The Persistence and Pricing of Earnings, Accruals, and Cash
Flows When Firms Have Large Book Tax
Differences
The Persistence and Pricing of Earnings, Accruals, and Cash
Flows When Firms Have Large Book Tax
Differences
Michelle Hanlon
Presented by:
IRA GERALDINA
Outline
• Research Background
• Research Questions
• Theory & Hypothesis Development
• Methodology
• Results
• Conclusions
Overview
BTDBTD
Earning , Accrual, and Cash Flow
Persistence
Earning , Accrual, and Cash Flow
Persistence
Market AssessmentMarket Assessment
Backgrounds
• The difference between pre-tax financial reporting and taxable income can provide information about current earning
• Book tax differences can be informative about management discretion in the accrual process
- Revsine et al. (1999); Palepu et al. (2000); Penman 2001• Large differences between book and taxable income an
indicator as low quality of financial reporting earning• Book tax differences as an indicator of earnings
management (Mills dan Newberry, 2001; Philips et al. 2003; Joos et al. 2000; dan Lev dan Nissin, 2004)
• Extend litelatur on book tax differences
Research Questions
Q1
How is the role of book tax differences in indicating in persistence of earnings, accruals, and cash flows?
Q2
How is the role of book tax differences in indicating in influencing investors’ assessments of persistence of earnings and earnings components?
Theory
• Accounting earnings Vs Taxable income• Permanent and temporary differences• SFAS No. 109 uses balance sheet approach in
reporting temporary differences
• Future taxable Vs future deductible amounts• Future taxable amounts increase deferred tax
liability & recognize deferred tax expense
• Future deductible amounts increase deferred tax asset & recognize deferred tax benefit
Hypotheses Development• FASB’s Concept Statements No. 2 Qualitative
Characteristics of Accounting Information:
- predictive value (part of relevance)
• Earning persistence as determinant of earning quality (Jonas and Blanchet, 2000)
• Earning persistence as a relevant-value characteristics of earnings (Ohlson, 1995)
• Book tax differences reflecting information about current earnings persistence.
• The objectives of financial reporting and tax reporting are differences
- financial income as
signal of management
performance (Dechow,
1994)
- IRC provides frameworks
in determining tax liability
(Scholes et al. 2002
Manzon dan Plesko 2002)
Hypotheses Development
• Increase in deferred tax liability might be an
indication of deteriorating of earnings quality
• Deferred tax assets as a way to artificially
increasing earnings (Revsine et al., 1999)
• Book tax differences can be generated as tax planning strategies
- larger book tax
differences the
greater the likelihood
of IRS audit and
adjustment (Mills, 1998)
• Firms with large book tax differences are suspected having lower earnings quality
(Jones et.al., 2000)
Hypotheses Development
HYPOTHESES 1
Pre-tax earning persistence for firm years with large negative or positive book tax differences is lower than earning persistence for firms with
small book tax differences
Pre-tax earning persistence for firm years with large negative or positive book tax differences is lower than earning persistence for firms with
small book tax differences
HYPOTHESES 2
- Large book tax
differences indicate
low earnings quality- book tax differences
are indicative of
subjectivity in financial
reporting accrual
process
The persistence of the accruals component of
earnings is lower for firms with years with
large negative or positive book tax
differences relative to firm years with small book tax differences
The persistence of the accruals component of
earnings is lower for firms with years with
large negative or positive book tax
differences relative to firm years with small book tax differences
HYPOTHESES 3
- Lower ERC for firm-
years with large book
tax differences introducing
possibility of manager’s
opportunistic on discretion
(Jones et at.,2000)
- If investor use book tax
differences as information
about persistence of
accruals, they may not
misprice (Sloan, 1996)
The expectation of pre-tax earnings persistence reflected in stock prices
for the accrual component of pre-tax earnings is consistent
with observed persistence of accruals
for firm years with relatively large boob tax
differences
The expectation of pre-tax earnings persistence reflected in stock prices
for the accrual component of pre-tax earnings is consistent
with observed persistence of accruals
for firm years with relatively large boob tax
differences
Methodology
Methodology
Methodology
Methodology
Methodology
RESULTSDescriptive Statistics Panel A
Mean & Median of PTACC is negative
RESULTSDescriptive Statistics Table 1 Panel B
PTACC is correlated with DTE only -0,008
RESULTS• LNBTD: AVETA, BM, Sales, Sales Growth
• LPBTD : BTD
RESULTS• γ4 = -0.100 and γ5 = -0.212
• Consistent with H1
RESULTS• γ7 = -0.115 and γ8 = -0.187 & γ6 < γ3 consistent with H2
• γ2 < γ31
RESULTSSee LPBTD Pre-tax earning performance
RESULTSSee LPBTD Pre-tax accrual performance
RESULTS• See LPBTD Subsample, ((γ1
* /γ1 )) <1
• See LNBTD Subsample , γ1* closed to γ1
• See SmallBTD subsample, underestimate
RESULTS
• Full sample and SmallBTD : γ2* > γ2 and γ1
* < γ1
• LPBTD, consistent with H3
• LNBTD inconsistent with H3
RESULTS
• PTACC abnormal return= 4%• LNBTD, insignificant• LPBTD, significant : Rationally perception
Additional Analysis
The effect of special items:• Firm years with large book tax differences having
lower persistence in earnings, accruals, and cash flows
• Firm years with large positive (negative) book tax differences having lower persistence in accruals relative to firm years small book tax differences having lower
• Firm years with large positive (negative) book tax differences having lower persistence in cash flows, somewhat weaker.
Examination of the disclosure of changes in DTA and DTL:
• Only 27 out of the 60 firms does the DTE tie out to the change of DTA and DTL
• Change of in DTA and DTL of Firm years with large positive book tax differences is from the depreciation, bad debt reserved, pensions, postretirement benefits and others.
• The largest categories for LNBTD from reserves and accruals
• Consistent with subsample’s accruals having a lower persistence for future earnings as compared to accruals for SmallBTD.
Additional Analysis
Scaler• Coefficient on the accrual interaction term for
LPBTD group continues to be negative and significant.
• Firms years with large positive (negative) book tax differences have lower persistence in earnings and accruals
Additional Analysis
ROE on Equity as a correlated omitted
variables
• The coefficient for interaction term is significantly negative (-0, 428)
• Consistent with higher ROE firms having more mean reverting income.
Additional Analysis
Additional Analysis
Book-tax differences as a proxy for
discretionary accruals:• Coefficient on cash flows is 0.747, the coefficient
on accruals excluding the book-tax differences is 0.481 (significantly differences)
• Coefficients on the book tax differences is 0.402 (significantly different than the coefficient on accruals excluding book tax differences )
• Consistence with book tax differences proxying for for discretion.
Conclusions
• Firm years with large positive book tax differences have lower persistence in earnings than firm years with small book tax differences.
• Firm years with large negative book tax differences have significantly less persistent in earnings, accruals, and cash flows.
• Market asses a lower expectation of earning persistence for the firm years with large positive book tax differences, but underestimate the persistence of cash flows
• Firm years with large negative and small book tax differences, investor overestimate the persistence of the accrual component
• Sample size and time period
• Sample partition
Limitations
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