The effects of alternative treatments of deferred income tax credits on the predictive ability of financial ratios in bond ratings

The accounting for corporate income taxes has received renewed attention among accounting academicians and practitioners. Consider-able debate centers around the proper accounting for the deferred income tax credit. The deferred income tax credit is reported in the corporate financial statements as a result of timing differences in the recognition of certain transactions on the corporate financial statements versus the recognition of the items on the income tax return. The issues of interperiod income tax allocation and the resultant deferred income tax credit were addressed in this study with the Financial Accounting Standards Board's decision-usefulness criterion for accounting information operationalized as the predictive-ability criterion.

Financial ratios were restated under three alternative user treatments of deferred income tax credits for a sample of debt-issuing firms. The three treatments of the deferred income tax credits in the calculation of the financial ratios were the liability treatment, the stockholders' equity treatment, and the asset reduction treatment. Multiple discriminant analysis was used to examine the effects of the alternative treatments of the deferred income tax credits on the predictive ability of the financial ratios in a bond rating context.

The results were consistent for several combinations of financial ratios. The null hypotheses of equal probability of correct classification into bond rating categories under the three user treatments were not rejected. Also, a comparison of misclassified observations across the user treatments was made. No differences were found in the tendencies of the models to misclassify observations at various bond rating categories.

Two possible explanations exist for the absence of differences in predictive ability across the user treatments. The results suggest that no one user treatment of the deferred income tax credits is employed exclusively in decision making. Another possible explanation of the results is that the deferred income tax credits are not considered in the decision-making processes of bond raters.