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with negative topic values in equity and also exclude firms with less than 1% and
higher than 99% of the estimated drift parameters and variance parameters of net
income after-tax. Thus, the numbers of firm observations are a maximum of 1,374
firms for calendar year 2007, and a minimum of 989 firms for calendar year 2000.
12
The data source for financial variables is the Nikkei NEEDS Database, and for stock
returns, the Nikkei Portfolio Master Database.
4.2
The Simulation Method
We compute the present value of the future net income stream after-tax, using a simulation
method proposed by Shahnazarian (2011). He uses the accounting identity equation and
its first difference derivative to generate a simulation path of future cash flow and discount
this cash flow, in which firms are assumed to react optimally in a dynamic optimization
context. However, our approach is different in the sense that we estimate production
functions at the industry level and use the residual income model. The definition of net
income before-tax in our study is the sum of earnings before-tax plus the net deferred tax
balance, divided by statutory tax rates. Note that Japanese accounting standards require
firms to report the deferred tax balance on an after-tax basis
13
The simulations are based on our estimated production function (2) where the
argument is based on estimates obtained from the systems of equations (1), and
original estimates are obtained from industry-wide OLS regressions. Into this
equation we plug in random generators of white noise and generate 10,000 different
paths.
14
For each path we extrapolate future net income after-tax, and the stream of
this is used as an input to the fundamental valuation equation (9) along with the
estimates of each firm's cost of equity. When we compute the net income after-tax as
well as the balance of deductible temporary tax differences in equations from (6) to
(8), we take into account both the outstanding tax carry-forward balances and future
tax-loss possible allowances. This happens when a firm incurs losses on any one of
the 10,000 simulation paths 20 years into the future.
15
We use the expected statutory
tax rate to readjust the future tax deferral balance by using Japanese accounting
standards.
16
In the simulation we assume that the remaining balance on deferred tax
12
The Japanese financial reporting system changed from individual to consolidated filings in
fiscal year 1999. This is why we start the sample observations in 2000. The estimation using
individual financial statements for a longer observation period is a subject for our future
research.
13
Note again Japanese financial and tax reporting follow the uniform reporting system.
However, since fiscal year 1999, the tax deferral account in balance sheets was recorded in
financial statements on the condition that such a deferred amount had a high probability of
being reversed.
14
This may be an arguable assumption and the bootstrapping method using past data is our
future work. We thank an anonymous referee of the ESSA 2013 Conference for pointing
this out.
15
For firms which have experienced losses less than 7 years ago, the tax loss carry-forward
benefits will accrue. We extend our simulations for 20 consecutive years to fully account for
future cumulative effects.
16
The recommendation to include tax deferral accounts in Japanese accounting standards,
Accounting
Standards
for Tax Effect Accounting, was released October 30, 1998 and
enacted in April 1999. Some firms began voluntary disclosure in April 1998.
