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