THE IMPACT OF DEFERRED TAX ALLOCATION ON EARNINGS AS A MEASURE OF FIRM PERFORMANCE

Deferred tax allocation is a controversial accounting accrual. A product of the standard-setting process, the impact of deferred tax allocation on earnings as a measure of firm performance is an empirical question. The objective of this paper is to investigate that question. Deferred tax allocation could improve earnings as a measure of firm performance because, like many other accruals, it solves mismatching problems that exist with cash flows. Alternatively, deferred tax allocation could weaken earnings as a performance measure because it is not discounted and the associated cash flows might not occur. Predictions are developed based on the association of deferred taxes with expected future cash flows, as reflected in stock returns. The results support the argument that deferred tax allocation improves earnings as a measure of firm performance. Earnings after deferred tax allocation has a higher association with returns. When earnings are decomposed into earnings before deferred tax allocation and the change in deferred tax, the coefficient on the change in deferred tax is negative, significant and similar in magnitude to that on earnings. The results are similar whether pooled, time-series or cross-section tests are conducted, with some evidence that for within firm comparisons, only part of the deferred tax amount is associated with returns. The association between returns and deferred taxes is shown to be a function of the cash flows with which deferred taxes are most likely to be associated, future tax payments. Deferred tax allocation is shown to improve earnings as a measure of firm performance more for utilities, consistent with their revenue-generating process and capital intensity. The association between returns and deferred taxes does not appear to be due to deferred taxes proxying for future investment cash flows that are excluded from accounting earnings. Overall, the results indicate that deferred tax allocation improves earnings as a measure of firm performance, although it is unclear which future cash flows deferred taxes are associated with.