The Valuation of the Deferred Tax Liability: Evidence from the Stock Market

Author(s): Dan Givoly and Carla Hayn

Source: The Accounting Review, Vol. 67, No. 2 (Apr., 1992), pp. 394-410
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 67, No. 2
April 1992
pp. 394-410

The Valuation of the Deferred Tax

Liability: Evidence from the
Stock Market
Dan Givoly
Tel-Aviv University and Northwestern University
Carla Hayn
Northwestern University

SYNOPSIS AND INTRODUCTION:Currentreportingrules requireinter-

period tax allocation whereby the income tax expense reported in the
income statement is determinedon the basis of pretax book (accounting)
income, adjusted for permanentdifferences between the period'staxable
income and book income. The temporarydifferences accumulate on the
balancesheet as a deferredtax liabilityand are assumed to reversein future
years, graduallyreducingthe liability.
Opponents of interperiodtax allocation argue that reversalof these
temporarydifferences is unlikelyor will occur only in the remote future.
Thus, support has developed for either partialallocation (e.g., allocating
only short-termtemporarydifferences)or no deferralat all. Regardlessof
such concerns, in 1987 the FinancialAccounting StandardsBoard(FASB)
reaffirmedthe use of comprehensiveinterperiodtax allocation.
In this study, we performcross-sectionalanalyses relatingunexpected
stock returnsaroundnews disclosuresabout the Tax ReformAct of 1986to
pertinentfirm characteristicsin an attempt to assess whether the deferred
tax liabilityis viewed as a liability.The main findings of the study are
consistent with the hypothesisthat investorsview the deferredtax liability
as a real liability.They appear to discount it accordingto the timing and
likelihoodof the liability'ssettlement.
The remainder of the article is organized as follows. Section I
describes the previous research on the informativenessof tax deferrals,
The financial support of the Accounting Research Center at the J. L. Kellogg Graduate School of
Management is gratefully acknowledged. The work has benefitted from comments made by participants in
workshops at the University of Arizona, University of California at Berkeley, University of Chicago, University
of Illinois, University of Illinois-Chicago Circle, Michigan State University, New York University, North-
western University, SUNY at Buffalo, Tel-Aviv University, Rutgers Univesity, the University of Washington
and the University of Wisconsin.

Submitted September 1989.

Accepted September 1991.

394

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Givoly and Hayn-Valuation of the DeferredTax Liability 395

outlines the hypotheses of this study, and details the procedures used to
test them. Section 11 presents and discusses the results, and the final
section provides concluding remarks.
Key Words: Deferred tax liability, Tax deferrals, Interperiod tax allocation,
Tax Reform Act of 1986.
Data Availability: To the extent allowed by licensing agreements, the
authors will make the data used in this study available
to others on request upon their completion of a related
research project.

I. Testing the Valuation of the Deferred Tax Liability

rT HE information content of tax accruals has been examined by several previous
research studies.' Beaver and Dukes (1972)find that unexpected stock returns are
more strongly correlated with earnings measures that incorporate tax deferrals
than with earnings measures that do not. They conclude (1972, 331) that "[D]eferral
earnings are most consistent with the information set used in setting security prices
while cash flow is least consistent."2Rayburn(1986),however, reports mixed results on
the information content of tax deferrals.
Beaver and Dukes' methodology has some drawbacks:the conclusions are based on
a relatively small number of observations in which the highly correlated alternative
unexpected earnings measures have opposite signs, proxies were used for the ex-
pectation of earnings and its components, and their methodology cannot assess
the extent to which the market discounts the deferred tax liability (DTL). A further
limitation of their approach is that the economic significance of the obtained
association between unexpected returns and reportedearnings (which are based on tax
deferrals) is unclear. As Beaver and Dukes point out, functional fixation is an
alternative explanation of their findings (1972, 331).
The enactment of the Tax ReformAct of 1986 (TRA)provides an opportunityto test
the manner by which investors evaluate tax deferrals in a more powerful way. The
TRA, among other things, reduced the corporate tax rate from 46 to 34 percent. If the
DTL is viewed as a real and imminent liability, this tax rate cut would lead to a
proportional decline in the value of this liability and a corresponding increase in the
value of the equity.
Accordingly, our study tests the following hypothesis:
Hi: The reduction of the corporate income tax rate from 46 to 34 percent by the
TRA increases the equity value of firms in proportion to their DTL balance.
The increase in the equity value of an individual firm would depend on the extent to
which its DTL is discounted by investors. The discount factor is hypothesized to be a
function of the expected growth rate in the DTL and the likelihood of future losses. The
higher the expected growth rate, the more distant is the reversal of timing differences

' Several studies indicate that some accruals have incremental information content (see, e.g., Wilson 1986,
1987; Bowen et al. 1987).
2 Anthony and Gupta (1988) replicate Beaver and Dukes' study, obtaining similar results.

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396 TheAccountingReview,April1992

and the lower is the liability's present value. Similarly, the higher the likelihood of
future losses, the lower is the probability that reversal of temporary differences will
result in a tax payment, and, thus, the lower is the expected value of the liability. Our
second hypothesis thus addresses the discount factor:
H2: After controlling for the firm's DTL balance, the reduction in the tax rate
increases the firm's equity value by a magnitude that is a function of the likeli-
hood and expected timing of the settlement of its DTL.
To test these hypotheses, we conduct a cross-sectional analysis in which the
reduction in the deferred tax liability (ADTL), a measure of this liability's growth rate
(GROWTH),and a measure that captures the probabilitythat the firm will incur a loss
for tax purposes (PROB) are used to explain each firm's cumulative abnormal return,
CAR, over the TRA period. Since the various provisions contained in the TRA are
expected to affect the equity value of individual firms differently, we also incorporate
pertinent firm characteristics in the analysis. We estimate the following linear
regression:
n+3

CAR it=a!+: j1,ADTLMit + j2,GROWTHi, + 3, PROBi, + S fjt CVijt+ Eit 9

j=4

where i is the firm index, t is the time index, and each CVjdenotes one of the n control
variables. The explanatory variables are discussed below. Computationaldetails for all
variables are provided in appendix A.
The main variable of interest, ADTLM,is the ratio of the firm's A DTL to the market
value of its equity.3 If investors view the DTL as a real obligation, according to
hypothesis Hi the estimated coefficient 0, is expected to be positive. That is, the tax
cut, by effectively reducing the market value of the DTL, is expected to increase the
value of equity.
The GROWTHvariable should capture both the DTL's growth rate and magnitude.
GROWTHiis computed as an interactivevariable,gi * ADTLMi,where gi is the proxy for
expected growth, computed as the compound rate of growth in the ratio of DTL to the
book value of the firm's total assets over the most recent five years. Similarly, PROB
should capture both the magnitude of the DTL and the probability that the firm will
experience a loss for tax purposes. PROBiis derived as the product pi x A DTLML.The
value pi is the probability that firm i will experience a loss for tax purposes. (The
computations of gi and pi are detailed in appendix A.)
The change in equity value resulting from the TRA's tax rate reduction is expected
to be negatively related to both the firm's DTL growth and its probabilityof incurring a
loss, consistent with hypothesis H2. Thus, we expect both f,3 and /33 to be negative.
Control Variables
Several firm characteristics have been used in the economics literature to sur-
rogate for the anticipated effect of the TRA on individual firms (Arthur Andersen
1986; Coopers and Lybrand1986; Dolde 1986;Sinai 1986).In addition, economists have
3Deflating by the market value of equity allows an intuitive interpretation of the coefficient of the cross-
sectional regression (i.e., the change in equity induced by a $1 decrease in the DTL). It also reduces the potential
of a correlated omitted variables problem (see Christie 1987, 237-80).

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GivolyandHayn-Valuationof the DeferredTaxLiability 397

incorporated firm characteristics in theoretical models to predict the effect of the new
legislation on capital formation, stock returns, or capital structure.4
On the basis of these studies, we incorporate several variables in the cross-sectional
regression to control for the effect of the TRA on stock prices. (Computationaldetails
are provided in appendix A.) The first control variable,investment tax credit (ITC),
captures the effect that repeal of this credit had on firm's equity values. We compute
this variableby measuringthe extent of these benefits that the firm garneredin the past.5
We expect the coefficient of ITC to be negative: the greater the firm's past use of this
credit, the greaterwould be the decline in the marketvalue of its equity as a result of the
curtailment of this credit.
The second control variable (TAX) proxies for the increase in the firm's tax
payment caused by other provisions in the act, such as the alternative minimum tax,
designed to equate the effective tax rate across corporations. The change in tax
payments resulting from these provisions is expected to be inversely related to the
firm's initial effective tax rate. Two alternative measures of the TAX variable are used.
In the first, the added tax payment is estimated as the difference in the effective tax rate
between the period preceding the TRA and the period following it. Given the short post-
TRA period,7we also use a TAX measure based only on the effective tax rate in the pro-
TRA period. We expect the coefficient of TAX (with either measure) to be negative.
The third control variable is net operating loss carryforwards available for tax
purposes (NOLC). Post-TRA, companies with carryforwards were in a relatively less
favorable position than they were prior to the act for two reasons. First, the decrease
in the tax rate reduced the expected value of the tax savings arising from the
carryforwards.8 Second, additional constraints were imposed on the use of such
carryforwards, particularly in acquisitions. Because of the resulting decrease in the
economic value of the carryforward balances, a negative coefficient on NOLC is
expected.
In addition to its effect on future tax payments, the repeal of the investment tax
credit reduces the net-of-tax return to new equipment while increasing the value of
equipment in place.9 Accordingly, the fourth control variable, ME, is the amount of
machinery and equipment owned by the firm prior to the implementation of the TRA.
This variable may also proxy for the amount of depreciation deductions lost because of
the TRA.10To the extent that the lost depreciation is not fully captured by the TAX
variable, the effect of ME on equity cannot be stated a prior.
I For
example, Auerbach (1987,1989) and Downs and Hendershott (1987) examine the effect of the TRA on
investment levels, economic returns, and equity values. Cutler (1988) and Givoly and Hayn (1991) use firm-
specific variables to explain the stock price response of individual firms to the TRA.
s The investment tax credit was designed to stimulate capital investment and was computed according to a
specified percentage of the cost of qualifying assets.
6 A primary objective of the TRA was to shift the tax burden to firms that
previously enjoyed generous tax
breaks. This objective was stated repeatedly by major players in the tax reform legislation. A summary of the
act's objective is given by the Joint Committee on Taxation in General Explanation of the Tax Reform Act of 1986
(U.S. Congress 1987, 8-9).
7 Data for the post-TRA period are available for only three years: 1987, a transition year when some of the

TRA provisions were only partially implemented, and the following two years.
8 Hayn (1989) finds that these carryforwards affect firm value.

9 See Auerbach (1987) and Downs and Hendershott (1987) for an estimate of the resulting increase in the

economic value of the firm's existing machinery and equipment and in the value of its equity.
10 Note, however, that the loss in depreciation deductions resulting from the TRA applies only to new
assets,

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398 TheAccountingReview,April1992

The last control variable, AGEME,proxies for the age of the assets in place. For a
given level of ME, the repeal of the investment tax credit gives firms with newer assets
a comparative advantage. The coefficient of this variable is expected to be positive."
Sample and Data
The initial sample used for the study consists of all firms that appear on the 1987
COMPUSTAT Annual Primary/Supplementary/TertiaryIndustrial files, with the
exclusion of firms that belong to the insurance and banking industries.12 Return data
were retrieved from the CRSPDaily Stock Returnand Master files. Data on the amount
of NOLC available for tax purposes were obtained from the tax footnote in firms'
financial statements.13 Complete return and accounting data were available for 1,348
firms.
Identifying Relevant Test Periods
The pertinent test periods are those in which there is a revision in investors'
assessment of the likelihood of the TRA's passage. The ideal test "window" is the one
in which the probabilityassigned by marketparticipantsto the passage of the TRA was
revised continuously from one extreme (zero probability)to the other (certainty).14
The almost constant flow of news reports concerning the TRA over the two years
preceding its enactment creates difficulties in identifying the test periods. Given that
the TRA legislation was preceded by much public discussion and deliberation, it is
apparent, however, that expectations about the TRA were formed gradually over an
extended period and, therefore, that the final enactment was partially anticipated.
We searched three major newspapers (the Washington Post, The Wall Street Journal,
and the New YorkTimes) and the records of Congressional proceedings concerning the
House and Senate versions of the tax reform bill (including the committee and
subcommittee hearings) to determine the beginning of the pertinent test period as well
as to identify periods during which changes occurred in the public's assessment of the
degree of certainty assigned to the likelihood of passage of the TRA. Discussions and
proposals pertaining to tax reform appear to have begun in September 1984, which we

11 In an extended version of the cross-sectional regression, whose results are not presented, industry
dummy variables were added to control for industry effects that might not be captured by the other control
variables. Although some industry variables were significant, their inclusion had a negligible effect on the
other slope coefficients and on the (adjusted) RI of the regression.
12 These firms (SIC 6022-6200 and 6312-6400) were excluded for two reasons. First, the TRA contained
specific provisions pertaining to these industries and controlling for the effect of these provisions would
unnecessarily encumber the analysis. Second, many financial institutions have a deferred tax asset rather than
a liability, the balance of which is unavailable on COMPUSTAT (since it is combined with other deferred
charges).
13 The tax footnotes for all firms that were likely to have an NOLC for tax purposes were examined. These

consisted of (1) firms with COMPUSTAT and CRSP data showing a loss in any year from 1983 to 1987, (2) firms
that had a NOLC for book purposes in any one of these years, as reported by COMPUSTAT, or (3) firms that
had positive earnings in these years but were in the bottom decile of firms with positive earnings in a given
year.
14 Selecting a long enough window may reasonably ensure that, during that period, investors' beliefs were

revised over the full probability range. However, by extending the test window, periods during which no
revisions occur are added. This is likely to result in an increase in variability ("noise") in the estimation of the
parameters of interest and a weakening of the tests.

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Givoly and Hayn-Valuation of the DeferredTax Liability 399

therefore selected as the beginning of the test period."5Subsequently,the pace of events

leading to tax reform accelerated rapidly during 1985 and 1986,16 culminating with the
passage of the act by both houses of Congress in September 1986, which marksthe end
of our test period. The act was signed into law by President Reagan in October 1986.17
We identified a total of 130 TRA events within this time interval of 25 months
(September 1984 to September 1986). Each news event was characterized as indicating
either an increasing or decreasing probability of the passage of the TRA.18For each
event, we identified an event period consisting of three trading days-the event day and
the days preceding and following it. The total number of days contained in the test
period is 252.19
Although our primary analysis focuses on changes in the firms' equity over the 130
events, we separate the events according to their news content, either increasing or
decreasing likelihood of enactment, and then examine the hypotheses over these two
subsets of events. This analysis accentuates the relationship between the returns and
the independent variables.20Further,contrasting the regression results obtained for the
two subsets of events provides furtherevidence on the validity of the events selected; if
the events selected are relevant, we would expect the signs of the coefficients to reverse
for the two subsets.
To further test the validity of the events identified, as well as for expositional
purposes, we classified the events into subperiods. To do this, we first identified five
major stages in the TRA's passage. Then, within each stage, we divided the events into
those with similar news content regarding the likelihood of the TRA's passage. Thus,
each stage is represented by an increasing likelihood and a decreasing likelihood
subperiod as shown in table 1 for a total of ten subperiods. To ascertain whether market
expectations concerning the passage of the TRA were indeed revised over the
identified events, we analyze the returns of individual firms during these subperiods.
While different firms might be affected by the TRA to a different extent and in a
" During that month, Representative Rostenkowski, chairman of the House
Ways and Means Committee,
endorsed tax reform and made it a major item on the House Ways and Means Committee agenda. President
Reagan also expressed his support for tax reform and Treasury Secretary Regan introduced the Treasury's first
attempt at a tax reform plan in October 1984.
16 The upsurge in public interest in revising the tax code is evident from the extent of news
coverage on the
issue. For example, the number of news items relating to tax overhaul in the Washington Post was 11 in 1982,37
in 1983, 30 in the first nine months of 1984,84 in the last three months of 1984, 515 in 1985, and 506 in 1986. The
two other newspapers examined also reflect this dramatic increase in the number of articles on tax revision
beginning in the last quarter of 1984.
17 The passage of the act by both houses of Congress
is selected as the end of the test period because, at this
time, enactment became certain. President Reagan had been a strong supporter of tax reform over the
preceding two years, and his approval of the act was a foregone conclusion.
1I Throughout the period examined, there was a great deal of
uncertainty regarding the eventual passage of
this far-reaching tax reform, with many skeptics expressing serious doubts about its viability only a few days
before the actual passage of the act.
19 Several events occur on consecutive days. Usually, the content of the news occurring on these
consecutive days was the same (i.e., all indicating either an increasing or decreasing likelihood of the act's
passage). For these events, we included the days on either side of these events as well as the event days in the
test period. In a few cases, the events occurring on consecutive days were of opposite news content (i.e., one
event indicating an increasing likelihood of enactment, while the other indicated a decreasing likelihood). We
excluded these events from the analysis.
20 If the selection of the subperiods is correct, the probability of the TRA's
passage during the "increasing
likelihood" events must have cumulatively increased by more than 1.0.

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400
Description of Events Leading to Enactment of
the Tax Reform Act of 1986 (TRA)
Major Stages of TRA Legislation
I. Introductionof "TreasuryI"
Subperiod1: News events indi-
eating increasing likelihood of
TRA's passage.
Subperiod2: News events indi-
eating decreasing likelihood of
TRA's passage.
II. Introductionof "TreasuryII"
Subperiod3: News events indi-
cating increasing likelihood of
TRA's passage.
Subperiod4: News events indi-
cating decreasing likelihood of
TRA's passage.
III. Passage of the House Bill
Subperiod5: News events indi-
cating increasing likelihood of
TRA's passage.
Subperiod6: News events indi-
eating decreasing likelihood of
TRA's passage.
IV. Passage of the Senate Bill
Subperiod7: News events indi-
eating increasing likelihood of
TRA's passage.
Subperiod8: News events indi-
cating decreasing likelihood of
TRA's passage.
V. Passage of the Tax Reform Act of 1986
Subperiod9: News events indi-
cating increasing likelihood of
TRA's passage.
Subperiod10: News events in-
dicating decreasing likelihood
of TRA's passage.
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The Accounting Review, April 1992
Table 1
Major Events
The White House introduced "TreasuryI," the first tax reform
plan. House Democrats, led by Rostenkowski, chairman of the
House Ways and Means Committee,strongly support tax reform.
Congress strongly opposed "TreasuryI." The White House was
delinquent in introducinga revised tax reformplan, leading many
to doubt that President Reagan was serious about tax reform.
A new, compromise tax plan was presented to Congress. Presi-
dent Reagan began campaigning heavily for congressional sup-
port.
Congressional and public support for tax reform waned due to
lack of enthusiasm for new plan. President Reagan decided to
shift his attention elsewhere.
The House Ways and Means Committeedrafted a tax reformbill.
It was approved by the House after intensive lobbying by House
Democrats and President Reagan.
Congressionaland public supportfor tax revision slipped further.
Serious disputes arose between the White House and the House
Ways and Means Committee. House Republicans abandoned
President Reagan in his drive for tax reform.
New tax plan that was considered more lenient was offeredby the
Senate Finance Committee, led by Packwood. Compromises
reached with the House and the White House. The committee
passed a bill that was subsequentlyapproved by the full Senate.
The House and the White House rejected the Senate Finance
Committee's tax bill. Some felt that the many "tax breaks"
included would kill tax reform.
Conference members from the House and Senate, appointed to
draft a bill for submission to Congress, reached agreement on a
numberof key points. They drafteda bill that gained strong presi-
dential support. Both the House and the Senate passed the bill.
Membersof the tax conference argued over various provisions of
the final bill.
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GivolyandHayn-Valuationof the DeferredTaxLiability 401

different direction, we expect a given firm's returns in any two subperiods to be

positively correlated if the news in the two subperiods is of a similar content (e.g.,
increasing likelihood in both subperiods) and negatively correlated if the news in the
two subperiods is of an opposite content." Accordingly, we compute the cross-
sectional correlations of firms' returns between all pairs of the ten subperiodsY2
The correlation results are presented in table 2. Thirty-sevenof the 45 correlations
are in a direction consistent with the assumption that the TRA-relatednews in the
subperiods affected firms' returns in the assumed direction: positive (negative)
correlations are obtained for most pairs with similar (opposite) news content?3
These results do not necessarily imply that the identified test period contains all
pertinent events nor do they mean that irrelevant events are not included. They do
suggest, however, that the selected events are relevant for our tests.

II. Results
Descriptive statistics for the variables of the 1,348 sample firms are presented in
table 3. The mean expected reduction in DTL (scaled by the market value of equity,
ADTLM)is 2.9 percent. The exact amount of increase in a given firm's equity resulting
from the reduction in this liability depends on the extent to which it is discounted.
There is, on average, an increase in the relative weight of the DTL over the preced-
ing five years. This is reflected in the compound annual growth measure, g,, which has
a mean value of 6 percent, with 25 percent of the firms showing a growth rate of more
than 12.8 percent. The probability of reporting a loss for tax purposes in a given year,
pi, is 21 percent across the sample of firm years. However, most firms did not
experience a loss in the period examined (the median value of pi is zero).
The value of the ITC variable, representing the annual amount of investment tax
credit lost as a result of the TRA, is, on average, 1.2 percent of the market value of the
firm. About 20 percent of the firms had NOLCavailablefor tax purposes,which amounts
to an average of 15.4 percent of the market value of the sample. The average effective

21 Note that the content of the proposed act itself evolved over the period
examined. The stock price re-
sponse to the TRA-related news is expected, therefore, to reflect not only the likelihood of the act's passage, but
also its expected content. However, the primary objectives of the tax reform (e.g., a more equitable sharing of
the tax burden across firms) and thus its main proposed provisions (a tax rate cut coupled with the elimination
of tax preferences) were not altered over the period. Therefore, cross-sectional differences in the direction of
stock price movements in response to TRA-related news could be viewed as stemming primarily from the
changing likelihood of the act's passage.
2
Noreen and Sepe (1981) use a similar approach for assessing bi-directional effects. The correlations are
between raw returns. The correlations between abnormal returns will not capture new aggregate effects, if
any, of the TRA on the stock market.
'3 To rule out the possibility of an omitted variable that might induce
serial correlation in the returns of
firms and thus invalidate the conventional significance test, we generated "simulation statistics" which serve
as the null parameters in testing the hypothesis that the sample correlation coefficients are no different from
those prevailing in "normal" times. To generate these statistics, we replicate our test period using randomly
selected time intervals of the same length (about 25 months) and that mirror the subperiods in their event
composition. We then compute the correlation in firms' returns between any pair of the replicated subperiods,
producing 45 (9 x 10/2) pairwise correlation coefficients. We repeat this procedure 100 times, each time
randomly replicating our test period in the manner described. At the end of the process, we obtain the
"simulation statistics" (e.g., the mean and standard deviation of the correlation coefficient for each of the 45
combinations of paired subperiods). The means produced by the simulation are very close to zero (ranging
from -0.021 and 0.015). The refinement provided by the simulation-based statistics leads to essentially
identical inferences.

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402 The Accounting Review, April 1992

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Givoly and Hayn-Valuation of the DeferredTax Liability 403

Table 3
Distribution Statistics for Variables in the Cross-sectional Regression
In = 1,348)

Variables*

CAR ADTLM g p ITC TAX NOLC ME AGE

Mean -0.011 0.029 0.060 0.210 0.012 0.005 0.154 0.445 0.511
Standard Dev. 0.212 0.043 0.203 0.305 0.040 0.047 0.832 0.719 0.440
First Quartile -0.142 0.002 0.000 0.000 0.000 -0.008 0.000 0.134 0.310
Median -0.014 0.013 0.011 0.000 0.003 0.000 0.000 0.281 0.452
Third Quartile 0.122 0.035 0.128 0.348 0.013 0.012 0.000 0.506 0.647
*
Detailed definitions and computations are provided in the text and appendix A.
CAR= cumulative abnormalreturn for the entire TRA period;
ADTLM=reduction in deferred tax liability (DTL)due to corporate tax rate cut, deflated by market
value of equity;
g =annual growth rate in the ratio of the DTLto the book value of assets (used in computing the
GROWTHvariable);
p=probability of a loss for tax purposes (used in computing the PROBvariable);
ITC= averageannual amount of investment tax credit eliminated by TRA,deflatedby marketvalue
of equity;
TAX= added amount of tax payments due to change in effective tax rate;
NOLC=net operating loss carryforward,deflated by marketvalue of equity;
ME= amount of machinery and equipment in place, deflated by marketvalue of equity; and
AGE=age of machinery and equipment in place (used in computing the AGEMEvariable).

tax rate is 39.4 percent in the pre-TRA period, which is significantly lower than the
statutory rate of 46 percent.
The main results of estimating the cross-sectional regression are shown in table 4.
The results are reported for the entire period (consisting of the 130 events) and
separately for the two subsets containing news events of similar content.
The most relevant test period is the entire period, since it is over this period that the
probability investors assigned to the eventual passage of the TRA is hypothesized to
have been revised through the entire probability range from zero to 1. The coefficients
resulting from this analysis for all of the variables are significant at the 5 percent level
and have the expected signs. Furthermore, consistent with the hypothesized effect of
the TRA, all coefficients reverse signs between the increasing and decreasing
likelihood subsets of events.
The main variable of interest, ADTLM,has a positive and significant coefficient for
the regression over the entire period, indicating that the anticipated decline in the
nominal value of the deferred tax liability leads to an equity appreciation. The negative
coefficients on GROWTHand PROBin this period suggest that this appreciation varies
cross-sectionally with the expected timing and likelihood of the DTL's settlement.
Specifically, for a given DTLbalance, firms whose DTLbalances have grown faster and
firms with a higher probability of reporting a tax loss in any given year experienced
lower equity appreciation than other firms.

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404 The Accounting Review, April 1992

Table 4
Results for the Cross-sectional Regression
CAR,,=Ca,+31,tADTLM ,,+02,GROWTH,,+33,PROB,,+04,ITCi, + 035,TAXi,
+06tNOLCi,+7, MEi,+ 8,AGEME,+ si
(n = 1,348; t-values are given in parentheses)

Entire Period
Adjusted
Intercept ADTLM GROWTH PROB ITC TAX NOLC ME AGEME Rf2 (F)

-0.033 0.558 -0.184 -0.386 -0.636 -0.595 -0.012 0.019 0.069 0.068
(-4.01)* (3.30)* (-2.67)* (-3.28)* (-3.66)* (-4.65)* (-2.33)* (2.20)* (3.20)* (12.96)*

"IncreasingLikelihood"Eventsa
Adjusted
Intercept MDTLMGROWTH PROB ITC TAX NOLC ME AGEME R2(F)

-0.058 0.745 -0.226 -0.341 -0.876 -0.734 -0.023 0.036 0.082 0.106
(- 8.32)* (3.71)* (-2.83)* (-4.98)* (-4.71)* (-5.30)* (-2.81)* (3.73)* (3.54)* (20.44)*

"DecreasingLikelihood"Eventsa
Adjusted
Intercept ADTLM GROWTH PROB ITC TAX NOLC ME AGEME R2(F)

0.025 -0.187 0.042 0.145 0.240 0.139 0.011 -0.017 - 0.013 0.041
(9.35)* (-2.80)* (1.88)* (1.58)* (2.50)* (3.78)* (3.26)* ( -3.88)* (-3.03)* (8.01)*

Note: Detailed definitions and computations are provided in the text and appendix A.
CAR= cumulativeabnormalreturnfor the entire TRA period (or for the subset of events);
ADTLM= reduction in DTL due to corporate tax rate cut, deflated by marketvalue of equity;
GROWTH= an interactive variable equal to g * A DTLM,where g is the compound growth rate in the
ratio of the firm's DTL to the book value of its assets;
PROB=an interactive variable equal to p . ADTLM,where p is the probabilitythat the firm will
experience a loss for tax purposes;
ITC=average annual amount of investment tax credit eliminated by TRA, deflated by market
value of equity;
TAX= proxy for added amount of tax payments due to increase in effective tax rate;
NOLC=amount of net operating loss carryforward,deflated by marketvalue of equity;
ME= amount of machinery and equipment in place, deflated by marketvalue of equity; and
AGEME= an interactive dummy variablethat receives the value of ME when age of machineryand
equipment is below average, 0 otherwise.
Significant at the 5 percent significance level.
*
Significant at the 10 percent significance level.
**
"Increasinglikelihood"and "decreasinglikelihood"events are those in which the TRA-relatednews
reflects an increase or decrease, respectively, in the likelihood of the TRA's passage.

Further support for this conclusion is provided by analyzing the two subsets of
similar-news-content events. The signs of the coefficients of ADTLM, PROB, and
GROWTHfor the increasing likelihood events are the same as those for the entire
period, whereas they reverse for the decreasing likelihood events. The reversal of the
signs of the regression coefficients provides further evidence that our identification of
the content of the events is valid.

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Givoly and Hayn-Valuation of the DeferredTax Liability 405

The control variables are all significant at the 5 percent level and have the expected
directions. Note that the coefficient of ME is positive, which suggests that firms with
assets in place have a comparative advantage over others due to the repeal of the
investment tax credit on new acquisitions.
Further insight on how investors discount the DTL can be gained from examining
the magnitude of the regression coefficients. The coefficient of ADTLMfor the entire
period is 0.558, suggesting that the DTL is being discounted by investors. Conditional
on the control variables, one dollar of DTL is valued, on average, at about 56 cents. For
a firm that belongs to the fourth quartile of the population in terms of growth of its DTL
balance (i.e., a firm whose gi is equal to 0.128, as shown in table 3) and probabilityof a
loss (i.e., pi is equal to 0.348), one dollar of DTL appears to be more heavily discounted,
valued at only 40 cents.24
If discounting of the DTL takes place, we would also expect the discount factor to
be correlated with firm risk. That is, the magnitude of the ADTLMcoefficient for a
given subsample of firms would decrease with the risk of the firms in that subsample.
Accordingly, we partitioned the sample into two: firms with above median betas and
firms whose betas were equal to or below the median beta. The estimates of the ADTLM
coefficients for the two groups for the entire test period are 0.82 and 0.39, respectively
(both significant at the 5 percent level), consistent with the economic interpretationof
the coefficient as a discount factor.
Diagnostic Checks
Several statistical problems may impair the inferences drawn from the results
reported in table 4. One is misspecification of the market model (e.g., the selected
variables may proxy for omitted variables). In this case, the estimated regression
coefficients could differ from zero without implying a rejection of the respective null
hypotheses.
The presence of cross-sectional dependence in the regression residuals may also
lead to incorrect inferences. It has been documented that such dependence, resulting
possibly from dependence in contemporaneous abnormal returns of different firms, is
minor for daily or weekly abnormal returns but becomes stronger for longer accumula-
tion periods.25Cross-sectional dependence results in a downward bias in the estimates
of the regression coefficients' variance.26Other potential statistical problems are multi-
collinearity and heteroskedasticity, which induce inefficiency in estimation.
Diagnostic tests and corrective procedures are presented in appendix B. They
provide evidence that our previously mentioned inferences are not affected by the
statistical problems discussed above. In particular,(1) no spurious relationship appears
to exist between the dependent and explanatory variables, (2) cross-sectional depen-
dence in residuals is not influential, and (3) no serious multicollinearity in the data or
heteroskedasticity of the disturbance term of the regression appear to be present.

24 This is computed by using the value of the coefficients as follows:

(0.558 - [0.184 x 0.128] - [0.386 x 0.348]).
25 See Collins and Dent (1984) and Bernard (1987).
26 See Christie (1987) and Bernard (1987) for further discussion of cross-sectional dependence.

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406 The Accounting Review, April 1992

III. Concluding Remarks

This study shows that investors view deferred taxes as a real liability and that they
discount it to its present value according to the likelihood and timing of its settlement.
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-makingbodies,
the results indicate that deferred taxes, arising from comprehensive interperiod tax
allocation, are being transformedby investors into a value that appears to be consistent
with the notion of partial allocation.
The FASB recently suspended FAS 96 and issued a new exposure draft on account-
ing for income taxes. Both documents maintain the principle of comprehensive alloca-
tion. Our results, however, lend support to changing the principle in favor of selective,
partial allocation.

Appendix A
Definitions of Variables in the Cross-sectional Regression

Variableand
Definition Computation

CAR Cumulativeabnormalreturns are computed by compounding abnormalreturnsover

Cumulative the test period, t. Abnormal returns are calculated as Rid-E(Rjd). Rid is the actual
abnormalreturns return and E(Rjd) is the expected return of firm i on day d. E(Rid) is assumed to be
generatedby the market model E(Rj,)=&i+,iRM using daily stock returns over the
75 trading days preceding and the 75 trading days following the test period. In
estimating the marketmodel, RKis proxied by the value-weightedreturnof all firms
on the NYSE and AMEX. The Scholes and Williams (1977) procedure that reduces
the problems associated with nonsynchronous trading is used in the estimation.

ADTLM Computed as the balance of the DTL account at year-end times (0.46-0.34)/0.46,
Reduction in the divided by the market value of the firm's equity at the year-end.
deferred tax
liability
GROWTH Computedas A DTLM* g. The value of g is computed as the geometric mean annual
Growth in the growth in the ratio of the DTLto the book value of the assets (BVA) over the recent
ratio of the DTL five years, as follows:
to the book g-[(DTL,/BVA,)/(DTL,-s/BVA,-s)]'s- 1,
value of assets g[DLB~/DL~/V~sP51
where r is the year index.

PROB Computed as ADTLM. p. The probabilitythat a firm will not pay taxes in a given
Probability future year, p, is based on the numberof years in the most recent five-yearperiod in
of not which the firm did not have to pay taxes (before applying the investment tax credit
paying taxes (ITC)).Because recent experience is likely to be more relevantfor assessing this prob-
ability, more recent years were given a greater weight (a variablebased on an equal
weighting scheme did not change the regression results materially).Each year r was
assigned a value, p,, where p. equals 0 if the firm paid taxes in year r (i.e., the amount
of current taxes, before applying the ITC, is positive) and 1 if the firm did not pay
taxes in year r. Geometricallydeclining weights (by 35 percent each year), w,, were
assigned to the five years;the most recent year had a weight of 0.40 and the fifth year
had a weight of 0.07. (Use of a ten-yearestimationperiod producedsimilar results.)P,
is defined as the weighted average of p,:

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Givoly and Hayn-Valuation of the DeferredTax Liability 407

Appendix A-Continued
Definitions of Variables in the Cross-sectional Regression

Variable and
Definition Computation

ITC Computed as the average investment tax credits used over the most recent five-year
Past use of period divided by the market value of the firm's equity at the end of 1986.
investment tax
credits

TAX Computed as the difference between the firm's effective tax rate (ETR) in the post-
Proxy for the TRA period (1987-89) and the ETR over the pre-TRA period (1981-86), times the
added tax average pretax income over the pre-TRA period, deflated by the market value of the
payment due to firm's equity at the end of 1986. The firm's effective tax rate is defined as the ratio of
the increase in the total current income taxes (before the investment tax credit) divided by pretax
effective income where the numerator and the denominator each represent an aggregation
tax rate over the relevant years. (The TAX variable was also computed by using the statutory
tax rate in the post-TRA period (0.34) rather than the effective tax rate. The results
with this measure are essentially the same as those for the above definition of TAX,
and therefore only the latter are reported.)
An alternate measure of TAX, TAXi is also used. This measure is computed as the
average ETR over the ten years preceding the TRA period.

NOLC Computed as the ratio of the net operating loss carryforward available for tax pur-
Net operating poses at the end of 1986 deflated by the market value of the firm's equity at the end of
loss carryforward 1986.

ME Computed as the ratio of machinery and equipment on the firm's books at the end of
Machinery and 1986 divided by the market value of the firm's equity at the end of 1986.
equipment in
place

AGEME Assigned a value of 0 if AGE, is less than or equal to the average AGE, of the sample,
Age of machinery and a value of ME, if AGE, is greater than the average AGE, of the sample. AGE,
and equipment is computed as the sum of capital expenditures in 1985 and 1986, divided by net
in place plant, property, and equipment at the end of 1986.

Appendix B
Diagnostic Tests and Corrective Procedures
Misspecification
To examine whether our inferences are due to misspecification of the model, the cross-sectional regres-
sion was estimated for 100 essentially non-overlapping, non-event periods.2- Each non-event period had the
same chronological length as the test period (about 25 months) and contained subperiods of the same length,
chronological order, and separating intervals as the original test subperiods.28 The mean t-values of each of
the regression coefficients in the non-event periods are close to zero. The null hypothesis that an individual
variable's t-value is distributed normally with a zero mean and a standard deviation of 1 (using the X2 test)
could not be rejected for all variables.

27 Similar randomization procedures were used by Leftwich (1981) and Lys (1984).
28 A slight overlapping (of about 5 percent of the days) was necessary for the construction of 100 such
periods from the available CRSP data.

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408 The Accounting Review, April 1992

Table Bi
The t-values of Cross-sectional Regression Coefficients Corrected
for Bias from Cross-sectional Dependence
CARE,=a,+ l3,ADTLMi,+ 2,GROWTHi,+03,PROB,,+ 04,ITC, + Os,TAX,,
+O6,N0LC. +O7,,ME,,+ 08,AGEMEj,+ e-it

Period
Examined Intercept ADTLMGROWTH PROB ITC TAX NOLC ME AGEME

Entire Period -1.21 2.18* -1.36 - 2.52* -2.14* -2.29* -1.70** 1.75** 2.85*
"Increasing
Likelihood"
Events - 3.12* 2.34* -1.89* -2.25* - 2.52* -3.03* - 2.31* 2.45* 3.65*
"Decreasing
Likelihood"
Events 4.61* -1.92* 1.53 1.26 2.05* 3.12* 2.02* -1.85** -2.34*

Note: Detailed definitions and computations are provided in the text and appendix A.
CAR= cumulativeabnormalreturnfor the entire TRA period (or for the subset of events);
ADTLM=reductionin DTL due to corporatetax rate cut, deflated by marketvalue of equity;
GROWTH=aninteractive variable equal to g *ADTLM,where g is the compound growth rate in the
ratio of the firm's DTL to the book value of its assets;
PROB= an interactive variable equal to p . ADTLM,where p is the probabilitythat the firm will
experience a loss for tax purposes;
ITC=average annual amount of investment tax credit eliminated by TRA, deflated by market
value of equity;
TAX= proxy for added amount of tax payments due to increase in effective tax rate;
NOLC=amount of net operating loss carryforward,deflated by marketvalue of equity;
ME= amount of machinery and equipment in place, deflated by marketvalue of equity; and
AGEME= an interactive dummy variablethat receives the value of ME when age of machineryand
equipment is below average, 0 otherwise.
* Significant at the 5 percent significance level.
** Significant at the 10 percent significance level.
" "Increasinglikelihood"and "decreasinglikelihood"events are those in which the TRA-relatednews
reflects an increase or decrease, respectively, in the likelihood of the act's passage.

Cross-sectionalDependencein the Residuals

We use the proceduresuggested by Bernard(1987)to correct for the bias in the estimated standarderror
of the regressioncoefficients caused by potentialcross-sectionaldependence in the residuals.Under this pro-
cedure, we calculate for each coefficient 13kthe ratio Rkbetween its time-seriesvariance (&2(B,), based on the
values of the coefficients derived from a series of cross-sectionalOLSregressions)to the mean (over a series
of cross-sectionalOLS regressions)of its regression variance.29 A ratio of 1 suggests no bias. A value greater
than 1 means that the OLS estimate of the coefficient's variance understatesthe true variance. The above
ratio is used to "correct"the reported results for potential bias.
29
In other words,
N

1/(N- 1) ,
(Oh.)2
Rh=~~~=
R=N l n=1. N,
1/NEVar(UOk)
N-1

where:
N

N
n is the regressionindex, and N is the total numberof cross-sectionalregressions.

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Givoly and Hayn-Valuation of the Deferred Tax Liability 409

To obtaina time-seriesof askandof U2(03), we estimatethe cross-sectional regressionoverthe 100 non-

event periods. Most of the values of Rk generated by this procedure are between 1.5 and 3.6, indicating a
downward bias in the estimates of the coefficients' variance.30The corrected t-values for the combined
period and the "increasing likelihood" and "decreasing likelihood" subperiods are provided in table B1.
Although the new t-values are lower, as expected, the coefficient of the variable of most interest, ADTLM,
maintains a significance level of 5 percent in all of the subperiods examined.
Multicollinearity
The results do not seem to be affected by multicollinearity.The corrrelation coefficients between the
explanatory variables are mostly between -0.10 and 0.10. The only high correlations are between zDTLM
and its two relatedinteractivevariables,GROWTHand PROB(0.32 and 0.34, respectively).This dependence,
however, is induced by the mannerin which these variablesare constructed.
Heteroskedasticity
To correct for this problem, we reestimatedthe cross-sectionalregression with each individual observa-
tion deflated by the standard deviation of the firm's abnormal return. The latter is estimated from the 100
non-event periods described earlier. The results are similar to those obtained without the correction.

30
These values appear to be somewhat higher than those derived by Bernard (1987) for two typical cross-
sectional studies of abnormal return behavior. The higher values may be due to our larger sample: in the
absence of a proportional increase in the number of industries represented in the sample, an increase in the
sample size adds to the bias.

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