DEPRECIATION, DEFERRED TAX EXPENSE AND CAPITAL STRUCTURE ADJUSTMENTS FOR REDUCING MEASUREMENT ERROR IN ACCOUNTING EARNINGS

This study investigates earnings measurement errors arising from the use of historical cost depreciation and deferred tax expense in determining accounting income. First, the failure of financial statements to reflect the real costs of employing capital--given the general trend of rising prices in the United States--tends to overstate earnings because of effects from inflation. Since any increase in profits from recognizing historical cost rather than real depreciation misrepresents the ability of a firm to distribute dividends or to expand operations, accounting earnings can be adjusted to the extent of the difference between historical cost depreciation and real depreciation to obtain better estimates of the market value of a firm's equity. This dissertation finds that the overstatement of earnings caused by historical cost depreciation is value-relevant, and this dissertation contributes to the literature by providing a general technique that reduces earnings measurement error. This dissertation also shows that including capital structure effects in the depreciation adjustment increases information content.; Second, the comprehensive allocation of deferred tax expense results in understatement of accounting earnings because the time value of money is ignored in measuring deferred tax expense. When deferred tax expense is divided into two components: real and nominal expense by analyzing the historical trend of a firm's deferred tax expense over the past twelve years, this dissertation finds that the nominal portion of deferred tax expense is not value-relevant. Accordingly, this dissertation proposes a practical technique that reduces earnings measurement error created by current deferred tax expense.