Review of Accounting Studies, 6, 275–297, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Aggregation and Valuation of Deferred Taxes
Recanati Graduate School of Business, Tel Aviv University, Tel Aviv 69978, Israel
MICHAEL KIRSCHENHEITER AND KRISTEN WILLARD
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.
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
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