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Contracting Cost Determinants of the Accounting Change for Income Tax

by Wong, Norman

Abstract (Summary)
This thesis adopts a contracting cost perspective to examine the decision of firms in New Zealand to change their accounting policy for income tax. It uses efficient contracting theory to posit that firms change to new accounting procedures if they lead to firm value maximisation. Specifically, an empirical study and six case studies are presented. These examine the contracting cost determinants of the decision of firms to change from the comprehensive tax allocation procedure to the partial tax allocation procedure to account for income tax which has the effect of (a) reducing the income tax expense recognised in the statement of financial performance, thereby increasing earnings after tax, and (b) reducing the deferred tax liability reported in the statement of financial position. I hypothesise that, under the comprehensive tax allocation procedure firms experiencing growth in depreciable assets encounter economic "friction" (i.e., contracting costs that do not maximise firm value). This is because comprehensive tax allocation recognises deferred tax liabilities which may not result in cash outflows, thereby producing an unintended and potentially ever growing liability on the statement of financial position. Overstatement of these liabilities could result in inadvertent adverse consequences such as perceived increased risk, leading to higher borrowing costs and debt covenant violation which is costly. As a result, these firms are likely to switch accounting procedures to mitigate the friction. Further, these firms are also likely to recontract with debtholders to incorporate the new, more efficient accounting technology (i.e., the partial tax allocation procedure) for monitoring compliance with the debt covenants. The results suggest the following. First, the extent of investment in depreciable assets, which gives rise to depreciation timing differences thereby increasing deferred tax liabilities, is an important determinant in the firms' decision to change interperiod tax allocation policy to the partial basis. In particular, firms that change are more likely to have greater levels and rates of investments in depreciable assets than those firms that remain using the comprehensive basis. This is consistent with the efficient contracting argument. Second, firms that change to the partial basis are more likely to include partial deferred tax liabilities in their leverage ratio calculations by choosing to do one of the following: (l) companies change their accounting-based debt covenants to allow the explicit inclusion of partial deferred tax liabilities; or (2) companies do not need to change their accounting-based debt covenants to include partial deferred tax liabilities if the accounting-based debt covenants already allow this; or (3) companies do not need to change their accounting-based debt covenants to include partial deferred tax liabilities if the accounting-based debt covenants state that liabilities include those reported using the accounting policies in the financial statements. The specification of any of these policies in companies' debt contracts is the result of efficient contracting. All these options are written in debt contracts to enable the efficient accounting policy to be used in calculating the leverage ratio constraint when changing firm circumstances create unintended economic "friction" with the use of an inefficient accounting policy. While there is empirical support for the efficient contracting argument, the effect that opportunism may have on firms' decision to change to the partial tax allocation basis cannot be totally ruled out.
Bibliographical Information:

Advisor:Professor Jilnaught Wong; Professor David Emanuel

School:The University of Auckland / Te Whare Wananga o Tamaki Makaurau

School Location:New Zealand

Source Type:Master's Thesis

Keywords:

ISBN:

Date of Publication:01/01/1999

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