Book-Tax Differences Influence Investors' Expectations
New study supports Congressional efforts to require additional tax disclosure by firms.
ANN ARBOR, Mich. A new study by a University of Michigan business professor lends support to the efforts by some in Congress for requiring additional tax disclosure by firms.
Michelle Hanlon, assistant professor of accounting at the U-M's Stephen M. Ross School of Business, argues that more complete disclosure of taxable income would likely provide additional information (i.e., a benchmark) to help investors better assess companies' current and future earnings performance.
The hypothesis underlying Hanlon's tests is that because less discretion is allowed in the computation of taxable income than in the computation of financial accounting income, the difference between book and taxable incomes (i.e., book-tax differences), can be informative about whether a firm is manipulating its accounting earnings.
If book-tax differences indicate manager discretion, she says, firm-years with large book-tax differences will have less persistent earnings than firm-years with small book-tax differences.
Hanlon finds evidence consistent with book-tax differences serving as an indicator of the persistence (quality) of its earnings, accruals and cash flows for one-period-ahead earnings. She also reports that the level of "book-tax differences" influences investors' expectations about the continuing quality of earnings and earnings components.
"In the wake of recent accounting scandals, some are wondering whether the large differences between book and taxable incomes should have been an indicator of low-quality financial reporting earnings," Hanlon says.
For example, the consequences of Enron's collapse and other similar corporate meltdowns prompted one Congressman, Rep. Lloyd Doggett, to observe, "When investors hear only of rosy earnings while at tax time Uncle Sam hears only of regrets and red ink, something is very wrong."
In her research, Hanlon studied 4,048 U.S. firms between 1994 and 2000 to obtain a sample of 14,106 firm-years. The sample was divided into groups with large positive book-tax differences (where book income exceeds taxable income), large negative book-tax differences (where book income is lower than taxable income), or small book-tax differences (where the gap between book and taxable incomes is not very big).
The results of the study show that firm-years with large positive and large negative book-tax differences have significantly less persistence in pre-tax earnings than firm-years with small book-tax differences. Although these results are somewhat weakened by adjustments for special items, they still show that firm-years with large book-tax differences have lower persistence in earnings, accruals and cash flows.
Hanlon also finds that the market pricing of total pre-tax book income is affected by book-tax differences.
"When book income is greater than taxable income, investors appear to recognize that these firm-years will not have persistent earnings and subsequently lower their expectation of future earnings quality," she says.
Hanlon concludes that more complete disclosure in financial statements would help investors assess the information in book-tax differences and make better investment decisions.
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