Deferred Taxes Revisited

Abstract

The study examines the deferred tax accounting theory and procedures required by the FASB in the context of the unit problem. The unit problem involves the selection of the appropriate perspective (either individual or aggregate) for applying measurement and recognition conventions to phenomena of interest. From an individual event perspective, the FASB's conclusions regarding liability recognition are inconsistent with the definition of liabilities found in the Statement of Financial Accounting Concepts No. 6. In addition, the use of inconsistent perspectives by S109 creates disagreements with the FASB’s position, where both the individual and aggregate perspectives are used simultaneously as the basis of the FASB's decisions. The study argues that the income tax accounting issue should be viewed from an aggregate perspective and concludes that the flow-through method of accounting for income taxes should be adopted. The impact of eliminating deferred taxes and adjusting the liability and stockholders equity balances on the debt-to-equity (DTE) ratio is computed for the entire COMPUSTAT database (20 years). For the 817 firms that persist throughout the 20-year period, each year, the net deferred tax balance for each company is compared to the balance in the previous year, with increases (53%) outnumbering decreases (32%), and the remainder (15%) showing no change. In addition, the average annual net deferred tax balances of entire sample show increases for the 15 of the 20 years examined and the balances for persisting firms show increases for 17 of the 20 years examined. Finally, the relative size of the net deferred tax balances as a percentage of total assets and total liabilities for both the overall sample and the persisting firms range from 4.1% to 5.8% of total assets and from 7.9% to 11.8% of total liabilities. Statistical results show that the decreases in the DTE ratio are significant for each year, with an overall average decrease of 19%. Thus, the flow-through method results in significant changes in a key ratio that is used in the financial evaluation of most companies. Conversely, the DTE ratios currently used in the financial evaluation of companies are flawed because the net deferred tax balances are included in liabilities, when it is clear that these accounts do not meet the liability criteria specified in accounting theory.

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