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The Accounting Cycle
Deferred Income Taxes Should be Put to Rest

March 2010One of the silliest constructs in the world of accounting happens to be deferred income taxes. I don't understand why we bother with deferred tax liabilities and deferred tax assets because they are neither liabilities nor assets. If the FASB and the IASB are serious about principles-based accounting -- which I am becoming to believe is rhetoric without referents -- then they would eliminate these bastard accounts without delay.

Consider Procter & Gamble’s annual report for 2009, for instance.  They report deferred income tax assets (net) of $5.2 billion and deferred income tax liabilities of $13.7 billion.  But, are the former really assets and the latter really debts?

The FASB defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions.”  The IASB defines them similarly as “a present obligation arising from a past event, the settlement of which results in an outflow of resources embodying future economic benefits.” 

Suppose a business enterprise uses accelerated depreciation for tax purposes and straight-line for financial reporting such that depreciation for tax purposes amounts to $320,000 and for financial purposes $200,000.  There is a difference of $120,000 and, if we assume a tax rate of 25%, this leads to an increase in deferred income taxes of $40,000.  But what is the nature of this $40,000?

This $40,000 is not a probable future sacrifice—the sacrifice will be in the nature of future taxes paid to the U.S. and other governments.  At most, the $40,000 helps one better to predict future cash flows for taxes.  Yet that does not make this $40,000 a liability.

Even if it were a probable future sacrifice, there is a bigger problem.  This future sacrifice is not a present obligation of the firm.  The incremental tax becomes a “present obligation” only when the next tax year rolls around.  Taxes are statutory requirements that arise only in the year they are imposed.  Just because taxes are an unending penalty for living in advanced societies doesn’t make any of them present obligations today (the boulder pushed up the mountain by Sisyphus was actually his income taxes).

Furthermore, these deferred income tax liabilities are not a result of past transactions between the tax authority and the taxpayer.  We have the transaction when the taxpayer purchased the plant or equipment and we have past tax transactions.  But, it requires a lot of imagination to think that any of these transactions give rise to some present obligation.

If they were liabilities, one would expect them to be discounted.  All long-term obligations are measured at the present value of their future cash flows, including mortgages and bonds and long-term notes payable.  I think the FASB does not require discounting of deferred tax liabilities because it knows that fundamentally the numbers used in the computation of deferred taxes are not cash flows.  If they were, discounting would be meaningful; as they aren’t cash flows, discounting only compounds this monstrosity.

I view Procter & Gamble’s $13.7 billion of deferred tax liabilities as not representing probable future sacrifices, nor present obligations, and certainly not resulting from past transactions.  Even if they were, the number is vastly inflated because they are raw, undiscounted numbers.

The FASB defines assets as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”  The IASB’s definition is again quite similar: an asset is “a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.” 

Suppose a firm has estimated warranty expense of $1 million but the tax expense is zero because nobody has filed a warranty claim by year-end.  The FASB asserts that there is a deferred tax asset of $250,000 (assuming again the marginal tax rate is 25%) because these represent future deductible amounts.

Note, however, they are not future economic benefits yet if for no other reason, the government’s tax laws can change.  Even if they were, they are not the result of any past transactions or event.  Nobody has made a warranty claim; there has only been an adjusting entry that the entity made within itself.  It has not contracted or exchanged anything involving these warranties.  And not requiring any discounting is again telling—there is no discounting because there is no event and no cash flows.

A corporation must write down the supposed value of the deferred tax asset if it is more likely than not that it will not realize some of the asset.  If this asset were real, where is the market valuation (mark-to-model)?  As firms cannot conduct such a valuation (even as a Level 3 estimate per FAS 157), this valuation process is hollow.

I do not view Procter & Gamble’s deferred income tax assets of $5.2 billion to be real.  Just fluff and nonsense.  And who knows what P&G’s valuation allowance of $104 million means.  It certainly says nothing about valuation.

Probably the most illogical aspect of deferred taxes occurs on the income statement.  P&G determines for 2009 that earnings from continuing operations before income taxes is $15.3 billion.  Then it records income tax expense of $4.0 billion.  This close proximity gives the reader the idea that there is a relationship between the two, but of course, there is no association.  The actual amounts owed to the IRS are computed on taxable income, not on the financial reporting earnings before taxes.

Expenses are supposed to be sacrifices incurred during the operating activities of the entity.  Ok, the current portion of the income tax expense is indeed a sacrifice.  But, the deferred portion is clearly not a sacrifice of any resources of the firm.  That’s why firms employ MACRS—they want to reduce their sacrifices to Uncle Sam.

P&G shows the current portion of income tax expense in its tax footnote.  The current portion is $3.4 billion and the deferred portion is $0.6 billion.

I realize that academics have shown a statistical association between market returns and deferred income taxes; however, they usually overstate their conclusions.  The correlation between market returns and deferred income taxes merely indicates that market agents find the disclosures useful in predicting future cash outflows to the IRS.  This statistical association doesn’t make these constructs assets or liabilities.  If the FASB wants to require these disclosures, it should require firms to stick them in a footnote rather than contaminate the balance sheet with their presence.

Analysts and researchers have an easy time dealing with the problem of deferred income taxes, as the misinformation is in plain view.  We just eliminate the phony assets and liabilities from the balance sheet and restate income tax expense to the current portion.  Nevertheless, the FASB and the IASB still should eliminate these deferred accounts and clean up the balance sheet, especially if they are serious about principles-based accounting.  It makes the financial statements more representationally faithful and thus more reliable.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) published by BNA in 2007.


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