The Impact of Earnings Management and Tax Planning on the Information Content of Earnings

Article (PDF Available)inSSRN Electronic Journal · November 2007with532 Reads
DOI: 10.2139/ssrn.1028808
Abstract
This paper examines the effect of tax planning and earnings management on the relative informativeness of book income and taxable income. We conduct two sets of tests documenting (1) the incremental effect of tax planning and earnings management on the relative informativeness of book and taxable income and (2) the relation between voluntary conformity and the relative informativeness of book and taxable income. Based on these two sets of tests, we conclude that tax planning and earnings quality jointly affect the relative informativeness of book and taxable income.

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The Impact of Earnings Management and Tax Planning
on the Information Content of Earnings
Linda H. Chen
Dan S. Dhaliwal
Mark A. Trombley *
Eller College of Management, University of Arizona, Tucson, Arizona 85721
November 2007
Abstract
This paper examines the effect of tax planning and earnings management on the relative
informativeness of book income and taxable income. We conduct two sets of tests documenting
(1) the incremental effect of tax planning and earnings management on the relative
informativeness of book and taxable income and (2) the relation between voluntary conformity
and the relative informativeness of book and taxable income. Based on these two sets of tests,
we conclude that tax planning and earnings quality jointly affect the relative informativeness of
book and taxable income.
JEL classification: G12; G32; H24; H25
Keywords: Earnings management, taxable income, book income, information content
_________________________
We thank Michelle Hanlon and Ed Maydew for useful comments and suggestions on earlier
drafts of this paper.
* Corresponding author: Telephone: (520) 621-4805; Fax (520) 621-3742; E-mail address:
trombley@email.arizona.edu
Page 1
Electronic copy available at: http://ssrn.com/abstract=1028808
1
The Impact of Earnings Management and Tax Planning
on the Information Content of Earnings
1. Introduction
This paper examines the effect of tax planning and earnings management on the relative
informativeness of book income and taxable income. Hanlon, Laplante and Shevlin (2006) find
that although book income exhibits greater explanatory power for returns, both book income and
taxable income exhibit incremental explanatory power. Building on this result, Hanlon, Maydew
and Shevlin (2006) examine the effect of time-series differences in book-tax conformity on the
information content of book income. Consistent with Guenther, Maydew and Nutter (1997) they
argue that increases in mandatory book-tax conformity have the effect of encouraging firms to
report lower book income, decreasing the information content of book earnings. For a sample of
firms where book-tax conformity increased due to a change in tax law, they find a decrease in the
information content of book income that is consistent with this argument.
In contrast to prior work, we focus on voluntary book-tax conformity. In a way, cross-
sectional differences in voluntary conformity summarize the net effect of differences in both
earnings management and tax aggressiveness, where earnings management generally consists of
income-increasing book accounting choices and tax aggressiveness consists of income-reducing
tax accounting choices. Increasing voluntary conformity requires either reducing the use of
“free” earnings management devices (those that increase book income but not taxable income) or
reducing the use of “free” tax planning devices (those that decrease taxable income but not book
income), or both. That is, increasing voluntary conformity reduces tax aggressiveness, or
increases earnings quality, or both.
1
Since information content of book income is positively
1
Throughout the paper, we frequently use the term “earnings quality” to denote the absence of earnings-increasing
accruals, i.e., the absence of earnings management.
Page 2
2
related to earnings quality, and information content of taxable income is negatively related to tax
aggressiveness, we predict that increasing voluntary conformity will increase the informativeness
of book income, taxable income, or both. In contrast to Hanlon, Maydew and Shevlin (2006),
who examine the effect of a tax law change that increased statutory conformity on the
informativeness of book income of some firms, we examine the effect of cross-sectional
differences in voluntary conformity on the informativeness of both book income and taxable
income. Our study is the first to examine the effect on earnings informativeness of cross-
sectional differences in voluntary book-tax conformity. Also, our research design provides a
more complete understanding of the implications of differences in book-tax conformity, since it
provides insight into the impact of conformity on the relative informativeness of both book and
taxable income. Consistent with our expectations, we find that the information content of both
book income and taxable income are significantly greater for firms exhibiting greater voluntary
conformity than for firms with lower voluntary conformity.
Interestingly, our finding that greater voluntary conformity increases information content
appears to be in contrast to Hanlon, Maydew and Shevlin (2006), who find that increased
statutory conformity leads to a reduction in informativeness of book income. However, these
results are not inconsistent because the source of differences in conformity is different between
the two studies. In Hanlon, Maydew and Shevlin (2006) the time-series change in conformity is
driven by the addition of accounting accruals to what was previously cash-basis income
reporting for tax purposes. This type of change in book-tax conformity encourages a reduction in
reported income to save on taxes. In our study, cross-sectional differences in voluntary
conformity are due to the absence or presence of tax planning and earnings management. This
type of difference may not necessarily lead to a negative bias in reported income, which drives
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3
the result in Hanlon, Maydew and Shevlin (2006). In light of the difference in results between
our study and Hanlon, Maydew and Shevlin (2006), it appears that the effect of changes or
differences in conformity on the informativeness of book income may depend on the nature of
the change or difference.
We view these tests and results on the effect of differences in voluntary conformity on
the informativeness of book income and taxable income as tests of the joint effects of tax
planning and earnings quality. We also investigate this issue by explicitly considering the joint
effect of tax planning and earnings quality on informativeness of book income and taxable
income. Ayers, Jiang and Laplante (2006) investigate the effect of tax planning and earnings
quality on the relative information content of book income and taxable income. They argue that
tax aggressiveness (also referred to as tax planning) reduces the information content of taxable
earnings relative to book earnings, and that lower earnings quality increases the information
content of taxable income relative to book income. They document empirical results that are
consistent with these arguments.
In contrast to Ayers et al. (2006), we note that book income and taxable income are not
independent. Each of these earnings constructs effectively constrains the degree to which the
other can be managed, because tax planning and earnings management each have the potential to
affect both book income and taxable income. For example, a tax planning mechanism that
reduces taxable income will also either reduce book income or leave book income unchanged.
Similarly, an earnings management device that increases book income will also either increase
taxable income or leave taxable income unchanged. The supply of “free” earnings management
devices (those that decrease taxable income but not book income) and the supply of “free” tax
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planning devices (those that decrease taxable income but not book income) are limited.
2
Once
these free earnings and tax management methods are exhausted, additional tax planning will
have some negative effect on book income, and additional earnings management will have some
positive effect on taxable income. Since tax planning and earnings manipulation each have the
potential to affect both book income and taxable income, we examine the effect of both tax
planning and earnings quality on the relative information content of taxable income and book
income. While prior research indicates that tax planning and earnings quality are each separately
related to the relative informativeness of book and taxable income, the fact that they are not
independent means that there is no assurance that each is incrementally related to the relative
informativeness of book and taxable income. We investigate the joint effect of tax planning and
earnings quality, and find that both of these constructs are each incrementally related to the
relative informativeness of book income, and that tax planning is related to the informativeness
of taxable income. However, in contrast to Ayers et. al (2006) we find that once loss firms are
included, there appears to be no relationship between earnings quality and informativeness of
taxable income.
In summary, we conduct two sets of tests documenting (1) the incremental effect of tax
planning and earnings management on the relative informativeness of book and taxable income
and (2) the relation between voluntary conformity and the relative informativeness of book and
taxable income. Based on these two sets of tests, we conclude that tax planning and earnings
quality jointly affect the relative informativeness of book and taxable income. This finding is the
primary contribution of the paper.
2
We use the term “free” to denote this type of earnings management and tax planning, but the term “lower cost”
might be more accurate.
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5
The remainder of the paper is organized as follows. In section 2, we discuss the
relationship between tax planning and earnings management. In section 3, we document the
measurement of our tax planning, earnings management, and conformity variables, and sample
selection and descriptive statistics are discussed in section 4. Empirical tests and results are in
section 5, and robustness tests are in section 6. Section 7 concludes the paper.
2. Tax planning, earnings management, and book-tax conformity
2.1 Tax planning, earnings management and informativeness
Financial reporting and tax reporting are characterized by different revenue and expense
recognition rules. Under financial accounting rules, revenue is recognized when revenue
recognition criteria are met, and expenses are recognized during the period incurred or at the
same time as related revenues. In general, the timing of receipt or payment of cash flows is
irrelevant to the timing of recognition for financial reporting purposes. In contrast, tax reporting
rules may accelerate recognition of revenues where cash is received prior to financial reporting
recognition, and may defer recognition of expenses where cash is paid after financial reporting
recognition. Other differences in financial and tax reporting result from differences in
depreciation and depletion methods, from differences in treatment of income earned by foreign
subsidiaries, and from other temporary or permanent differences.
Companies have different incentives in reporting book and taxable income. Because
book income is implicitly or explicitly used in contracting (e.g., compensation plans and debt
covenants) and stock valuation, company managers generally prefer higher income and have
incentives to manage earnings upward. The extensive literature on earnings management
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6
generally supports the existence of widespread earnings management by companies.
3
In contrast,
taxable income is used to determine the taxes the company is required to pay, with higher taxable
income resulting in higher tax payments, so the incentives favor decreases in taxable income.
4
Hanlon, Laplante and Shevlin (2006) suggest that these different incentives applying to
book and taxable income have the effect of making each of these income measures incrementally
informative relative to the other, and they present evidence that taxable income is informative
even after controlling for book income. Consistent with other research in this area, the focus for
informativeness is on investors’ use of information for valuation purposes; a measure is deemed
to be informative if it is correlated with contemporaneous stock returns. Similarly, each measure
is deemed incrementally informative if it is correlated with contemporaneous stock returns after
controlling for the other income measure.
Ayers, Jiang and Laplante (2006) argue the informativeness of book and taxable income
depends on the extent to which each income number measures the real economic performance of
the firm, and that earnings management and tax planning are unrelated to real economic
performance. This implies that the information content of taxable income is likely to be reduced
by tax planning (i.e.. by income-reducing tax reporting choices) because tax planning
mechanisms do not provide information about actual firm performance. Accordingly, tax
planning should reduce the informativeness of taxable income relative to book income.
Similarly, earnings management increases book income and reduces the informativeness of book
income because earnings management devices do not provide information about actual firm
3
Our analysis generally assumes that companies manage earnings upward, reducing earnings quality. However, we
recognize that under certain conditions, companies may have incentives to manage earnings downward (e.g., see
Defond and Park 1997). If income-increasing and income-decreasing earnings management have asymmetrical
effects on the informativeness of earnings, the presence of firms that manage earnings upward in our sample
constitutes a source of noise and possibly bias in our empirical tests.
4
Desai (2006) argues that aggressive tax planning to reduce taxes may not necessarily be beneficial to stockholders
because “the extra latitude afforded by the dual reporting system can be costly to investors".
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7
performance. So, earnings management should reduce the informativeness of book income
relative to taxable income. The empirical results in Ayers, Jiang and Laplante (2006) support
these arguments.
5
In contrast to Ayers et al. (2006), we note that tax planning and earning management are
not independent. Each of these earnings constructs effectively constrains the degree to which the
other can be managed, because tax planning and earnings management each have the potential to
affect both book income and taxable income. Some tax planning mechanisms that reduce
taxable income will leave book income unchanged, but many tax planning mechanisms also
reduce book income. For example, accelerating the purchase of fixed assets allows earlier
recording of depreciation expense for tax purposes, reducing taxable income, but also results in
recording of depreciation expense for book purposes, reducing book income. Similarly, an
earnings management device that increases book income may leave taxable income unchanged,
but many earnings management devices will also increase taxable income. For example,
increasing book income by delaying year-end sales cut-off to allow recording of additional sales
also increases taxable income because the additional sales must also be recognized for tax
purposes. Erickson et al. (2004) find that firms managing earnings may be willing to pay
additional taxes to accomplish earnings management goals if earnings management also
increases taxes.
While prior research (Ayers, Jiang and Laplante, 2006) indicates that tax planning and
earnings quality are each separately related to the relative informativeness of book and taxable
income, respectively, the fact that they are not independent means that there is no assurance that
5
Lev and Nissim (2004) argue that if tax planning results in “smoothing” of taxable income to minimize the present
value of tax paid, such planning would have the opposite effect of increasing the informativeness of taxable income.
However, Graham and Smith (1999) argue that tax incentives drive firms to simply minimize current period taxes
rather than engaging in more elaborate smoothing of taxable income.
Page 8
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each is incrementally related to the relative informativeness of book and taxable income, or that
the informativeness of one is not subsumed by the other. The following two hypotheses, stated
in alternative form, examine the incremental informativeness of book and taxable income:
H1: High tax planning firms have relatively less informative taxable income than low tax
planning firms, controlling for earnings management.
H2: High earnings management firms have relatively less informative book income than
low earnings management firms, controlling for tax planning.
The supply of “free” earnings management devices (those that increase book income but
not taxable income) and the supply of “free” tax planning devices (those that decrease taxable
income but not book income) are limited. Once these free earnings and tax management methods
are exhausted, additional tax planning will have some negative effect on book income, and
additional earnings management will have some positive effect on taxable income. Since tax
planning and earnings manipulation each have the potential to affect both book income and
taxable income, we examine the effect of both tax planning and earnings quality on the relative
information content of taxable income and book income. We expect that tax planning has a
negative effect on the informativeness of book income, and earnings management has a negative
effect on the informativeness of taxable income:
H3: High tax planning firms have relatively less informative book income than low tax
planning firms, controlling for earnings management.
H4: High earnings management firms have relatively less informative taxable income
than low earnings management firms, controlling for tax planning
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9
2.2 Book-tax conformity and informativeness
The relation between book income and taxable income depends on tax law, financial
accounting rules, and reporting choices made by firms. Book income and taxable income can be
close together either because firms are statutorily required to conform taxable income to book
income (statutory conformity) or because firms voluntarily make reporting choices that reduce
the difference between book and taxable income (voluntary conformity). The relation between
book and taxable income may be the same for statutory and voluntary conformity, but the
interpretation of earnings by security markets may be different.
When statutory conformity causes book income to match taxable income, reporting firms
have an incentive to reduce taxable income, with the corresponding required reduction in book
income, in order to reduce tax payments. Guenther, Maydew and Nutter (1997) find that firms
decreased book income when changes in tax laws required them to increase conformity between
book and tax. In this situation, the usefulness of financial accounting income is reduced because
the incentive to reduce taxes may interfere with the objective to convey information about firm
performance (Harris, Lang and Moller, 1994; Hanlon, Maydew and Shevlin, 2006).
In contrast, voluntary conformity between book and taxable income results from firms
making consistent financial accounting and tax reporting choices. That is, if a firm decides to
forgo earnings management and tax planning decisions that result in differences in book and
taxable income, the result is voluntary conformity between book and taxable income.
An important implication of distinguishing between statutory conformity and voluntary
conformity is that under voluntary conformity there are cross-sectional differences in conformity
that do not exist if conformity is considered only in terms of statutory requirements. In a way,
cross-sectional differences in voluntary book-tax conformity summarize the net effect of
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differences in both earnings management and tax aggressiveness, where earnings management
generally consists of income-increasing book accounting choices and tax aggressiveness consists
of income-reducing tax accounting choices. Increasing book-tax conformity requires either
reducing the use of “free” earnings management devices (those that increase book income but
not taxable income) or reducing the use of “free” tax planning devices (those that decrease
taxable income but not book income), or both. That is, increasing voluntary book-tax conformity
reduces tax aggressiveness, or increases earnings quality, or both.
Voluntary conformity is more likely in situations where book income may also serve as a
constraint on tax planning for reasons other than statutorily required conformity. For example,
the Internal Revenue Service audit manual directs attention to differences between book and
taxable income during IRS audits of corporate tax returns (Ayers et al., 2006). Mills (1998)
finds that IRS audit adjustments increases as the book-tax gap widens.
In contrast to Hanlon, Maydew and Shevlin (2006) who examine the effect of a tax law
change that increased statutory conformity on the informativeness of only book income of some
firms, we consider the effect of cross-sectional differences in voluntary conformity on the
informativeness of both book income and taxable income. Since information content of book
income is inversely related to earnings management, and information content of taxable income
is negatively related to tax planning, and voluntary conformity is the net effect of earnings
management and tax planning, we predict:
H5: High voluntary conformity firms have more informative book income and taxable
income than low voluntary conformity firms.
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3. Measurement of tax planning, earnings management, and conformity
Our measure of tax planning is the current effective tax rate (CurETR), consistent with
Ayers et al. (2006).
6
Current effective tax rate for each period is the current tax expense divided
by pre-taxable income. To reduce the effect of transitory tax items, we calculate CurETR as the
sum of five year (t-4 to t ) income tax expense minus the sum of the same period deferred tax
expense, divided by the sum of the same period pre-tax book income.
7
Since the goal of tax
planning is to minimize the current tax paid, greater tax planning is indicated by lower CurETR.
If the firm’s CurETR is below the industry median, the firm is designated as aggressive
(Tax_Agg=1).
Our earnings management measure is estimated pre-tax discretionary accruals (PTDA).
PTDA is calculated as follows. First, we estimate performance matched discretionary accruals as
proposed by Kothari et al. (2005). Since our focus is on pre-tax accruals, we calculate accruals
using pre-taxable income and cash flows. Pre-tax book income (PTBI) is calculated as pre-tax
book income less minority interest.
8
Pre-tax accruals is the difference between PTBI and pre-tax
cash flows, where pre-tax cash flows is calculated as total operating cash flow minus cash flow
due to extraordinary items plus taxes paid in cash.
9
The ROA augmented accrual model
suggested by Kothari et al. is:
,)/1(
32110 tttttt
ROAPPESalesAssetscrualsPre-tax ac
ε
β
β
β
β
+
+
+
+
=
(1)
where pre-tax accruals, change in sales (Sales ), and net property, plant and equipment (PPE)
6
Ayers et al. (2006) find consistent results using CETR and using the cash effective tax rate based on taxes actually
paid, as suggested by Dyreng, Hanlon and Maydew (2007). We also find that our results do not change if we
substitute the cash ETR for CETR.
7
Income tax expense is Compustat data item 16, deferred tax expense is data item 50, and pre-tax book income is
data item 170.
8
Minority interest is Compustat data item 49.
9
Operating cash flow is Compustat data item 308, extraordinary items is data item 124, and taxes paid in cash is
data item 317. The calculation of the earnings management variable is similar to Hanlon (2005), Hanlon et al. (2005)
and Ayers et al. (2006).
Page 12
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are all scaled by the beginning-of-year total assets.
10
Return on assets (ROA) is the performance-
matching control variable, a ratio where the numerator is pre-tax book income, and the
denominator is the beginning-of-year total assets.
We estimate equation (1) cross-sectionally each year within the same industry group
(two-digit SIC) to obtain the expected value of pre-tax accruals and the estimation error,
,
ˆˆˆ
)/1(
ˆ
32110 ttttt
ROAPPESalesAssetscrualspre-tax acEstimated
ββββ
+++=
(2)
accruals.pre-taxEstimatedaccrualsPre-taxPTDA
t
= (3)
In each year, if a firm's PTDA is above the median within the same industry group, then the firm
is designated as “low” in terms of earnings quality, otherwise, it is designated as "high".
Our firm-specific voluntary conformity measure is based on the historical relationship
between changes in taxable income and changes in book income. We use the correlation of
changes in book income and taxable income ρ(PTBI, TI) over five years from t-4 to t as the
book-tax conformity measure, where PTBI and TI are scaled by the beginning-of-year total
assets. We use the correlation of changes in the two income measures rather than the correlation
of levels because of systematic differences in the measurement of book and tax items such as
depreciation method, write-off treatment, and loss and credit carry-forward/back rules. By
focusing on the growth rate of PTBI and TI, we implicitly control for these systematic
differences.
11
Following Hanlon et al. (2005) and Ayers et al. (2006), taxable income is
calculated by adding current federal income expense plus current foreign tax expense, then
dividing by the top U.S. statutory tax rate for the year, then subtracting the change in net
10
Sales are Compustat data item 12, property, plant and equipment is data item 7, and total assets is data item 6.
11
Results are substantively unchanged when conformity is based on the correlation of ρ(PTBI,TI) rather than
ρ(PTBI,TI).
Page 13
13
operating loss carryforwards.
12
The change in net operating loss carryforwards is subtracted to
obtain a taxable income measure without the effect of any carrybacks or carryforwards.
13
4. Sample and Descriptive Statistics
The sample consists of firms with required financial statement information in the 2006
Compustat annual data files that also have stock returns available in the CRSP (Center for
Research in Security Prices) data files. Firms in regulated industries, consisting of financial (SIC
code 6xxx) and utility (SIC code 49xx) companies, are excluded. These criteria result in 60,636
firm-year observations over the period from 1993-2005.
Descriptive statistics for the variables used in the primary regression tests (Eq. (4) and
(5), described in the next section) are shown in Panel A of Table 1. Mean assets are $2,035
million, while median assets are $115 million, indicating the presence of some very large firms
in a population generally consisting of smaller firms. Pre-tax book income is slightly larger than
taxable income, indicating the presence of positive book-tax differences. Consistent with this,
the distribution of PTBI is shifted to the right relative to the distribution of TI. The correlation of
PTBI and TI, ρ(PTBI, TI), is consistently positive but generally well below 1. The large
spread of this variable (interquartile difference of 0.71) indicates substantial variation in
voluntary book-tax conformity among firms.
To minimize the potential effect of non-linearity in the relation between our variables of
interest and contemporaneous returns, we convert tax aggressiveness, earnings quality, and book-
tax conformity to categorical variables as follows. Tax_agg (tax-aggressiveness or tax planning
12
Current federal income tax expense is Compustat data item 63, foreign tax expense is data item 64, and loss
carryforwards are data item 52.
13
If current federal income expense is missing from Compustat, we estimate taxable income as the difference
between total income tax expense (Compustat data item, 16) and deferred taxes (data item 50), divided by the top
U.S. statutory tax rate for a given year, minus the change in net operating loss carryforwards.
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14
is an indicator variable based on the level of CurETR (current effective tax rate), assigned a
value of 1 if a firm’s CurETR is below the median CurETR for a given year within the firm’s
industry group (two-digit SIC), and 0 otherwise. Low_Quality, our earnings quality or earnings
management variable, is an indicator variable with the value of 1 if the firm's discretionary total
accruals is above the industry median, and 0 otherwise. Conformity is an indicator variable with
the value of 1 if a firm’s ρ(PTBI, TI) is above the median for the firm’s industry group and
zero otherwise.
14
Descriptive statistics for groups of firms based on the dichotomous Tax_agg,
Low_Quality and Conformity variables are shown in Panel B of Table 1. Firms with Tax_agg=1
are statistically different from firms with Tax_agg=0 across a number of dimensions, including
size (tax-aggressive firms have lower Assets, t=15.38), profitability (tax aggressive firms have
lower PTBI, t=72.86), and conformity as measured by ρ(PTBI, TI), with tax-aggressive firms
having lower conformity (t=43.86). Tax-aggressive firms also have lower CurETR, of course,
since we coded tax-aggressiveness based on CurETR. Firms with lower earnings quality
(Low_Quality=1) also tend to be smaller (lower Assets, t=6.34) and less profitable (lower PTBI,
t=21.22) than other firms, and also have lower conformity as measured by ρ(PTBI, TI),
(t=10.08). The differences between high conformity (Conformity=1) and low conformity
(Conformity=0), have a similar pattern, although the statistical significance of the differences are
much lower. We emphasize two points regarded the descriptive statistics in Panel B. First, the
significant differences in conformity between high and low tax aggressiveness firms and between
high and low earnings quality firms reinforces the notion that voluntary conformity as we
measure it here captures aspects of both tax aggressiveness and earnings management. Second,
14
As a sensitivity test, we excluded the middle one-third of each of these median based measures. That is, we
assigned a value of 0 if in the lowest one-third of the distribution, a value of 1 if in the highest one-third, and
discarded observations in the middle third. Results were substantively unaffected by this change in procedure.
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15
the differences between profitability (PTBI) of the firms in each of the pairs of groups raises the
concern that loss firms are not distributed randomly across the groups. Accordingly, later in the
paper we examine the sensitivity of our results to inclusion or exclusion of loss firms.
Table 2 shows the frequency count of earnings quality and voluntary book-tax conformity
conditioned on tax aggressiveness. Interestingly, high tax aggressiveness firms tend to have low
earnings quality, and low tax aggressiveness firms tend to have higher earnings quality. If tax
aggressiveness tends to decrease book earnings, and earnings management tends to increase
taxable income, as we expect, these relationships should be reversed from what we observe.
However, the correlation between these two measures is quite modest (0.152). A regression of
voluntary conformity on earnings quality and tax aggressiveness has the following results (t-
statistics in parentheses:
Conformity = 0.619 – 0.203*Tax_agg – 0.010*Low_Quality + ε
(166.78) (-42.48) (-2.11)
While both low earnings quality and tax aggressiveness are negatively associated with the book-
tax conformity measure, the association is much stronger for the tax aggressiveness measure.
However, the correlation of voluntary book-tax conformity and tax aggressiveness is only
0.203.
5. Empirical tests and results
In our first regression test, we examine how earnings quality (earnings management) and
tax aggressiveness (tax planning) simultaneously affect information content of book and taxable
earnings. The regression model for the first test is as follows:
Page 16
16
.__
__
__.
87
65
43210
εββ
ββ
β
β
β
β
β
+++
++
+
+
++=
aggTaxTIQualityLowTI
aggTaxPTBIQualityLowPTBI
aggTaxQualityLowTIPTBIRETAdj
(4)
where Adj.RET, is the buy-and-hold market-adjusted return for a firm's common stock over the
16-month return window which starts at the beginning of a fiscal year and ends four months after
the beginning of the following fiscal year, PTBI is pre-tax book income scaled by the beginning-
of-year total assets, TI is taxable income scaled by beginning-of-year total assets, Low_Quality is
an indicator variable with the value of 1 if a firm's discretionary total accruals is above the
industry median, and 0 otherwise, and Tax_agg is a dummy variable with the value of 1 if a
firm's estimated tax rate (CurETR) is below the industry median CurETR, and 0 otherwise.
The estimation results for eq. (4) are shown in Table 3. Consistent with Hanlon, Laplante
and Shevlin (2005), model 1 indicates that both PTBI and TI are informative, although PTBI
is relatively more informative. Model 2 measures the main effects of earnings quality and tax
aggressiveness. Both Low_Quality and Tax_agg are negative and significant, indicating that
firms with aggressive tax and earnings management earn relatively lower returns. The result for
tax aggressiveness is consistent with Hanlon and Slemrod (2007), who find evidence that
aggressive tax planning, in the form of tax shelters, is viewed as a value-reducing event by the
capital market.
Model 3 directly tests hypothesis 1 and 2. Hypothesis 1 predicts that high tax planning
firms (Tax_agg=1) have relatively less informative taxable income than low tax planning firms,
controlling for earnings management, i.e., the coefficient on TI*Tax_agg is negative, while
Hypothesis 2 predicts that high-earnings-management firms (Low_Quality=1) have less
informative book income than low-earnings-management firms, controlling for tax planning, i.e,
the coefficient on PTBI*Low_Quality is negative. Model 3 provides both of these results,
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consistent with hypotheses 1 and 2. Model 4 indicates that the presence of the main effects for
PTBI and TI does not change the result relative to model 3.
Model 5 adds variables for the cross effects, between taxable income and earnings quality
(TI*Low_Quality) and between book income and tax aggressiveness (PTBI*Tax_agg). Both
of these cross effects are negative, indicating that the informativeness of book income is reduced
by the presence of aggressive tax planning, consistent with H3, and the informativeness of
taxable income is reduced when the firm engages in earnings management, consistent with H4.
The model 5 results are unchanged by the addition of the main effects for PTBI and TI in
model 6.
In our second regression test, we examine how cross-sectional differences in voluntary
conformity affect the information content of book and taxable earnings. The regression model
for this second test is as follows:
15
.
.
43
210
εββ
β
β
β
+++
++=
ConformityTITI
ConformityPTBIPTBIRETAdj
(5)
where Adj.RET is the buy-and-hold market adjusted return for a firm's common stock over the
16-month return window which starts at the beginning of a fiscal year and ends four months after
the beginning of the following fiscal year. PTBI is pre-tax book income scaled by the beginning-
of-year total assets. TI is taxable income scaled by beginning-of-year total assets. Conformity is
an indicator variable with the value of 1 if a firm’s ρ(PTBI, TI) is above the median for the
firm’s industry group.
The estimation results for eq. (5) are shown in Table 4. Hypothesis 5 predicts that firms
with high voluntary conformity (Conformity=1) have relatively more informative book income
15
Conformity is not included as a main effect since we have no predictions regarding any relationship. In
untabulated tests we find no relation between Conformity and returns.
Page 18
18
and taxable income than low conformity firms, i.e., coefficients on PTBI*Conformity and
TI*Conformity are both positive. Model 1 shows that PTBI is informative, and provides a
basis for comparison with Model 2. In model 2, the interaction variable PTBI*Conformity is
positive and significant, indicating that PTBI is more informative for high-conformity firms
than for low-conformity firms, consistent with hypothesis 3. Similarly, model 3 shows that TI
is informative, providing a basis for comparison with Model 4. In model 4, the interaction
variable TI*Conformity is positive and significant. Because the coefficient on TI is not
significantly different from zero, model 3 indicates that TI is informative for high-conformity
firms but not for low-conformity firms. This result is also consistent with hypothesis 3. In
model 5, the results of the other models are confirmed with all the variables present, i.e., the
results supporting hypothesis 3 are robust to simultaneous inclusion of all of the variables.
6. Additional robustness tests
In this section we examine robustness of our results to two changes in specifications of
our tests, related to substitution of alternative tax aggressiveness measures and related to the
effect of financially distressed firms and low-growth firms on the results.
6.1 Alternative tax aggressiveness measures
Several different versions of effective tax rate have been used in prior studies to measure
tax aggressiveness. Dyreng, Hanlon and Maydew (2007) and Blouin and Tuna
(2006) use the cash effective tax rate, CETR, which is the ratio of tax payments to pre-taxable
income. Chen et. al (2007) use the effective tax rate (ETR) as well as the Dyreng et al. (2007)
Page 19
19
CETR measure, where ETR is based on total tax expense divided by pretaxable income.
16
We
test the sensitivity of our results to use of these alternative measures by redefining the Tax_agg
variable based on ETR and CETR. Results are shown in Table 5.
The first column of Table 5 corresponds to the Model 5 results in Table 3. The models
are then estimated with ETR substituted for CurETR and with CETR substituted for CurETR in
the regression. The results in the second and third column of Table 5 are very similar to the
results in the first column. In particular, the magnitude and sign of the coefficients on the
interaction variables are very consistent for all three regressions. Based on this result, we
conclude that our results are not sensitive to the definition of the ETR measure used to identify
tax aggressiveness.
6.2 Effect of financial distress
An extensive body of prior research supports the conclusion that the earnings- returns
relationship is systematically different for profit and loss firms. Hayn (1995) finds that including
loss firms in cross-sectional returns-earnings regressions results in lower estimated earnings
response coefficient and reduced explanatory power of the model. Similarly, Burgstahler and
Dichev (1997) show that in regressions of market values on earnings and other value-relevant
factors, the weight attached to earnings for loss firms is not significantly different from zero.
Joos and Plesko (2005) build on the prior results in Hayn (1995) by examining the components
of earnings for categories of loss firms, finding evidence that for transitory loss firms, investors
16
Chen et. al (2007) also use two measures based on book-tax differences, specifically measures proposed by
Manzon and Plesko (2002) and Desai and Dharmapala (2006). Chen et al. (2006) use these measures as the
dependent variables in regressions that have lagged book-tax differences as a control variable. When we substituted
these book-tax measures for CurETR as independent variables in our tests, the resulting regressions had low R
2
and
generally inconsistent coefficients (between the two book-tax measures), suggesting that these measures are noisier
than the ETR-based measures when used in our setting..
Page 20
20
ignore negative accruals, correctly interpreting such accruals as being transitory and therefore
not value-relevant. Dopuch, Seethamraju and Xu (2005) find that the persistence of the accruals
portion of earnings is significantly greater for profit firms than for loss firms, that accruals are
priced differently for profit and loss firms, and that the well-known accruals-overpricing
anomaly documented in Sloan (1996) is restricted primarily to profitable firms (i.e, the mostly
negative accruals of loss firms tend to be correctly priced or even underpriced).. Similarly,
Melendrez, Schwartz and Trombley (2007) find that when earnings are separated into accruals
and cash flows, unexpected cash flows have greater persistence than unexpected accruals, and
that this difference is driven primarily by loss firms.
Based on this prior research it seems likely that the information content of book income
and taxable income may differ systematically between profit and loss firms. Accordingly, we
repeat the Table 3 and Table 4 tests for reduced samples which include only profitable firms.
We also extend this analysis by excluding firms with low market-to-book ratios, since these
firms are most likely to have losses or other symptoms of financial distress. The results of these
reduced sample tests are shown in Table 6.
We first compare the full-sample Table 3 model to the Table 3 model excluding loss
firms. Consistent with Hypothesis 1, the coefficient on TI*Tax_agg remains negative, and
consistent with Hypothesis 2, the coefficient on PTBI*Low_Quality also remains negative. The
cross effect between book income and tax aggressiveness (PTBI*Tax_agg) remains strongly
negative as well, consistent with the Hypothesis 3 prediction and indicating that the
informativeness of book income is reduced by the presence of aggressive tax planning.
However, the cross effect between taxable income and earnings quality (TI*Low_Quality) is
not significant when loss firms are excluded. The finding that this cross effect was negative was
Page 21
21
the weakest result in Table 3, and it was apparently generated by the inclusion of loss firms in
the sample. The explanatory power of the Table 4 models, indicated by adjusted R
2,
nearly
doubles from 7.9% to 14.9% when the loss firms are excluded. It appears that the loss firms
introduce substantial noise in this regression as well as producing the unreliable cross-effect
result between taxable income and earnings quality.
The sign and statistical significance of coefficients in the Table 4 results are essentially
unchanged when loss firms are excluded. However, the adjusted R
2
increases from 6.1% to
13.7% when the loss firms are excluded, again consistent with loss firms adding noise to the
model.
An alternative approach to considering financial distress is to focus on market-to-book
ratio. Fama and French (1992) find that firms that have low market-to-book ratios tend to have
poor accounting performance measures, e.g., low ratios of earnings to assets. These poor-
performing firms are also firms most likely to exhibit financial distress, and Fama and French
(1993) suggest that the well-known market-to-book return effect is related to the risk of distress
of low market-to-book firms. In addition, Collins and Kothari (1989) and Black (1998) find that
the earnings of low-growth firms are less informative than the earnings of growth firms, and the
book-to-market ratio may also capture this effect. We assess the sensitivity of our results to the
presence of financially distressed and low growth firms by removing the 25% of firms with the
lowest market-to-book ratios each year from our sample. These results are also shown in Table 6.
For both the Table 3 and Table 4 regression models, the results are substantially unchanged from
the full sample results. Further, the adjusted R
2
is not substantially changed when low market-to-
book firms are excluded. These results suggests that financial distress and growth, considered
separately from the presence of losses, does not seem to have any effect on the relative
Page 22
22
information content of book and taxable income or on the relation between relative information
content, tax aggressiveness, earnings quality, and voluntary book-tax conformity.
7. Conclusion
This paper examines the effect of tax planning and earnings management on the relative
informativeness of book income and taxable income. We conduct two sets of tests documenting
(1) the incremental effect of tax planning and earnings quality on the relative informativeness of
book and taxable income and (2) the relation between voluntary book-tax conformity and the
relative informativeness of book and taxable income.
Based on the results of our tests of the effect of tax planning and earnings management
on the relative informativeness of book and taxable income, we conclude that high tax planning
firms have relatively less informative taxable income than low tax planning firms, controlling for
earnings management, and that high-earnings-management firms have less informative book
income than low-earnings-management firms, controlling for tax planning. We also find a
consistent cross effect for book income and tax planning, i.e., the informativeness of book
income is reduced by the presence of aggressive tax planning. Although the cross effect between
taxable income and earnings management appears in our full sample, it disappears in a reduced
sample that excludes loss firms, so we conclude that the informativeness of taxable income
essentially unchanged by earnings management behavior. These results contrast with Ayers et
al. (2006), who find that the information content of taxable income to relative book income is
significantly lower for high tax planning firms (consistent with our results) and significantly
higher for low earnings quality firms (not consistent with our results). Thus, our research design,
Page 23
23
which examines the effect of both tax planning and earnings quality on earnings informativeness,
results in a different conclusion than the Ayers et. al (2006) study.
The second contribution of the paper is our focus on voluntary book-tax conformity, a
cross-sectional construct summarizing the firm’s earnings management and tax planning choices.
This notion of conformity contrasts with prior research (e.g., Hanlon, Maydew and Shevlin,
2006) which has focused on statutory conformity. Our finding that greater voluntary conformity
increases information content appears to be in contrast to Hanlon, Maydew and Shevlin (2006),
who find that increased book-tax conformity leads to a reduction in informativeness of book
income. However, these results are not inconsistent because the source of differences in
conformity is different between the two studies. In Hanlon, Maydew and Shevlin (2006) the
time-series change in conformity is driven by the addition of accounting accruals to what was
previously cash-basis income reporting for tax purposes. This type of change in book-tax
conformity encourages a reduction in reported income to save on taxes. In our study, cross-
sectional differences in voluntary conformity are due to the absence or presence of tax planning
and earnings management. This type of difference may not necessarily lead to a negative bias in
reported income. In light of the difference in results between our study and Hanlon, Maydew
and Shevlin (2006) it appears that the effect of changes or differences in conformity on the
informativeness of book income may depend on the nature of the change or difference.
Page 24
24
References
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Effects of Tax Planning and Earnings Quality,” Working paper, University of Georgia
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Blouin, J. and I. Tuna, 2006, “Tax contingencies: Cushioning the blow to earnings?” Working
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Burgstahler, D., and I. Dichev, 1997, “Earnings, Adaptation and Equity. Value,” The Accounting
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Dopuch, N., C. Seethamraju and W. Xu, 2005, “The Pricing of Accruals for Profit and Loss
Firms" Working paper, Washington University
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have large book-tax differences," The Accounting Review 80(1): 137-166.
Hanlon, M., E. L. Maydew, and T. Shevlin, 2006, "Book-tax conformity and the information
content of earnings in a U.S. Setting", Working paper, University of Michigan,
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of conforming book income and taxable income." Journal of Law and Economics
XLVIII: 407-442.
Hanlon, M. and J. Slemrod, 2007, "What does tax aggressiveness signal? Evidence from stock
price reactions to news about tax aggressivenss," Working paper, University of Michigan.
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Hayn, C., 1995, “The information content of losses,” Journal of Accounting & Economics 20:
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Kothari, S. P., A. J. Leone and C. E. Wasley, 2005, “Performance matched discretionary accrual
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Scholes, M., M. Wolfson, M. eriskson, E. Maydew, and T. Shevlin, 2004, Taxes and Business
Strategy: A Planning Approach, 3rd Edition, Upper Saddle River, NJ: Prentice Hall.
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Page 27
27
Table 1
Descriptive Statistics
Panel A: Statistics for full sample
Variable N mean 25% 50% 75%
Assets
60,636 $2,035.17 $21.120 $115.071 $629.347
Pre-tax Book Income
60,636 $127.968 $-2.445 $1.770 $32.296
PTBI
60,636 -0.070 -0.083 0.034 0.111
Taxable Income
60,619 $115.028 $-0.002 $1.757 $28.514
TI
60,619 0.004 -0.0000 0.024 0.103
CurETR
60,636 0.187 0.0 0.167 0.332
ρ(PTBI,TI)
53,101 0.488 0.192 0.682 0.908
M/B
56,066 2.600 0.946 1.765 3.215
Panel B: Statistics for subgroups
Tax_agg
Low_Quality Conformity
Variable N 0 1 t(diff) 0 1 t(diff) 0 1 t(diff)
Assets
60,636 3011.7 1230.3 15.38 2575.4 1816.2 6.34 2406.3 2259.4 1.11
Pre-tax Book Income
60,636 229.7 25.1 22.77 171.0 101.6 7.54 136.8 157.1 -1.97
PTBI
60,636 0.090 -0.121 72.86 0.024 -0.036 21.22 -0.024 0.031 -1.70
Taxable Income
60,619 200.3 26.2 7.90 170.7 69.8 4.09 104.9 150.3 -1.63
TI
60,619 0.086 -0.048 22.31 0.058 -0.009 11.70 0.011 0.042 -4.90
CurETR
60,619 0.598 -0.253 17.77 0.228 0.195 0.67 0.180 0.259 -1.41
ρ(PTBI,TI)
53,101 0.607 0.394 43.86 0.538 0.489 10.08 0.118 0.874 22.74
M/B
56,066 2.63 2.73 -0.98 2.79 2.54 2.59 2.70 2.66 0.49
Assets is current year total assets, Pre-tax book income is pre-tax book income minus minority interest. PTBI is pre-tax book income scaled by the
beginning-of-year total assets. Taxable income is current federal income expense plus current foreign tax expense, divided by the top U.S. statutory tax
rate for a given year, minus the change in net operating loss carryforwards. If current federal income expense is missing, taxable income is the difference
between total income tax expense and deferred taxes, divided by the top U.S. statutory tax rate for the year, minus the change in net operating loss
carryforwards. TI is taxable income scaled by beginning-of-year total assets. CurETR is the sum of five year (t-4 to t) total tax expense minus the sum of
the same period deferred tax expense, divided by the sum of the same period pre-tax book income. ρ(PTBI,TI) is the book-tax conformity measure,
which is based on the rolling five year PTBI and TI. Low_Quality is an indicator variable with the value of 1 if for a given year, a firm's discretionary
total accruals is above the median for the firm’s industry group, and 0 otherwise. Tax_agg is a dummy variable with the value of 1 if a firm's stimated
tax rate (CurETR) is below the median industry (two-digit SIC) CurETR for the year and 0 otherwise. Conformity is an indicator variable with the value
of 1 if a firm’s ρ(PTBI, TI) is above the median for the firm’s industry group. M/B is market-to-book ratio.
Page 28
28
Table 2
Frequency Count of Earnings Quality and
Book-Tax Conformity Conditioned on Tax Aggressiveness
Tax
Aggressiveness
Tax
Aggressiveness
Low High Low High
Low 12,622 17,443 Low 10,561 16,990 Earnings
Quality
High 16,908 13,484
Book-tax
Conformity
High 16,769 11,096
Tax aggressiveness is based on the ranking of current effective tax rate (CurETR) for a given
year within the same industry group (two-digit SIC). If a firm's CurETR is below the industry
median CurETR , then the firm is designated as "low" in terms of tax aggressiveness (equivalent
to “high” in terms of tax planning), otherwise, it is designated as "high" (“low” in terms of tax
planning). Earnings quality is based on the discretionary component of total accruals (PTDA). If
a firm's PTDA is above the median within the same industry group, then the firm is designated as
"low" in terms of earnings quality (“high” in terms of earnings management), otherwise, it is
designated as "high" (“low” in terms of earnings management). The measure of book-tax
conformity is ρ(PTBI,TI), which is based on the rolling five year PTBI and TI. For a
given year, if a firm's ρ(PTBI,TI), is above the industry median, then the firm is designated as
"high" in book-tax conformity, otherwise, it is designated as "low".
Page 29
29
Table 3
Regression Tests of the Relation between Information Content of Book and Taxable Income,
Earnings Quality, and Tax Planning (N=47,590)
Pred.
sign Model 1 Model 2 Model 3 Model 4 Model 5 Model 6
PTBI
(+) 0.35 0.35 0.51 0.50 1.56 1.51
(26.54) (26.82) (27.43) (26.98) (43.05) (42.24)
TI (+) 0.01 0.01 0.17 0.16 0.18 0.18
(2.90) (2.81) (12.22) (11.87) (13.46) (13.13)
Low_Quality
(-) -0.03 -0.03 -0.03
(-4.44) (-3.88) (-3.68)
Tax_agg
(-) -0.08 -0.07 -0.06
(-11.11) (-10.26) (-8.25)
PTBI *Low_Quality (-) -0.32 -0.29 -0.30 -0.28
(-12.08) (-11.17) (-11.54) (-10.78)
PTBI *Tax_agg (-) -1.23 -1.21
(-33.63) (-32.98)
TI *Low_Quality (-) -0.04 -0.04
(-4.16) (-4.12)
TI *Tax_agg (-) -0.17 -0.16 -0.16 -0.15
(-11.76) (-11.43) (-10.89) (-10.63)
Adj R
2
0.052 0.056 0.057 0.060 0.079 0.081
The dependent variable in each regression is Adj.RET, the buy-and-hold market adjusted return
for a firm's common stock over the 16-month return window which starts at the beginning of a
fiscal year and ends four months after the beginning of the following fiscal year. PTBI is pre-tax
book income scaled by the beginning-of-year total assets. TI is taxable income scaled by
beginning-of-year total assets. Low_Quality is an indicator variable with the value of 1 if for a
given year, a firm's discretionary total accruals is above the median for the firm’s industry group,
and 0 otherwise. Tax_agg is a dummy variable with the value of 1 if a firm's estimated tax rate
(CurETR) is below the median CurETR for a given year within the firm’s industry group (two-
digit SIC), and 0 otherwise. Annual intercepts were included in the model but are not shown in
the table. t-statistics are shown in brackets.
Page 30
30
Table 4
Regression Tests of the Effect Book-Tax Conformity on Information Content of Book and
Taxable Income, 1993-2005 (N=43,082)
The dependent variable in each regression is Adj.RET, the buy-and-hold market adjusted return
for a firm's common stock over the 16-month return window which starts at the beginning of a
fiscal year and ends four months after the beginning of the following fiscal year. Year is PTBI is
pre-tax book income scaled by the beginning-of-year total assets. TI is taxable income scaled by
beginning-of-year total assets. Conformity is an indicator variable with the value of 1 if a firm’s
ρ(PTBI, TI) is above the median for the firm’s industry group. Annual intercepts were
included in the model but are not shown in the table. t-statistics are shown in brackets.
Pred.
Sign Model 1 Model 2 Model 3 Model 4 Model 5
PTBI
(+) 0.40 0.26 0.26
(28.21) (14.06) (14.08)
TI (+) 0.02 -0.00 0.00
(4.07) (-0.08) (0.70)
PTBI *Conformity (+) 0.33 0.31
(11.60) (10.66)
TI *Conformity (+) 0.09 0.03
(9.25) (3.29)
Adj R
2
0.058 0.061 0.041 0.043 0.061
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31
Table 5
Regression Tests of the Relation between Information Content of Book and Taxable Income,
Earnings Quality, and Tax Planning Using Alternative Measures of Tax Agressiveness
Tax_Agg based on
Pred.
sign
CurETR
ETR
CETR
PTBI
(+) 1.56 2.23 2.50
(43.05) (40.84) (39.24)
TI (+) 0.18 0.35 0.31
(13.46) (9.56) (6.93)
PTBI *Low_Quality (-) -0.30 -0.47 -0.96
(-11.54) (-10.68) (-14.11)
PTBI *Tax_Agg (-) -1.23 -1.41 -0.31
(-33.63) (-24.49) (-4.30)
TI *Low_Quality (-) -0.04 -0.14 -0.16
(-4.16) (-5.09) (-4.25)
TI *Tax_Aggressive (-) -0.16 -0.17 -0.07
(-10.89) (-5.04) (-1.92)
N 47,590 34,636 30,169
Adj R
2
0.079 0.130 0.166
The dependent variable in each regression is Adj.RET, defined in Tables 3 and 4. Other variables
are also defined in Tables 3 and 4. Tax_agg is a dummy variable with the value of 1 if a firm’s
tax rate (CurETR, ETR, or CETR) is below the median tax rate for a given year within the firm’s
industry group (two-digit SIC), and 0 otherwise. CurETR is the sum of five year (t-4 to t) total
tax expense minus the sum of the same period deferred tax expense, divided by the sum of the
same period pre-tax book income. ETR is the sum of five year (t-4 to t) total tax expense,
divided by the sum of the same period pre-tax book income. CETR is the sum of five year (t-4
to t) cash taxes paid, divided by the sum of the same period pre-tax book income. Annual
intercepts were included in the model but are not shown in the table. t-statistics are shown in
brackets.
Page 32
32
Table 6
Reduced Sample Regression Tests of the Relation between Information Content of Book and
Taxable Income, Earnings Quality, Tax Planning, and Book-Tax Conformity
Table 3 Regressions (Model 5) Table 4 Regressions (Model 5)
Pred.
sign
Full
Sample
Exclude
Loss Firms
Exclude
Low M/B
Firms
Full
Sample
Exclude
Loss Firms
Exclude
Low M/B
Firms
PTBI
(+) 1.56 2.79 1.76 0.26 1.34 0.36
(43.05) (46.41) (41.19) (14.08) (28.37) (14.45)
TI (+) 0.18 0.15 0.23 0.00 0.02 0.00
(13.46) (4.83) (14.93) (0.70) (1.36) (0.61)
PTBI *Conformity (-) 0.31 0.43 0.22
(10.66) (6.31) (6.39)
TI *Conformity (-) 0.03 0.18 0.04
(3.29) (5.14) (3.29)
PTBI *Low_Quality (-) -0.30 -0.76 -0.33
(-11.54) (-12.35) (-10.31)
PTBI *Tax_agg (-) -1.23 -1.27 -1.36
(-33.63) (-19.29) (-30.86)
TI *Low_Quality (-) -0.04 0.01 -0.03
(-4.16) (0.54) (-3.05)
TI *Tax_agg (-) -0.16 -0.16 -0.20
(-10.89) (-5.39) (-12.67)
N 47,590 31,602 37,442 43,082 29,242 43,082
Adj R
2
0.079 0.149 0.082 0.061 0.137 0.060
The dependent variable in each regression is Adj.RET, defined in Tables 3 and 4. Other variables
are also defined in Tables 3 and 4. Annual intercepts were included in the model but are not
shown in the table. t-statistics are shown in brackets.
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    • "Consistently, previous studies on earnings quality (e.g. Barth, Landsman, and Lang, 2008; Chen, Dhaliwal, and Trombley, 2007; Van Tendeloo and Vanstraelen, 2005) use the term 'earning quality' to denote the absence of earnings management. In addition, Levitt (1998) mentioned that when earnings management is on the rise, the quality of financial reporting is on the decline. "
    [Show abstract] [Hide abstract] ABSTRACT: This paper reviews prior studies that provide an understanding of earnings quality concepts. It presents various definitions of earnings quality and discusses proxies used in empirical literature to measure earnings quality. Prior studies measure earnings quality by using time-series properties of earnings including earnings persistence, predictability, timeliness and volatility; relating accruals to future cash flows, associating earnings with stock market metrics such as stock prices and returns and assessing the level of discretionary accruals. The literature emphasizes that the quality of earnings is very important as the earnings figure is widely used in many contractual agreements and investing decisions.
    Full-text · Article · Aug 2014
    • "According to the financial accounting rules, revenue is recognized when the criteria for this recognition are satisfied, and expenses are recognized when incurred or at the same time as the related revenues. In general, the time of receipt or the flow of payments is irrelevant to the moment of recognition for purposes of financial accounting (Chen, Dhaliwal & Trombley, 2007). The objectives of tax and financial accounting are also different. "
    [Show abstract] [Hide abstract] ABSTRACT: This article analyzes the information content of taxable income in relation to book income in Brazil before and after the Transition Tax Regime (RTT), which was established as of calendar year 2010 to neutralize the tax effects of convergence of the country’s accounting standards to IFRS. We define informativeness as the ability to cause changes in stock prices. Our sample is composed of firms listed on the BM&FBovespa between 2005 and 2011. The results indicate greater informativeness of taxable income in relation to book income in the sample as a whole. Despite the advent of the RTT and the process of convergence to international accounting standards, the informative content of taxable income continued being more significant than book income after this advent, although the relative difference fell.
    Full-text · Article · Nov 2013 · The International Journal of Accounting
    • "Similar to prior capital market studies (e.g., Hanlon et al., 2008; Chen et al., 2007), we use the following model to test the potential impacts of ABTDs and NBTDs on the earnings-returns relation: "
    [Show abstract] [Hide abstract] ABSTRACT: Prior studies document that book-tax differences (BTDs) reflect divergent reporting rules for book and tax purposes, and contain information about earnings management and tax planning. In this paper we investigate whether the regulatory and opportunistic information impounded in BTDs differentially influences earnings persistence and the earnings-returns relation. Using BTD data from China, we separate BTDs into normal BTDs (NBTDs) and abnormal BTDs (ABTDs). NBTDs are more likely driven by regulatory differences between accounting and tax rules and ABTDs are more likely driven by earnings and tax management activities. We find that firms with large positive and negative ABTDs (NBTDs) exhibit less earnings persistence compared to firms with small ABTDs (NBTDs). However, the level of earnings persistence for large unsigned ABTD firms is significantly lower than that for large unsigned NBTD firms. While large unsigned NBTDs appear to enhance the earnings-returns relation, we find no evidence that large unsigned ABTDs affect the earnings-returns relation. Overall, the results suggest that the differing components of BTDs have differential implications for earnings quality. Additional tests show that ABTDs and NBTDs can provide incremental information about earnings persistence beyond the information in discretionary accruals and total accruals, suggesting that the investigation of BTDs adds value to financial analysis.
    Full-text · Article · Sep 2012
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