Comprehensive versus Partial Deferred Tax and Equity Market Values

Abstract

This paper investigates the value relevance of the deferred tax liability recognized using comprehensive allocation, an accounting method where the tax effect of all timing differences is recognized on the balance sheet, and partial allocation, where the tax effect of only reversing timing differences is recognized. Our research examines New Zealand firms who, prior to the introduction of international financial reporting standards, were free to choose between comprehensive and partial allocation. We test the joint hypothesis that the partial, as opposed to comprehensive, deferred tax liability is relevant for equity valuation and is sufficiently reliable to be reflected in investors’ valuation assessments. Our results indicate that the partial (comprehensive) deferred tax liability is (not) value relevant and sufficiently reliable to be reflected in share prices, and that share returns are (not) significantly related to annual changes in the partial (comprehensive) deferred tax liability. These findings indicate that investors find partial allocation useful for valuation. Investors’ preference for partial allocation has an important implication for accounting standard-setters like the International Accounting Standards Board because they should reconsider partial allocation as an alternative to the prescribed comprehensive allocation.