The nature of deferred income taxes arising from differences in depreciation methods

Abstract

This research is an investigation into the underlying nature of deferred tax balances. The investigation entails obtaining evidence about whether markets treat changes in these balances that arise from depreciation differences as changes in debt or equity. This is accomplished by relating changes in firm systematic risk to discounted measures of those changes. If deferred tax balances are in the nature of debt (equity), then increases in these balances should be associated with increases (decreases) in systematic risk. Further, market association is hypothesized to be conditional on the way these changes arose: whether from accounting method selection or from tax law changes.

Econometric improvements include testing in changes, rather than levels, and estimation of systematic risk in a state-space framework. Inferences are made about how changes in beta are associated with changes in deferred tax balances over two different tax periods using a regime-switching regression equation methodology.

Evidence is provided that changes in deferred taxes arising from depreciation are different than conventional debt and are in the nature of a subsidy, when these deferred tax balances arise from favorable tax law changes. No evidence provided supports the position that changes in deferred taxes are in the nature of conventional debt. The net-of-tax method of deferred income tax allocation is not tested in this study.