Does Interperiod Income Tax Allocation Enhance Prediction of Cash Flows?

Abstract:     
This paper investigates whether interperiod income tax allocation, a controversial accounting accrual, facilitates prediction of cash flows. Preparers of financial statements contend that interperiod tax allocation is too complex and costly. Similarly, users of financial statements, particularly financial analysts, often ignore deferred tax information in their assessments of solvency and corporate performance (White et al. 1994). The Financial Accounting Standards Board (FASB), however, maintains that non-allocation of a corporation's income tax expense hinders the prediction of its future cash flows. Our research contributes to this debate by performing an empirical verification of the usefulness of interperiod tax allocation in predicting cash flows. The hypothesized linkage between deferred taxes and future cash flows rests on a linkage between deferred taxes and future income tax payments. We first provide evidence that deferred tax information aids in predicting future tax payments. We then use Lorek and Willinger's (1996) multivariate cash flow prediction model as a benchmark model and provide evidence that the inclusion of deferred tax information enhances prediction of future operating cash flows. This is especially true when deferred tax amounts are large. Overall, our results are consistent with the FASB's view that interperiod tax allocation enhances the prediction of cash flows.

JEL Classification: M41, M44

Accepted Paper Series