Review of Accounting Studies, 6, 275–297, 2001


C 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.

The Aggregation and Valuation of Deferred Taxes

ELI AMIR
Recanati Graduate School of Business, Tel Aviv University, Tel Aviv 69978, Israel

MICHAEL KIRSCHENHEITER AND KRISTEN WILLARD mtk4@columbia.edu

Columbia University, School of Business, 621 Unis Hall, NY 10027

Abstract. This paper clarifies some of the conflicting arguments about the value relevance of deferred taxes. We
address two questions. First, does accounting aggregation hold, or in other words, are deferred tax expense and
liability balances valued the same as operating earnings and asset balances, respectively? Second, what accounting
method for deferred taxes preserves classical accounting relations, or should deferred taxes be recorded as equity,
as debt, or as some combination of these categories? We answer these questions using a model of depreciable
assets and cashflow dynamics identical to Feltham and Ohlson (1996). We find that aggregation does not hold;
rather deferred taxes are valued less than earnings and book value. Deferred taxes add value because they represent
the deferral of tax payments, so their value is the net present value of the tax benefits. We interpret this result to
mean that the timing of the reversal of temporary differences does matter, consistent with recent empirical work.
Our analysis shows that the deferred tax liability, as currently recorded in accordance with US GAAP, overstates
the liability. Also, we find that the classical accounting relations hold only when deferred taxes are adjusted to their
net present value. Further, the extent of this adjustment depends on whether or not the tax benefits are capitalized
into the cost of the operating asset. If the benefits are reflected in the asset’s cost, deferred taxes should be adjusted
down based on the ratio of the discount rate over the sum of the tax depreciation and discount rates. Otherwise,
the entire balance should be treated as equity.

Keywords: deferred taxes, proper accounting, valuation

We address two issues related to the value relevance of deferred taxes.1 First, does accounting
aggregation hold, i.e., is the deferred tax expense valued similar to operating earnings and
are deferred tax liabilities valued the same as operating assets? Second, what accounting
method for deferred taxes preserves classical accounting relations, i.e., should deferred
taxes be valued as equity, as debt, or as some combination of these categories?
The answer to the first question is no. Using a model of depreciable assets and cashflow
dynamics identical to Feltham and Ohlson (1996) (henceforth F&O), we find that aggrega-
tion does not hold under current GAAP accounting for deferred taxes. Instead, deferred tax
expense is valued less than income and the deferred tax liability is valued less than equity.
This holds because deferred taxes from accelerated depreciation are not discounted under
US GAAP, even though the value of deferred taxes depends on the time value of money and
the rate at which depreciation may be deducted. This result provides theoretical support for
empirical evidence suggesting that deferred tax expense and liability are valued less than
earnings and book value of equity and that the timing of the reversal of the book-to-tax
difference matters.
To answer the second question, we seek an accounting method that preserves classical
accounting relations; that is a method where zero net present value projects result in zero
abnormal earnings, assuming certainty and unbiased book accounting of depreciation. This
276 AMIR, KIRSCHENHEITER AND WILLARD

requirement is met by accounting that records only the net present value of the deferred
taxes as an expense and liability. Relative to this standard, current US GAAP overstates
the liability; the overstatement should be accounted for as equity. Further, the extent of this
overstatement depends on whether or not the tax benefits are capitalized into the original
cost of the asset. If so, the deferred tax liability should be reduced to net present value; if
not, the entire balance should be reversed through equity.

1. Background and Related Literature

In accordance with Statement of Financial Accounting Standards No. 109: Accounting for
Income Taxes (FASB, 1992), accounting for income taxes in the US embraces a comprehen-
sive inter-period tax allocation approach, using the asset-liability method. Companies must
recognize deferred tax assets and liabilities on all temporary book-to-tax differences. These
differences arise when book and taxable income are not equal and they eventually reverse.2
The main criticisms of US GAAP accounting for income taxes center on the discounting
argument. Unlike other long-term liabilities, deferred taxes are not discounted to reflect the
time value of money. These criticisms appear to have influenced deferred tax accounting
outside the US. For example, accounting for income taxes in the UK requires partial income
tax allocation; so that only temporary differences that are expected to reverse in the fore-
seeable future (usually not beyond 5 years) are recorded as deferred taxes. This accounting
method discounts to zero deferred tax assets and liabilities that reverse in the long run.
Effectively, accounting in the UK regards long term deferred taxes as equity rather than
debt. We show that in our model, the US GAAP accounting overstates reported liabilities
and understates the book value of shareholders’ equity.
Research interest in the theory of deferred tax accounting was particularly heavy in the
period prior to the issuance of APB Opinion #11: Accounting for Income Taxes (APB, 1967).
Studies by Davidson (1958), Bierman (1961), and especially Drake (1962) argue forcefully
that the essence of the deferred tax liability rests in its deferral of payments, and so should
be presented at its present value.3 These studies argue that the cost of a depreciable asset
equals the anticipated net cashflows that this asset will generate, discounted at an appropriate
rate. The additional deduction afforded by accelerated depreciation for tax purposes, which
gives rise to the deferred tax liability on these assets, is just another of these cashflows. It
follows that the deferred taxes are like contra-operating assets, and should be recorded at
their discounted value. Amir et al. (1997) provides support for this view.
Despite the considerable amount of research devoted to this subject, the question of
how to account for deferred taxes remains open, as recent papers make clear. Sansing
(1998) investigates the value relevance of the deferred tax liability in a model involving a
depreciable asset where the economic and tax depreciation rates differ. While the deferred
tax liability on each asset reverses, investment occurs at a rate that exceeds the rate of
economic depreciation, insuring that the total deferred tax liability balance never reverses.
Sansing shows that the deferred tax liability has value; and interprets this to mean that the
deferred tax liability is value relevant even though the liability never reverses. Expanding
on this model, Guenther and Sansing (2000) argue that the reversal rate has no impact on
firm value. We agree with these results, but interpret them to mean that the reinvestment
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 277

rate has no impact on the value of the deferred tax liability. We show that the reversal rate,
or rate at which the deferred tax liability on each asset reverses, plays a critical role in the
value relevance of deferred taxes.
Using the abnormal earnings valuation framework of F&O, we show that to aggregate the
deferred tax expense with earnings and the deferred tax liability with equity, the deferred
taxes must be adjusted down by a factor that we refer to as the “net present value” (NPV)
factor. The NPV factor is the ratio of the discount rate over the sum of the tax and discount
rates, the same factor as was derived in Sansing (1998). We show that both the deferred tax
expense and liability need to be adjusted by the NPV factor to obtain a parsimonious valua-
tion relation. We show that adjusting by the NPV factor is required regardless of whether or
not the book accounting is biased, whether or not the projects have zero net present value,
and regardless of the level of reinvestment. Further, we show that this adjustment is equiva-
lent to recognizing the liability based on its net present value, as had been argued in the late
1950’s and early 1960’s, and that, holding book and economic depreciation constant, the
larger the tax depreciation the larger the adjustment. We interpret these latter two results to
mean that the timing of the reversal does matter. Finally, we show that adjusting deferred
taxes by the NPV factor preserves the classical accounting relations. This last point high-
lights the importance of clarifying whether or not the tax benefits are implicitly capitalized
into the cost of the operating asset, which we argue is ultimately an empirical question.4

2. Model

Consider an infinitely-lived firm, financed only by equity, which invests these funds in
operating assets (see Table 1 for notation). This firm pays investors dividends at each date
t (t = 0, 1, 2, . . .), denoted as dt . Assume that there are no personal taxes, that investors are

Table 1. Notation.

τ = corporate tax rate

bvtn = the book value of equity, date t, for n = GAAP, CASH or NPV, if deferred tax accounting is given by
assumption DTGAAP, DTCASH or DTNPV, respectively
oat = book value of operating assets, date t
tat = tax basis of operating assets, date t
oxt = pre-tax operating earnings for period (t − 1, t)
yt = taxable income for period (t − 1, t)
dtlt = deferred tax liability at date t
dtet = deferred tax expense for period (t − 1, t) (i.e., dtet = τ (oxt − yt ))
dt = net total cashflow, paid out as dividends, for period (t − 1, t)
crt = cash flows received, for period (t − 1, t)
ci t = cash flows invested, for period (t − 1, t)
γ = persistence in cash receipts. This is also the economic rate of asset maintenance, so that (1 − γ ) is the
rate of economic depreciation.
δ B = the financial accounting rate of asset maintenance, so that (1 − δ B ) is the rate of book depreciation.
δτ = the tax accounting rate of asset maintenance, so that (1 − δ B ) is the rate of tax depreciation, i.e., the
rate at which depreciation may be deducted for taxes.
Vt = firm’s market value, date t
r = risk-free borrowing rate (let R be 1 plus this rate, or R = 1 + r )
278 AMIR, KIRSCHENHEITER AND WILLARD

risk neutral with homogenous beliefs, that interest rates are non-stochastic and that the no
arbitrage condition holds. Following Dybvig and Ross (1986), the no arbitrage assumption
insures that the expected return on all tradeable claims is the same and equals the risk-free
rate, which we denote as r , and where R = 1 + r is the riskless return. Hence, the price of
equity at date t, denoted as Vt , can be characterized by Assumption A.1 where
∞

Vt = R −n E t [dt+n ]. (A.1)
n=1

Assumption A.1 is known in the literature as the present value relation, or PVR.
At each date t, the firm discloses accounting data reflecting the state of its operating,
tax and financial activities. The non-tax related cashflow in period t is comprised of cash
receipts (crt ) and cash investments (ci t ). Tax expense accrues at the corporate tax rate, τ,
but may differ from taxes paid due to temporary differences between operating earnings
(oxt ) and taxable income (yt ). In order to focus on the interaction between operating assets
and tax assets, set net financial assets equal to zero by assuming that all cashflow is paid
out at the end of each period as dividends, so that dt = crt − ci t − τ yt .
The firm generates cash flows from assets that depreciate at a constant rate. Let (1 − δ B )
denote the rate of book depreciation, so (1 − δ B )oat−1 is the book depreciation expense in
period t for beginning asset balances of oat−1 . Analogously, let (1 − δτ ) denote the constant
rate of tax depreciation, so (1 − δτ )tat−1 is the tax depreciation deduction in period t for
assets with a beginning tax basis of tat−1 .
Using the assumption of constant depreciation for book and tax purposes, we summarize
the tax and book accounting policies by relations for the book and tax assets and for the
book and tax income. First, Assumption A.2.a gives the tax accounting for the balance sheet,
while A.2.b gives the tax accounting for the income statement. These are given as follows:
tat = δτ tat−1 + ci t , (A.2.a)
and
yt = crt − (1 − δt )tat−1 . (A.2.b)

We call Assumption A.2.a the tax asset relation (TAR) and A.2.b the tax earnings relation
(TER). In an analogous fashion, the book accounting for operating assets and earnings is
summarized by assumptions A.3.a and A.3.b, which are given as follows:
oat = δ B oat−1 + ci t , (A.3.a)
and
oxt = crt − (1 − δ B )oat−1 . (A.3.b)
We refer to A.3.a as the operating asset relation (OAR) and A.3.b as the operating earnings
relation (OER). Refer to the four assumptions, A.2.a through A.3.b, as the Basic Accounting
Relations (or BAR).
The next step in building the model involves deciding how to account for deferred taxes.
We consider three different methods, and in specifying these methods, the following def-
initions prove useful. Using dtet to denote the deferred tax expense in period t and dtlt
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 279

to denote the deferred tax liability at date t, respectively, we define these two variables as
follows:
dtet ≡ τ ((1 − δτ )tat−1 − (1 − δ B )oat−1 ),
and
dtlt ≡ dtlt−1 − dtet .
Each of the three alternative deferred tax accounting methods differ only in how they account
for dtet and dtlt . The balance sheet equation, which states that book value of equity equals
operating assets minus the deferred tax liabilities, holds for each of these methods. But since
the amount of deferred tax recorded as a liability will differ, so will the value of equity.
Similarly, operating income is the same, but net income will differ depending on the method
for accounting for deferred taxes. Since book value and net income depend on the deferred
tax accounting, so will the clean surplus equation.
As mentioned above, we distinguish among three methods for accounting for deferred
taxes. First, current US GAAP requires deferred taxes be accounted for in a separate lia-
bility account. If the deferred tax liability account is considered a financial liability, this is
equivalent to accounting for deferred taxes as debt. Hence, the method for accounting for
deferred taxes as debt is called DTGAAP (since it resembles US GAAP). Second, one may
use cash accounting, and record the taxes payable as the total tax expense. Since this is
achieved by reversing the entire deferred tax expense through income, this is equivalent to
accounting for deferred taxes as equity. We call this set of deferred tax accounting assump-
tions DTCASH (since they set tax expense equal to tax payable). Third, one could record
the net present value of the deferred tax liability as a liability, with the remaining balance
being recorded to equity. This final method, which accounts for deferred taxes based on
their net present value, is called DTNPV. These three methods are given as follows:
DTGAAP (Accounting for deferred taxes as debt): Denote book value of equity as bvtGAAP ,
where
bvtGAAP = oat − dtlt (A.4.a.GAAP)
and
bvtGAAP = bvt−1
GAAP
+ (1 − τ )oxt − dt (A.4.b.GAAP)
DTCASH (Accounting for deferred tax as equity): Denote book value of equity as bvtCASH ,
where
bvtCASH = oat (A.4.a.CASH)
and
bvtCASH = bvt−1
CASH
+ (1 − τ )oxt + dtet − dt (A.4.b.CASH)
DTNPV (Accounting for the net present value of deferred taxes as debt): Denote book
value of equity as bvtNPV and define ψ ≡ (R − 1)/(R − δτ ) where
bvtNPV = oat − (1 − ψ)dtlt (A.4.a.NPV)
and
bvtNPV = bvt−1
NPV
+ (1 − τ )oxt + ψdtet − dt (A.4.b.NPV)
280 AMIR, KIRSCHENHEITER AND WILLARD

Assumption A.4.a.GAAP shows the balance sheet equation when the deferred taxes are
accounted for in a manner consistent with current US GAAP.5 In this case the book value
of equity equals operating assets less the deferred tax liabilities, so the deferred taxes are
treated as if they were debt. Assumption A.4.b.GAAP is the clean surplus relation with
deferred taxes as debt.
The structures of DTCASH and DTNPV are analogous to that of DTGAAP. In DTCASH,
the entire deferred tax expense each period is recorded as an addition to equity. This is
reflected in the new clean surplus relation, A.4.b.CASH. Since deferred taxes are recorded
as equity, the deferred tax liability balance is always zero, so bvtCASH = oat will always hold.
In DTNPV, a portion of the deferred taxes is recorded as a liability and a portion is
recorded as equity. The portion which is added to liability is (1 − ψ) of the total deferred
tax expense each period, where ψ is the ratio of the risk free interest rate (R − 1), divided
by the sum of the tax depreciation and interest rates, (R − 1) + (1 − δτ ) . We demonstrate
in Sections 3.2 and 3.3 that reducing the deferred tax liability by a factor of ψ results in the
liability being recorded at its net present value. For this reason, we refer to ψ as the NPV
factor. Assumption A.4.b.NPV is the new clean surplus relation, where ψ of the deferred
tax expense is added to equity as additional income each period.
The valuation representation given in PVR (assumption A.1) above is independent of the
accounting used, as long as clean surplus holds. Hence, the choice of accounting has no
impact on the expression for firm value until we move from future to current accounting
data, which is done in the next section.

3. Results

3.1. Valuation Based on Cashflow Data

To derive equity value in terms of either current cashflow or accounting data, dynamics
must be specified. As noted earlier, we adopt cashflow dynamics identical to those provided
in F&O. Hence, we distinguish cash receipts (crt ) from cash investments in operations (ci t )
and assume the cashflow dynamics (CFD) are given by the following two assumptions:

crt+1 = γ crt + κci t + ê1,t , (A.5.a)

ci t+1 = ωci t + ê2,t . (A.5.b)

The γ ∈ (0, 1) parameter represents the persistence of the prior period cash receipts, κ > 0
represents the impact of lagged investment on current period cash receipts and ω ∈ [0, R)
measures investment growth, with ω = 1 representing the no growth or steady state case.
Three points about CFD require emphasis. First, CFD does not depend on the accounting
policy adopted; in particular CFD does not depend on δ B . Second, while there is an im-
plicit cashflow for tax payments, it is fully determined by CFD and A.2.b (TER); there is
no uncertainty about the implicit cashflow for tax payments separate from the uncertainty
embodied in CFD. Third, introducing taxes changes the zero net present value (NPV) con-
dition. Without taxes, investments have zero NPV when γ κ = 1, where γ ≡ 1/(R − γ )
represents the persistence of cash receipts. With taxes, the zero NPV condition becomes
γ κ(1 − τ ) + τ (1 − δτ )τ = 1, where τ ≡ 1/(R − δτ ) represents the persistence of
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 281

the tax payments.6 To simplify subsequent discussion, define λ as the present value of
future after-tax cash flows generated by one dollar of investment, or λ ≡ γ κ(1 − τ ) +
τ (1 − δτ )τ . Hence, the net present value of a dollar invested is λ − 1. Next we present
our first result, which provides an expression for firm value in terms of the current cash
flow data.

Theorem 1 Let PVR and CFD hold. Then firm value at date t is written in terms of current
cashflow information as follows
(λ − 1)ci t ω
Vt = {(1 − τ )γ γ crt + τ (crt − yt )δτ τ + λci t } + . (V.1)
R−ω

Expression V.1 breaks equity value down into the value of current and past cashflows
(i.e., the term in the brackets) and the value of future cash investments (i.e., the final term in
V.1). Future cash investments have no impact on value either if none are expected (ω = 0)
or if they are zero NPV investments (λ = 1). Current investments are valued based on the
NPV of the cashflows they generate, or by a factor of λ, so zero NPV investments increase
firm value on a dollar-for-dollar basis. The value of past investments can be broken down
into the persistence in after-tax cash receipts and the persistence in the reduction in taxes
due to the depreciation deduction. The discounted value of the persistence of cash receipts
is γ γ , so after-tax cash receipts have a value of γ γ (1 − τ )crt . The discounted value
of the persistence in the cash savings due to the depreciation deduction is δτ τ , while the
depreciation deduction is given as (1 − δτ )tat−1 = (crt − yt ), so the present value of the
cash saved is given as τ (crt − yt )δτ τ .
Next we explore three benchmark cases for the level of δτ .7 First, if δτ = 0, the entire
investment is deductible for tax purposes at the end of the period immediately following the
investment. In this case, the tax becomes a tax on net cash flows, except that the deduction for
the initial cash outflow is delayed one period. Second, if δτ = 1, no depreciation deduction
is allowed for tax purposes and the corporate tax reduces to a tax on gross cash receipts.
Third, if δτ = γ , the corporate tax acts as a true “income” tax. Corollary 1 characterizes
firm value under each of these benchmark cases.

Corollary 1 Let the conditions of Theorem 1 hold. Then firm value at date t can be written
in terms of current cashflow information, depending on the level of δτ , as follows
 
(γ κ − 1)ci t ω
(a) if δτ ≡ 0, then Vt = (1 − τ ) γ (γ crt + κci t ) +
R−ω
 
τ ci t rω
+ 1− ; (V.1.a)
R R−ω
((1 − τ )γ κ − 1)ci t ω
(b) if δτ ≡ 1, then Vt = (1 − τ )γ (γ crt + κci t ) + ; (V.1.b)
R−ω
(c) if δτ ≡ γ , then Vt = γ {γ (crt + τ yt ) + ((1 − τ )κ + τ (1 − γ )) ci t }
(λ − 1)ci t ω
+ . (V.1.c)
R−ω
282 AMIR, KIRSCHENHEITER AND WILLARD

Corollary 1 describes three benchmark cases for tax incidence. First, if δτ ≡ 0, equation
(V.1.a) shows that firm value can be written as the sum of two expressions. The final term is
an adjustment for the delayed deductible of the initial investment. For the first expression,
shows that all future investments are immediately deductible. It was shown in F&O that,
assuming no corporate taxes, the value of the firm is given by the expression in the brackets
(“{·}”). Hence the first expression represents the net pre-tax cash flows from the investment,
which equal the pre-tax value of the firm, multiplied by a factor of (1 − τ ). Assuming either
that the initial investment is immediately deductible, or that we are in steady state (i.e.,
ω = 1), the final term drops out, and the tax policy reduces simply to a tax on net cash
flows.
Second, if δτ ≡ 1, then taxable income equals cash receipts, and imposing an income tax
represents a tax on the gross cash receipts. To see this is, assume the firm invests in zero
NPV projects (i.e., let (1 − τ )γ κ = 1). In this case, equation (V.1.b) simplifies to

Vt = (1 − τ )γ γ crt + ci t ,

so that the tax reduces the cash receipts to investors at a rate of τ.

Third, when δτ = γ , the tax may act as a “true” income tax. Assume that projects are all
zero NPV, so that firm value becomes Vt = γ γ (crt − τ yt ) + ci t , and that cashflows are
certain. Then with δτ = γ , taxable income equals economic earnings, and the tax depreci-
ation policy becomes a tax on income.8

3.2. Valuation Based on Accrual Data

Next we turn to the accounting data to obtain an expression for firm value. We derive
the value of the firm based on current abnormal accounting earnings and book value in
Theorem 2.

Theorem 2 Let PVR, BAR, CFD and DTGAAP hold. Then, defining abnormal earnings at
date t as anx t ≡ (1 − τ )oxt − (R − 1)bvt−1
GAAP
, Equation (V.2) gives firm value in terms of
current accrual data as

Vt = bvtGAAP + β1 anxt + β2 ci t + (1 − τ )β3 oat−1 + τ ψβ4 tat−1 , (V.2)

where
(λ − 1)R
β1 = γ γ ; β2 = ; β3 = Rγ (γ − δ B ); and β4 = Rγ (γ − δτ ).
R−ω

Theorem 2 says that firm value can be represented by ending book value, current abnormal
earnings, the current cash investment, and other book and tax balance sheet amounts for
the operating assets, and is analogous to Proposition 2 in F&O. If the accounting for both
book and tax are unbiased, in the sense that the depreciation policies coincide, (i.e., when
γ = δ B = δτ ), then oat = bvtGAAP = bvtCASH = bvtNPV since dtlt = 0 always holds. In this
case, firm value can be expressed solely in terms of current book value, abnormal earnings
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 283

and cash investment. Specifically, V.2 reduces to

Vt = oat + β1 anxt + β2 ci t ,

closely resembling the results of F&O. Just as in F&O, assuming all projects have zero
NPV implies current cash investments play no additional direct role in valuation, since
λ = 1 implies β2 = 0.
The beginning book balances play roles analogous to the role played by the beginning
book value of operating assets without taxes in F&O. When financial accounting is biased
(i.e., when γ = δ B ), firm value is directly affected by the beginning book value of the
operating assets. The effect is identical to the effect shown in F&O, multiplied by the factor
(1 − τ ). When tax accounting is biased (i.e., when γ = δτ ), firm value is directly affected
by the beginning balance of the operating asset’s tax basis (i.e., tat−1 ).9 Also, when tax and
book accounting coincide (i.e., for δ B = δτ ), then once again dtlt = 0 for all t and again
we have oat = bvtGAAP = bvtCASH = bvtNPV . Hence, V.2 becomes

Vt = oat + β1 anxt + β2 ci t + β3 oat−1 ,

and the beginning book value of operating assets has the same value relevance (i.e., has the
same coefficient) as it does when no corporate tax is imposed.
Further insight is provided by noting that the coefficient on the tax basis adjustment differs,
in part, from the coefficient on the book value adjustment by the factor ψ ≡ (R − 1)τ .
Deferred tax liabilities are valuable because they defer the tax payment; the increase to
firm value from deferring one period is based on the time value of money, measured by the
interest rate (R − 1). Since these liabilities persist at a rate of δτ , the effect on firm value
is discounted by the factor (R − δτ )−1 ≡ τ . Alternatively we can write the denominator
as the sum of the interest and depreciation rates, (R − 1) + (1 − δτ ). Hence a dollar in
the beginning tax basis balance has less impact, the higher the tax depreciation rate. The
ratio ψ plays a more pronounced role in our next result.10
Prior research has shown that the accounting value relation given by book value plus a
multiple of residual income can be replaced by a weighted average of book value plus a
multiple of earnings adjusted for dividends. This suggests that a parsimonious expression of
firm value in terms of current period after-tax earnings, book value and dividends, adjusted
by using the deferred tax expense and deferred tax asset balances, should be possible. This
is shown in Corollary 2.

Corollary 2 Assume the conditions of Theorem 2 hold, cash is invested in zero NPV projects
(λ = 1) and let φ ≡ R/(R − 1) and k ≡ γ (R − 1)γ . Then firm value at date t can be
written in terms of current accrual data as follows

(a) if δ B =
γ ≡ δτ , then Vt = k(φ(1 − τ )yt − dt ) + (1 − k)tat . (V.2.a)
(b) if δ B ≡ γ =
δτ , then Vt = k (φ ((1 − τ )oxt + ψdtet ) − dt )
+ (1 − k)(oat − (1 − ψ) dtlt ) (V.2.b)
284 AMIR, KIRSCHENHEITER AND WILLARD

Hence, assuming δ B ≡ γ , the three benchmark cases for tax depreciation policy give firm
value as
 
dtlt
(b.i) if δτ ≡ 0, then Vt = k(φ(1 − τ )oxt + dtet − dt )+(1 − k) oat − .
R
(V.2.b.i)
(b.ii) if δτ ≡ γ , then Vt = k(φ(1 − τ )oxt − dt ) + (1 − k)oat . (V.2.b.ii)
(b.iii) if δτ ≡ 1, then Vt = k(φ((1 − τ )oxt + dtet ) − dt ) + (1 − k)oat . (V.2.b.iii)

Corollary 2 shows that the impact of deferred tax accounting can be divided between the
“income statement” impact of current period deferred tax expense and the “balance sheet”
impact of the end of period deferred tax balance.11 Further, the adjustments
required depend, in an intuitive fashion, on the relative depreciation policies adopted.
Tax accounting satisfies clean surplus in our model. If in addition it is unbiased, equation
V.2.a follows in a straightforward fashion. In this case, the value of the firm is a weighted
average of the taxable income plus the tax basis of the firm’s assets (i.e., tat ).
Second, part (b) shows that deferred tax accounting affects both the flow and stock portion
of the expression of firm value in a similar way when book depreciation equals economic
depreciation. Specifically, the value of both deferred tax expense and liability is given as
(1 − δτ )τ = (1 − ψ) times the reported amount. If δτ < δ B , deferred tax expenses and
liabilities arise, so dtet > 0 initially and dtlt > 0 for each period t. Hence, to properly
aggregate deferred taxes when δτ < δ B , we add ψ times the reported deferred tax expense
to earnings and ψ times the deferred tax balance to book value of equity. For δτ > δ B ,
deferred tax benefits and assets arise, and we need to subtract by the same proportion.
This answers the question about aggregation posed in the introduction: aggregation does
not hold. Recall ψ is the ratio of the discount rate over the sum of the discount and tax
depreciation rates. Value is created from deferred tax expense due to the deferral of tax pay-
ments, and this value creation is measured by the ratio ψ. Hence, a dollar of deferred tax
expense (or liability) decreases value by (1 − ψ) as much as a dollar of pre-tax earnings (or
operating asset) increases value. This result is supported by empirical findings, in particular,
see Ohlson and Penman (1992).12
Parts (b.i) through (b.iii) show firm value under the three benchmark depreciation policies.
Beginning with tax depreciation policy that allows full deduction in the first period following
the investment (δτ = 0), we see that deferred tax expense is valued like cash, increasing
value by a factor of k. The deferred tax liability balance decreases firm value by a factor of
1/R, the net present value of the interest on the liability. As the tax depreciation deduction
falls (i.e., as δτ increases), both the deferred tax expense and liability decrease until they
are zero when tax and book depreciation are the same (i.e., in expression V.2.b.ii for δ B =
γ = δτ ).13
As δτ increases further, there are two effects on firm value equation (V.2.b). First, the
flow is now a deferred tax benefit, so the effect reduces firm value. Second, it decreases
firm value more as δτ increases, both because the benefit grows and also because the impact
of the deferred taxes increases since the factor ψ increases in δτ . For the extreme policy
where no depreciation deduction is allowed (δτ = 1), the deferred tax benefit is valued like
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 285

earnings, decreasing value by a factor of kφ. The impact of the deferred tax asset balance
also increases as δτ increases, until at δτ = 1, it reduces book value dollar for dollar. Since no
deduction is allowed, the deferred tax asset will never be realized, so this asset should be
treated as equity, reducing the value of the firm by the amount of the deferred tax asset. This
is best seen by noting that under DTCASH, (1 − τ )oxt + dtet is the reported income and
the book value of equity equals the book value of operating assets. Hence, V.2.b.iii shows
firm value as a weighted average of net income less dividend and book value of equity.

3.3. Deferred Taxes as Liability or Equity

In this final section, we address the question of whether accounting for deferred taxes as
a liability or as equity is the “appropriate” approach. This requires that we explain what
“appropriate” accounting means. As Ohlson (1995) made clear, firm value can be expressed
in terms of book value and the discounted future expected abnormal earnings, as long as
clean surplus holds. In particular, firm value does not depend on the accounting policy
adopted. Therefore, it is not meaningful to ask whether deferred taxes should be recorded
as a liability or equity from the standpoint of firm value. Any differences in these approaches
merely shift value between the book value of equity and future abnormal earnings, without
affecting total firm value.
However, accounting does matter in so far as analysts use the accounting information to
assist them in forecasting future profitability, i.e. at arriving at the future abnormal earnings
estimates. Hence, it makes sense to define appropriate accounting in terms of expected
future profitability, in particular, expected future abnormal earnings. Assuming certainty in
the cashflow dynamics and unbiased book accounting of depreciation, we seek the deferred
tax accounting method such that zero abnormal earnings are recorded when zero net present
value (NPV) assets are employed.
Results in the preceding section indicated that deferred taxes are valued differently based
on the timing of the tax savings. Recall from Theorem 2 that, with unbiased book accounting
and zero NPV investments, deferred taxes were valued at a factor of (1 − ψ) = (1 − δτ )τ ,
where ψ ≡ (R − 1)τ . Reducing the reported deferred tax expense in period t by ψdtet ,
from dtet to (1 − ψ)dtet , is consistent with an approach which records the deferred taxes
at their net present value, similar to the effective interest approach for valuing long term
debt. Adjusting the calculation of deferred tax expense by this factor preserves the classical
accounting relations, as is shown in the following theorem.

Theorem 3 Let PVR, BAR, DTNPV and CFD hold, and assume the book accounting is
unbiased (δ B = γ ), projects have zero net present value (λ = 1), and the cashflows are
certain (i.e., êit ≡ 0, i = 1, 2). Then mark-to-market accounting holds at each date t, or
Vt = bvtNPV = oat − (1 − ψ) dtlt .

F&O show that, assuming γ = δ B , zero NPV investments, and cashflow certainty, certain
classical results hold in the economy without corporate taxes. F&O interpret this to mean
that the depreciation policy induced by γ = δ B leads to the “proper” measures of book
value and earnings. Analogous to this, Theorem 3 shows that, if deferred tax accounting
286 AMIR, KIRSCHENHEITER AND WILLARD

follows DTNPV, then the deferred tax liability is “properly” recorded, and NPV projects
under unbiased book accounting result in zero abnormal earnings.
To summarize, we find that the “classical” results follow under two sets of condition. First,
if the rates of economic, book and tax depreciation are all set equal, that is if γ = δ B = δτ ,
then there are no deferred taxes and the classical results hold. Second, if γ = δ B = δτ ,
so that deferred taxes arise, but the deferred tax accounting is given by DTNPV, then the
classical results hold, with net income in each period reflecting the reversal of the current
deferred tax expense or benefit. We summarize the classical results in an economy with and
without corporate taxes and with and without deferred taxes in Table 2.
As mentioned earlier, deferred tax accounting that follows DTNPV results in the present
value of the tax benefits, not the nominal value, being recorded as the expense. The differ-
ence between DTNPV and DTGAAP (which reflects current US GAAP) is recorded as an
increase in equity. This result provides theoretical support for the argument that deferred
taxes should be recorded at their net present value and for the partial tax allocation approach
followed in the U.K. It also shows the importance played by the timing of the reversal of
the temporary differences, a role about which there is confusion in the literature.
The confusion concerns the interpretation of the reversal rate. Sansing (1998) and
Guenther and Sansing (2000) interpret the “reversal rate” of the deferred tax liability as
the difference between the rate of economic depreciation and the rate of reinvestment. If
reinvestment occurs faster than the asset depreciates, then the net deferred tax liability
grows. This is what these authors mean when they claim that the deferred tax liability never
reverses; they define the reversal rate as the difference between the economic depreciation
and reinvestment rates. They then show that the deferred tax liability has value despite it
never reversing and that the value of the liability is not dependent on the rate of reversal.
We interpret the “reversal rate” as the rate at which the timing differences on each asset,
and the associated deferred tax liability, reverse. Even though additional investment may
prevent the net deferred tax liability balance from falling, it is clear that the deferred tax
liability on each asset reverses in the above models as well as our own (see note 5 above).
Consistent with the results in Sansing and Guenther and Sansing, our model showed that
the rate of reinvestment does not affect the value relevance of the deferred tax liability.
However, the rate of reversal of the deferred tax liability, as we define it, does.
We argue that the rate of reversal of the deferred taxes depends on the difference between
the book and tax depreciation rates. The value of the tax benefits from accelerated depre-
ciation deductions depends on the timing of the related cashflows; this does not seem in
dispute. Changing either the economic or tax depreciation rates will affect the value of these
benefits. Hence, changing the reversal rate by changing the tax depreciation rate, leaving
the book and economic rates equal, will change the value of these benefits. Alternatively,
changing the reversal rate by changing the economic and book rates, leaving the tax rate
unchanged, will change the benefits. It is also clear that changing the book depreciation
rate while holding both the economic and tax rates constant will leave the value of the
tax benefits unchanged, while changing the level of deferred tax liability. What was not
clear was how the change in the value of the tax benefits (as measured by the timing of the
cashflows) and the deferred tax expense and liability are related to changes in the book,
economic and tax depreciation rates, as well as to the reinvestment rates. Theorems 2 and
3 and Corollary 2 clarify these relations.
Table 2. Classical accounting results with and without corporate taxes.

Descriptions Without Taxes (F&O) With Taxes But None Deferred With Deferred Taxes
Assumptions:
i) unbiased accounting i) γ = δ B i) γ = δ B = δτ i) γ = δ B
ii) zero NPV investments ii) γ κ = 1 ii) λ = 1 ii) λ = 1
iii) certainty in cashflow dynamics iii) êit ≡ 0, i = 1, 2 and iii) êit ≡ 0, i = 1, 2 and iii) êit ≡ 0, i = 1, 2 and
iv) deferred tax accounting iv) not applicable iv) not applicable iv) Let DTNPV hold.
Results:
a) market value = book value a) Vt = oat a) Vt = oat a) Vt = bvtNPV = oat − (1 − ψ)dtlt
b) market value plus cashflows b) Vt + crt − ci t = φoxt b) Vt + dt = φ(1 − τ )oxt b) Vt + dt = φ{(1 − τ )oxt =
R/(R − 1) times accounting earnings where φ ≡ R/(R − 1) + ψτ (oxt − yt )}
THE AGGREGATION AND VALUATION OF DEFERRED TAXES

c) economic earnings = c) aoxt ≡ oxt − (R − 1)oat−1 = 0 c) Vt − Vt−1 + crt − ci t = (1 − τ )oxt c) Vt − Vt−1 + crt − ci t = (1 − τ )oxt
accounting earnings + ψτ (oxt − yt )
d) abnormal accounting earnings = d) aoxt ≡ oxt − (R − 1)oat−1 = 0 d) anxt /(1 − τ )oxt − (R − 1)oat−1 = 0 d) anxt ≡ (1 − τ )oxt + ψτ (oxt − yt )
NPV
zero −(R − 1)bvt−1 =0
287
288 AMIR, KIRSCHENHEITER AND WILLARD

Two other points arise from Theorem 3. First, while the deferred tax liability balance
is overstated in the above case, it is not necessarily true that all deferred tax balances are
overstated. For example, deferred tax assets on Other Post Employment Benefits are based
on the estimated net present value of these benefits, so these are recorded at a level closer to
their net present value. This suggests that these deferred tax assets may not be overstated.
Second, the above analysis is based on the assumption that the cost of the operating asset
reflects the tax benefits of the accelerated depreciation deduction allowed for tax purposes.
The tax savings from deducting depreciation are given by the term τ (1 − ψ). This amount
can be written as the sum of the tax savings under unbiased tax accounting, τ (1 − γ )γ ,
and the tax savings due to the bias in the tax accounting, given as τ ψ(γ − δτ )γ . It is
this latter expression that measures the savings from deducting depreciation for taxes at
a rate faster than economic depreciation (i.e., when γ > δτ ). While competitive pressure
may insure that the asset’s price reflects all cashflows, including those from the deferred
tax savings, other situations are possible.14 Which situation holds is an empirical question.

4. Summary

This paper contributes to the literature in two ways. First, building on the model of an all
equity firm composed solely of depreciable operating assets from F&O, we analyze the
value relevance of deferred taxes, especially whether they aggregate in the same fashion
as earnings and the book value of operating assets. We first derive firm value in terms of
current cash investment, cash receipts, and tax payments. Using this model of cashflows,
we analyze the economic impact of three benchmark tax accounting policies. We show that
assuming no tax deduction for depreciation, full immediate deduction, and equal rates of
tax and economic depreciation, imply the corporate tax functions as a tax on capital, on
cashflow, and on income, respectively.
Next, assuming a constant book depreciation rate, we derive firm value in terms of current
accounting data. Our expression is similar to F&O’s result, except that in addition to the
adjustment for beginning book value of operating assets required when book accounting
is biased (i.e., book and economic depreciation differ), an adjustment for beginning tax
basis of operating assets is required when tax accounting is biased (i.e., tax and economic
depreciation differ). The valuation coefficient on the tax basis adjustment is lower than
that on the book value adjustment by the ratio of the interest rate over the sum of the tax
depreciation and interest rates, which we denote by ψ. Next we decomposed the value
of deferred taxes into a weighted average of the deferred tax expense and liability, where
the weights on the tax expense and liability differ from the weights on earnings and book
value, respectively, by the ratio ψ. This demonstrates that aggregation does not hold, and
highlights why. Deferred taxes affect value through deferral, so their impact on value is
measured by the net present value of the benefits. This calculation depends on both the
discount rate and the speed of the tax deduction. We interpret this to mean that the rate of
reversal does matter, contrary to other recent theoretical research on this issue, but consistent
with empirical evidence.
Finally, we find that, when tax benefits are included in the cost of the asset, classical
accounting relations are preserved by the expensing of only a portion of the deferred tax
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 289

expense that is expensed under current US standards. The portion of deferred taxes required
to be expensed is the net present value of the tax benefits and is given by 1 − ψ, consistent
with our other results. However, this result relies on the assumption that the tax benefits are
capitalized into the price of the asset. If the tax benefits are not reflected in the price of the
operating assets, proper accounting requires deferred taxes be valued as equity, increasing
the value of the firm on a dollar for dollar basis. The extent to which the tax benefits are
capitalized into the price is an empirical question that, to our knowledge, remains open.

Appendix

Proof of Theorem 1 The dynamic equations comprising CFD together with TER provide
the following expectations.
κ
E t [crt+n ] = γ n crt + (γ n − ωn )ci t ;
γ −ω
E t [ci t+n ] = ωn ci t ;

and
 
1 − δt
E t [crt+n − yt+n ] = ((δt )n − ωn )ci t + (δt )n (crt − yt ).
δt − ω

These expectations have the following discounted present values.

∞
  
−n κ γ ω
R E t [crt+n ] = γ γ crt + − ci t ;
n=1
γ −ω R−γ R−ω
∞
ci t ω
R −n E t [ci t+n ] = ;
n=1
R−ω

and
∞
  
−n (1 − δτ ) δτ ω δτ (crt − yt )
R E t [crt+n − yt+n ] = − ci t + .
n=1
δτ − ω R − δτ R−ω R − δτ

Since dt+n = crt+n − ci t+n − τ yt+n = (1 − τ )crt+n − ci t+n + τ (crt+n − yt+n ), we have
∞
 ∞

Vt = R −n E t [dt+n ] = R −n E t [(1 − τ )crt+n − ci t+n + τ (crt+n − yt+n )];
n=1 n=1
   
κ γ ω ci t ω
= (1 − τ ) γ γ crt + − ci t −
γ −ω R−γ R− R−ω
   
1 − δτ δτ ω δτ (crt − yt )
+τ − ci t + .
δτ −  R − δτ R−ω R − δτ
290 AMIR, KIRSCHENHEITER AND WILLARD

Further, rearranging and canceling gives

   
κ γ ω ω
− = κγ 1 +
γ −ω R−γ R−ω R−ω

and
     
1 − δτ δτ ω 1 − δτ ω
− = 1+ .
δτ − ω R − δτ R−ω δτ − ω R−ω

Using these equations and defining τ ≡ 1

R−δτ
, express firm value as
   
ω ci t ω
Vt = (1 − τ ) γ γ crt + κγ 1 + ci t −
R−ω R−ω
  
1 − δτ ω δτ (crt − yt )
+τ 1+ ci t +
R − δτ R−ω R − δτ
= γ (1 − τ )γ crt + (γ κ(1 − τ ) + τ (1 − δτ )τ )ci t
(γ κ(1 − τ ) + τ (1 − δτ ) − 1)ci t ω
+ + τ δτ τ (crt − yt ),
R−ω
which completes the proof of Theorem 1.

Proof of Corollary 1: This proof proceeds by specifying the different benchmark levels
of δτ and simplifying the expression for firm value that results. First, for part (a), if δτ ≡ 0,
then the expression simplifies to

τ ci t  τ  ci ω
t
Vt = γ (1 − τ ) (γ crt + κci t ) + + (1 − τ )γ κ + − 1
R R R−ω
   
(γ κ − 1)ci t ω 1 R−ω ci t ω
= (1 − τ ) γ (γ crt + κci t ) + −τ 1− −
R−ω R Rω R−ω
 
(γ κ − 1)ci t ω τ ci t (ω − 1)
= (1 − τ ) γ (γ crt + κci t ) + −
R−ω R−ω
   
(γ κ − 1)ci t ω τ ci t rω
= (1 − τ ) γ (γ crt + κci t ) + + 1− ,
R−ω R R−ω

as required for part (a).

((1−τ )γ κ−1)ci t ω
For part (b), if δt ≡ 1, then Vt = (1 − τ )γ (γ crt + κci t ) + R−ω
follows
immediately since in this case crt = yt for all t. For part (c), if δτ ≡ γ , then again the
derived expression

(γ ((1 − τ )κ + τ (1 − γ )) − 1)ci t ω

Vt = γ {γ (crt − τ yt ) + (1 − τ )κ + τ (1 − γ )ci t } +
R−ω
follows immediately since in this case γ = τ . This completes the proof of Corollary 1.
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 291

Proof of Theorem 2: Begin by noting that anxt+1 can be written as follows:

anxt+1 = (1 − τ )oxt+1 − (R − 1)(oat − dtlt )

= (1 − τ )(crt+1 − (1 − δ B )oat ) − (R − 1)(oat − dtlt )
 
dtlt
= (1 − τ )crt+1 − (1 − τ )(R − δ B )oat − τ (R − 1) oat − .
τ

−oxt+1 crt+1 −yt+1

Using OER and TER, we have oat = crt+11−δ B
and oat −dtl
τ
t
= tat = 1−δτ
, so that
writing the abnormal earnings in terms of the flow variables, we have

(1 − τ )(R − δτ ) τ (R − 1)
anxt+1 = (1 − τ )crt+1 − (crt+1 − oxt+1 ) − (crt+1 − yt+1 ).
(1 − δ B ) 1 − δτ

Substituting into the expression for firm value from Theorem 1, we have
∞

Vt = bvtGAAP + R −n
F E t [anx t+n ]
n=1
∞
 
(1 − τ )(R − δτ )
= bvtGAAP + R −n (1 − τ )E t [crt+n ] − E[crt+n − oxt+n ]
n=1
F
1 − δB

τ (R − 1)
− E[crt+n − yt+n ] .
1 − δτ

From above we have

∞
  
κ γ ω
R −n
F E t [cr t+n ] = γ γ cr t + − ci t ;
n=1
γ −ω R−γ R−ω
∞
  
1 − δB δB ω δ B (crt − oxt )
R −n
F E t [cr t+n − oxt+n ] = − ci t + ,
n=1
δB − ω R − δB R−ω R − δB

and
∞
  
1 − δτ δτ ω δτ (crt − yt )
R −n
F E t [cr t+n − yt+n ] = − ci t + .
n=1
δτ − ω R − δτ R−ω R − δτ

The coefficients on ci t simplify as follows:

 
κ γ ω κ R
(1 − τ ) − = (1 − τ ) ;
γ −ω R−γ R−ω R−γ R−ω
  
R − δB δB ω R
(1 − τ ) − = (1 − τ ) ;
δB − ω R − δB R−ω R−ω
292 AMIR, KIRSCHENHEITER AND WILLARD

and
    
R−1 δτ ω R−1 R
τ − =τ .
δτ − ω R − δτ R−ω R − δτ R−ω

Letting γ = 1
R−γ
and τ ≡ 1
R−δτ
, the coefficient on ci t becomes
  
R−1 R (γ κ(1 − τ ) + τ (1 − δτ )τ − 1)R
(1 − τ )γ κ − (1 − τ ) − τ =
R − δτ R−ω R−ω
(λ − 1) R
=
R−ω
Use (crt − oxt ) = (1 − δ B )oat−1 and (crt − yt ) = (1 − δτ )tat−1 , substitute, simplify and
rearrange to get

τ (R − 1)δτ R
Vt = bvtGAAP + (1 − τ )γ γ crt − (1 − τ )δ B oat−1 − tat−1 + (λ − 1) ci t .
R − δτ R−ω
Finally, using (1 − τ )crt = anxt + (1 − τ )(R − δ B )oat−1 + τ (R − 1)tat−1 , substituting
and simplifying gives

Vt = bvtGAAP + β1 anxt + β2 ci t + (1 − τ )β3 oat−1 + τ ψβ4 tat−1 ,

where β1 = γ γ ; β2 = (λ − 1) R−ω R
; β3 = Rγ (γ − δ B ); β4 = Rγ (γ − δτ ) as in the
corollary, completing the proof of Theorem 2.

Proof of Corollary 2: Assume the conditions of Theorem 2 hold. Performing the usual
transformation of abnormal earnings and book value into a weighted average of earnings,
dividends and book value, gives

Vt = k(φ(1 − τ )oxt − dt ) + (1 − k)bvtGAAP + β2 ci t + (1 − τ )β3 oat−1 + τ ψβ4 tat−1 .

Next, by construction we have dtlt = τ (oat − tat ) . This fact, together with TAR and OAR,
give the ending deferred tax liability in terms of the beginning book value and tax basis of
the operating assets, or

dtlt
= oat − tat = δ B oat−1 − δτ tat−1 .
τ
Also the above fact together with assumption A.4.a.GAAP give the ending deferred tax
liability in terms of the beginning book value and tax basis of the operating assets and the
current deferred tax expense, or

dtlt = τ (oat−1 − tat−1 ) + dtet .

Using these two equations, we can write the beginning book value and tax basis of the
operating assets in terms of the current deferred tax expense and ending deferred tax liability
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 293

balances as follows:

(δτ dtet + (1 − δτ )dtlt ) (δ B dtet + (1 − δ B )dtlt )

oat−1 = − , and tat−1 = − .
τ (δτ − δ B ) τ (δτ − δ B )

R (R−1)(γ −δ )
Recall β3 = Rγ (γ − δ B ) and β4 = γ R−δτ τ . For part (a), γ = δτ implies β4 = 0,
so the final term drops out, while the second last term becomes

(1 − τ )Rγ (γ dtet + (1 − γ )dtlt

(1 − τ )β3 oat−1 = − .
τ

The flow portion of the expression in part (a) follows since yt = oxt − dtet /τ and kφ =
Rγ γ , while the stock portion follows since tat = bvtGAAP − (1 − τ )dtlt /τ and (1 − k) =
Rγ (1 − γ ).
Next, for part (b), γ = δ B implies β3 = 0, so the second last term drops out while the
final term becomes

τ ψβ4 tat−1 = ψ Rγ (γ dtet + (1 − γ )dtlt ).

Again, the expression in part (b) follows immediately. The expressions in parts (b.i), (b.ii)
and (b.iii) follow from substituting for δτ and simplifying. This completes the proof of
Corollary 2.

Proof of Theorem 3: From the proof of Corollary 2 we know tat = oat − dtlt /τ . Using
this fact, substituting and rearranging terms, we can write out the abnormal net income for
period t under DTNPV as follows:

anxt ≡ (1 − τ )oxt + ψdtet − (R − 1)bvt−1

NPV

= (1 − τ )oxt + ψτ ((1 − δτ )tat−1 − (1 − δ B )oat−1 )

− (R − 1)(oat−1 − (1 − ψ) dtlt−1 )
   
dtlt−1
= (1 − τ )oxt + ψτ (1 − δτ ) oat−1 − − (1 − δ B )oat−1
τ
− (R − 1)(oat−1 − (1 − ψ) dtlt−1 )
= (1 − τ )(crt − (1 − δ B )oat−1 ) + ψτ (δ B − δτ ) oat−1 − (R − 1)oat−1
− (ψ(1 − δτ ) − (R − 1)(1 − ψ)) dtlt−1
= (1 − τ )crt − (R − δ B )oat−1 + τ ((1 − δ B ) + ψ (δ B − δτ )) oat−1 .

The final equality followed since ψ(1 − δτ ) = (R − 1)(1 − ψ). Further by the certainty
assumption we have

crt = ci 0 κ(ωt−1 + ωt−2 γ + ωt−3 γ 2 + · · · + ωγ t−2 + γ t−1 )

294 AMIR, KIRSCHENHEITER AND WILLARD

and

oat−1 = ci 0 ωt−1 + ωt−2 δ B + ωt−3 δ 2B + · · · + ωδ t−2

B + δB
t−1
.

The assumption of unbiased book accounting implies we can write abnormal earnings as

anxt = ci 0 (ωt−1 + ωt−2 γ + · · · + ωγ t−2 + γ t−1 )

  
(R − 1)(γ − δτ )
× (1 − τ )κ − (R − γ ) + τ (1 − γ ) + ,
R − δτ

where we substituted for ψ = R−1

R−δτ
. Factoring the expression in the brackets by (γ )−1 ,
we get
  
−1 (R − 1)(γ − δτ )γ
(γ ) (1 − τ )κγ − 1 + τ (1 − τ )γ +
R − δτ
  
(1 − γ )(R − δτ ) + (R − 1)(γ − δτ )γ
= (γ )−1 (1 − τ )κγ − 1 + τ
R − δτ
  
−1 (R − γ δτ − Rγ − Rδτ )γ
= (γ ) (1 − τ )κγ − 1 + τ
R − δτ
  
1 − δτ
= (γ )−1 (1 − τ )κγ − 1 + τ = (γ )−1 (λ − 1) = 0
R − δτ

where the final equality follows by the assumption of zero NPV investments. Since this
holds for all periods, the sum of future abnormal net earnings is zero, completing the proof
of Theorem 3.

Corollary 3 Under unbiased book accounting, the net present value of the current deferred
tax liability at date t, dtlt , assuming no new investments, is given as the negative of the
discounted future deferred tax based cashflows, which can be written as follows:

∞

− R −n
F dtet+n = dtl t (1 − ψ) − τ ψ(γ − δτ )γ oat .
n=1

Proof of Corollary 3: First, assuming no new investments, the sum of the future deferred
tax expense must, by construction, equal the negative current deferred tax liability balance,
or −dtlt = ∞ n=1 dtet+n . Next, under unbiased book accounting, the deferred tax expense
in period t + n can be written as follow:
 
dtet+n ≡ τ [(1 − δτ )tat−1+n − (1 − γ )oat−1+n ] = τ (1 − δτ )tat δτn−1 − (1 − γ )oat γ n−1 .
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 295

Using this expression, the discounted future deferred tax expenses can be written as follows:
∞
 ∞

R −n
F dtet+n = R −n
F τ [(1 − δτ )tat−1+n − (1 − γ )oat−1+n ]
n=1 n=1
∞  
(1 − δt )tat n (1 − γ )oat n
= R −n
F τ δτ − γ
n=1
δτ γ
 ∞  ∞ 
(1 − δτ )tat  −n n (1 − γ )oat  −n n
=τ R F δτ − RF γ
δτ n=1
γ n=1
 
(1 − δτ )tat (1 − γ )oat
=τ −
R − δτ R−γ
   
(1 − δτ ) (1 − δτ ) (1 − γ )
=τ (tat − oat ) + − oat
R − δτ R − δτ R−γ
   
(R − 1)(γ − δτ )
= τ (1 − ψ)(tat − oat ) + oat
(R − δτ )(R − γ )
 
(γ − δτ )
= −dtlt (1 − ψ) + τ ψ oat
(R − γ )
= −dtlt (1 − ψ) + τ ψ(γ − δτ )γ oat .

For the fourth equality, we used the fact that for R > γ , we have ∞ −n γ
n=1 R F γ = R−γ , the
fifth equality added and subtracted (1 − ψ)oat in order to write the equation in terms of the
deferred tax liability balance.
The first term in the last line of the expression is what is described in the paper as the net
present value of the tax benefits related to the deferred tax liability balance, or simply the
NPV of the deferred tax liability. The second term is the product of the book balance of
the operating assets at time t, or oat , and τ ψ(γ − δτ )γ . This latter term is described in
the paper (see Section 3.3, page 288) as the tax savings due to the bias in the tax accounting.
Hence, we interpret the calculation of the net present value of the future deferred tax
expenses, without investment and with unbiased book accounting to be composed of two
parts. The first is the NPV of the tax benefits that have been recorded up to date t, which
is given as the negative of the NPV of the deferred tax liability. The second is the tax
savings due to the bias in the tax accounting on the balance of the operating assets left to
be depreciated in the future.

Acknowledgments

We are thankful for comments provided by participants at the 2000 Review of Accounting
Studies Conference, the 1995 Arden House Conference, seminar participants at the City
University of New York, Baruch College, and at Columbia, Notre Dame, and The Ohio State
Universities. Also to comments by Bill Gentry, Hugo Nurnberg, James Ohlson, Richard
Sansing, and especially the associate editor Gerry Feltham, as well as three anonymous
referees.
296 AMIR, KIRSCHENHEITER AND WILLARD

Notes

1. See Hackel and Livnat (1992) and White, Sondhi and Fried (1994) for textbook discussions of both the positive
and normative aspects of the debate.
2. Temporary differences arise for many reasons, but in our model only depreciation related differences arise.
3. We appreciate H. Nurnberg for directing us to this research. See Nurnberg (1971) for a good summary of the
literature up to 1970, and Amir et al. (1997) for a survey of the more recent empirical work.
4. By saying the asset price capitalizes the tax benefits, we mean that the tax benefits from the accelerated
depreciation deduction are passed on to the seller of the asset. See note 14 for more details.
5. As explained in section 1 above, in this model the deferred tax liability reverses, but only over infinity. In
particular, while a deferred tax expense is recorded in the initial periods if δτ < δ B , it can be shown that a
benefit will be recorded for all periods t ≥ t ∗ , where t ∗ is the minimum integer which solves the inequality
∗
(1 − δτ )/(1 − δ B ) < (δ B /δτ )t −1 . For example, if we let δτ = 0.4 and δ B = 0.8, then a benefit is recorded
∗ ∗
for periods t ≥ 3, since (1 − δτ )/(1 − δ B ) = 3 < (δ B /δτ )t −1 = (2)t −1 implies t ∗ = 3.
6. To see this, consider the cashflows from $1 invested at date 0. In period 1, investors receive the cash from the
investment, less the taxes paid on these receipts, plus the tax depreciation deduction, or (1 − τ )κ + τ (1 − δτ ).
In period 2, γ of the period 1 cash receipts persist, so investors receive cash receipts of (1 − τ )κγ , while δτ of
the depreciation deduction persists, so the investors receive tax savings in period 2 of τ (1 − δτ )δτ . Extending
these cash flows in the usual fashion and discounting gives the above condition.
7. In a study of the incidence of corporate taxes, Stiglitz (1976) argued that the corporate tax may act as a tax
on capital, a tax on profits, or a tax on entrepreneurship and risk-taking, depending on the tax policy. While
related to our work, our focus is different.
8. Alternatively, this also holds under uncertainty if mark-to-market is used for tax purposes. We are grateful to
the journal’s associate editor for correcting our interpretation of this point.
9. The adjustment to firm value required when economic and tax depreciation rates differ is identical to the
result in Sansing (1998). The difference between our models is that our adjustment is derived in terms of a
more general valuation model. Specifically, we show the impact of the bias in both book and tax accounting
simultaneously, and we investigate the adjustment required for both deferred tax expense and liability balances.
Also, we show that it amounts to using an NPV approach to valuing deferred taxes, which leads us to interpret
the results very differently.
10. An alternative approach that also demonstrates that adjusting the deferred tax liability by a factor of ψ represents
the net present value of the tax benefits from the deferred taxes was suggested by the comments raised in the
discussion at the Review of Accounting Studies conference. This alternative approach derives the net present
value of the tax benefits by discounting the future reversal, assuming no additional investment. This derivation
is shown as Corollary 3 in the appendix, and we thank the discussant for this suggestion. The discussion at
the Review of Accounting Studies Conference also made clear that Corollary 2 can be generalized to include
non-zero NPV projects. See Lundholm (2000) for more details.
11. The method used in corollary 2 replaces the beginning of period balances with current flow variables and end
of period balances. This method is general, for example, it can applied to the model in F&O. Proposition 2 in
F&O shows that for zero NPV investments, firm value can be expressed as follows
Vt = k(γ oxt − dt ) + (1 − k)oat + γ R(γ − δ B )oat−1 .

Using OER and OAR, we have oat−1 = oat − (oxt − dt ), so that substitution gives
  γ − δB

Vt = k ∗ γ oxt − dt 1 + + (1 − k ∗ )oat ,
δ B (R − 1)

where k ∗ = γ (R − 1)δ B = kδ B /γ . When we base the weights on the accounting persistence variable, δ B ,
instead of the economic persistence variable, γ , the impact of over depreciation is captured by the new weights,
except for the adjustment to the cashflow variable.
12. Ohlson and Penman find that, in long window return regressions, all income components except taxes have co-
efficients of approximately 1.3, as compared to income tax expense, which has a significantly lower coefficient
of −0.78 They state that this is “consistent with the traditional perception that these items pose particularly
vexing measurement problems.” Corollary 2 offers an alternative view: the market has solved the measurement
problems in a manner consistent with the above modeling.
THE AGGREGATION AND VALUATION OF DEFERRED TAXES 297

13. In the more general equation V.2 in theorem 2, changing the tax depreciation would affect the weights on the
current period investment (β2 ) and the coefficient on tax basis of the assets (β4 ). Assuming zero NPV projects
nullifies the first effect. Corollary 2 shows that the tax basis adjustment (the final term in Equation (V.2)) can
be rewritten in terms of adjustments due to the deferred tax expense (kφψdtet ) and due to the deferred tax
liability (−(1 − k)(1 − δτ )t dtlt ), both of which are increasing in tax depreciation. We are grateful to the
associate editor for this clarification.
14. While one may expect the benefits to be capitalized into the asset price, a simple counter example is the si-
tuation of the depreciation deduction for small businesses. Small businesses are allowed to deduct the entire
cost of long-lived assets up to a specified amount. Since this deduction is not allowed for most firms, the value
of the excess deduction would presumably not be reflected in the cost of these assets. The argument that the
asset price may or may not include the associated tax benefits depends upon a number of issues, as made clear
in the study of the benefits of investment tax credits by Goulder and Summers (1989). Under one argument,
the tax benefits are all passed onto the sellers, the long-run supply curve is infinitely elastic, and the effect
of the tax benefits would be reflected only in the equilibrium level of the quantity of assets produced. The
argument that there would be a price effect, and that some of the benefits would be retained by the operators of
the assets, is presented in Goolsbee (1998). We are grateful to our colleague Bill Gentry for help in clarifying
this connection.

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