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Hanlon (2010)
Hanlon (2010)
Book-Tax Differences
Author(s): Michelle Hanlon
Source: The Accounting Review, Vol. 80, No. 1 (Jan., 2005), pp. 137-166
Published by: American Accounting Association
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I. INTRODUCTION
investigatethe role of book-tax differencesin indicatingthe persistenceof earnings,
I accruals, and cash flows for one-period-aheadearnings. I also examine whether the
level of book-tax differencesinfluences investors'assessmentsof futureearningsper-
sistence. Financialaccountingtexts claim that the differencebetween pre-taxfinancialre-
porting earnings and taxable income (i.e., book-tax differences)can provide information
aboutcurrentearnings.The underlyingmaintainedhypothesisis thatbecauseless discretion
is allowed in the computationof taxable income, book-tax differencescan be informative
137
TheAccountingReview,January2005
3 Chaneyand Jeter's(1994) studyis pre-SFASNo. 109 when only deferredtax liabilities(not deferredtax assets)
were requiredto be recorded.
4 In my sample,the scaled deferredtax expense and scaled total accrualsare not highly correlated(correlation
of -0.008); thus, the deferredtax expense does not simply equal accrualsbut rathera subsetof total accruals.
5 I discuss the possible implicationsof the cash flow resultsbelow.
TheAccountingReview,January2005
taxable incomes for these firm-yearsdo not appearto aid investorsin estimatingaccruals
persistence.
I performseveral additionalanalyses. First, I investigatethe effect of special items on
my results. I assume that all special items create a book-tax difference and remove the
special items from my measuresof book-taxdifferences,earnings,and accruals.I find that
while the resultsare somewhatweaker,firm-yearswith largebook-taxdifferencesstill have
significantlylower persistencein both accrualsand cash flows.
Second, I investigatewhetherthe book-taxdifferenceshave lower persistencefor one-
year-aheadearningsthan accrualsexcluding the book-taxdifferences.Specifically,I parti-
tion total pre-taxaccrualsinto the book-taxdifferences(a proxy for discretionaryaccruals)
and the remainingportionof accruals(a proxy for nondiscretionaryaccruals)and include
both of these separatelyin the regression of future earnings on currentcash flows and
accruals.I find that the book-taxdifferencesare less persistentfor futureearningsthan are
accrualsexcludingthe book-taxdifferences.Thus,using the book-taxdifferencesas a proxy
for discretionaryaccruals,as in Phillips et al. (2003), I find that the discretionaryaccruals
have lower persistencethan nondiscretionaryaccruals,consistentwith Xie (2001).
The rest of the paperproceedsas follows. The next section providesinstitutionaldetail
about book-tax differences. The third section contains common argumentsboth for and
against the book-tax differencescontaininginformationabout earningspersistence and a
statementof my hypotheses.The fourthsection providesa descriptionof the sample selec-
tion and data used for the tests, and the fifth explains the empiricalmethods used. The
sixth section describes the results and discusses sensitivity tests and additionalanalyses,
and the final section concludes.
6 In fact, some prior studies rely on the consistencies in tax and book accruals to formulate empirical tests. For
examples, see Guenther (1994), Manzon (1992), Maydew (1997), and Guenther et al. (1997). An exception to
the requirement of accrual tax accounting is in IRC Section 448, which provides that a corporation with average
annual gross receipts of $5 million or less for its three most recent taxable years may use the cash method for
tax purposes.
7 Technically, the term "permanent difference" is not used in SFAS No. 109. The concept of permanent differences
under SFAS No. 109 is limited to events recognized in the financial statements that do not have tax consequences,
such as tax-exempt interest. This type of permanent difference continues to impact the calculation of current
tax expense under SFAS No. 109 (KPMG 1992).
TheAccountingReview,January2005
income tax expense.8In addition, statutorytax breaks (e.g., tax-exemptinterest and the
dividendreceived deduction)are often includedin these calculationsand are not indicative
of earningsqualityrelatedto the accrualsprocess.9Thus, due to the difficultyin measuring
true permanentbook-tax differencesand the financialaccountingtextbook suggestions to
exclude the effects of permanentdifferences I do not examine the relation between per-
manentdifferencesand earningspersistence.
The remainingbook-taxdifferencesare temporarydifferencesand constitutethe focus
of this study.SFAS No. 109 uses a balancesheet approach.Temporarydifferencesbetween
book and taxable incomes each year are changes in the firm's book-basis balance sheet
relative to its tax-basisbalance sheet. Basis differencesarise because of differingrequire-
ments for the timing of recognition of income and expense items. For book purposes,
revenue is recognized when earnedand expense recognitionis either matchedagainstthe
related revenue or recorded in the accountingperiod in which the expense is incurred.
However, GAAP provides managers with considerablediscretion in their choice of ac-
counting procedures(Wattsand Zimmerman1986, 215). Managersmay choose between
differentaccountingmethods,use varyingperiodsand estimatesfor cost amortization(e.g.,
for depreciationand goodwill) and exercise judgment with respect to recordingreserve
allowances(e.g., bad debt allowances,warrantyreserves,accruedcompensation,etc.) (Mills
and Newberry2001).
For tax purposes,however,firmsmust "clearlyreflectincome."'oRevenueis generally
recordedwhen cash is received;thus, deferred(or unearned)revenue does not exist under
the IRC. In addition,for tax purposesconservatismis not an objective (for the Treasury)
and thus an item may not be deducteduntil more stringentconditionsare satisfied,reducing
the level of discretionin the calculationof taxable income."
Temporarybook-taxdifferencesinclude futuretaxable and futuredeductibleamounts.
Futuretaxableamountscreate or increasedeferredtax liabilitiesand requirerecognitionof
a deferredtax expense. In contrast,future deductibleamountscreate or increase deferred
tax assets and require the recognition of a deferred tax benefit (credit to deferred tax
expense). All else equal, an increase in deferredtax liabilities is consistent with a firm
currentlyrecognizing revenue and/or deferringexpense for book purposes relative to its
tax reporting(book income in excess of taxable income). All else equal, an increase in
deferredtax assets is consistentwith a firm currentlyrecognizingexpense and/or deferring
TheAccountingReview,January2005
revenue for book relativeto tax income (book income less than taxable income) (Phillips
et al. 2003).
12 Schipperand Vincent(2002, 2) state "Althoughthe phrase 'earningsquality'is widely used in the financial
press, in analystreports,in documentsissued by regulators,and in accountingresearch,there is neitheran
agreed-uponmeaningassignedto the phrasenor a generallyacceptedapproachto measuringearningsquality."
13 Corporatetax sheltersof the 1990s were very aggressivestrategiesthatconformedto the letterof the tax law
but not the intent.Some of the sheltershavebeen overturnedin the courtsandbroadlegislationhas beenenacted
in orderto eliminatetheiruse. For moreinformationon tax shelterssee Novackand Saunders(1998) andU.S.
Treasury(1999). However,not all firms engaged in these aggressivetransactions,indicatingcross-sectional
variationin tax aggressiveness.
TheAccountingReview,January2005
HI: Pre-tax earnings persistence for firm-yearswith large negative or large positive
book-tax differencesis lower than pre-taxearningspersistencefor firm-yearswith
small book-taxdifferences.
My final hypothesis investigates whether stock prices reflect different investor expec-
tations about future earnings based on the level of book-tax differences. Sloan (1996)
TheAccountingReview,January2005
H3: The expectationof pre-tax earnings persistencereflected in stock prices for the
accrualcomponentof pre-taxearningsis consistentwith the observedpersistence
of accrualsfor firm-yearswith relativelylarge book-tax differences.
15 I exclude observations with a foreign incorporation code because of different tax reporting in foreign countries.
I exclude financial services and utility industry firm-years because of different reporting requirements (tax and
book) and the lack of Compustat disclosure of the deferred tax accounts for financial institutions.
16
Assuming no deferred tax asset valuation allowance is placed on the net operating loss (NOL), the creation of
an NOL will reduce deferred tax expense. For example, suppose a firm generates an NOL with a temporary
difference, say depreciation. The tax effects of the depreciation book-tax difference will be a debit to the deferred
tax expense (credit to deferred tax liability) and the NOL will be recorded as a credit to the deferred tax expense
(debit to deferred tax asset), thus reflecting a lower (or possibly zero) deferred tax expense when there is a true
book-tax difference for depreciation. Though I cannot eliminate firms that have a valuation allowance established
against deferred tax assets, a change in which may also obscure the information in the deferred tax expense
account, eliminating firms with NOLs should mitigate the effect of the valuation allowance because the NOL
is a common deferred tax asset to which the valuation allowance is applied. I also eliminate firms with a negative
current tax expense as an additional screen to help mitigate the coding errors (Mills et al. 2003).
TheAccountingReview,January2005
of 1,663 firms), LNBTD (2,823 firm-yearsconsisting of 1,751 firms), and small book-tax
differences(8,460 firm-yearsconsisting of 3,236 firms)."
V. RESEARCH DESIGN
Hypotheses 1 and 2: Earnings Persistence
I estimatethe persistenceof pre-taxearningsusing the following equation:
17 Note the total numberof firmsin the subsamplesexceeds the numberof firmsin the total samplebecausefirms
move from being in one subsampleto anothersubsamplefrom year to year. For example,approximately76
percentof the firmsin the SmallBTDgroupare in eitheror both the LPBTD and LNBTD groupsin at least
one yearof the sampleperiod.Thus,the same firmsare not includedin the same subsamplein each yearwhich
controlsfor any time-seriesstationarycorrelatedomittedvariables.
18 I use pre-taxbook income because it is the differencebetweenpre-taxbook income and taxableincome that
constitutesbook-taxdifferences.In contrast,Sloan (1996) uses operatingincome afterdepreciation(item#178)
and Xie (2001) uses income before extraordinary items (item #18). For firm-yearswith a minorityinterest,I
calculatepre-taxbook income as data item #170 less minorityinterest(item #49) to obtainthe pre-taxbook
income on which the tax provisionis calculated.
19 To calculatethe deferredtax expense (benefit)I use the sum of federaland foreigndeferredtax expense (item
#269 and item #270, respectively)and wheremissing I use total deferredtaxes (item #50). I includeforeignas
well as U.S. deferredtaxes because pre-tax financialreportingincome includes income of foreign entities.
However,I exclude state-deferredtaxes since these are taxes on the same income as federaldeferredtaxes. I
grossup the deferred
tax expenseby the statutorytaxrateduringthe sampleperiod(35 percent)in orderto
convertthe numberintoan estimateof the firm'stemporary ratherthanthetaxeffectof
book-taxdifferences
thedifferences.
TheAccountingReview,January2005
+ + + ,t+,
PTBI,h+ = y0 y1PTCF, y2PTACC, (3)
+ + *
PTBIt+i = _o + yILNBTDt y2LPBTDt + y3PTCF, 1y4PTCFt LNBTDt
+ * + y6PTACC, + *
y•PTCFt LPBTDt y7PTACCt LNBTDt
*
+ y8PTACCt LPBTD, + (4)
et+l
where PTACC,is pre-taxaccruals,PTCF, representspre-taxcash flows, and all other var-
iables are as defined above. I calculate the earningscomponentamountsas pre-taxto be
consistent with the dependent variable measure. I calculate pre-tax cash flows as total
operatingcash flow (item #308) less cash flow due to extraordinaryitems (item #124) plus
taxes paid in cash (item #317).20 I calculate pre-tax accrualsas pre-taxbook income less
pre-taxcash flows.21
In Equation(4), y6 reflects the persistenceof accrualsfor firm-yearswith small book-
tax differencesand ,7 (Y8) reflects the difference,if any, in the persistenceof accrualsfor
firm-yearswith large negative (positive) book-taxdifferences.If the large book-taxdiffer-
ences are associatedwith less persistentaccruals,then y7 < 0 and < 0, consistentwith
H2. The coefficient y3 reflects the persistence of cash flows. Based •8
on prior research I
expect ,6 Y3 (Sloan 1996).
< The coefficient y4 (Y5) reflects the difference,if any, in the
persistence of cash flows for firm-yearswith large negative(positive)book-taxdifferences.
While I have no predictionfor y4 or y5, these coefficientsmay be significantif firm-years
with large book-taxdifferenceshave more (or less) transitorycash flow components.
+ - - +
SAR,, = P31(PTBIt+, yo y•PTBI) Et+,- (5)
Marketrationalitywith respectto earningscomponents(H3):
TheAccountingReview,January2005
22
Firmsthat were delisteddue to poor performance(delistingcodes 500 and 520-584) frequentlyhave missing
delistingreturns.I correctfor this, as recommendedin Shumway(1997) and ShumwayandWalther(1999), by
using delistingreturnsof -35 percentfor NYSE/AMEX firmsand -55 percentfor NASDAQfirmsfor these
delistingcodes.
23
I note thatwhile the Mishkin(1983) test of marketrationalityhas been used extensivelyin accountingresearch,
the Mishkinframeworkas employedin the accountingliteraturehas recentlycome underscrutiny.Forexample,
Kraftet al. (2001) examinethe use of the Mishkin(1983) frameworkand find evidenceconsistentwith speci-
ficationproblemswhen applyingthe Mishkin(1983) frameworkto data similarto that in accountingstudies.
However,they statethey view theirresultsas preliminary.
TheAccountingReview,January2005
stocks of the firm-yearswith positive weights and a shortposition in the stocks of the firm-
years with negativeweights (Bernardand Thomas 1990; Dechow and Sloan 1997; Frankel
and Lee 1998). To enable interpretationof the coefficients as zero investmentportfolio
returns,the returnsused in the regressionsmust all be for the same time period and the
accountinginformationused as independentvariablesmust be availableto the marketat
the time the returnaccumulationperiod begins. To addressthis issue, I estimate the re-
gressionsusing only the Decemberyear-endfirm-yearsfrom my sample(n = 7,497). Thus,
I estimateEquation(7) annuallyfor Decemberyear-endfirm-yearsand reportthe average
coefficient over the years. I test significance by calculating the standarderror from the
distributionof annualcoefficients (n = 7). If investorsoverweightthe accrualcomponent
of earningsin each subsampleof firm-years,then P, < 0. If book-taxdifferencesfacilitate
the assessment of the persistenceof accruals,then p, should not be significantfor firm-
years with large book-taxdifferences,consistentwith H3.
VI. RESULTS
Descriptive Statistics
Table 1 presents descriptivestatistics and variablecorrelationsfor the entire sample.
All financialstatementvariablesare winsorized(reset) at the 1st and 99th percentiles.The
mean and median accruals are negative, consistent with prior research (Dechow 1994),
primarilyreflectingthe depreciationaccrual.
Panel B presents univariatecorrelations.Scaled pre-tax accruals and scaled deferred
tax expense are correlatedat only -0.008 (p = 0.3227), suggestingthatthe two measures
are not merely substitutesfor each other. Cash flows and accrualsare significantlynega-
tively correlatedconsistentwith prior studies (Dechow 1994).
Table2 providesdescriptivestatisticsfor the three subsamplesof firm-years.The table
reveals several characteristicsof the subsamples.For example, firm-yearswith large neg-
ative book-taxdifferencesare smallerin termsof total assets, but not significantlydifferent
in terms of marketvalue of equity than the other two subsamples.In addition,these firm-
years appearto be higher growthfirms as sales growthand net operatingasset growthare
larger for this set of firm-yearsrelative to the other two groups. The LPBTD subsample
appearsto obtain at least part of the high book-tax differences throughtax planning as
evidenced by the lower currenteffective tax rate (currenttax expense divided by pre-tax
income).
In untabulateddata, I find no industryclusteringwithin the groups. Industrycompo-
sition is similar across the subsamples with no one industry comprising more than 17
percentof any subsampleand industriesthat are more highly representedin one subsample
are also more highly representedin the others. As a result, industrycontrols are not used
in the following tests.
Tests of Hypotheses 1 and 2: Earnings Persistence
Panels A and B of Table 3 presentthe results from estimatingEquations(1) and (2).
Panel A indicates that firm-years in my sample have mean reverting earnings performance
consistent with previous findings in Sloan (1996) and Xie (2001).
Panel B reveals that firm-years with large book-tax differences have lower persistence
in pre-tax earnings than firm-years with small book-tax differences. Firm-years with large
negative and large positive book-tax differences have significantly less persistent earnings
than firm-years with small book-tax differences (y4 = -0.100 and y, = -0.212, two-tailed
p-value of 0.0001), consistent with the alternative hypothesis stated in H1.
TheAccountingReview,January2005
TABLE 1
Descriptive Statistics and Correlations among Selected Variables
(14,106 firm-years, 1994-2000)
Panel A: Descriptive Statistics
Standard
Variable Mean Deviation 25% Median 75%
PTBIt+ 0.093 0.121 0.0368 0.093 0.157
PTBI, 0.132 0.092 0.066 0.113 0.176
PTCF, 0.143 0.114 0.073 0.136 0.207
-0.010 0.094 -0.065 -0.023 0.030
PTACCt
DTE, 0.001 0.037 -0.014 0.001 0.018
AVETA, 1,726 10,938 55.250 168.590 617.890
SARt+ 1 -0.026 0.343 0.000 0.000 0.000
I next decompose earningsinto cash flow and accrualsto test H2. Panels A and B of
Table4 presentthe resultsof estimatingEquations(3) and (4), respectively.Consistentwith
priorresearch,I find that the accrualscomponentof earningsis significantlyless persistent
than the cash flow componentwith coefficientweightingsof 0.49 and 0.75, respectively.24
The results in Panel B are consistent with the accrualscomponentof earningsbeing sig-
nificantlyless persistentfor both the LNBTD and LPBTD subsamplesas comparedto firm-
years with small book-tax differences (y7 = -0.115 and yN = -0.187). In addition,the
24
An F-testrevealsthatthese coefficientsare significantlydifferentat the 0.0001 level.
c,
O TABLE 2
X
;s
F~
Descriptive Statistics for Subsamples of Firm-Years Partitioned Based on Level of Tempora
;s
Crq
3CI
LNBTD SmallBTD
n = 2,823a n = 8,460a
Variable Mean St. Dev. 25% Median 75% Mean St. Dev. 25% Median 75% Me
C
0.112 0.140 0.041 0.114 0.195 0.088 0.115 0.036 0.089 0.150 0.0
X
a
PTBI,+,
PTBI, 0.153 0.110 0.069 0.131 0.210 0.123 0.086 0.059 0.106 0.167 0.1
R) PTCF, 0.165 0.130 0.085 0.156 0.243 0.132 0.109 0.067 0.128 0.194 0.1
O
O PTACC, -0.011 0.110 -0.081 -0.026 0.046 -0.009 0.088 -0.060 -0.022 0.027 -0.01
DTE, -0.050 0.033 -0.061 -0.037 -0.026 0.002 0.011 -0.007 0.000 0.010 0.0
AVETA, 1,069 6,233 42.18 114.56 383.29 1.891 12,905 57.65 176.07 642.02 1,8
ROE, 0.179 0.136 0.086 0.158 0.239 0.150 0.108 0.081 0.135 0.195 0.1
MVE, 3,051 20,759 64.84 215.13 855.34 2.535 15,023 59.93 198.35 793.20 2.3
BM, 0.470 0.486 0.209 0.362 0.605 0.608 0.557 0.301 0.492 0.778 0.5
SAR, 0.046 0.485 0.000 0.000 0.000 0.000 0.335 0.000 0.000 0.000 -0.00
SAR,,+ -0.018 0.435 0.000 0.000 0.000 -0.029 0.317 0.000 0.000 0.000 -0.02
Beta, 1.150 0.796 0.709 1.000 1.536 0.956 0.696 0.559 0.942 1.268 0.9
ETR, 0.403 7.241 0.285 0.365 0.400 0.432 2.059 0.339 0.377 0.400 0.3
CETR, 0.802 0.790 0.350 0.400 0.510 0.399 2.318 0.269 0.316 0.354 0.1
TaxPaid, 0.053 0.047 0.019 0.042 0.074 0.040 0.034 0.015 0.032 0.060 0.0
Sales, 1,246 6,497 58.56 162.82 557.97 1,883 8,669 78.99 242.44 856.98 1,9
SalesGrow, 0.365 0.779 0.074 0.210 0.438 0.298 1.981 0.046 0.137 0.285 0.2
NOAGrow, 1.465 0.879 1.019 1.209 1.606 1.349 0.755 1.019 1.142 1.389 1.3
Leverage, 0.046 15.289 0.001 0.108 0.490 0.634 2.334 0.042 0.338 0.810 0.5
Specialltems,-0.013 0.044 0.000 0.000 0.000 -0.001 0.039 0.000 0.000 0.000 0.0
TI, 0.169 0.112 0.085 0.151 0.233 0.108 0.082 0.047 0.092 0.151 0.0
BTD-total, -0.016 0.052 -0.041 0.030 0.002 0.014 0.030 -0.001 0.011 0.023 0.0
a
Samplesize variesbecause some datanecessaryto computethe variablesthat are not includedin the regressionsare not a
Bold font indicatesthatthe amountis significantlydifferentfrom the amountfor the SmallBTDgroup.Italic font indicates
betweenthe LPBTDgroupand the LNBTDgroup.All significancelevels are at p = 0.05 or smaller.
PTBI,+I = pre-taxbook income one-year-ahead (item #170);
PTBI,= pre-taxbook income in the currentyear (item #170);
PTCF, = pre-taxcash flow for the currentyear (item #308 + item #317 - item #124);
PTACC, = pre-tax accruals for the current year (PTBI - PTCF);
DTE, = deferredtax expensein the currentyear grossedup by statutorytax rate ((sum of items #269 and #270 an
(each of the above are shown scaledby averagetotal assets and winsorized(reset) at the 1 percentand 99
AVETAt= averagetotal assets for the firm (item #6) (in millions);
ROE,= earnings(item #18)/average shareholders'equity (item #216);
MVE,= marketvalue of equityat fiscal-yearend of year t (item #199 * item #25) (in millions);
BM, = ratioof the firm'sbook value of equity to its marketvalue of equity at time t (item #60/MVE);
SAR,= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a s
returnaccumulationbegins in the fourthmonthof fiscal year-endt to allow the disseminationof financialr
= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a s
SARt+1 return accumulationbegins in the fourthmonthafterthe fiscal year-endof t to allow the disseminationof f
Beta, = systematicrisk estimatedfrom regressionof monthlyraw returnson the returnto a value-weightedmarket
priorto the abnormalreturnaccumulationperiod.Fifteenmonthsof returndata are requiredto calculatebe
"3
~sl ETR,= effective tax ratein year t (totaltax/pre-taxbook income (item #16/item #170);
CETR,= currenteffectivetax rate (currenttax expense/pre-taxbook income ((item #16 - item #50)/item #170);
Sales, = sales in year t (item #12) (scaledby averagetotal assets);
= in sales from year t-1 to t ((item #12 in year t - item #12 in year t-1)/(item #12 in year t-l1));
O SalesGrowt growth
X NOAGrow, = net operating assets in year t/net operating assets in year t-1 (item #2 + item #3 + item #68 + item #8 +
~Zc. #72 - item #75);
;s
Crq Leverage,= debt-to-equityratio (item #34 + item #9/item #216);
3t~ = special items scaledby averagetotal assets (item #17/average total assets);
SpecItemst = estimate of taxableincome calculatedas currenttax expensegrossedup by statutorytax rate;and
TI,
BTD - total, = estimateof total differencebetweenbook and taxableincomes (PTBI-TI),scaled by averagetotal assets.
LPBTD(LNBTD)representsthe groupof firm-yearswith a deferredtax expense,positivebook-taxdifferences,(deferredta
C the top (bottom)quintileof firm-yearsin the sample.SmallBTDrepresentsthe groupof firm-yearsnot includedin the grou
with relativelysmall book-taxdifferences).
a
R)
O
O
TABLE 3
Regression Results: OLS Regressions of Future Pre-Tax Earnings Performance on Current
Pre-Tax Earnings Performance
(n = 14,106)
Panel A: Earnings Forecasting Equation
PTBI,,, = Yo0+ y-1PTBI,+ v,+, (1)
Variables '1o Y1 Adj. R2
Estimate 0.003 0.678 0.267
t-stat 2.120** 71.620*
Panel B: Earnings Forecasting Equation with CoefficientsAllowed to Vary for Firm-Yearswith
Large Book-Tax Differences
PTBIh+= Yo+ + y2LPBTD,+ y3PTBI,
y•aLNBTD,
+ y4PTBI, * LNBTD,+ y5PTBI,* LPBTD,+ (2)
F,+1
Variables To 71 7Y2 ^3 74 T_5 Adj. R2
coefficients representingthe differencein the persistenceof cash flows for both the large
book-taxdifferencegroupsare significantlydifferentfrom zero (y4 < 0 and y, < 0). Thus,
althoughI had no predictionfor the cash flow interactionterms, it appearsthe firm-years
with large book-taxdifferenceshave less persistentcash flows.25
Figure 1 shows the pre-tax earnings and accruals patternsfor the sample firm-years
with data availablefor the two years prior to the currentyear (where currentyear is the
year used to rank the firm-yearsand place them into subsamples)and two years afterthe
currentyear. Figure 1, Panel A shows that the LPBTD group has a larger increase and
subsequentdecreasein mean-scaledpre-taxearningsthan do the othertwo groupsof firm-
years. Figure 1, Panel B provides even more striking results for pre-tax accruals. The
subsamplewith large positive book-taxdifferenceshas a sharpincreasein pre-taxaccruals
in the currentyear and a sharpdecreasein pre-taxaccrualsin the following year.
In sum, the results for the Hi and H2 tests indicate that firm-yearswith large book-
tax differenceshave lower earningsand accrualpersistenceconsistentwith these firm-years
having a higher level of discretionaryaccrualsthat subsequentlyreverse. In supplemental
tests describedbelow, I investigatepotentialsources of this lower persistence.
The lower persistencein the cash flow componentof earningsfor the firm-yearswith
largebook-taxdifferenceswarrantsfurtherdiscussion.Althoughthe informationaboutearn-
ings quality in temporarybook-taxdifferences,if any, is not generallythoughtto be about
the quality or persistenceof cash flows, there are potential explanationsex post of why
book-tax differencesand the persistenceof cash flows are associated.For example, firms
likely manageearningsby managingcash flows in additionto managingaccruals.Managing
25
I discuss this finding more fully below.
TheAccountingReview,January2005
Panel A: Earnings Forecasting Equation with Accrual and Cash Flow Components as Independent Var
= + y1PTCF, + y2PTACC, +
PTBI,+1 Y7 5,t+
Variables '1
To02
Estimate -0.010 0.752 0.490
t-stat -6.280* 79.550* 42.400*
F-test of y, = Y2: 799.69 (p = 0.0001)
Panel B: Earnings Forecasting Equation with the Coefficients on the Accrual and Cash Flow Componen
Allowed to Vary for Firm-Years with Large Book-Tax Differences
= + + + * + *
PTBI,+1 Y7 y1LNBTD, y2LPBTD, + y3PTCF, y4PTCF, LNBTD, y5PTCF, LPBTD,
+ y6PTACC, + y7PTACC, * LNBTD, + * + t+,,
?5 y8PTACC, LPBTD,
Variables To 7 12 73 Y4 75 76
•,•?
Estimate -0.014 0.011 0.009 0.806 -0.083 -0.167 0.557
t-stat -6.990* 2.880* 2.120** 62.510* -3.790* -6.200* 34.720*
(h F-test of y4 = y5: 8.11 (p = 0.0044) F-test of y7 = 4.25 (p
y•:
S****** Denotes significanceat the .01, .05 and .10 levels, respectively.
All variablesare as definedin Table2.
FIGURE 1
Graph of Pre-Tax Earnings Performance and Pre-Tax Accrual Performance
for Each Subsample Based on the Level of Temporary Book-Tax Differences
Panel A
0.1600
m 0.1400
"E 0.1200
S M
- - LNBTD
C
L 0.060000
20.0400SmaBTD
0.0200
0.0000
-2 -1 0 1 2
Event Year
Panel B
C
0.0000
E
.
-0.0100
-0.0200
t -0.0300 -.- LNBTD
x -0.0400SmaBTD
-i-- LPBTD
S-0.0500
S-0.0600
-2 -1 0 1 2
Event Year
Sample includedin the figureare firm-yearsin the sample for the regressionsthat have nonmissing
data for two years priorto the currentyear and two years afterthe currentyear (9,560 firm-year
observations).
Pre-taxearningsis pre-taxbook income (item #170) scaled by averagetotal assets (item #6).
Pre-taxaccrualsis measuredas pre-taxbook income less pre-taxcash flow (item #108 - item #124
+ item #317). LPBTD is the subsampleof firm-yearswith large positive book-taxdifferences,
LNBTD is the subsampleof firm-yearswith large negativebook-taxdifferences,and SmallBTDis
the subsampleof firm-yearswith relativelysmall book-taxdifferences.
cash flows would avoid the scrutiny of auditors and regulators more than accrual manage-
ment. Burgstahler and Dichev (1997) present evidence on how firms accomplish earnings
management around the 0 earnings level. They plot the 25th, 50th, and 75th percentiles of
cash flows from operations (CFO) for each earnings interval and find that the distribution
of CFO shifts upward in the first interval to the right of 0. They argue that this is evidence
TheAccountingReview,January2005
that firms manage the cash flow component of earnings upward to report small profits
instead of losses. They also find similar evidence with accruals.Thus, there is evidence
that firms manage both cash flows and the accrualscomponentsmaking both potentially
less persistentwhen book-tax differencesare large.26
Further,Grahamet al. (2004) using survey responses from 401 financial executives
provide evidence consistent with executives claiming that earnings are often managed
throughcash flows. For example, they find that 80 percent of survey participantsreport
that they would decreasediscretionaryspendingon researchand development,advertising,
and maintenanceand more than half say they would delay startinga new projectto meet
earningstargetseven if such a delay entails a small sacrificein value. Thus, their findings
provide furtherevidence that cash flows are also managedto achieve earningsgoals.
Thus, while book-tax differences reflect discrepanciesin the calculation of accruals
betweenbook and tax methods,high levels of book-taxdifferenceswill likely be associated
with the persistenceof cash flows as well becausefirmsmanagingearningsthroughaccruals
are likely also managingcash flows. However,because the link between book-tax differ-
ences and accrualsis more directand because the claims in financialaccountingtextbooks,
recent academic literature,and the press focus on the persistence (quality) of accruals,I
base my ex ante predictionsand tests on accrualsratherthan cash flows.
TheAccountingReview,January2005
= o + - yo - y*PTBI) + e,,
SARt+1 P3I(PTBIt+,
LNBTD
(book income<tax income) SmallBTD
Asymptotic Asymptotic
Standard Standard
Parameter Estimate Error Estimate Error
P, 0.581 0.067 0.681 0.035
y* (PTBI) 0.699 0.127 0.533 0.058
y1 (PTBI) 0.642 0.021 0.742 0.012
Ratio 1.088 0.718
(y*/-y1)
Tests of RationalPricingof Pre-TaxEarnings
+ +
PTBI,t+ = Yo y1PTCFt + y2PTACCt ,t+1
ac;s Equations(1) and (5) and (3) and (6) are estimatedusing iterativegeneralizednonlinearleast squaresestimationprocedureb
2000.
All variablesare definedas in Table2.
oo
~I
with Sloan (1996) but inconsistentwith H3, and appearto price cash flows rationally(Ty
1
= y0).27
Overall,the results suggest that for firm-yearswith large positive book-taxdifferences
either investorsuse the book-tax differencesto infer lower persistencein accrualsor the
type of accrualsthat the book-tax differencesare associatedwith are easily identifiedand
pricedby the market.However,the evidence also indicatesthatinvestorsunderestimatethe
persistenceof the cash flow componentfor these firm-yearssuggestingthatinvestorsover-
weight the informationin the book-tax differences.Conversely,for firm-yearswith large
negativebook-taxdifferences,the resultsindicatethatinvestorsoverestimatethe persistence
of the accrualcomponentof earnings,consistentwith priorresearchexaminingbroadcross-
sections of firm-years(e.g., Sloan 1996).
Abnormal Returns Regressions
Table6 presentsthe resultsof the annualreturnregressiontests intendedto complement
the Mishkin (1983) tests of marketrationality.As noted previously,I use only December
year-endfirms and estimatethe regressionsannuallyin orderto estimatethe returnsto an
implementablehedge portfoliostrategy.I find thatfor the entiresamplethe abnormalreturn
to an accrual-basedstrategyis 4 percent (p = 0.046). For firm-yearswith large negative
book-tax differences,the returnto an accrualinvestmentstrategyis marginallysignificant
at the 0.10 level. Consistentwith my Mishkintests, I find thatfor firm-yearswith relatively
large positive book-taxdifferences,an investmentstrategybased on the accrualcomponent
of earningsdoes not earn a significantreturn(p = 0.16). Thus, overall the regressiontests
supportthe resultsfrom the Mishkin(1983) test: in firm-yearswith large positive book-tax
differences investors appearto price accrualsrationally.This evidence is consistent with
the large positive book-taxdifferencesprovidingadditionalinformationto investorsabout
the persistenceof accruals.
Additional Analysis
An Investigationof the Specific Sources of Lower Persistence
The effect of special items. I examine the effect of special items on my results to
determineif the persistencedifferencesI find reflect aggressivereportingin currentoper-
ating accrualsor if the persistencedifferencesare largely drivenby transitoryitems below
operatingincome (i.e., special items). Specifically,I performthe persistencetests in Equa-
tion (4) using the definitionsof earnings,accruals,and cash flows as in Sloan (1996). Sloan
(1996) defines earnings as operatingearnings after depreciation(data item #178), which
excludes the effects of special items. In my originaltests I use total pre-taxearnings,which
includes the effects of special items because the deferredtax expense numberis relatedto
the total pre-taxearningsnumber.
There is no way to separatethe book-tax differencesrelatedto special items.28As a
result, I assume that all special items create a book-taxdifferenceand subtractthe amount
of special items for each observationfrom the amountof book-tax differences.I then use
this adjusted measure of book-tax differences to partition the firm-years into subsamples
27 I have no explanationfor why cash flows are pricedcorrectlyfor this groupof firms.However,the resultsare
similarto those in recentstudies.Forexample,in Bradshawet al. (2001) the ratioof investorimpliedto observed
persistencein cash flows is 0.97 (significancenot reported)and Barthand Hutton(2004) reporta ratioof 0.95
(p = 0.362) for one subsampleof firms (those with consistentaccrualand forecastrevision signals) in their
study.
28 Handcollectionwouldnot reliablyaccomplishthis taskeitheras only materialdeferredtax assets andliabilities
are requiredto be reportedand changesin these are often affectedby mergersand acquisitionsand the taxes
relatedto extraordinary items.
TheAccountingReview,January2005
;S
t0
0P•
0,
t• TABLE 6 (continued)
t-statistic(secondnumber)is computedas the ratio of the mean of the annualcoefficientsto the standarderrorcalculatedfr
p-valuesare in parentheses.
VariableDefinitions:
= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a size
SARt+,
begins in the fourthmonthafterthe fiscal year-endof t to allow the disseminationof financialreports;
= accrualsdividedby averagetotal assets, transformedto a scaled-decilevariablewith values rangingfro
PTACCtd'e pre-tax
= the naturallogarithmof the marketvalue of commonequity,transformedto a scaled-decilevariablewith valu
InMVEtdec the natural
lnBMdec = logarithmof the book to marketratio,transformedto a scaled-decilevariablewith values rangingf
Beta"dec = systematicrisk estimatedfrom regressionof monthlyraw returnson the returnto a value-weightedmarketpor
to the abnormalreturnaccumulationperiod,transformedto a scaled-decilevariablewith values rangingfrom 0
requiredto calculatebeta;
EPdec = earnings-to-price ratio,transformedto a scaled-decilevariablewith values rangingfrom 0 to 1; and
= annualbuy-and-holdraw returnfor the securityless the buy-and-holdreturnto a size-matchedportfolioof fir
SARtdec
accumulationperiodtransformedto a scaled-decilevariablewith values rangingfrom 0 to 1.
and performtests similar to those above. Although some of the results are weakenedby
excluding the effects of special items, I continueto find results consistentwith firm-years
with large book-tax differences having lower persistence in earnings, accruals, and cash
flows. More specifically,I find in a regression analogous to Equation(4), but excluding
special items from the variablecomputations,that firm-yearswith both large negative and
large positive book-tax differences have a lower persistencein accrualsrelative to firm-
years with small book-tax differences (y, = -0.096 and y8 = -0.075). Both groups of
large book-taxdifferencefirm-yearsalso have significantlylower persistencein cash flows
as well (y4 = -0.068 and = -0.100). Thus, while the results of this test appearto be
y5
somewhatweaker(i.e., the coefficientsare smaller)indicatingthatthe special items do have
an effect, overall they are robustto the adjustmentfor special items.29
Examination of the disclosure of changes in deferred tax assets and liabilities. I
hand-collectthe changesin deferredtax assets and liabilitiesfor a small subsampleof firm-
years in both the large book-tax differences groups to examine what types of book-tax
differencesare generatingthe deferredtax expense for these groups of firms. However,I
providea caveatto the examinationof these data.One reasonI use the deferredtax expense
(income statement)numberratherthan the change in the deferredtax assets and liabilities
in the formal tests above is that the change in the deferredtax assets and liabilities listed
in the tax footnote does not always tie out to the deferredtax expense as one might expect.
The changes in the deferredtax asset and liabilities in the notes to the financialstatements
can include changes resultingfrom mergerand acquisitionactivity and changes relatedto
deferredtaxes attributedto income or losses from discontinuedoperationsor extraordinary
items. Thus, it is very difficult to identify the actual "components"of the deferredtax
expense (income statementnumber)even when hand-collectingthe data.30In the sample I
have hand-collected,I find that in only 27 out of the 60 firm-yearscollected does the
deferredtax expense tie out exactly to the change in the deferredtax assets and liabilities.
This caveat notwithstanding,I find that most of the change in the deferredtax assets
andliabilitiesfor firm-yearswith largepositivebook-taxdifferencesis fromthe depreciation
book-tax difference (or other differencesthat affect property,plant, and equipment)with
the next largestcategoriesincludingbad debt reserve,pensions and postretirementbenefits,
the category labeled "other,"and investments in affiliates, partnerships,and unrealized
securitygains.
For firm-yearswith large negativebook-taxdifferencesthe largestcategoriesof change
are reserves and accruals(both individuallylabeled and those called "miscellaneous"ac-
cruals), the line item labeled "other,"and depreciationdifferences.The largest category,
reserves and accruals,includes the accountsthat are generallysuspectedof earningsman-
agement in the texts (warrantyexpense, miscellaneous reserves, etc.). This is consistent
29 I also performanotheranalysisto examinethe effects of special items. I use the same definitionsof earnings,
accruals,and cash flows as in the originaltests, but I use a samplethat excludes all firm-yearswith material
special items (definedas those firm-yearswith special items that are largerin absolutevalue than one percent
of averagetotal assets). I find that all the results are qualitativelysimilarto those found in the originaltests
with the exceptionof firm-yearswith largepositivebook-taxdifferencesnot havinglowerpersistencein accruals
relativeto firm-yearswith small book-taxdifferences.Specifically,when I estimateEquation(4) over the sub-
sampleof firm-yearswithoutmaterialspecialitems, I findthatthe coefficienton the interactionof accrualsand
the indicatorvariableLPBTDis -0.040 (p = 0.274). Thus,this test would indicatea strongereffect of special
items on the results.However,a caveatto this test is that it excludes approximately2,900 observationsand it
may be the case thatthese observationswith largespecialitems arefirmsthatmanageearningsin otheraccounts
as well.
30 For furtherexplanationsee Revsineet al. (1999) and Hanlon(2003).
TheAccountingReview,January2005
Scaler
My two researchquestionsare (1) whetherfirm-yearswith largerbook-taxdifferences
have less persistentearnings and (2) whetherthe large book-tax differencesinfluence in-
vestors' assessmentsof persistence.In looking at the first question,I follow priorresearch
in using earningsperformance(returnon assets). However,recent researchby Fairfieldet
al. (2003) arguesthat the persistenceeffect documentedby Sloan (1996) is partiallyattrib-
utable to growth in operatingassets (i.e., growth in the denominatorratherthan reversals
in the numeratorgenerate the results in the forecasting regressions). As a result, I re-
estimatethe above forecastingEquation(4) using total assets in year t- 1 as the common
scale for all variablesin the regression.I find that the coefficienton the accrualinteraction
term for the LPBTD group continuesto be negative and significantbut that the coefficient
on the accrualinteractiontermfor the LNBTD groupis not statisticallysignificant.In order
to furtherinvestigatethis issue, I re-estimatethe tests thatuse lagged assets as the common
scaler in ranks and find that firm-yearswith both large positive and large negative book-
tax differences have lower persistence in earnings and accruals as found in the original
tests. Thus, these rankresults suggest that the lagged asset deflatoris a noisier measureof
scale than averagetotal assets and that the inferencesof the originaltests above are robust
to the alternativescaler measure.32
33 I also conducta sensitivitytest includingloss firms (i.e., both book and tax loss firms)and using an estimate
of total book-tax differences(althoughthis estimate is likely subject to much more measurementerroras
discussedpreviouslyin the manuscript).I estimatetotal book-taxdifferencesby grossing up the currenttax
expense by the statutorytax rate (35 percent).The sample with availabledata consists of 29,101 firm-years.
When annualreturnregressionsare estimatedthere is not a significantassociationbetweenabnormalreturns
and the book-taxdifferencesconsistentwith investorsrealizingthatincome thatis differentbetweenbook and
tax is less persistent.
TheAccountingReview,January2005
In untabulatedresults I find that the coefficienton cash flows is 0.747, the coefficient
on accruals excluding the book-tax differences is 0.481 (significantlydifferent from the
coefficient on cash flows, p-value on an F-test of 0.0001), and the coefficient on the
book-tax differences is 0.402 (significantlydifferentthan the coefficient on accruals ex-
cluding book-tax differences,p-value of an F-test of 0.0005). Thus, these results are con-
sistentwith book-taxdifferenceshaving lower persistencefor one-year-aheadearningsthan
accrualsexcludingthe book-taxdifferences,consistentwith the book-taxdifferencesprox-
ying for discretion.
TheAccountingReview,January2005
Second, for the main tests, I partition the sample based on the level of temporary book-
tax differences and investigate the relative earnings persistence between groups. To the
extent there are omitted correlated variables that cause the firm-years to be partitioned
similarly, these other factors could be contributing to my results. However, tests of industry,
scale (growth), and return on equity indicate that the results are robust to these controls.
My findings lend support to the case being made by some in Congress for requiring
additional tax disclosure by firms. Large book-tax differences as disclosed in the financial
statements appear to provide information about the persistence of current earnings perform-
ance and have predictive power for future earnings. In addition, it appears that investors
assess different persistence expectations for firm-years with large book-tax differences.
More complete disclosure of the book-tax differences (such as more detailed disclosure of
the components of the change in deferred tax assets and liabilities and a reconciliation of
the total change to the deferred tax expense) would likely provide additional information
that would help investors assess the information in book-tax differences.
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