Summary and conclusions belonging to the thesis The Relevance of Comprehensive Interperiod Income Tax Allocation Ewout Naarding 1. Introduction In my dissertation I have studied the value relevance of comprehensive interperiod income tax allocation. In my research I have empirically tested the key aspects of the comprehensive interperiod income tax allocation model under various Generally Accepted Accounting Principles (GAAPs) including International Financial Reporting Standards as endorsed by the European Union (IFRS EU) and United States GAAP (US GAAP). I have examined the value relevance of the reported deferred tax balances from a balance sheet perspective and from an income statement perspective using local GAAPs, IFRS EU and US GAAP data. In addition, I have studied the value relevance from a cash flow statement perspective using the income taxes paid. In my research I have included EU countries that already incorporated comprehensive interperiod income tax allocation in their local GAAP standard prior to the adoption of IFRS EU. I have also included US firms reporting under US GAAP since these firms have been using the comprehensive interperiod income tax allocation model for decades. My research is motivated by the significant critique users and preparers have on the comprehensive interperiod income tax allocation model. The model is often criticised for lacking decision usefulness because deferred tax balances are insufficiently related to cash flows. In addition there is critique on the current model since it prohibits the discounting of deferred tax balances and therefore ignores the value of time incorporated within deferred tax balances. The critique on International Accounting Standard 12 ‘ Income taxes’ (IAS 12) has recently been summarized in a discussion paper of the European Financial Reporting Advisory Group (EFRAG, 2011). In this discussion paper EFRAG discusses alternatives that could be used to replace IAS 12. In my research I empirically test suggested alternatives such as improving IAS 12 through discounting, the flow-through model and the partial tax allocation approach. My results show that income tax measures which are based upon income tax cash flows are more relevant for investors than the income tax expense reported under the comprehensive interperiod income tax allocation model. The current tax only, an often suggested alternative, does not offer a solution to the comprehensive interperiod income tax allocation model neither does discounting of deferred tax liabilities. The comprehensive interperiod income tax allocation does provide value relevant information in relation to the recognition of deferred tax assets. I also find that deferred tax liabilities which are expected to 1 reverse in the foreseeable future have value relevance. My results in total indicate that comprehensive interperiod income tax allocation could be improved by further aligning the reported deferred tax balances with the actual income tax cash flows. This would result in a more realistic reporting of deferred tax balances and would therefore address the significant critique of users and preparers. 2. The value relevance of deferred tax assets in the Netherlands My research results find support for the balance sheet liability method under Dutch GAAP in which deferred tax assets are separately recognized based upon management judgement. A deferred tax asset arising from tax losses carry forward or deductible differences can reduce future income tax payments, but only when firms are expected to earn future taxable profits. Firms that do not earn (sufficient) taxable profits in the future are unable to fully offset the available tax losses carry forward against taxable profits and are therefore not able to fully utilize the benefits arising from the deferred tax asset. Since the realization of deferred tax assets depends on the availability of future taxable profits accounting standards, such as Dutch GAAP, require that management can only recognize deferred tax assets if it is ‘probable’ (likelihood greater than 50 percent) that there will be sufficient taxable profits. The recognition of deferred tax assets therefore depends on management judgement. The portion of the deferred tax asset for which management estimates that the realization is not probable should be disclosed in the footnotes of the financial statements and is also referred to as the valuation allowance. The concept of valuation allowance has been introduced under US GAAP in which it is a mandatory disclosure item. Under Dutch GAAP and also IFRS EU the unrecognized deferred tax assets are not separately disclosed. Listed firms need to disclose the amount of unrecognized tax losses carry forward and other deductible differences. However, the corresponding value of unrecognized deferred tax asset, which is derived at by taking into account the applicable tax rate, does not need to be disclosed. As the recognition of deferred tax asset depends on management judgement the question arises whether investors accept these estimates and associate deferred tax assets with firm value. A deferred tax asset, in particular arising from carry forward losses, has something of a paradox. From a measurement perspective a deferred tax asset will potentially reduce future income tax payments which increases firm value. However, from an information perspective the existence of tax losses is a signal that there is a higher risk of more future losses. This higher risk increases the cost of capital of a firm thereby reducing firm value (see Amir and Sougiannis, 1999). My results demonstrate that investors associate the recognized deferred tax asset under Dutch GAAP with the market value of firms. In addition the valuation allowance which has been applied by management for the portion of the deferred tax assets, for which the future realization is not probable, is negatively associated with the market value of firms. The research results show that investors consider deferred tax assets recognized under Dutch GAAP as true assets and that they take into account the implications arising from management’s estimates regarding the future realization. A limitation of my research is that I had 2 to estimate the valuation allowance applied by management. Dutch listed firms were under Dutch GAAP only required to disclose the amount of carry forward losses and other deductible temporary differences. Unless firms had dual listings in the Netherlands and in the US, I had to estimate the valuation allowance. Although I acknowledge this limitation, I also believe that the estimate is sufficiently accurate in particular since the model is focussing on the correctness of the sign rather than the magnitude of the slope coefficient of the independent research variables. 3. Does discounting of deferred tax liabilities address the criticism on IAS 12? My results find support for the decision of the International Accounting Standard Board (IASB) and the Financial Accounting Standard Board (FASB) to prohibit discounting of deferred tax liabilities. Under IAS 12 and ASC 740 firms listed in the EU and in the US are not allowed to take into account the time value of money. Many believe that the prohibition of discounting leads to an overstatement of deferred tax balances since a tax payment in the future has less value than a tax payment today due to the accretion of interest. The IASB and the FASB however believe that discounting is too complex and impractical. In addition it is unclear how deferred tax balances should be discounted and what discount rate should be used. My research shows that the undiscounted deferred tax liabilities reported by French firms under IFRS EU are value relevant, whereas the discounted deferred tax liabilities reported by French firms under French GAAP have no value relevance. The results show that the method French firms use to discount their deferred tax liabilities adversely impact their value relevance. French firms discount their deferred tax liabilities based upon the reversal rate if the impact of time can be estimated reliable. This approach creates noise which adversely impacts the overall value relevance of the discounted deferred tax liabilities under French GAAP. The results under IFRS EU show that the undiscounted deferred tax liabilities reported by French firms under IAS 12 are negatively associated with firm value, although their significance is modest. The limited value relevance can be attributed to the fact that the deferred tax liabilities are insufficiently related with the actual income tax payments. After controlling the sample for depreciable assets I find that deferred tax liabilities are only value relevant at the lower level of these depreciable assets. Taxable temporary differences in relation to depreciable assets are in total not expected to reverse. Firms on an going concern basis continue to invest in their depreciable assets thereby creating new taxable temporary differences. As a result these taxable temporary differences will on an overall basis not result in income tax payments. I finally find evidence that deferred tax liabilities reported under French GAAP are negatively associated with the market value of firms when firms have a high level of intangible assets. French GAAP did not (always) allow the recognition of deferred tax liabilities on temporary differences arising from indefinite useful life time intangible assets acquired in a business combination. I find that consistent with prior literature (Citron, 2001) the alignment of deferred tax liabilities with the foreseeable tax cash flows enhances the value relevance. 3 Overall my results show that the discounting of deferred tax liabilities using a reversal rate adversely impacts their value relevance. This result is consistent with the analytical papers of Guenther and Sansing (2000; 2004) and is therefore an important addition to their studies. My research also contains empirical support for the arguments of the IASB which does not allow the discounting of deferred tax liabilities under IAS 12. My research shows that the discounting of deferred tax liabilities is complex and does not resolve the critique on the current model on IAS 12 from users and preparers. I furthermore find that only deferred tax liabilities that are expected to reverse have value relevance. This result is consistent with recent research of Chludek (2011b) using IFRS EU data from Germany and also prior research using US GAAP data (Amir et al., 1997). In total my research indicates that the IASB should further explore the partial approach as a possible solution to address the current shortcomings in IAS 12. The partial approach is also in the EFRAG (2011) discussion paper considered an alternative to the current comprehensive approach included in IAS 12. My results provide empirical support for the arguments in favour of the partial approach, in particular that the amount of deferred taxes reported in the financial statements would have a clearer meaning since it has the ability to predict the future tax cash flow (EFRAG, 2011). Although I believe that this does not influence the results, there are certain limitations in this research. First of all I was not able to collect data with respect to the underlying temporary differences as these are not disclosed in the financial statements prepared under French GAAP. As a result, I have used alternative proxies to determine taxable temporary differences in relation to depreciable assets. Moreover, I have not been able to separately control for the current deferred tax liabilities reported under French GAAP. French firms were required to report the current portion of the deferred tax liability under the current liabilities under French GAAP. I have not been able to collect the current portion because these are not separately disclosed in the French GAAP financial statements on a consistent basis. 4. The characteristics of the income tax expense reported in France and the UK The research results from an income statement perspective show that the reported income tax expense of French and UK firms is strongly associated with the reported earnings before income taxes, both under local GAAP and under IFRS EU. These results show that the application of accounting standards, based upon the (comprehensive) interperiod income tax allocation method, results in the matching of the income tax expense with the earnings before income taxes. I also find that the asymmetric verification requirements for income tax benefits versus income tax expense has a strong influence on this matching relationship. I find that firms are cautious to recognise an income tax benefit when they report losses for book purposes. I attribute this to the strict verification requirements which are included in accounting standards for such income tax benefits. The benefit of a deferred tax asset can only be recognised when it is ‘probable’ that there will be sufficient future taxable profit. I further find that there are cross sectional differences under local GAAP and IFRS EU in the association between earnings before income taxes and the income tax expense which can be attributed to the country’s institutional settings. I 4 find these differences both under local GAAP and IFRS EU which show that the incentives for stakeholders are stronger than the relative influence of IFRS EU. French listed firms report under influence from their institutional settings an income tax expense which is smoother and therefore stronger related to earnings before income taxes, than the income tax expense reported by UK listed firms. Stakeholders of French firms expect such a smooth strong relationship due to their institutional settings arising from a dependent tax system and code law. They therefore demand a smooth income tax number which gives French firms an incentive to report accordingly. The income tax standards under local GAAP and also IFRS EU provide sufficiently flexibility as these are complex and require significant management judgement. This allows French listed firms to report a smooth income tax expense. Such incentives are limited for UK listed firms due to a historical background of an independent tax system and common law. This research and its results should be considered in the context of accounting for income taxes and the characteristics of the income tax expense based upon the matching principle and the concept of conservatism. My results are therefore limited to these accounting characteristics and should be considered in this context. I believe that the proxies I have used fairly represent the country specific institutional settings relevant for the accounting for income taxes. However, I acknowledge that these could capture also other specific country elements. Therefore my results should not be generalized to the overall reporting under IFRS EU. The proxies used are representing the institutional settings relevant for the accounting of income taxes and my results should be read in that context. 5. The value relevance of income taxes paid My results, from a cash flow perspective reveal that the income taxes paid has value relevance over other income tax measures such as the income tax expense reported under US GAAP and the current income tax expense. I find that at the one, five and ten year return interval the income taxes paid is the best proxy for income taxation of a firm. My results show that other income tax measures such as the income tax expense in accordance with GAAP as well as the current income tax expense do not have any or only have limited value relevance. The income tax expense based upon comprehensive interperiod income tax allocation appears to suffer from too many measurement errors which reduces its value relevance. The deferred income tax expense is not significant in any of the tests and does not seem to be associated with the shareholders returns of firms. An often suggested alternative, the current tax only approach also does not demonstrate significant value relevance. Under the current income tax only approach the income tax expense equals the amount included in the tax return and temporary difference between tax and book are ignored. This approach, also referred to as the flow-through method, considers income taxes as an expropriation of profits rather than an appropriation of profits. My results however indicate that the current income tax expense is not or limited value relevant. The lack of value relevance of the current income tax expense is attributed to intraperiod tax allocation under which certain transactions including its income tax effects are recognized outside the income 5 statement in other comprehensive income (OCI) or directly in equity. In addition the accounting for prior year adjustments are also included in the current income tax expense. Both elements create noise in the reported current income tax expense which negatively impacts its value relevance. My results show that the income taxes paid is the best proxy for income taxation for firms regardless whether the return interval is short or long. My results are an important addition to the results of Dyreng et al. (2008), as I find that income taxes paid are not only the best measure income for tax avoidance but that these are also considered by the capital markets as the best proxy for income taxation. In my research I had certain limitations. I was for example not able to collected the tax impact from OCI and equity adjustments nor was I able to collect the impact from prior year adjustments on the reported income tax expense. I was therefore not able to separately control for these elements although I expect that these adversely impact the value relevance of the current income tax only approach. Although this is a limitation of my research, I believe that it does not impact my overall results since I was primarily interested to test whether the income taxes paid have value relevance for investors. 6. Implications of my research The results from my dissertation are important for the FASB and the IASB in their elaborations on the amendments of the current accounting model for income taxes. The results of my research also contributes to users of financial statements such as investors and analysts. My results will enhance their understanding and interpretation of the reported income tax expense reported by listed firms in the EU and the US. My results are moreover important for prepares since this will allow them further insight on the implication of the current interperiod income tax allocation on the valuation of firms. My results confirm the shortcomings of the comprehensive interperiod income tax allocation model using the balance sheet liability model. Income tax measures which are based upon cash flows are more relevant for investors than the income tax expense reported under the comprehensive interperiod income tax allocation model. The smoothing of the income tax expense under the comprehensive interperiod income tax allocation method does not enhance the ability to predict future tax cash flows of firms. The current tax only, an often suggested alternative, does not offer a solution to the comprehensive interperiod income tax allocation model in its current form. The current income tax expense has measurement errors because it includes prior year adjustments. In addition, not all elements of the current income tax expense are recognized in the income tax line, the intraperiod tax allocation model requires that certain income tax effects are recognized outside the income statement. My empirical research results demonstrate that the current income tax only approach does not result in a value relevant taxation proxy. In addition my research results indicate that the discounting of deferred tax liabilities is neither able to address the issues of comprehensive interperiod income tax allocation. Discounted deferred tax liabilities using a reversal rate adversely impacts the value relevance of deferred tax balances. The comprehensive interperiod income tax allocation does provide value relevant information in relation to the recognition of deferred tax assets. My research result finds 6 support for the recognition of deferred tax assets using the ‘probable’ threshold and the concept of valuation allowances. These results are consistent with prior research from the US (e.g. Miller and Skinner, 1998; Kumar and Visvanathan, 2003). Furthermore I find evidence that deferred tax liabilities which are expected to reverse in the foreseeable future also are incorporated in the market value of firms. This evidence is consistent with the research results of Chludek (2011b). Overall my results indicate that comprehensive interperiod income tax allocation could be improved by further aligning the reported deferred tax balances with the actual tax cash flows. This would result in a more understandable reporting of deferred tax balances and would therefore address the significant critique of users and preparers. I would in this respect be a proponent of the partial income tax allocation model, since this would increase the value relevance of the reported tax balances through the alignment with tax cash flows. Under the partial approach deferred tax balances, both on the asset and the liability side, would only be recognized if these would result in income tax reductions or income tax payments in the foreseeable future. The application of the model would address the critique of practitioners that deferred tax balances are not discounted. The impact of discounting would be significantly reduced since only deferred tax balances are recognized which will result in income tax payments in the foreseeable future. The partial approach would also be consistent with current valuation practises under which investors often reverse out deferred tax liabilities and consider these quasi equity. The application of the partial approach would further ensure that the asymmetrical recognition criteria for deferred tax liabilities versus deferred tax assets are resolved or at least reduced since both assets and liabilities would now be depending on expected future income tax payments to the tax authorities. A major concern on the application of the partial approach is that management would be given too much discretion on the recognition of deferred tax balances what could lead to earnings management. Although I acknowledge that the partial approach would provide more opportunity for earnings management, I also note that there were similar concerns on the recognition of deferred tax assets in the past. Empirical evidence as well as anecdotal evidence has, however, demonstrated that the recognition of deferred tax asset based on management’s judgement results in decision useful information (e.g. Ayers, 1998; Chludek, 2011a). In addition various studies on the partial allocation model from the UK (e.g. Citron, 2001; Gordon and Joos, 2004) have demonstrated that this results in value relevant information. More recently also Chludek (2011b) concluded that the partial approach could be a solution to enhance the decision useful information of deferred tax balances. I therefore agree with the conclusions of normative researchers (see for example Kampschöer, 1993), that in the debate on deferred taxes the arguments for relevance should prevail the concerns over reliability. I also agree with Chambers (1968) that the current accounting standard for income taxes can only be justified with arguments of conservatism .The current comprehensive interperiod income tax allocation model results in an overstatement of the amounts of reported deferred tax balances. I therefore suggest that the FASB and IASB consider to fundamentally change the current 7 accounting model and if doing so there should be an explicit focus on the alignment of the accounting model to actual income tax payments. 7. Suggestion for future research In my research I have empirically tested the value relevance of comprehensive interperiod income tax allocation from different perspectives. I have tested the value relevance from a balance sheet perspective, an income statement perspective and a cash flow statement perspective. In my research I have furthermore tested whether suggested improvements by EFRAG (2011) to the current model such as discounting of deferred tax balances would enhance the decision usefulness. I have furthermore tested whether alternatives suggested by EFRAG (2011) such as the flow-through model or the partial allocation model would increase the value relevance of the comprehensive interperiod income tax allocation model. In my research I have however not tested all suggested alternatives approaches by the EFRAG (2011). A suggestion for future research would be to also test other suggested alternatives by EFRAG (2011) such as the valuation adjustment approach or the accruals approach. Another suggestion for future research is to test the value relevance of the valuation allowance reported under IAS 12 in the EU. Since the IASB is now considering to adopt the valuation allowance concept from US GAAP into IFRS this would be an interesting and useful follow up research. Another suggestion for future research is to test the value relevance implications on the discounting of deferred tax assets. In my research I have specifically chosen for deferred tax liabilities because the critique from users and preparers is pre-dominantly focussed on deferred tax liabilities. However it will be interesting to test the value relevance of discounted deferred tax assets in particular in relation to deferred tax assets arising from carry forward tax losses. A further suggestion for future research is to test the value relevance of the income taxes paid for EU listed firms. In my research I have used US data since IFRS EU does not yet allow me to collect data for a ten years interval. It will however be interesting to test whether the results for the one year period and five years period for EU listed firms are similar to US firms. Finally, in my research I have fully focussed on the measurement perspective of accounting for income taxes. I have not specifically tested whether from an information perspective enhanced disclosures could increase the decision usefulness of comprehensive interperiod income tax allocation. A final suggestion for future research is therefore to examine whether improvements in relation to presentation and disclosures could potentially overcome the measurement issues of comprehensive interperiod income tax allocation. In the discussion paper of EFRAG (2011) several suggestions are brought forward including, but not limited to, additional disclosures regarding the effective tax rate reconciliation and disclosures on future tax cash flows. 8