Deferred Tax Assets and Credit Risk

This paper examines the impact of deferred tax assets on firm creditworthiness. Specifically, I investigate whether the proportion of a firm’s total assets that are composed of deferred tax assets is associated with Standard & Poor’s credit ratings. The benefits associated with deferred tax assets are primarily realized through deductions from future taxable income. If declines in financial performance lead to a subsequent default, deferred tax assets may provide no value to creditors seeking recovery of their investment. I document a significant negative association between deferred tax assets and credit ratings. The evidence is consistent with credit market participants incorporating the risk associated with deferred tax assets into their assessment of credit risk and suggests that deferred tax assets may adversely affect the quality of a firm’s balance sheet. Additionally, I find that the magnitude of the association is strongest for a subsample of firms rated just above or below investment grade (i.e. BBB-/BB+) where credit risk is particularly sensitive.