Does IFRS information on tax loss carryforwards and negative performance improve predictions of earnings and cash flows?

Abstract

We analyze the usefulness of accounting information on tax loss carryforwards and negative performance to predict earnings and cash flows. We use hand-collected information on tax loss carryforwards and corresponding deferred taxes from the International Financial Reporting Standards tax footnotes for listed firms from Germany. Our out-of-sample tests show that considering accounting information on tax loss carryforwards does not enhance performance forecasts and typically even worsens predictions. The most likely explanation is model overfitting. Besides, common forecasting approaches that deal with negative performance are prone to prediction errors. We provide a simple empirical specification to account for that problem.

Tax Loss Carryforward Disclosure

“…These findings advance the understanding of tax disclosure decisions and tax footnote heterogeneity (e.g., Kvaal and Nobes 2013;Smith Raedy et al 2011). We document how firms cater to the expected shareholders' information needs about TLCF, contingent on the uncertainty signal, and thus we connect with Dreher et al (2024) who investigate the predictive ability of certain disclosed TLCF information. However, our study does not delve into whether accounting for the nuanced heterogeneity in the content and type of voluntary disclosure could improve the prediction of earnings or cash flows.…”

“…However, Chludek (2011) and Flagmeier (2022) examine German firms and do not find value relevance of deferred tax assets for TLCF. In a similar setting Dreher et al (2024) show that mandatory TLCF items do not improve predictive ability regarding future performance. These findings suggest that deferred tax assets for TLCF are not informative in certain settings and raise the question whether firms anticipate a stakeholder demand for information and use an alternative channel-the voluntary disclosure of additional, yet complex information in the notes-to reduce information asymmetries.…”

“…Fourth, if investors deem voluntarily disclosed TLCF information as not valuable, particularly in predicting future earnings or cash flows (as indicated by Dreher et al 2024), the effective demand for such information may diminish. Hence, firms may refrain from responding to uncertainty signals by increasing voluntary disclosure.…”

“…Importantly, institutional circumstances and the firm's economic environment may render TLCF-related balance sheet information less useful (Badenhorst and Ferreira 2016;Flagmeier 2022;Hanna et al 2019). In particular, investors do not seem to rely on recognized deferred tax assets under International Financial Reporting Standards (IFRS) in a German setting (Chludek 2011;Flagmeier 2022) and the TLCF items seem not to be useful to predict future performance in such settings (Dreher et al 2024). In such accounting regimes firms may complement financial statements with voluntary guidance in the tax footnote as an alternative to communicate TLCF usability.…”