotheses in this section. The reason for
this is that the different perspectives give rise to conflicting predictions. Table 1
provides an overview of our expectations regarding current period accruals.
If the measurement perspective is adopted for deferred tax liabilities, an
increase in this account should be negatively associated with firm value while a
decrease would be positively valued. However, this association is tempered by
the likelihood of reversal in the near future which is argued to be fundamental to
the value relevance of deferred tax liabilities (Chaney and Jeter, 1994; Amir
et al., 1997). In fact, Givoly and Hayn (1992) find that although the market
views deferred taxes as a liability the value is discounted based on the timing and
likelihood of its settlement (refer to Table 1).
The additional information perspective looks to the composition of deferred
tax liabilities and argues that the components of deferred tax liabilities provide
information about other underlying accounting treatments rather than future tax

Ó The Authors


payments. Studies that decompose deferred tax liabilities into recurring and
non-recurring events find that the market attributes different values to them.
Amir et al. (1997) show that the coefficient on components of deferred tax
liabilities arising from depreciation and amortization charges are not value relevant
where firms are growing because these accruals do not reverse. An alternate
interpretation is that the components of deferred tax accruals provide information
about accounting changes and adjustments that are not disclosed elsewhere in the
accounts. Chaney and Jeter (1994) argue that their examination of tax components
supports the view that deferred tax accruals tell the market something about
earnings management rather than information about future tax payments. Overall,
the additional information perspective does not predict a specific relation between
adjustments to deferred tax liabilities and firm value. Rather, the relation depends
on the firm’s context and individual components of the adjustment (see Table 1).
Deferred tax asset accruals can arise from timing differences and carry
forward tax losses. If deferred tax assets represent a balance sheet asset, then
irrespective of the source, we would expect increases in this asset to be positively
valued by the market and decreases negatively valued. This is consistent with
the measurement perspective. We also consider the possibility that deferred tax
assets provide a signal to the market about the firm’s likely profitability (i.e.
additional information view). We suggest that this perspective is most relevant
for recognized deferred tax assets from carry-forward losses. With a requirement
of ‘virtually certain’ for recognition of tax assets due to losses, recognition provides
a strong signal to the market of management’s expectations of reporting profits
in the near future. Therefore, an increase in the recognition of carry forward
losses as a deferred tax asset is expected to be positively associated with returns.
Applying the same reasoning, it would follow that a reduction in tax assets (from
carry forward tax losses) is negatively associated with returns (refer to Table 1).
In light of the strict recognition criteria for tax assets arising from timing
differences (beyond reasonable doubt) and tax losses (virtually certain), the
disclosure in the notes of the amounts of deferred tax assets not recognized may
provide a signal to the market about firms’ future prospects. Ideally, we would
investigate the effect of changes in unrecognized tax assets due to carry forward
losses and due to timing differences separately. However, the minimum disclosure
requirements of the income statement method make it difficult to isolate these
changes for all of our sample firms. As a result, in this study we investigate the
information content of cumulative changes in unrecognized deferred tax assets
due to all items that do not meet the recognition criteria for deferred tax
assets.13 Our expectation is that increases in unrecognized deferred tax assets are
likely to signal low expectations for future earnings resulting in a negative

13
Only a proportion of sample firms provided sufficient disclosure to distinguish between
changes in unrecognized deferred tax assets due to tax losses and due to timing differ-
ences. In other cases the disclosure was unclear. As a result, we maintain the sample size
by not distinguishing between losses and other deferred tax assets here.

Ó The Authors


association between unrealized deferred tax assets and a firm’s market value.
On the other hand, if the market views the accounting rule as restrictive in its
application, then unrecognized deferred tax assets may still be seen by the market as
an asset of the firm (see Table 1).

3. Sample and methodology

3.1. Sample selection

A random sample of 300 companies was selected from the top 1000 companies
(by market capitalization) listed on the Australian Stock Exchange in 2002. Data
are collected for each company for the years 2002–2004. In forming the final
sample, 126 companies were excluded for the following reasons.
1. Eight banks and one insurance company were excluded from the sample
due to the industry’s highly regulated nature.
2. Nineteen early adopters of the balance sheet method of deferred tax
accounting were excluded from the sample.
3. Sixty-four firms were excluded due to missing price or financial statement data.
4. One company was deleted due to its suspended status; three trust companies
were deleted because these companies are not liable for income tax; and an
additional three pooled development funds that enjoy special tax concessions
were also deleted.
5. Twenty-eight companies had no record of a deferred tax asset, deferred tax
liability or unrecognized deferred tax assets in any of the sample years.
The final sample comprises 173 companies that recognized deferred tax
assets and liabilities or disclosed unrecognized deferred tax assets in at least
one of the financial years 2002–2004. The resultant sample is an unequal panel
data set of 478 firm-years. Data for market value, book value, total assets and net
income were downloaded from the Aspect FinAnalysis database. The deferred
tax information was hand collected from the annual reports available from the
Connect4 database. Annual reports missing from Connect4 were obtained from
the Aspect FinAnalysis database.
The industry concentration of the companies is presented in Table 2. The
sample comprises companies from 10 different industry sectors. The sample is
highly concentrated in the materials and energy sectors, with 57 companies out
the total of 173 located in these sectors.14 It is likely that an industry effect may
have a potential confounding effect for the regression models used in this study.
We include industry controls in the models and undertake additional analysis to
understand the impact of industry on our results.

14
These sectors represent the sectors from which the resource sector is drawn. The
resource sector represents a large component of the Australian market and the character-
istics of these firms are collectively quite different from firms in other industries. Forty of
the 48 companies in our sample from the materials sector are resource companies.

Ó The Authors


Table 2
Industry classification

GICS two-digit sector Number of companies

Energy 9
Materials 48
Industrials 24
Consumer Discretionary 18
Consumer Staples 5
Health Care 15
Financials 25
Information Technology 22
Telecommunication Services 3
Utilities 4
Total 173

A total of 173 companies are included in the sample over the 2002–2004 sample period. Industry
classification is based on the Global Industry Classification Standard (GICS) classifications.

3.2. Research design

Our analysis is conducted using both levels and changes models. The levels
model is used to test Hypotheses 1–3 which take a measurement perspective
and predict that the market perceives deferred tax assets and liabilities as if they
were assets and liabilities of the firm. The returns model is used to test the
information content of current period adjustments to these items. The levels
model used in this study is specified as equation (1) and is loosely based on the
Ohlson (1995) valuation framework.

Pit ¼ b0 þ b1 Xit þ b2 ABVit þ b3 DTLit þ b4 DTAit þ b5 UDTAit þ b6 Grit
þ b7 Matit þ b8 Finit þ b9 LOSSit þ b10 LOSS ÃXit þ b11 LOSS ÃABVit
þ b12 LOSS ÃDTLit þ b13 LOSS ÃDTAit þ b14 LOSS ÃUDTAit þ e1it ;
ð1Þ

where Pit is the share price of company i 3 months after financial year end t. Share
prices and shares outstanding are obtained from the Australian Graduate School
of Management’s CRIF database. Xit is the reported net profit after tax and
abnormal items less outside equity interests and preference dividends for company
i during the year t. ABVit is the book value of equity before deferred tax assets and
liabilities and excluding outside equity for company i at the end of year t. DTLit is
the end-of-period recorded book value of deferred tax liabilities for company i.
DTAit is the end-of-period recorded book value of deferred tax assets for company i.
UDTAit is the balance of the carry forward deferred tax asset, for company i at
the end of year t, that does not meet the recognition criteria of the standard but

Ó The Authors


which is disclosed in the notes to the accounts. All of the accounting variables
are deflated by the number of shares outstanding 3 months after balance date.
A number of controls are also included in the model. A measure of growth is
included in the model since growth in assets is likely to be highly correlated with
increasing deferred tax liabilities arising from timing differences on depreciation
(Chaney and Jeter, 1994). Omission of a growth variable in the model may
overstate the coefficient on the deferred tax liability. We measure Grit as the
percentage growth in total tangible assets over the year.15 Industry controls are
included in the model. An indicator variable, Mat, is used for materials and
energy sector companies with a value of one if company i comes from the GICS
industry group of materials (1510) or energy (1010), otherwise 0. Similarly, an
indicator variable, Fin, is used for the financials industry with a value of one if
company i comes from the financials industry, otherwise 0. Selection of these
two controls was based on differences in the nature of the underlying assets,
liabilities, revenues and expenses of firms in these industries compared with
other firms as well as differences in industry regulatory requirements.
The model also takes into account whether a firm earns a profit or loss in the
financial year. A loss dummy variable, LOSS, is included in the model and
interacted with the other financial variables in the model. This specification of
the model recognizes that the coefficients on the financial variables are likely to
differ for profit and loss firms. The rationale here is that although the market
expects profits to persist, losses are not expected to persist in the future (Hayn,
1995). This is reflected in an expectation that the coefficient on net profit will
have a value of greater than one for profit firms while the coefficient on losses
is likely to be statistically insignificant. For loss-making firms, value should
load on the book value of equity instead.
Hypothesis 1 predicts that b3 will be significantly less than zero, indicating
that, on average, investors value deferred tax liabilities negatively under the
income statement method. An insignificant result on b3 would suggest that
investors generally do not view deferred tax liabilities as liabilities of the firm.
Hypothesis 2 predicts that b4 will be significantly greater than zero, indicating
that, on average, investors take a measurement perspective on deferred tax
assets. Hypothesis 3 is non-directional. A significant result on b5 would indicate
that unrecognized deferred tax assets are associated with firm market value
either as an unrecognized asset of the firm (positive coefficient) or as a signal
of more losses in the future (negative coefficient).
The returns model incorporated in this study is set out as equation (2). Prior
research suggests that the valuation coefficients on the components of tax accruals

15
We also use an alternative measure of growth in our sensitivity testing. We substitute
the growth in tangible assets with growth in net cash from investing activities. Our key
results are substantively unchanged by the use of this alternative measure. The results for
this analysis have not been reported in this paper.

Ó The Authors


differ. However, reporting requirements under the income statement method do
not allow us to identify the components underlying tax accruals. Disclosure
requirements allow us to identify changes to recognized deferred tax assets arising
from carry forward tax losses; therefore, we are able to decompose the deferred
tax asset to this degree (i.e. deferred tax assets from carry forward losses and
deferred taxes assets from other items). However, there is insufficient disclosure
under the income statement method to decompose deferred tax liabilities.

Rit ¼ c0 þ c1 NIa þ c2 DNIa þ c3 CDTLit þ c4 CDTATit þ c5 CDTALit
it it
þ c6 URDTAit þ c7 Grit þ C8 Matit þ c9 Finit þ c10 LOSSit þ c11 LOSSÃNIa
it
þ c12 LOSSÃDNIa þ c13 LOSSÃCDTLit þ c14 LOSS ÃCDTATit
it
þ c15 LOSSÃCDDTALit þ c16 LOSSÃURDTAit þ e2it : ð2Þ
Returns (Rit) are measured as market adjusted returns. An annual raw return is
calculated for each firm using monthly price relatives. Similarly, a return on the
market is calculated using monthly market price relatives. The market-adjusted
return is then calculated as the difference between the annual raw return for a
firm and the matching market return for the period. Price relative data is collected
from the CRIF database. The beginning price relative is collected for the fourth
month following balance date and the subsequent monthly price relatives are
collected for a 12 month period.
The explanatory variables are deflated by the lagged market value of the firm
measured 3 months after the start of the financial year. Net income (NIa) is
measured after tax with the addition or subtraction of net timing difference and
current period carry forward tax loss amounts. DNIa is the change in NIa from
the prior year. The current period net change in the balance of deferred tax liabilities
is captured by CDTL. Similarly, the net change in the deferred tax assets from
items other than losses is captured by CDTAT. The net change in the deferred
tax losses reported as part of the recognized deferred tax asset is measured by
CDTAL. The net change in unrecognized deferred tax assets is measured by
URDTA. The control variables also included in the model are identical to those
included in the levels regression. These variables control for growth, industry
and reported losses. As with the levels model, the returns model distinguishes
loss-making years from the rest of the sample to allow for the coefficients to
vary due to any non-linearity arising in loss years.

4. Results

4.1. Descriptive statistics

Summary statistics for the sample data are presented in Table 3. Statistics for
years in which firms make a profit and years in which they make a loss are presented
separately in line with the approach taken in the regression analysis. Panel A of

Ó The Authors


Table 3 presents statistics for the 256 firm-year observations with a profit and
the 222 firm-year observations with a loss used in the levels regression. Panel
B presents descriptive statistics for the 175 firm-year observations with a profit
and the 182 firm-year observations with a loss used in the returns model. The
reduction in the sample for the returns regression is due to insufficient disclosure
by firms regarding the annual incremental changes in deferred tax accruals. In
these firm-years we were unable to work out the net change in any or all of the
following: deferred tax liabilities, deferred tax assets from losses, or deferred
tax assets from other items. Outliers are identified at the univariate level, and
extreme values are winsorized.
The summary statistics for the levels model sample are reported in Panel A
of Table 3. Deferred tax liabilities and recognized deferred tax assets are, on
average, higher for profit firms than for loss firms, while the balance of
unrecognized deferred tax assets is, on average, higher in loss years than in
profit years. The median growth in tangible assets for profit firms is 12 per cent
while for loss-makers median growth is –3 per cent. The overall poor financial
performance of loss firms relative to profit firms suggests that the former likely
have a history of losses. Materials and energy sector companies were more
likely to be loss makers with 45 per cent of the loss-making sample representing
these sectors (only 23 per cent of the profit-making sample comprises materials

Table 3
Descriptive statistics

Panel A: Levels model (n ¼ 478)

Profit firm-years (n ¼ 256) P X ABV DTL DTA UDTA Gr

Mean 2.48 0.171 1.300 0.061 0.045 0.047 33%
Median 1.46 0.106 0.754 0.013 0.016 0.000 12%
Minimum 0.03 0.000 –0.032 0.000 0.000 0.000 –74%
Maximum 13.20 1.100 8.400 0.500 0.290 1.000 400%
Standard deviation 2.73 0.205 1.691 0.109 0.065 0.146 72%
Materials & Energy 23% FY 2002 31%
Finance 20% FY 2003 34%
Tax consolidators 30% FY 2004 35%

Loss firm-years (n ¼ 222) P X ABV DTL DTA UDTA Gr

Mean 0.34 –0.071 0.197 0.004 0.006 0.070 26%
Median 0.17 –0.023 0.072 0.000 0.000 0.021 –3%
Minimum 0.01 –0.620 –0.488 0.000 0.000 0.000 –93%
Maximum 2.76 0.000 3.319 0.297 0.290 1.000 400%
Standard deviation 0.46 0.129 0.421 0.024 0.033 0.165 100%
Finance 7% FY 2003 34%
Tax consolidators 13% FY2004 26%

Ó The Authors


Table 3 (continued)

Panel B: Returns model (n ¼ 357)

Profit firm-years (n ¼ 175) R NI a DNI a CDTL CDTAT CDTAL URDTA Gr

Mean 0.28 0.142 0.135 0.007 0.004 0.001 –0.023 31%
Median 0.14 0.084 0.031 0.000 0.001 0.000 0.000 14%
Minimum –0.88 –0.045 –0.086 –0.208 –0.024 –0.069 –2.171 –73%
Maximum 4.02 2.211 2.965 0.215 0.060 0.129 0.088 400%
Standard deviation 0.69 0.207 0.356 0.033 0.009 0.014 0.169 60%
Finance 16% FY 2003 38%

Loss firm-years (n ¼ 182) R NI DNI CDTL CDTAT CDTAL URDTA Gr

Mean 0.24 –0.393 –0.006 –0.002 0.001 0.000 –0.004 27%
Median –0.08 –0.182 –0.014 0.000 0.000 0.000 0.000 –2%
Minimum –1.04 –3.000 –4.000 –0.254 –0.026 –0.181 –1.166 –93%
Maximum 5.00 –0.001 2.652 0.061 0.077 0.062 1.209 400%
Standard deviation 1.06 0.539 0.716 0.020 0.009 0.016 0.171 104%
Finance 4% FY 2003 37%

P is the share price 3 months after financial year-end. X is the reported net profit after tax and abnor-
mal items less outside equity interests and preference dividends. ABV is the book value of equity
before deferred tax assets and liabilities and excluding outside equity for company. DTL is the end-
of-period book value of deferred tax liabilities. DTA is the end-of-period book value of deferred tax
assets. UDTA is the balance of the unrecognized deferred tax asset. All of the accounting variables
are deflated by the number of shares outstanding 3 months after balance date. Gr is the 1 year per-
centage growth in total tangible assets. R is the market adjusted return over the year. NIa is after-tax
income with net timing difference and current period carry forward tax loss amounts added or
subtracted back. DNIa is the change in NIa. The current period net change in deferred tax liabilities
is CDTL. The net change in deferred tax assets from items other than deferred tax losses is CDTA.
Deferred tax losses reported as part of the deferred tax asset are CDTAL. URDTA is the current per-
iod amount of unrecognized deferred tax assets disclosed in the notes to the accounts. All variables
are deflated by the market capitalization of the firm 3 months after the start of the financial year (FY).

and energy sector companies). In contrast, companies from the financial industry
were more likely to be profitable comprising 20 per cent of the profit sample
and 7 per cent of the loss sample. Our sample period encompasses the introduc-
tion of the voluntary tax consolidation regime for financial periods ending on
30 June 2003. Of our sample, there were 22 initial adopters in 2003 which
increased to 82 firms in 2004. The summary statistics in Panel A indicate that
profitable firms were more likely to adopt tax consolidation than loss-makers
(30 per cent of profit firms as compared with 13 per cent of loss firms).
The sample for the returns model comprises a greater number of loss years
(182 firm-years) than profit years (175 firm-years). Although the average return

Ó The Authors


for the two groups was similar (Rprofit ¼ 28 per cent; Rloss firms ¼ 24 per cent),
the median returns reflect a different picture at 14 per cent and –8 per cent,
respectively. The average net amount of deferred tax accruals recognized each year
is small with the median levels being around zero. As can be expected there are,
on average, larger net increases in recognized deferred tax assets from timing
differences and tax losses for profitable firms relative to loss firms. Also, the average
net change in the unrecognized deferred tax assets for profit firms is negative,
suggesting that these items are likely being brought to account. Interestingly,
the average change for the loss-makers is also negative for this item. If these
firms are recognizing these deferred tax assets it would seem to contradict
standard setter’s expectations and may be an indicator of potential earnings
management.16
Pearson correlations are computed for the dependent and independent variables
in both the levels and returns regressions, and are reported in Table 4. Panel A
shows the correlation coefficients for the variables used in the levels model.
The figures reveal a high level of correlation between many of the variables.
This is likely to lead to problems of multicollinearity in the model. Panel B
shows the correlations for the returns model which are lower, suggesting that
multicollinearity is less likely to be an issue. Therefore, findings from the
returns model that corroborate our results from the levels model will give us
confidence that our interpretation is not being unduly impacted by multicollinearity.

4.2. Deferred tax liabilities and assets

The results of testing Hypotheses 1–3 are documented in Table 5. To control
for potential problems arising from heteroscedacity and serial correlation, we
use a number of corrective measures. Our model incorporates cross-sectional
random effects and Whites corrected standard errors and covariances. In sensitivity
analysis (not reported in the paper) we include dummy year variables and find
no change to our inferences. Table 5 presents the results of the pooled sample.
The results for the full sample are reported in the first column of the table. The
analysis is re-run separately for firms and years where tax consolidation is not
used to control for any potential confounding effects. The results for these subsets
of the sample are presented in the last two columns of the table. For the full
sample, the results on net income and book value are positive and statistically
significant. Furthermore, the magnitude of the coefficients on net income and
book value are theoretically consistent with, and similar to prior research.
Interaction of these variables with the loss dummy reveals that the coefficient on
earnings reduces when the firm makes a loss. This is consistent with expectations.

16
This is consistent with the findings of Herbohn et al. (2008). They find that managers
use unrecognized deferred tax assets due to losses to manage earnings upward when pre-
tax earnings are below the median analyst forecast and historical earnings levels.

Ó The Authors


Table 4
Pearson correlation matrices

Panel A: Levels model variables

P X ABV DTL DTA UDTA Gr

P 1.00 0.81 0.87 0.70 0.68 –0.09 –0.04
X 1.00 0.72 0.62 0.54 –0.24 0.02
ABV 1.00 0.74 0.66 –0.05 –0.06
DTL 1.00 0.59 –0.07 –0.05
DTA 1.00 –0.11 –0.07
UDTA 1.00 –0.02
Gr 1.00

Panel B: Returns model variables

R NI a DNI a CDTL CDTAT CDTAL URDTA Gr

R 1.00 –0.05 0.16 0.10 0.04 0.08 0.08 0.07
NIa 1.00 0.49 0.23 0.13 0.18 –0.54 0.12
DNIa 1.00 0.18 0.02 0.14 –0.34 0.00
CDTL 1.00 0.23 0.64 –0.01 0.22
CDTAT 1.00 0.06 –0.05 0.09
CDTAL 1.00 –0.01 0.19
URDTA 1.00 –0.05
Gr 1.00

P is the share price 3 months after financial year-end. X is the reported net profit after tax and abnor-
mal items less outside equity interests and preference dividends. ABV is the book value of equity
before deferred tax assets and liabilities and excluding outside equity for company. DTL is the end-
of-period book value of deferred tax liabilities. DTA is the end-of-period book value of deferred tax
assets. UDTA is the balance of the unrecognized deferred tax asset. All of the accounting variables
are deflated by the number of shares outstanding 3 months after balance date. Gr is the 1 year per-
centage growth in total tangible assets. R is the market adjusted return over the year. NIa is after-tax
income with net timing difference and current period carry forward tax loss amounts added or sub-
tracted back. DNIa is the change in NIa. The current period net change in deferred tax liabilities is
CDTL. The net change in deferred tax assets from items other than deferred tax losses is CDTA.
Deferred tax losses reported as part of the deferred tax asset are CDTAL. URDTA is the current per-
iod amount of unrecognized deferred tax assets disclosed in the notes to the accounts. All variables
are deflated by the market capitalization of the firm 3 months after the start of the financial year.

Growth in tangible assets is only statistically significant for the tax consolidation
firms with a coefficient of 0.055 (p < 0.001).
The predictions of Hypothesis 1 are tested by the direction and significance
of the coefficient on DTL. Our results for Hypothesis 1 are mixed. For the full
sample and firms that do not use tax consolidation, the coefficient on the
deferred tax liability is statistically insignificant which does not support the
predictions of Hypothesis 1. This result does not alter when DTL is interacted

Ó The Authors


Table 5
Levels regressions using unequal panel data and Generalised Least Sequares (GLS)
Pit ¼ b0+b1Xit+b2ABVit+b3DTLit+b4DTAit+b5UDTAit+b6Grit+b7Matit+b8 Finit+b9LOSSit
+ b10LOSS*ABVit+b12LOSS*DTLit+b13LOSS*DTAit+b14LOSS*UDTAit+e1it.

Cross-sectional random effects and White corrected standard errors

Full sample Excluding tax consolidators Tax consolidators

Intercept 0.486 0.557 0.315
t-statistics 4.976** 3.875** 7.123**
X + 5.090 5.984 5.498
6.830** 6.000** 6.865**
ABV + 0.702 0.575 0.778
9.436** 6.210** 29.567**
DTL – –0.074 1.275 –1.112
–0.033 0.611 –0.546
DTA + 5.814 2.649 7.646
2.105* 2.006* 23.982**
UDTA –0.163 –1.972 –0.708
–0.359 –3.471** –6.565**
Gr 0.021 –0.002 0.055
0.906 –0.074 2.733**
Mat –0.316 –0.274 –0.337
–11.387** –4.468** –2.454*
Fin –0.094 –0.027 –0.374
–0.931 –0.527 –70.995**
LOSS –0.126 –0.211 0.068
–2.638** –4.411** 3.150**
LOSS*X –5.472 –6.389 –5.278
–5.931** –5.606** –2.926**
LOSS*ABV + 0.037 0.114 0.106
0.706 4.436** 104.617**
LOSS*DTL 0.235 –0.524 –64.288
0.165 –0.236 –2.529*
LOSS*DTA –1.653 0.063 3.918
–0.628 0.021 0.918
LOSS*UDTA 0.362 1.512 1.170
0.989 1.485 1.733*

n 478 374 104
Cross-sections 173 172 84
Adjusted R2 0.792 0.803 0.853
F-statistic 130.7** 109.7** 43.8**

*Indicates significance at p < 0.10 and **indicates p < 0.01. P is the share price 3 months after
financial year end. X is the reported net profit after tax and abnormal items less outside equity inter-
ests and preference dividends. ABV is the book value of equity before deferred tax assets and liabili-
ties and excluding outside equity for company. DTL is the end-of-period book value of deferred tax
liabilities. DTA is the end-of-period book value of deferred tax assets. UDTA is the balance of the
unrecognized deferred tax asset. All of the accounting variables are deflated by the number of shares
outstanding 3 months after balance date. Gr is the 1 year percentage growth in total tangible assets.
Two industry control dummy variables are included in the model: Mat takes a value of 1 for firms in
the energy and materials sectors while Fin takes the value of 1 for firms from the financial sector. A
dummy variable capturing loss years, LOSS, is included in the model and interacted with the key
financial variables to allow for differences on the coefficients of profit versus loss-making firms. The
model is run using a Swamy and Arora estimate of component variances.

Ó The Authors


with LOSS. Therefore, unlike prior studies by Beaver and Dukes (1972), Givoly
and Hayn (1992), Amir et al. (1997) and Ayres (1998), we do not find that the
market views deferred tax liabilities as financial liabilities. Instead, our findings
are consistent with Chaney and Jeter (1988, 1989), Defliese (1991) and Lasman
and Weil (1978), who argue that as long as a company is growing or at least
maintaining its operating capacity, deferred tax liabilities arising from recurring
items are unlikely to reverse and, hence, are not viewed as liabilities by market
participants. Therefore, we infer from our result on DTL that the market expects
the major source of these deferred tax liabilities to be timing differences arising
from depreciation of non-current assets. Our results for Hypothesis 1 change
when we focus on loss-making, tax-consolidating companies. The coefficient
on DTL is large and statistically significantly negative (–64.288) at less than
1 per cent. This indicates that for this subset of firms the market views the
deferred tax liability as a liability of the firm. In light of the poor financial
performance of these firms, this result likely reflects a limit on the capacity for
growth in these firms and, therefore, the expectation that DTLs of these firms,
on average, are more likely to reverse in the future.
We find strong support for the predictions of Hypothesis 2. The coefficient
for DTA in the full sample regression is statistically significantly positive
(5.814) at the 1 per cent level. This result is robust to additional testing. It
persists when we interact this variable with the dummy variable LOSS, as well
as when the sample is divided into non-tax consolidators and tax consolidators.
This result is consistent with prior US research by Amir and Sougiannis (1999)
and Zeng (2003) that documents a positive value for deferred tax assets. Overall,
it suggests that the market perceives that future tax savings are likely to be
realized. This result also confirms our expectation that in an Australian setting
the market views deferred tax assets from losses as reliably communicating the
likelihood of future tax savings, because of the strict recognition requirement
of AASB 1020.
Finally, for the full sample the coefficient on unrecognized deferred tax
assets, UDTA, is statistically insignificant. However, when the sample is split
between firms that use tax consolidation and those that do not, the results
become statistically significant for all firms. The coefficient on UDTA is –1.972
for firms that do not consolidate for tax purposes and –0.708 for those that do.
For both samples these coefficients are significant at less than 1 per cent. This
provides some support for Hypothesis 3 which predicts that the unrecognized
balance of deferred tax assets is associated with market value. The negative
direction of this relation is consistent with our prediction that the inability of
these accruals to meet the recognition criteria provides a signal about the future
profitability (or lack thereof) of the firm.
Given the high incidence of loss-making entities within our sample that are
located in the materials and energy sectors and likely differences in the com-
ponents underlying the tax accruals, we re-run our analysis separately for these
firms. The results for this analysis are documented in Table 6. The results for

Ó The Authors


Table 6
Levels regression: Materials and Energy versus other sectors

Pit ¼ b0 + b1Xit + b2ABVit + b3DTLit + b4DTAit + b5UDTAit + b6Grit + b7LOSSit + b8LOSS*Xit
+ b9LOSS*ABVit + b10LOSS*DTLit + b11LOSS*DTAit + b12LOSS*UDTAit + e1it.

Cross-sectional random effects model
with White corrected standard errors Other sectors Materials and Energy

Intercept 0.464 0.009
t-statistics 2.908** 0.144
X + 5.163 4.721
3.540** 5.791**
ABV + 0.701 0.790
10.048** 5.507**
DTL – –1.697 2.064
–0.606 1.465
DTA + 7.812 2.541
2.186* 1.012
UDTA 0.107 –0.531
0.126 –9.948**
Gr –0.002 0.059
–0.067 19.842**
LOSS –0.183 0.077
–1.356 0.907
LOSS*X –4.869 –6.866
–2.914** –9.679**
LOSS*ABV + 0.176 –0.100
2.050* –0.573
LOSS*DTL –0.104 –5.999
–0.049 –10.392**
LOSS*DTA –1.461 2.045
–0.379 0.869
LOSS*UDTA 0.724 –0.503
1.277 –3.052**

n 317 161
Cross-sections 116 57
Adjusted R2 0.755 0.923
F-statistic 82.3** 160.2**

*Indicates significance at p < 0.10 and **indicates p < 0.01. P is the share price 3 months after
financial year end. X is the reported net profit after tax and abnormal items less outside equity inter-
ests and preference dividends. ABV is the book value of equity before deferred tax assets and liabili-
ties and excluding outside equity for company. DTL is the end-of-period book value of deferred tax
liabilities. DTA is the end-of-period book value of deferred tax assets. UDTA is the balance of the
unrecognized deferred tax asset. All of the accounting variables are deflated by the number of shares
outstanding 3 months after balance date. Gr is the 1 year percentage growth in total tangible assets.
A dummy variable capturing loss years, LOSS, is included in the model and interacted with the key
financial variables to allow for differences on the coefficients of profit versus loss-making firms.

Ó The Authors


the non-mining sector firms are largely consistent with those of the full sample
presented in Table 5, with the main tax accrual result arising on the DTA. However,
there is an industry effect apparent when we consider companies from the materials
and energy sectors separately. Prior research has not investigated possible
industry effects on the market’s perceptions of deferred tax accruals. Hence, our
results highlight the importance of industry context. In particular, we find that
the result on the recognized deferred tax assets disappears, while the unrecog-
nized deferred tax assets (UDTA) are negatively associated with firm value. The
coefficient on UDTA is –0.531 (p < 0.001). In fact, the coefficient on UDTA
becomes even more negative when the firm reports a loss (increasing by –0.503,
p < 0.001). This result is consistent with the market taking into account the
risks associated with these sectors and assessing that it is very dubious that
these firms will ever benefit from either their recognized or unrecognized
deferred tax assets. It is likely that this result is due to the carry forward loss
component of these assets.
A further difference in the results for the materials and energy sectors is
that the coefficient on the deferred tax liability for loss-making mining firms is
statistically significantly negative (–5.999, p < 0.001). This result indicates that
for these particular firms, the market perceives the deferred tax liability as a liability
of the firm leading to future tax payments.

4.3. Current tax deferrals

In the second stage of our analysis, the information content of the net increases
and reversals of current period deferred tax accruals is tested using a returns
regression. The returns regressions are run with period fixed effects. As returns
models are less subject to problems of heteroscedacity we do not adjust for this in
our analysis (Kothari and Zimmerman, 1995). As an extension to our study we
present results for the full sample and also for the sample first with tax-consolida-
tors removed and second with materials and energy sector companies removed.
The results for these regressions are presented in three columns of Table 7.
In Table 7, we observe that net income adjusted for tax accruals, NIa, is positively
and significantly related to returns for all samples. However, the measure of
unexpected earnings, DNIa, does not yield significant findings. The control
variables Gr and Mat, which measure growth and materials and energy sector
membership, are positively and significantly related to returns in a consistent
manner. The final statistically significant result is the interaction between the
loss dummy variable and earnings. The coefficient on this variable is negative
in all versions of the model and significant at a level of p < 0.01 in all cases.
In reference to the current tax accruals, the current period change in DTL is
negatively and statistically associated with returns for the full sample and the
subsamples. This result is consistent with the findings of Beaver and Dukes
(1972) and Givoly and Hayn (1992) and suggests that increases in deferred tax

Ó The Authors


Table 7
Returns regression using an unequal panel model with period fixed effects

Rit ¼ c0 þ c1 NIa þ c2 DNIa þ c3 CDTLit þ c4 CDTATit þ c5 CDTALit þ c6 URDTAit þ c7 Grit
it it
þ c8 Matit þ c9 Finit þ c10 LOSSit þ c11 LOSSÃNIa þ c12 LOSSÃDNIa þ c13 LOSSÃCDTLit
it it
þ c14 LOSS CDTATit þ c15 LOSSÃCDDTALit þ c16 LOSSÃURDTAit þ e2it :
Ã

Full sample Excluding tax consolidators Other sectors

Intercept –0.050 –0.130 –0.078
t-statistics –0.495 –0.993 –0.757
NI 1.418 2.276 1.946*
1.985* 2.276* 2.437
DNI 0.552 0.058 0.298
1.678* 0.119 0.650
CDTL –5.571 –6.683 –6.611
–2.040* –1.837* –1.817*
CDTAT 8.209 11.166 7.553
1.091 1.038 1.011
CDTAL 12.485 12.681 4.711
1.872* 1.354 0.399
URDTA 2.432 –1.199 –3.647
3.606** –0.532 –1.342
GROWTH 0.113 0.178 0.118
2.023* 2.539* 1.592
Mat 0.302 0.318 NA
3.037** 2.689**
Fin –0.021 –0.004 NA
–0.128 –0.017
LOSS –0.122 –0.034 –0.147
–0.952 –0.209 –1.004
LOSS*NI –1.998 –2.899 –2.507
–2.747** –2.866** –3.079**
LOSS*NI –0.108 0.423 0.143
–0.307 0.832 0.296
LOSS*CDTL 7.799 10.832 –2.548
1.585 1.789* –0.277
LOSS*CDTAT –3.734 –12.103 5.854
–0.332 –0.821 0.407
LOSS*CDTAL –10.285 –12.954 1.066
–1.074 –1.062 0.054
LOSS*URDTA –1.895 1.911 4.322
–2.281* 0.818 1.559

n 357 284 219
Cross-sections 146 141 94
Adjusted R2 0.145 0.157 0.180
F-statistic 4** 4** 4**

*Indicates significance at p < 0.10 and **indicates p < 0.01. R is the market-adjusted return over the year.
NIa is after tax income with net timing difference and current period carry-forward tax loss amounts added
or subtracted back. DNIa is the change in NIa. Current period net change in deferred tax liabilities is CDTL.
Net change in deferred tax assets from items other than deferred tax losses is CDTA. Deferred tax losses
reported as part of the deferred tax asset are CDTAL. URDTA is current period unrecognized deferred tax
assets disclosed in the notes. All variables are deflated by the market cap 3 months after the start of the
financial year. Mat is a dummy variable that equals 1 for energy and materials sectors firms while Fin takes
the value of 1 for financial sector firms. A dummy variable capturing loss years, LOSS, is included in the
model and interacted with the key financial variables to allow for differences on the coefficients of profit
versus loss-making firms.

Ó The Authors


liabilities are viewed as reflecting future tax payments. Our result on DTL is not
consistent with the argument that the value relevance of changes in deferred tax
liabilities is minimal because of the small likelihood of reversal in the near future
(Lasman and Weil, 1978; Defliese, 1991; Chaney and Jeter, 1994). Interestingly,
the returns model result differs from the finding in the levels regression, where
the balance of deferred tax liabilities was only statistically significantly negative
for loss firms that were either tax consolidators or materials and energy firms.17
It should be noted that the returns sample has more loss years than profit years,
while the opposite is true for the levels model. This may have some impact on
our findings.
The second significant result from the returns model is that current period
adjustments to unrecognized deferred tax assets, URDTA, are positively and
statistically associated with returns for the full sample but this association reduces
when the firm makes a loss as shown by the significantly negative coefficient on
the loss interaction term (LOSS*URDTA). The result is not robust across the
subsamples. Overall, these results are not consistent with our expectation that
increases in unrecognized deferred tax assets likely signal low expectations
for future earnings. Instead, the results suggest that the market perceives the
recognition rule for deferred tax assets as restrictive in its application and
accordingly views current period increases in unrecognized deferred tax losses
as increases to the assets of the firm when the firm makes a profit.
Interestingly, the returns model result on unrecognized deferred tax assets
differs to the findings from the levels model. Using the levels model, we found
some evidence that the balance of unrecognized deferred tax assets is negatively
associated with price. This result holds particularly for firms in the materials
and energy sectors where the effect is even more negative when the firm is
loss-making. Overall, this evidence from the levels model suggests that the
balance of the unrecognized deferred tax assets signals losses in the future. To
consider the possibility further, we examine the disclosure that is available about
the breakdown of the components making up the balance of the unrecognized
deferred tax assets. This preliminary investigation reveals that materials and
energy companies are more likely to have carry-forward tax losses and foreign
losses in this balance than firms from other industries. This may account for the
apparent signalling effect of the balance of unrecognized deferred tax assets of
materials and energy companies.
We find no relation between current period accruals from recognized deferred
tax assets (other than from losses), DTAT, and returns in any scenario. We do
find evidence that current period accruals due to losses, DTAL, are positively

17
We are unable to run the returns regression for just tax consolidators and Materials &
Energy sector companies in our study as the returns model has low explanatory power
and there are insufficient observations for these two subcategories of the sample to obtain
meaningful results.

Ó The Authors


associated with returns for the full sample (p < 0.1), although the result does
not persist when tax consolidators and materials and energy firms are removed.
Overall, there is limited support for our expectation that changes in deferred tax
assets are positively associated with returns because this result only holds for
deferred tax assets due to losses. The returns model result on DTAL is consistent
with our previous finding from the levels model. Taken together, we suggest they
provide evidence that the market perceives deferred tax assets as representing
likely future tax savings. This is consistent with prior research by Amir and
Sougiannis (1999) and Zeng (2003). Additionally, it supports our contention
that deferred tax assets due to losses and changes therein provide a reliable signal
about firms’ likely profitability because of AASB 1020’s stringent recognition
requirement for these deferrals.
The overall relevance of deferred tax assets to market value shown in both the
levels and returns models is not consistent with prior research on debt covenants.
The studies by Whittred and Zimmer (1986) and Ramsay and Sidhu (1998) find
that while leverage ratios are usually calculated including deferred tax liabilities,
deferred tax assets are excluded from the intangible assets in the calculation.
Prima facie, it appears that the debt market views deferred tax assets differently
to the equity market. However, recent research by Mather and Peirson (2006)
suggests that the debt market’s perception of deferred tax assets may be changing
slightly. They note that the definition of intangible assets in two-thirds of the
Australian debt contracts they review included reference to ‘in the opinion of
the auditor’ in relation to the identification of intangible assets to be excluded
from the computation of total assets. Therefore, it is possible that deferred tax
assets may be included in the computation of leverage covenants subject to the
input of the auditor. If this occurs in practice, the apparent difference in perceptions
of the debt and equity markets in Australia is narrowing.

5. Conclusion

This study examines how the market perceives the relevance of deferred tax
assets and liabilities reported by Australian companies under the income state-
ment method, and whether current period tax accruals have information content
to reported earnings. Our analysis is conducted using both levels and returns
models. The levels model is loosely based on the Ohlson (1995) valuation frame-
work. From prior research, we expect reported deferred tax liabilities to be
viewed as financial liabilities, although the relation may be tempered by recurring
items that have little likelihood of reversal. Similarly, prior research suggests that
reported deferred tax assets represent future tax savings, although the recogni-
tion of deferred tax assets due to losses may be interpreted as a signal of future
losses. Prior research has not considered the market’s perception of unrecognized
assets due to tax losses carried forward. We do so in this study, and argue that
the nature of the relation is undecided. On the one hand, the balances could be
positively perceived as representing future tax savings. On the other hand, the

Ó The Authors


balance of unrecognized deferred tax assets may be negatively interpreted as a
signal of future losses.
For the returns model, prior research highlights the importance of considering
the underlying components of tax accruals. However, disclosures under the income
statement method only allow us to clearly identify the tax loss component of
recognized deferred tax assets. We investigate two views on the information
conveyed by current tax deferrals. The first is espoused by standard-setters and
suggests that tax deferrals represent increases and decreases in balance sheet
assets and liabilities which reflect future tax savings or payments (measurement
perspective). The second suggests that the components of tax deferrals do not
necessarily reflect tax savings or tax costs; rather the deferrals convey information
about items such as the sustainability of current period earnings or the accounting
choices made by firms (additional information view).
Overall, our results from the levels and returns models provide evidence that
the market perceives deferred tax assets as representing likely future tax savings
and deferred tax liabilities as representing future tax costs. Our results on the
market’s perception of unrecognized deferred tax assets are mixed. However,
collectively it appears that the market views these amounts as a negative signal
about the future profitability of the firm. This signal is particularly strong where
firms are more likely to make losses as is the case for the materials and energy
sectors.
In conclusion, our results suggest that the income statement method provided
market participants with information relevant to market value. Further research
is necessary to fully understand the consequences of discontinuing the income
statement method in favour of the balance sheet method. In particular, AASB
112 provides a setting for expanding the focus of this research and providing a
more in-depth analysis of whether the results we document in this paper are due
to these accruals really being perceived as assets and liabilities, or whether they
reflect the underlying accounting which gives rise to the accruals in the first
instance. Other differences that arise from AASB 112 such as a loosening of the
recognition criteria for deferred tax assets also provide interesting avenues for
future research. Finally, our descriptive statistics highlight a possibility that
changes to the unrecognized deferred tax assets may be used for earnings
management given that, on average, firms in our sample showed a reversal of
these unrecognized deferrals irrespective of whether the firm had made a profit
or loss in the current year. This too provides an opportunity for future research.

References

Amir, E., M. Kirschenheiter, and K. Willard, 1997, The valuation of deferred taxes,
Contemporary Accounting Research 14, 597–622.
Amir, E., and T. Sougiannis, 1999, Analysts’ interpretation and investors’ valuation of tax
carryforwards’, Contemporary Accounting Research 16, 1–33.
Australian Accounting Standards Board, 1989, AASB 1020, Accounting for Income Taxes
(AASB, Melbourne, Vic.).

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