Earnings Management Through Deferred Taxes Recognized Under IAS 12: Evidence From Pakistan

Abstract

This study examines earnings management through deferred taxes calculated under the IAS 12 and its impact on firm valuation. The literature finds that book–tax nonconformity leads to better earning quality and a greater association between earnings and future expected cash flows. Given that Pakistan is a pioneering implementer of the International Financial Reporting Standards, our hypothesis is that the components of deferred tax disclosed under the IAS 12 provide value-relevant information to equity investors. We divide deferred tax components into three categories: those arising from (i) operational activities, (ii) investing activities, and (iii) financing activities. These are subdivided to ensure that no value-relevant component is aggregated with a nonvalue-relevant component, which might otherwise lead to an information slack. Our sample includes data on shariah-compliant companies listed on the Karachi Meezan Index (KMI-30). We find that deferred tax line items in firms’ balance sheets are reflected in market prices. Investors also tend to treat deferred tax line items (arising from operating, financing, and investing activities) differently. Furthermore, the value relevance is dissimilar for different components of deferred tax. Investors are wary of deferred tax assets and liabilities when pricing and are likely to penalize firms with a higher deferred tax position.