Making Deferred Taxes Relevant

Abstract

We analyse the conceptual problems in current accounting for deferred taxes and provide solutions derived from the literature in order to make International Financial Reporting Standards (IFRS) deferred tax numbers value-relevant. In our view, the empirical results concerning the value relevance of deferred taxes should find their way into the accounting standard-setting process. We conclude that deferred taxes should only be recognised for temporary differences that will result in real future tax payments and/or tax receipts. Temporary differences for which the tax cash flow has already occurred have valuation implications for the underlying asset or liability and should, therefore, be accounted for based on the valuation adjustment approach. Furthermore, we conclude that partial allocation should replace comprehensive allocation in order to better align deferred taxes with expected future cash flows and thus increase their relevance and understandability. Finally, we conclude that deferred tax balances should be measured on a discounted basis to address time value.

Keywords:

• IFRS
• deferred taxes
• book-first
• tax-first

Acknowledgements

We appreciate useful comments by Ralph ter Hoeven, Martin Hoogendoorn and Christopher Nobes and participants of the IASB Research Forum in Brussels on 28 November 2017.

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

1 See http://archive.ifrs.org/Current-Projects/IASB-Projects/Income-Taxes/Pages/Income-taxes-research-project.aspx

2 For instance, see a Discussion Paper prepared by the European Financial Reporting Advisory Group (EFRAG) and the UK Accounting Standards Board (ASB) that was published in 2011 (EFRAG and ASB, 2011).

3 See also p. 5 of the EFRAG and ASB Discussion Paper (2011): ‘Some question the underlying principle of IAS 12 and point to the many exceptions to the principle as evidence the standard is in some way fundamentally flawed’.

4 The discounted tax amortisation benefit is calculated by discounting the tax amortization of 1000/10 years * 25% = 25 for the years 1–10 through the following calculation: 25*(1 − (1 + 10%)⁻¹⁰)/10% = 154.

5 For instance, see paragraph 2.15 (p. 39) of Discussion Paper EFRAG and ASB Discussion Paper (2011): ‘In their view, the future obligation to pay tax is not a present obligation because it is contingent on the earning of future income.’

6 See https://www.frc.org.uk/accountants/accounting-and-reporting-policy/uk-accounting-standards/standards-in-issue/frs-19-deferred-tax.

7 See also paragraph 2.21 (p. 40) Discussion Paper by EFRAG and ASB (2011):

This relatively stable relationship may be useful in assessing the likely future reported effective tax rate that will apply to the entity’s income. Some, however, would consider that the most relevant information is that which assists assessment of future cash flow rather than future reported income.

8 See also Schultz and Johnson (1998) Exhibit 3 on p. 93 where, for example, Waytt, Dieter, and Stewart (1984) and Gilles (1976) are listed as supporters for using the balance sheet approach for book income before tax income items and the valuation adjustment approach for tax income before book income items.

9 In year one entity A could, for example, present their net result of 687 as income of 1000, depreciation cost of 100, interest income of 18 and income tax of total 231 with current tax of 200, a change in tax valuation adjustment of (−190–171) = −19 and a deferred tax expense of 50 (excluding interest). See also the analysis on p. 50 of the EFRAG and ASB Discussion Paper (2011).