The aggregation and valuation of deferred Taxes

This paper clarifies some of the conflicting arguments about the value relevance of deferred taxes. We address two questions. First, does accounting aggregation hold, or in other words, are deferred tax expense and liability balances valued the same as operating earnings and asset balances, respectively? Second, what accounting method for deferred taxes preserves classical accounting relations, or should deferred taxes be recorded as equity, as debt, or as some combination of these categories? We answer these questions using a model of depreciable assets and cashflow dynamics identical to Feltham and Ohlson (1996). We find that aggregation does not hold; rather deferred taxes are valued less than earnings and book value. Deferred taxes add value because they represent the deferral of tax payments, so their value is the net present value of the tax benefits. We interpret this result to mean that the timing of the reversal of temporary differences does matter, consistent with recent empirical work. Our analysis shows that the deferred tax liability, as currently recorded in accordance with US GAAP, overstates the liability. Also, we find that the classical accounting relations hold only when deferred taxes are adjusted to their net present value. Further, the extent of this adjustment depends on whether or not the tax benefits are capitalized into the cost of the operating asset. If the benefits are reflected in the asset's cost, deferred taxes should be adjusted down based on the ratio of the discount rate over the sum of the tax depreciation and discount rates. Otherwise, the entire balance should be treated as equity.