Question 1 [20 points]
Assume that a firm has had a loss in a previous year and therefore recognized a deferred tax asset (i.e.,
the firm knows that it can reduce future tax payments through compensation with this loss). A condition
for recognition of this asset is that it is likely that there will be future profits so that it will actually lead
to reduced tax payments. If prospects change, the change in expected value is recognized in the income
statement.
a. Does recognizing changes in the value of this deferred tax asset (DTA) in the income statement
make that accounting income reflects the economic concept of income better or worse?
(5 points)
b. Consider a proposal that prohibits firms to remeasure this DTA upward. Is this proposal mainly
driven by the stewardship role or by the information role of accounting? Explain your answer.
(5 points)
c. Suppose that this DTA is lowered by an amount X, which means that tax savings equal to X are
likely not to be realized. What would be a logical explanation for a decline in stock price that
represents losses much higher than the amount X? (5 points)
d. Suppose investors know that Big4 auditors are more conservative than other auditors in
estimating future tax benefits. Assume the auditors are comparable in other aspects. Now a
researcher uses the following model to compare the relation between price and DTA for firms
with a DTA of which some are audited by Big4 auditors and others are not:
Pit = α+β1(BVit – DTAit) + β2DTAit + β3BigFourit + β4DTAit*BigFourit + εit
[Here Pit equals the price of firm i in period t; DTA is the deferred tax asset of the firm in that
period; BV means book value of equity; and BigFourit is a dummy that equals 1 if firm i was
audited by a Big4 firm in period t.]
Question: What coefficient would the researcher be most interested in and what would be the
expected sign of that coefficient? Explain your answer. (5 points)
Answer:
a. Better. The economic concept of income is based on values and this implies recognizing
profits and losses as soon as these are expected. The fact that these expected benefits
are recognized in the income statement as soon as these are expected thus makes that
the income statement reflects economic income better than when these expected
profits are ignored.
b. There is likely to be information in the remeasurement, so prohibiting this is not likely
driven by the information role. However, as it is highly discretionary, it can be used by
management to obtain specific earnings targets. This would be problematic for the
stewardship role. This prohibition is thus likely driven by improving the stewardship role
of accounting income.
, c. The decrease of the DTA by X suggests that compared to the previous period it is less
likely that the taxable loss will be compensated. This signals a worse outlook for future
profits, so it does not only reveal the reduction of tax benefits, but it also signals bad
prospects to the market.
d. The most interesting coefficient is β4. (1 point) The expected sign is positive. As these
auditors are more conservative, the asset is more likely to yield benefits in the future.
Assume that a firm has had a loss in a previous year and therefore recognized a deferred tax asset (i.e.,
the firm knows that it can reduce future tax payments through compensation with this loss). A condition
for recognition of this asset is that it is likely that there will be future profits so that it will actually lead
to reduced tax payments. If prospects change, the change in expected value is recognized in the income
statement.
a. Does recognizing changes in the value of this deferred tax asset (DTA) in the income statement
make that accounting income reflects the economic concept of income better or worse?
(5 points)
b. Consider a proposal that prohibits firms to remeasure this DTA upward. Is this proposal mainly
driven by the stewardship role or by the information role of accounting? Explain your answer.
(5 points)
c. Suppose that this DTA is lowered by an amount X, which means that tax savings equal to X are
likely not to be realized. What would be a logical explanation for a decline in stock price that
represents losses much higher than the amount X? (5 points)
d. Suppose investors know that Big4 auditors are more conservative than other auditors in
estimating future tax benefits. Assume the auditors are comparable in other aspects. Now a
researcher uses the following model to compare the relation between price and DTA for firms
with a DTA of which some are audited by Big4 auditors and others are not:
Pit = α+β1(BVit – DTAit) + β2DTAit + β3BigFourit + β4DTAit*BigFourit + εit
[Here Pit equals the price of firm i in period t; DTA is the deferred tax asset of the firm in that
period; BV means book value of equity; and BigFourit is a dummy that equals 1 if firm i was
audited by a Big4 firm in period t.]
Question: What coefficient would the researcher be most interested in and what would be the
expected sign of that coefficient? Explain your answer. (5 points)
Answer:
a. Better. The economic concept of income is based on values and this implies recognizing
profits and losses as soon as these are expected. The fact that these expected benefits
are recognized in the income statement as soon as these are expected thus makes that
the income statement reflects economic income better than when these expected
profits are ignored.
b. There is likely to be information in the remeasurement, so prohibiting this is not likely
driven by the information role. However, as it is highly discretionary, it can be used by
management to obtain specific earnings targets. This would be problematic for the
stewardship role. This prohibition is thus likely driven by improving the stewardship role
of accounting income.
, c. The decrease of the DTA by X suggests that compared to the previous period it is less
likely that the taxable loss will be compensated. This signals a worse outlook for future
profits, so it does not only reveal the reduction of tax benefits, but it also signals bad
prospects to the market.
d. The most interesting coefficient is β4. (1 point) The expected sign is positive. As these
auditors are more conservative, the asset is more likely to yield benefits in the future.
