The ‘New’ Deferred Tax: a Comment on AARF Discussion Paper No. 22 ‘Accounting for Income Tax’

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  • BALJIT K. SIDHU

    THE NEW DEFERRED TAX: A COMMENT ON AARF

    DISCUSSION PAPER No. 22 ACCOUNTING FOR INCOME TAX

    he release of Discussion Paper No. 22 Accounting for Income Tax (DP 22) by T the Australian Accounting Research

    Foundation (AARF 1995a) has given impetus to the debate about whether, and how, to account for income taxes. T h e DP 22 proposals, if pursued, will effectively take Australian reporting for income taxes closer to the recently revised US Standard, SFAS 109 Accoanting for Income Tuxes (FASB 1992) and the current International Exposure Draft E49 Income Taxes, issued by the International Accounting Standards Committee (IASC 1994). DP 22 represents significant change through its advocacy of a balance sheet approach, rather than the currently prescribed income statement approach for the recognition of deferred tax assets and liabilities. T h e latter accounts for timing differences only, while the balance-sheet approach, a US innovation, accounts for all temporary differences.

    in terms of making Australian accounting requirements consistent with our conceptual framework. The re may also be an implicit desire to move closer to North American and international requirements. No judgment is made here on either motivation. This paper is intended to contribute to informed debate by demonstrating that a number of the arguments presented in D P 22 in support of the balance- sheet approach are logically inconsistent.

    T h e motivation for this change is expressed

    Discussion Paper No. 22 Accounting for Income Tax (DP 22), issued by the Australian Accounting Research Foundation, represents significant change through its advocacy of a balance sheet rather than the currently prescribed income statement approach for the recognition of deferred tax assets and liabilities. This paper clarifies the differences between the two methods and illustrates their effects on financial statements. I t evaluates D P 22s arguments in favour of the balance-sheet approach and provides some guidance on the usefulness of deferred tax numbers. The paper concludes that the logical inconsistencies in D P 22, coupled with the available evidence on income-tax al~ocat~on, suggest that we should be cautious in making changes to current reporting requirements.

    V O L . 6 N O . l 1 9 9 6 A U S T R A L I A N A C C O U N T I N G R E V I E W 3 7

  • Further, the empirical evidence on the usefulness of income-tax allocation is equivocal and indicates that a narrower, rather than wider, structure for recognising deferred tax assets or liabilities might be preferable. Indeed, the recent US debate questioned the credibility of the comprehensive approach to tax allocation; some have suggested a move to partial allocation.

    TIMING V TEMPORARY

    DOES IT MEAN? DIFFERENCES - WHAT

    T h e income-statement approach promulgated in AASB 1020 Accounting for Income Tax accounts for differences between accounting and taxable income that are expected to reverse in time. That is, it only accounts for the tax effects of timing differences between the two income measures. T h e tax effects of permanent differences are not allocated between accounting periods.

    suggests, takes account of (temporary) differences between tax and accounting balances in asset and liabilig accounts that give rise to future tax consequences. DP 22 describes temporary differences (p. 27) as those differences between carrying amounts and tax balances that have future tax consequences.

    items that affect current as well as future accounting or taxable income computations. These differences filter into accounting and tax balances (carrying amounts) of assets and liabilities. However, these carrying amounts also reflect permanent differences, if any. Since temporary differences are the difference between tax and accounting balances (carrying amounts), then, conceptually a t least, they must include both timing and permanent differences.

    However, in its application of the concept of temporary differences, DP 22 includes all timing but only certain permanent differences - ie, only those that have future tax consequences. T h e latter include revaluation increments (that are non-depreciable for tax purposes). Permanent differences arising from items that do not have future tax consequences, such as non-taxable income or non-deductible costs (eg, goodwill or certain long-term assets) are not to be accounted for under the balance-sheet approach.

    T h e balance-sheet approach, as its name

    Timing differences, by definition, arise from

    T h e following example illustrates the difference between the two approaches with respect to the deferred tax asset/liability recognised in the case of an asset revaluation, assuming that the asset is to be recovered through use rather than sale. It also illustrates how the computation of temporary differences under the balance-sheet approach effectively amounts to accounting for the more familiar timing as well as permanent differences.

    Example 1* An item of plant, which had originally cost

    $16,000 with an expected usejid l$e of 16 years and a residual value of ni& has been depreciated at annual amounts of $1,000 and$2,OOO for accounting and tax purposes respectively. By the end of 19x0, the carrying amounts in the accounting and tax balance sheets are $10,000 and$4,000 respectively. The tax rate is 40% and the dien-ed tux liability for this item ofplant is $2,400 (ie, 40% of $6,000).

    The asset is revalued to $20,000 at the beginning of 19x1 and accounting depreciation is increased to $Z,OOOperyear The reualuation does not afect the tax base of the asset. Assume that the asset will be used until the end of its ust$ul lqe (the remaining 10 years); that is, the asset? value is to be recovered through use rather than sale.

    Table1 illustrates the accounting and tax treatments with respect to depreciation of the asset for the years 19x0 to 19x10, including the year of the revaluation, 19x1. T h e effects on 19x1 itself are demonstrated both at the start and the end of that year.

    T h e annual depreciation charges and resulting carrying balances under accounting (Panel A) and tax (Panel B) treatments are straightforward. By the end of 19x2 the asset is fully depreciated for tax purposes and has a tax basis or tax carrying value of zero. (Notice that under the income-statement approach, timing differences start to reverse after this year, reducing to zero in 19x10). When the asset is revalued at the start of 19x1, the accounting treatment is to set accumulated depreciation to zero (by writing off the previously accumulated balance against the historical cost of the asset) and the excess of the new value over the written-down (book) value is credited to a revaluation reserve. For tax purposes nothing has changed. It can readily be seen that permanent differences between accounting and taxable income are introduced when the asset is revalued at the start of 19x1. This is equal to the revaluation

    3 8 A U S T R A L I A N A C C O U N T I N G R E V I E W

  • TABLE 1: ASSET REVALUATION

    Year X(-l) XOXl-beaX1-clsa X2 X3 X4 X5 X6 X7 X8 X9 XI0

    PANEL A: Accounting Depr Exp 1000 1000 0 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 Cost 16000 16000 20000 20M)O 20000 20000 20000 2oooO Zoo00 2oooO 2oo00 20000 ZoOO() Acc Depr 5000 6000 0 2000 4000 6000 8000 loo00 I2000 14ooo 16OOO 18000 2oooO CarryingAmt 11000 10000 20000 18000 I6000 14000 12000 I0000 8000 6OOO 4ooO 2000 0

    PANEL B: Tax

    Cost 16OOO I6000 10000 16000 16000 0 0 0 0 0 0 0 0 Depr Exp 20(0 2000 0 2000 2000 0 0 0 0 0 0 0 0

    AccDepr loo00 12000 12000 l4O()O 16OOO 0 0 0 0 0 0 0 0 CarryingAmt 6000 4000 4000 2MH) 0 0 0 0 0 0 0 0 0

    PANEL C: Income Stmt Approach Perm diffs 0 0 -10000 -9000 -8000 -7000 -6OOO -5000 -4000 -3000 -2000 -1000 0

    remaining

    diffs Cum timing -5000 -6000 -6000 -7000 -8000 -7000 -6OOO -5000 -4000 -3000 -2000 -1000 0

    DTL ZOO0 2400 2400 2800 3200 2800 2400 2000 1600 1200 800 400 0 (4096xtiming diffs)

    DTE 400 400 n.a. 40 400 -400 -400 -400 -400 -400 -400 400 -400 (DTL t - DTL t-I)

    PANEL D Bal. Sheet Approach Temporary -5000 -6000 -16000 -16000 -164 -14OOO -12000 -loo00 -8000 -6000 -4OOO -2000 0

    DrL 2000 2400 6100 6400 6400 5600 4800 40 3200 2400 1600 800 0 differences

    (40%xtemporary diffs) DTE 400 400 n.a. 4000 0 -800 -800 -800 -800 -800 -800 -800 -800

    (DTL t - DTL t-I)

    increment to the value of the asset which will never be tax-deductible. Thus the difference in the accounting and tax carrying amounts at the beginning of 19x1 represents a cumulative timing difference of -$6,000 and a permanent difference of -$lO,OOO. T h e timing difference continues to accumulate until the asset is completely written off for tax purposes (in 19x2) and then starts to reverse. T h e permanent difference between accounting and tax carrying amounts diminishes each year by the incremental amount of book depreciation now being charged ($2,000 instead of the previous $1,000; that is, the useful life of the asset is unchanged).

    Under the balance-sheet approach, it is assumed that the book value of the asset (including the revaluation increment) will be recovered either through use over the assets life or through sale. Recovery through use is

    assumed in the example here.3 Consequently, the difference between accounting and tax carrying amounts is considered to be a future taxable amount; a deferred tax liability is calculated by applying the enacted tax rate to this temporary difference. Notice that this temporary difference each year is the sum of timing and permanent differences.

    In summary, temporary differences or the difference between accounting and tax carrying amounts also amount to the sum of cumulative timing differences and remaining permanent differences. T h e emphasis under this approach is to ascertain the expected tax liability of recovering that asset through use or sale (assuming a sale would take place at the revalued amount at a minimum).

    Brief descriptions of the types of temporary differences recognised in DP 22 follow. These include all items currently described as timing differences plus certain (but not all)

    A U S T R A L I A N A C C O U N T I N G R E V I E W 3 9

  • types of permanent differences. T h e types of permanent differences included are:

    Revaluation of long-term assets DP 22 advocates accounting for the

    (temporary) differences between accounting and tax carrying amounts caused by the revaluation of an asset purchased after the implementation of capital gains tax (CGT) legislation. T h e amount of deferred tax recognised is dependent on whether the asset is expected to be recovered through use or sale: the treatment under the assumption of recovery through use is illustrated in Example 1 above, where the written-down tax base is relevant for computation of the temporary difference. If, on the other hand, recovery through sale is assumed, then potential C G T liabilities are to be recognised and the indexed cost base becomes relevant instead. Revaluation of pre-CGT assets is not considered to result in a tax liability, on the basis that the amount of deferred tax liability is dependent on the mode of recovery (zero C G T in the case of recovery through sale as against a non-zero future tax liability through non- deductibility of buildings in the case of recovery through use). Given that the incurring of any tax liability is completely at the discretion of management, no tax liability is considered to exist.

    Annual adjustments to the revaluation-related tax asset or liability are to be charged to income rather than equity. This asymmetrical treatment of the revaluation (typically taken to a revaluation reserve) and the annual adjustment is considered later in this paper.

    Tax losses

    acquisitions. First, in the presence of goodwill, while a future tax asset or liability would not be recognised under the income-statement approach (since goodwill represents a permanent difference), it would be recognised under the balance-sheet approach. Second, any revaluation of the subsidiarys net assets would give rise to tax assets or liabilities as in Example 1 above, regardless of whether

    the revaluation is done in the books of the subsidiary or as a consolidation adjustment.

    GIVEN THAT

    THE

    INCURRING OF

    ANY TAX

    LIABILITY IS

    COMPLETELY

    AT THE

    DISCRETION OF

    MANAGEMENT,

    NO TAX

    LIABILITY IS

    CONSIDERED

    TO EXIST.

    Retroactive adjustments These relate to adjustments made

    on adoption of an accounting standard which represents a change in accounting policy; for example, in changing from reporting leases as operating leases to finance leases. This involves booking a lease liability and a lease asset for financial reporting, the carrying amounts of which might vary from their tax bases. Such variations (temporary differences) would result in the recognition of tax assets and liabilities under the balance-sheet approach but not under the income- statement approach.

    Consolidation of an integrated

    Non-monetary assets of foreign operation

    integrated foreign operations are translated at their relevant historical rates of exchange. A curious example is given (p. 62) to illustrate why the balance-sheet approach might result in a tax asset or liability, while the income-statement approach would not. This example is evaluated later in the paper.

    T h e situation with tax losses is essentially unchanged.

    Acquisition of a subsidiary (where the purchase price exceeds the fair market value of the net assets of the subsidiary)

    DP 22 raises two issues concerning

    Unrealised profit on the intra- group sale of inventory (where

    the buying entity is a foreign entity) Under the income-statement approach, the

    tax paid by the selling entity on the unrealised inter-company profit will give rise to a deferred tax asset, to be realised when the goods are sold on to an external party. T h e situation remains the same if the buying entity is a foreign one, with a different tax rate. Under the balance-sheet approach, however, while the amount of the temporary difference is the

    4 0 A U S T R A L I A N A C C O U N T I N G R E V I E W

  • same (assuming a stable exchange rate) as the timing difference above, the deferred tax asset would not have the same value because of differential tax rates.

    effectively widens the coverage of differences between tax and accounting treatments of transactions beyond just the timing differences accounted for under the income-statement approach.

    In short, the balance-sheet approach

    CRITICAL E VAL U AT1 0 N OF AARF ARGUMENTS IN

    FAVOUR OF THE

    APPROACH BALANCE-SHEET

    T h e essential nature of the tax-related assets or liabilities arising from the timing difference components of temporary differences under the balance-sheet approach is no different from those recognised under the income-statement approach. Changing their label does not make them more or less hypothetical under different approaches. Further, the recognition of tax- related assets or liabilities arising from certain permanent differences, as required by a balance-sheet approach, is based on arguable reasoning.

    Hypothetical v real deferred tax

    D P 22 (p. 31) characterises tax assetshiabilities

    assets/liabilities recognised under the income statement approach as hypothetical on the grounds that such items do not meet the definitions of assets/liabilities in SAG 4 (AARF 1995b). On the other hand, those recognised under the balance-sheet approach are characterised as assets/liabilities in their own right because they are deemed to fall within the SAC 4 definitions (DP 22, p. 33). This conclusion is logically inconsistent with the definition of temporary differences. Given that temporary differences include timing differences, then by definition tax assets/liabilities based on the former include the same hypothetical assets/liabilities based on timing differences.

    It is instructive to re-examine the arguments in DP 22 in view of the definition of assets in SAC 4. SAC 4 (para. 14) defines assets as j5uture economic benefits controlled by the entity as a result of past transactions or other past ments.

    Now, consider the economic reality behind the example used in D P 22 to reject the

    income-statement approach in favour of the balance-sheet approach. T h e example is one of long-sewice leave provisions, which are charged to income for financial reporting purposes as they are accrued but only become tax deductible when actually paid. T h e question is whether timing differences give rise to tax assets (DP 22, pp. 30-l), and similarly for temporary differences (pp. 32- 7). llnder an income-statement approach, a deferred tax asset would be recognised since more tax has been paid in the current year than would have been payable had long-service leave provisions been deductible. When the long-service leave cost becomes deductible at some point in the future (on payout of the leave), the deferred tax asset is reduced and a corresponding increase in income-tax expense is made (tax payable would be lower than tax expense in this future period). D P 22 considers the deferred tax asset to be a hypothetical one (p. 31):

    From an income statement approach perspective, therefore, a hypothetical tax benefit shouM be recognised in the profit and loss or other operating statement. The objective is to match the tax benefit relating to long service leave to the year in which the long service leave is recognised as an expense in the profit and loss or other operating statement. The tax benefit is hypothetical because it represents the tax benefit that would have been received if long service leave had been deductible in the current year. On that basis, the tax benefit does not constitute future economic benefits. Instead, it is no more than an allocation of income tax between reportingperiods and therefore fails to meet the first characteristic included in the definition of an asset (emphasis added).

    of the definition of an asset under SAC 4 (of representing future economic benefits). Yet the identical situation is deemed to result in a deferred tax asset in its own right (and not a hypothetical one) under the balance-sheet approach. T h e arguments put in favour are more lengthy (DP 22, pp. 32-7) and are not repeated here; however, the essence of the AARF view is that (p. 33):

    For the purpose of discussion, the implications of a long service leave liability are considered. The definition of liabilities sujgests that recognition of a liability for long service leave presumes that the entity will sacrifice economic benefits in the future to settle that present obligation. Under the current income tax law, that sacrifice will

    Tha t is, the asset fails to satisfy the first limb

    A U S T R A L I A N A C C O U N T I N G R E V I E W 4 1

  • be an allowable deduction and therefore will reduce income tax in the future. Accordingly, from a baLance sheet approach perspective, an asset should be recognised for the future tax (economic) benefit that is a consequence of settling the long service leave liability (which is presumed will occur by virtue of that liability being recognised). Under this v i m , if it is appropriate to recognise a liability f o r long service leave, it is equally appropi.iate to recognise an asset for the future reduction in income taxes that occurs upon settlement of that long service leave liability (emphasis added).

    That is, if it is legitimate to recognise a future liability in respect of long-service leave commitments made to employees, then it is legitimate to recognise the associated tax- effect (of deferred tax deductibility) as an asset. T h e point of contention held in this paper is not whether this reasoning itself is logical, but how this differs from the tax asset recognised under the income-statement approach.

    Whether or not the accrual and (future) tax deductibility of long-service leave gives rise to a future economic benefit and, hence, tax asset, is strictly independent of the accounting approach taken. It does not become more (or less) hypothetical by virtue of being booked through the income-statement or balance- sheet approach. lJnder either, it simply represents a possibility that the firm will pay less tax a t some point in the future, if and when the long-service leave is paid out; only then will the tax benefit be realised. Under either approach, the realisation of the benefit is contingent on the continuation of currently legislated tax provisions and the earning of future income. The accounting approach taken does not alter the economic reality. What makes DP 22s reasoning even more erroneous is that in the example used, temporary differences (under the balance-sheet approach) are exactly what we refer to as timing differences (under the income-statement approach). Similar, and questionable, reasoning is applied in D P 2 2 to the tax liability issues.

    At this point it is useful to remember that Australian accounting standards on income tax allocation have always required the liability method rather than the deferral method. Arguments that the income-statement approach results in hypothetical assets or liabilities may have been more relevant in the US debate surrounding the release of SFAS 96 and 109, which for the first time required the

    liability method. T h e previous US reporting requirements specified the deferral method which (unlike the liability method) does not adjust tax asset/liability balances for changes in tax rates; the future tax-related balance sheet items were accordingly labelled deferred debits or credits. It would appear that D P 22 is appealing to the same arguments with respect to hypothetical tax assets and liabilities (that is, deferred debits or credits) without being sensitive to the different reporting environments. With SFAS 96 and 109, the US moved from a comprehensive deferral to a comprehensive liability method.

    T h e real difference between the current income-statement approach in Australia, based on the comprehensive liability method, and the proposed balance-sheet approach is the proposed recognition of future tax consequences of certain items, currently termed permanent differences, specified in D P 22. T h e justifications offered for two of these are evaluated here.

    Revaluation adjustments give rise to deferred tax liabilities

    T h e deferred tax liabilities considered (by D P 2 2 ) to arise in this situation are a function of (permanent) differences introduced by the revaluation itself, and in effect anticipate either a capital gains tax obligation (post-CGT asset recovered through sale) or the future non- deductibility of the revaluation component (post-CGT asset recovered through use). In contrast to the IASC position (E49), DP 22 suggests that the associated deferred tax expense is to be charged to the profit and loss account even though the revaluation adjustment is made to equity through an asset revaluation reserve6 T h e deferred tax expense amounts to the difference in the deferred tax liability balances between two consecutive years. Recall from Example 1 that there is a large increase in deferred tax expense in the year of revaluation, and in all subsequent years it is larger relative to that recognised under the income-statement approach, by an amount equivalent to the tax rate multiplied by the annual change in the total permanent difference.

    A number of questions arise. First, consider a situation of two identical

    firms with the same depreciation policies. One chooses to revalue. T h e revaluation firm records a deferred tax liability on the permanent difference created, under the assumption that the revalued amount will be

    4 2 A U S T R A L I A N A C C O U N T I N G R E V I E W

  • recovered through use or sale. In addition to charging the usual deferred tax expense arising from timing differences (common to both firms) to income, the revaluation firm also charges an amount equivalent to the revaluation-related permanent difference expired multiplied by the tax rate; that is, the deferred tax expense charged to income would be larger for the revaluation firm.

    future deductibility of $Nil. Therefore, a tax liability of $0.33M (that is $lM at 33% - the assumed tax rate) might be recognised. If, on the other hand, the building is recovered through sale (recovery of a pre-CGT building by sale does not give rise to assessable income), the question of the. amount of the tax balance does not arise and the tax liability would be $Nil.

    There is essentially no difference in the economic reality of the two firms - yet the revaluation firm would now show a higher liability and a different income number. Both firms could presumably recover their respective asset through sale for the same amount (sale price). Yet one is being forced to anticipate a potential C G T liability while the other is not. Expected capital gains obligations are independent of whether the asset has been revalued in the books of a firm. T h e differential effect on income also disturbs their previously comparable performance measure.

    actually realised, it could be quite different from the amount of the revaluation. T h e difference between book and tax carrying amounts need not be a good reflection of the future capital gain. There is an implicit assumption in D P 22 that assets recovered through sale will actually be sold at the revalued amount^.^ Is this a realistic assumption in determining a future tax liability? Is a tax asset/liability recognised on this basis any more or less hypothetical than that based on timing differences under the income- statement approach?

    Second, were a capital gain to be

    Third, in the case of pre-CGT

    N O TAX

    LIABILITY

    WOULD EXIST

    BECAUSE

    MANAGEMENT

    HAS

    DISCRETION

    OVER

    WHETHER TO

    RECOVER THE

    ASSET

    THROUGH lJSE

    OR SALE.

    DP 22 concludes that no tax liability would exist because management has discretion over whether to recover the asset through use or sale. Since the entity has discretion to avoid the future sacrifice, not recording the possible sacrifice is consistent with the definition of liabilities in SAC 4.

    because of the original assumption that buildings are not ordinarily tax- deductible (that is, timing differences are zero). What would happen if we were to assume a pre- C G T asset for which depreciation is tax-deductible, and that the tax depreciation rate is higher than that used for financial reporting; that is, we have timing differences. T h e treatment suggested in D P 22 that no liability at all be recorded implies that the timing differences that would currently be recognised under the income-statement approach would not be accounted for under the balance-sheet approach.

    Fourth, the DP 22 position on the charging of revaluation-related deferred tax expense to income effectively introduces an accrual to the profit and loss statement that, prima facie, does little to improve the resulting income number as a measure of performance. Price

    T h e example above works

    assets, DP 22 (p. 42) recommends that no deferred tax liability be recognised. T h e example used is that of buildings for which depreciation is not generally allowed as a tax deduction:

    . . . in the case of non-deductible pre-CGT buildings acquired for, say, $1M, which will be recovered through use, the carrying amount (that is, the amount to be recovered in the form of assessable income) of $lM exceeds the

    changes of long-term productive assets are typically outside the control of management. How useful is it, then, to introduce the possible tax effect of a revaluation, intended to bring productive assets in line with market values, into a performance measure?

    In summary, revaluation increments would typically result in deferred tax liabilities and annual adjustments in these liability balances would be charged to income. Quite apart from

    A U S T R A L I A N A C C O U N T I N G R E V I E W 4 3

  • the reservations expressed earlier, it is not difficult to predict that such a tax treatment may act as a powerful disincentive for firms contemplating revaluation of long-term assets. T h e proposed treatment could result in accounting policy choices unintended by AARE

    Consolidation of integrated foreign

    difference of 2500 and therefore a foreign tax liability of 2165 (assuming a tax rate of 33%). This liability would be translated at the prevailing exchange rate for inclusion in the domestic consolidated statements.

    operation, is required by AASB 1012 (Foreign Currency Translation) to be translated at the

    First, the asset, being an integrated

    subsidiary Part of the example provided in

    DP 22 (p. 62) is reproduced: . . . if a foreign subsidiary

    acquires land during the year at 21,000 when the exchange rate is $1: 21, then the cost (carrying amount) of the land for consolidation purposes at the end of the year is $1,000, irrespective of any changes in the exchange rate. From the foreign subsidiarys perspective the carrying amount of the land is 21,000 and the tax balance also is 21,000

    If the exchange rate should move to $1: 21.50, and assuming no revaluations of the land in the foreign subsidiarys financial statements occur, nothing has happened from the foreign subsidiarys perspective. T h e carrying amount of the land remains at 21,000 and the tax balance remains at 21,000.

    There is not much to dispute thus far. It is the reasoning that follows this scenario that is less than compelling.

    perspective, the foreign currency equivalent of the $1,000 carrying amount for the land is now 51,500. That is, 21,500 of foreign currency is necessary to recover the $1,000 cost of the land as reported in the consolidated financial statements (this is so due to the fact that the

    .

    However, from a domestic group

    historic exchange rate. Unless there is a

    WE FIND

    OURSELVES IN

    A POSITION OF

    RECOGNISING

    A DEFERRED

    TAX LIABILITY

    FOR A

    REVALUATION

    THAT NEITHER

    COMPANY HAS

    UNDERTAKEN.

    land will continue to be translated at the historical exchange rate by virtue of the entity being an integrated foreign operation). But the tax balance of the land is only 21,000. Thus 21,500 of foreign currency revenue needed to recover the $1,000 cost of the land will give rise to 2500 of assessable income (21,500 of revenue less 21,000 tax balance). Therefore, under the balance sheet approach, the change in exchange rate gives rise to a temporary

    4 4 A U S T R A L I A N A C C O U N T I N G R E V I E W

    revaluation, the book value of the land will not change. This is acknowledged in the example. Yet the subsequent view taken is one that forces a notional revaluation (by translating back into foreign currency at the current exchange rate) in order to calculate a foreign tax liability that does not exist.

    T h e foreign tax balance and carrying amounts are still only 21,000. T h e liability is assumed to exist because the notional revaluation (by backward translation at the current exchange rate) is assumed to reflect a foreign recoverable amount; that is, the land will be recovered through sale at 21,500. How realistic is the assumption that this is indeed the recoverable amount? Here we find ourselves in a position of recognising a deferred tax liability for a revaluation that neither company has undertaken.

    rates are prone to changes, how realistic is it to assume that the current exchange rate is indicative of the rate at which the asset will be recovered? And in the meantime, are we to recognise annual charges to income arising from fluctuations in the related deferred tax liability? It is difficult to understand why deferred tax liabilities of this nature, and related

    Second, and given that exchange

    charges to income, are not hypothetical.

    THE EMPIRICAL EVIDENCE

    Two strands of empirical research can inform the present debate. T h e first concerns the behaviour of timing differences and the crystallisation of related deferred tax balances and addresses the questions of whether or not

  • timing differences reverse in aggregate and whether the related deferred tax liabilities ever become payable. T h e second relates to the usefulness of deferred tax accruals in improving net income as a measure of performance, as well as the usefulness of related asset/liability numbers in a valuation

    to remove deferred debits and credits from the balance sheet, only recognising deferred tax assets/liabilities that are likely to crystallise, then a move to partial allocation is probably indicated instead. This implies recognising only the tax effects of the timing differences expected to reverse. On the

    sense.

    Deferred taxes, the definition of liabilities and evidence on their crystallisation

    T h e discussion paper ignores a considerable body of evidence that timing differences do not reverse in gross terms. Instead, a long-term growth trend is evident. For all practical purposes, timing differences and related deferred tax liabilities are permanently deferred in aggregate. Wise (1986, p. 443), in a study of New Zealand companies, finds that companies will disclose a deferred tax liability with a positive long-term growth trend, only occasionally interrupted by small decreases which will not always result in a cash outflow. For these companies the deferred tax liability is not attended by a high degree of certainty that there will follow a predictable cash outflow.

    Similar studies in the United States and Australia have reported results consistent with those above (Bartholomew 1987, Davidson, Skelton and Weil 1977, Davidson, Rasch and Weil 1984, Livingstone 1967a, 1967b, 1969, and Skekel and Fazzi 1984). All conclude that permanent deferral of taxes is more likely to occur than their realisation.

    Thus, the so-called real liabilities arising from timing

    contrary, D P 22 advocates not only the recognition of the tax effects of all timing

    SIMPLY RE-

    LABELLING

    THEM REAL

    LIABILITIES

    UNDER THE

    BALANCE-

    SHEET

    APPROACH

    DOES NOT

    CHANGE THEIR

    ESSENTIAL

    CHARACTER

    OF BEING

    DEFERRED

    CREDITS.

    differences which continue to be recognised as temporary differences under D P 22s balance- sheet approach will still be subject to permanent deferral. Simply re-labelling them real liabilities under the balance-sheet approach does not change their essential character of being deferred credits (the label that DP 22 attaches under the income- statement approach).

    If we accept the position that it is desirable

    differences but the recognition of certain permanent differences as well. This is likely to increase rather than reduce the amounts of tax assets/liabilities which, for all practical purposes, are permanently deferred.

    The usefulness of accounting for deferred taxes

    Several approaches have been used in evaluating the usefulness of deferred tax accruals and related deferred tax asset/liability balances. Some studies have addressed it by considering the extent to which financial analysts might find the information useful (eg, Jeter and Chaney 1988, Lasman and Weil 1978, Defliese 1991). Jeter and Chaney (p. 42) view financial analysts as a relatively informed group of users, regularly faced with the question of whether to treat the deferred tax account as debt, equity, or part-debt and part-equity, in ratio and other analyses. They consider the answer depends on the nature of the deferred item, the probability of reversal and whether the total balance is a growing one. Ideally, they argue, an analyst would prefer to remove the effect of recurring items (those whose effect is not expected to reverse in aggregate). However, given that comprehensive tax allocation does

    not separate recurring and non-recurring timing differences, the analyst is forced to remove the entire tax-effect. They argue that comprehensive tax allocation masks the real benefits of firms delaying their tax payments, often permanently.

    Jeter and Chaney recommend the partial allocation method with discounting in order to capture the economic essence of the events. Their view is supported by Defliese (p. 90):

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  • Financial analysts make much of the debtlequity ratio - a ratio that presumably is useful to evaluate the posture of an entity when it comes upon hard times. . . When a company finds itself in dire straits it is usually in a loss position and in that event deferred tax liabilities will certainly not be paid. If the debtlequity ratio is to be useful for any purpose, it would seem that deferred taxes should be excluded, and I suspect that many analysts do just that.

    Other studies examining the usefulness of deferred tax allocations in a sharemarket setting obtain equivocal results. These studies have typically taken one of the following forms.I0 Using firms share returns as the benchmark performance measure and assuming market efficiency, researchers have compared:

    The association of share returns with income measures inclusive and exclusive of deferred tax expense (Beaver and Dukes 1972,1973; Daley 1995).

    T h e association of share returns with components of earnings (eg, deferred tax expense and earnings before deferred tax), or with balance-sheet components (eg, deferred tax liability and other liabilities). These include Chaney and Jeter (1994), Ohlson and Penman (1992) and Daley (1995).

    The association of market value of equity (as opposed to share returns) with components of earnings (Bowen and Daley 1983). Beaver and Dukes (1972), Givoly and Hayn

    (1992) and Daley (1995) find evidence consistent with the market weighting deferred tax expense and deferred tax liabilities equally with other earnings and balance-sheet items. Givoly and Hayn report evidence consistent with investors discounting deferred tax liabilities according to the timing and likelihood of settlement.

    Other studies report contrary or weaker evidence; examples are Bowen and Daley (1983), Chaney and Jeter (1994), Ohlson and Penman (1992). Some researchers have attributed the lack of consistency in results to measurement errors or cross-sectional variations in attributes of firms. Chaney and Jeter, while finding limited evidence that the stockmarket uses at least some of the deferred tax information disclosed, also report that the association between security prices and deferred tax components of earnings is weaker for firms with relatively larger amounts of

    depreciation and other recurring differences. This evidence suggests that the market downplays the deferred tax amounts reported, especially for firms with large percentages of recurring items.

    T h e available empirical literature does not permit unambiguous conclusions. A further concern about drawing conclusions is that all the papers referenced here use data derived under the income-statement approach. Arguably, the balance-sheet approach will introduce more measurement error in deferred tax expense and in related assets and liabilities for the following reason. This paper has already questioned the usefulness of the new deferred tax expense as an accrual that affects a performance measure (income); under the balance-sheet approach it includes components which do not reflect the ability of management to affect performance. T h e deferred tax expense related to asset revaluations of productive assets is a case in point. This paper has also questioned the economic reality of tax assets/liabilities recognised under the balance-sheet approach; it is not clear that these are any more real than those recognised under the income-statement approach.

    The unresolved debate about partial allocation makes the picture even less clear. Givoly and Hayn (1992) document that investors view deferred taxes as a real liability, and provide evidence consistent with the market discounting the liability to its present value according to the likelihood and timing of its settlement. They conclude: For users of financial statements, our findings suggest that a portion of the deferred tax liability should be better viewed as part of equity. For accounting rule-making bodies, the results indicate that deferred taxes, arising from comprehensive interperiod tax allocation, are being transformed by investors into a value that appears to be consistent with the notion of partial allocation (p. 406).

    a comprehensive approach (Jeter and Chaney 1988, Chaney and Jeter 1989).

    Given the empirical evidence, one might well ask why there does not appear to have been an uproar in the US in response to the introduction of the balance-sheet approach. T h e answer may have more to do with the financial-statement effects of its adoption rather than a widespread belief in its usefulness. A study of the financial-statement

    Others likewise advocate a partial rather than

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  • effects of early adopters of SFAS 96/109* shows that adoption has typically enhanced the income statements and balance sheets for these firms (Gujarathi and Hoskin 1992).13 There is no published evidence on the financial-statement effects of later adopters of SFAS 96/109. Recent accounting pronouncements in the US have tended to accelerate accounting write-offs relative to tax write-offs, the result being that firms are now more likely to book future tax benefits (rather than deferred liabilities) and hence a credit to income tax expense. That is, the balance-sheet approach is both income-statement and balance-sheet enhancing for US companies.

    CONCLUSION

    The arguments presented in DP 22 are inconsistent with the definition of assets and liabilities in SAC 4. T h e arguments are also internally inconsistent. The recommendations disregard considerable empirical evidence that sheds light on two aspects of accounting for income taxes. First, we know that a large proportion of deferred taxes never become payable or crystallise. Second, the evidence on the usefulness of deferred tax accruals in improving operating income as a measure of performance is equivocal and some studies suggest a smaller degree of recognition of tax- related assets/liabilities. Several professional and academic papers advocate a partial allocation rather than an even more comprehensive approach, which is effectively the direction DP 22 is taking us in. It is also not clear, given the institutional (GAAP and tax law) differences between the US and Australia, that adoption of the US approach in Australia will not result in quite different financial-statement effects. Issues related to revaluations and notional capital gains tax recognition are a case in point.

    Bal j t K. Sidhu is a senior lecturer in the School of Accounting, University of N m South Wales. Although the author was a member of the AARF advisory panel for Discussion Paper No. 22 on Income Tax, the v i m s expressed in this paper are her own. The paper has benefited from comments provided by Graeme Dean, Malcolm MilleG John Shanahan and Greg Whittred.

    NOTES

    T h e effect of the alternative assumption (recovery through sale) is addressed later in this paper. This example draws on the facts used in Example 6 in the background paper on Income Taxes issued by the International Accounting Standards Committee (IASC 1994, p. 24) to accompany its Exposure Draft E49. T h e illustration provided here, however, is more extensive than in the background paper and also incorporates discussion of how temporary differences represent both timing and permanent differences. If the alternative assumption of recovery through sale is made, then a notional capital gains liability needs to be computed for the excess of the book value over the tax carrying amount. See Appendix 3.2 (p. 55) in DP 22 for details. Land is considered to be recoverable through sale only (DP 22, p. 45). T h e IASC position is that the total amount of deferred tax arising from the revaluation be charged to equity, consistent with the treatment of the revaluation itself. See example in DP 22 (pp. 43-4). No judgment is expressed here as to the desirability or otherwise of revaluations per se. Lasman and Weil(l978) go so far as to claim that analysts do not understand the required method of income tax allocation.

    10 T h e basic idea behind tests of this nature is articulated in Daley (1995): . . . deferred tax allocation will improve earnings as a measure of firm performance if deferred taxes are associated with expected future cash flows that are not contained in earnings.

    11 However, Beaver and Dukes (1973) reject their earlier result as being anomalous since they assume that deferred tax allocation does not give rise to future cashflows.

    12 SFAS 109 is substantially similar to SFAS 96. T h e former essentially made it easier to recognise deferred tax assets and reduced the computational complexity of SFAS 96 (Gujarathi and Hoskin 1992, p. 19).

    13 One of the reasons for this is the transition effect. Gujarathi and Hoskin (1992, pp. 20- 1) report: To make the transition to SFAS

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  • 96, firms needed to adjust the existing deferred tax amounts on the balance sheet to reflect future tax rates. Since the highest corporate tax rate was 46 percent through 1986, and wasmduced to 34 percent by 1988, early adoption meant that the deferred tax credits had to be significantly reduced to reflect the decrease in rates. This reduction in rates was likely to increase net income in the transition year for most cumulative effect adopters.

    REFERENCES

    Australian Accounting Research Foundation, 1995a, Accounting for Income Tax, Discussion Paper No.22.

    Australian Accounting Research Foundation, 1995b, Statement of Accounting Concepts SAC 4 Definition and Recognition of the Elements of FinanciaL Statements, March.

    Australian Accounting Standards Board, 1988, AASB 1012 Foreign Currency Translahon, July.

    Australian Accounting Standards Board, 1989, AASB 1020 Accounting for Income Tax (Tax-effect Accounting), October.

    Bartholomew, M., 1987, The Case for Partial Allocation of Company Income Tax, The Chartered Accountant in Australia, October, pp. 53-6.

    Beaver, W., and R. Dukes, 1972, Interperiod Tax Allocation, Earnings Expectations and the Behaviour of Security Prices, The Accounting h im , VO~. 47 pp. 320-33.

    Beaver, W., and R. Dukes, 1973, Interperiod Tax Allocation and Depreciation Methods: Some Empirical Results, The Accounting RezJiew, Vol. 48 pp. 549-59.

    Bowen, R., and L. Daley, 1983, Valuation of Earnings Components Resulting from Interperiod Tax Allocation, working paper, University of Washington.

    Chaney, P.K., and D.C. Jeter, 1989, Accounting for Deferred Income Taxes: Simplicity? Usefulness?, Accounting Horizons, June, pp. 6-13.

    Chaney, P.K., and D.C. Jeter, 1994, The Effect of Deferred Taxes on Security Prices, Journal of Accounting, AuditingandFinance, Vol. 9, No. 1 (new series), Winter, pp. 91-115.

    Daley, M., 1995, The Impact of Deferred Tax Allocation on Earnings as a Measure of Firm Performance, unpublished manuscript, Rice University.

    Davidson, S., L. Skelton and R. Weil, 1977, A Controversy Over the Expected Behaviour of Deferred tax Credits, Journal of Accountancy, April, pp. 53-6.

    Davidson, S., S. Rasch and R. Weil, 1984, Behaviour of the Deferred Tax Credit Account, 1973-82, Journal of Accountancy, October, pp. 138-42.

    Defliese, PL., 1991, Deferred Taxes -More Fatal Flaws, Accounting Horizons, March, pp. 89-91.

    Financial Accounting Standards Board, 1987, Statement of Financial Accounting Standards No. 96 Accounting for Income Taxes, December.

    Financial Accounting Standards Board, 1992, Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes, February.

    Givoly, D., and C. Hayn, 1992, The Valuation of the Deferred Tax Liability: Evidence from the Stock Market, The Accounting Revim, Vol. 67, No. 2, April, pp. 394-410.

    Gujarathi, M.R., and R.E. Hoskin, 1992, Evidence of Earnings Management by the Early Adopters of SFAS 96, Accounting Horizons, December, pp. 18-31.

    International Accounting Standards Committee, 1994, Proposed International Accounting Standard E49 Income Taxes, October, London.

    International Accounting Standards Committee, 1994, Income Taxes, background paper, October, London.

    Jeter, D.C., and P.K. Chaney, 1988, A Financial Statement Analysis Approach to Deferred Taxes, Accounting Horizons, December, pp. 41 -9.

    Lasman, D. and R. Weil, 1978, Adjusting the Debt-Equity Ratio, Financial Anahsts Journal, Sepetember-October, pp. 49-58.

    Livingstone, J.L., 1967a, Accelerated Depreciation and Deferred Taxes: An Empirical Study of Fluctuating Asset Expenditures, Empirical Research in Accounting: Selected

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  • Studies, Journal of Accounting Research (Supplement), Vol. 5, No. 2, Autumn, pp. 93-105.

    Livingstone, J.L., 1967b, A Behavioral Study of Tax Allocation in Electric Utility Regulation, The Accounting Revim, Vol. 42, No. 3, pp. 544-52.

    Livingstone, J.L., 1969, Accelerated Depreciation, Tax Allocation, and Cyclical Asset Expenditures of Large Manufacturing Firms, Journal of Accounting Research, pp. 245-56.

    Ohlson, J., and S. Penman, 1992, Disaggregated Accounting Data as Explanator). Variables for Returns, Journal of Accounting, Auditing and Finance, Vol. 7 , No. 4 (new series), Fall, pp. 553-73.

    Skekel, T. and C. Fazzi, 1984, The Deferred Tax Liability: Do Capital Intensive Companies Pay It?, Journal of Accountancy, October, pp. 142-6.

    Wise, TD. , 1986, A Note on Additional Evidence on the Behaviour of Deferred Tax Credits, Journal of Business Finance and Accounting, Vol. 13, Autumn, pp. 433-44.

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