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Journal of Accounting and Economics 50 (2010) 111125

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Journal of Accounting and Economics


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Book-tax conformity, earnings persistence and the association between earnings and future cash ows$
T.J. Atwood a, Michael S. Drake b, Linda A. Myers c,
a b c

Florida State University, USA The Ohio State University, USA University of Arkansas, Business Building 401, 1 University of Arkansas, Fayetteville, AR 72703, USA

a r t i c l e in fo
Article history: Received 1 November 2007 Received in revised form 22 September 2009 Accepted 5 November 2009 Available online 12 November 2009 JEL classication: H2 M4 M40 M41 M44 Keywords: Book-tax conformity Book-tax differences Usefulness of earnings Earnings persistence Future cash ows

abstract
Calls for eliminating differences between accounting earnings and taxable income in the US have been debated extensively. Proponents of increased book-tax conformity argue that tax compliance will increase and earnings quality will improve. Opponents argue that earnings quality will decline. We examine whether the level of required book-tax conformity affects earnings persistence and the association between earnings and future cash ows. We develop a comprehensive book-tax conformity measure and nd that earnings have lower persistence and a lower association with future cash ows when conformity is higher. Our evidence suggests that increased book-tax conformity may reduce earnings quality. Published by Elsevier B.V.

1. Introduction Potential benets and costs from increasing the required conformity between reported earnings and taxable income have been debated in the United States (US) for more than half a decade. Proponents suggest that increased book-tax conformity will simultaneously reduce aggressive nancial reporting and abusive corporate tax sheltering, thereby improving earnings quality and increasing tax compliance (Desai, 2005; Whitaker, 2006; Joint Committee on Taxation, 2006). Opponents argue that the information required by nancial statement users is substantially different from that required by taxing authorities, and because Congress (rather than an independent body like the Financial Accounting

$ We especially thank S.P. Kothari (the editor), and Ed Maydew for helpful comments and suggestions. We also thank Michelle Hanlon, James Myers, Tom Omer, Terry Shevlin, and workshop participants at Florida State University, Texas A&M University, and the University of North Texas. Linda Myers gratefully acknowledges nancial support from the PricewaterhouseCoopers Faculty Fellowship while at Texas A&M University. Michael Drake gratefully acknowledges nancial support from the Deloitte & Touche Foundation. Corresponding author. Tel.: + 1 479 575 5227. E-mail address: lmyers@walton.uark.edu (L.A. Myers).

0165-4101/$ - see front matter Published by Elsevier B.V. doi:10.1016/j.jacceco.2009.11.001

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Standards Board) is likely to control rule-making, increased book-tax conformity will lower earnings quality (Hanlon et al., 2005; Hanlon et al., 2008). We contribute to this debate by examining whether the degree of required book-tax conformity across countries affects earnings persistence and the association between earnings and future cash ows. According to proponents, increasing required book-tax conformity in the US will limit opportunistic management behavior, allow taxing authorities to act as additional monitors of reported prots, and allow shareholders to observe taxes paid, making the overall economic performance of rms more transparent (Desai, 2005). These arguments suggest that current earnings will be less (more) persistent and less (more) closely associated with future cash ows in countries with lower (higher) book-tax conformity. Opponents argue that, if required book-tax conformity is increased, tax policymakers will interfere in the standard-setting process, eroding the quality of earnings reported to investors (Shackelford, 2006). This argument suggests that current earnings will be more (less) persistent and more (less) closely associated with cash ows in countries with lower (higher) book-tax conformity. We suggest that rms operating in countries with lower required book-tax conformity will report greater book-tax differences, resulting in more unexplained cross-sectional variation in current tax expense. Thus, we infer the degree of required book-tax conformity in a country from the amount of observed variation in current tax expense that cannot be explained by the variation in pre-tax earnings, income from foreign operations, and dividends. This approach allows us to estimate the degree of required book-tax conformity on a country-by-country basis.1 This approach also allows for continuous differences in the degree of book-tax conformity and for changes in the degree of book-tax conformity over time.2 We nd that the one-year-ahead persistence of current earnings decreases as book-tax conformity increases. Furthermore, the association between current earnings and one-year-ahead future cash ows decreases as book-tax conformity increases. These ndings are robust to the inclusion of a control variable for cross-country variations in institutional and accounting structures (developed from a factor analysis using country-specic legal tradition, investor rights, and ownership concentration as components), as well as controls for characteristics of the rms economic environment (i.e., product type, barriers-to-entry, and capital intensity) which are associated with industry membership, for variability in pre-tax earnings, for statutory tax rates, and for xed differences in earnings persistence across countries. Thus, we conclude that higher book-tax conformity is associated with lower earnings persistence and a lower association between current earnings and future cash ows. Our study supports the position of those opposing increases in the required level of conformity between earnings and taxable income in the US (i.e., Hanlon et al., 2005, 2008; Shackelford, 2006). The primary benet of lower book-tax conformity is that it provides managers with the exibility to convey information about rm performance without incurring tax penalties. The primary costs are the additional compliance burden3 and the potential for manager opportunism. Our results suggest that earnings quality (dened as earnings persistence and the association between current period earnings and future cash ows) is lower when book-tax conformity is higher, even though conformity may restrain managers from using their discretion to report earnings opportunistically. We interpret this result as an indication that the benets derived from allowing all managers the exibility to convey their private information may outweigh the potential costs incurred if some managers choose to use their discretion to report opportunistically. Our study also contributes to the literature on international differences in the properties of accounting earnings. Ali and Hwang (2000) provide evidence that earnings are less value relevant when book-tax conformity is high, and Lang et al. (2009) suggest that managers smooth earnings less when the link between nancial and tax income is weaker. Other studies nd no effect of book-tax conformity on differences in the properties of earnings across countries (Hung, 2001; Leuz et al., 2003) or do not specically test for effects of book-tax conformity (Ball et al., 2000; DeFond et al., 2007). Our results suggest that book-tax conformity is an important determinant of the properties of accounting earnings, and that book-tax conformity should be considered in the design of cross-country studies. Finally, we contribute a new, comprehensive book-tax conformity measure to the literature. Our book-tax conformity measure includes more countries, can be easily calculated from publicly available data, allows for a continuum of book-tax conformity levels, and allows for changes in the level of book-tax conformity over time. Moreover, this measure is more powerful than those used in prior studies.4 The remainder of this paper is organized as follows. Section 2 discusses prior literature and develops our hypotheses. Section 3 describes our research design. Section 4 discusses sample selection, descriptive statistics, and test results.

1 Prior studies use an indicator variable based on subjective judgments made from information contained in summaries of international tax policies for high versus low book-tax conformity (see, for example, Ali and Hwang, 2000; Hung, 2001; Leuz et al., 2003; Lang et al., 2009). 2 Testimony before the US Senate Committee on Homeland Security and Governmental Affairs suggests that the degree of book-tax conformity in other countries has changed over time (Desai, 2007). 3 Hanlon and Shevlin (2005) nd that revenues of the Big Four accounting rms were approximately 3% of earnings reported by all Standard & Poors (S&P) 500 rms in 2003. This excludes the cost of in-house tax departments and information systems used to track potential tax accounting effects. Proponents argue that these costs will decrease substantially if rms report essentially the same numbers for tax and nancial reporting purposes. 4 Specically, our book-tax conformity measure subsumes the explanatory power of the traditional indicator variable measure in explaining earnings persistence and the association between earnings and future cash ows.

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Section 5 considers the effects of differences in institutional and accounting structures across countries, and Section 6 presents results of additional analyses. Section 7 concludes. 2. Prior literature and development of hypotheses Discussions about the potential benets and costs of required book-tax conformity often address whether the degree of book-tax conformity affects the quality of accounting earnings and/or the amount of information conveyed by accounting earnings. Proponents of conformity argue that the quality (or informativeness) of accounting earnings will improve if book-tax conformity increases, while opponents argue that the quality (or informativeness) of accounting earnings will deteriorate with increased conformity. 2.1. Alleged effects of book-tax conformity Among the proponents, Desai (2005) argues that low book-tax conformity has contributed to the degradation of reported prots because managers engage in transactions that are designed to exploit book-tax differences for the dual purposes of manipulating reported prots and avoiding tax payments. This degradation of reported prots is purported to be evidenced by the growing gap between accounting earnings and taxable income, by increases in revisions to estimated prots recorded in the National Income and Product Accounts generated by the Bureau of Economic Analysis, and by the declining value-relevance of earnings. Proponents generally assert that increasing book-tax conformity simultaneously provides incentives for managers to reduce tax avoidance and to report accounting earnings less aggressively, which will result in improved earnings quality (Yin, 2001; Desai, 2005; Joint Committee on Taxation, 2006; Whitaker, 2006). Opponents of increased book-tax conformity argue that high book-tax conformity will result in lower quality (or less informative) accounting earnings (Hanlon and Shevlin, 2005; Hanlon et al., 2005, 2008; Plesko, 2006; Shackelford, 2006). They argue that the information required by taxing authorities differs from that required by other stakeholders. Specically, the tax system is designed to meet the governments goals of raising revenue, providing economic incentives or disincentives for taxpayers to engage in particular activities, and rewarding particular constituencies. In contrast, accounting earnings provides information about rm performance and is intended to reduce information asymmetries between management and outside stakeholders. Thus, the accounting system is designed to allow managers exibility in conveying information to the market (Hanlon et al., 2005; Shackelford, 2006). As a result of these different goals, opponents argue that increasing book-tax conformity will reduce the quality of information available to investors and other nancial statement users because it may lead Congress to interfere in the standard-setting process. 2.1.1. Earnings quality: US evidence Prior research addressing the relation between book-tax conformity and earnings informativeness in the US includes Guenther et al. (1997) and Hanlon et al. (2008). These studies examine a small sample of rms that were required, under the Tax Reform Act of 1986, to change from the cash method to the accrual method for tax purposes. These two studies provide evidence that the required change caused these rms to defer income for nancial reporting purposes and resulted in accounting earnings that were less informative as measured by long-window earnings response coefcients. The authors attribute this result to the change from the cash method to the accrual method, which substantially increased book-tax conformity. However, the differences reported in these studies may represent temporary reductions in accruals, intended to partially offset the cumulative adjustments taken into taxable income in those years, rather than permanent changes in the quality of accounting earnings.5 Furthermore, the samples in these studies are small, consisting of an unusual set of rms that issued accrual method nancial statements but used the cash method for tax purposes. Thus, the result that increased book-tax conformity reduces earnings informativeness may not generalize to a broader set of rms. In another study addressing the relation between book-tax conformity and earnings informativeness, Hanlon et al. (2005) examine the information content of reported accounting earnings and taxable income (estimated from the current tax expense adjusted for net operating loss carryforwards). They nd that signicantly more of the variation in longwindow returns is explained by accounting earnings than by estimated taxable income, but both income measures exhibit signicant incremental explanatory power. They suggest that if accounting earnings were conformed to taxable income, the explanatory power of earnings would be reduced by approximately 50%.6 2.1.2. Earnings quality: international evidence Studies examining the value-relevance of accounting earnings across countries provide mixed evidence on the effects of book-tax conformity. Ali and Hwang (2000) provide evidence that accounting earnings are less value relevant in countries
5 Guenther et al. (1997) and Hanlon et al. (2008) compare mean nancial ratios and long-window earnings response coefcients, respectively, preversus post-change. However, the cumulative difference between the methods was generally taken into taxable income over 36 years (Rev. Proc. 8537, 1985-2 C.B. 438). Thus, the income deferral and loss of informativeness in the post-change period may result from management efforts to partially offset the taxable portion of the cumulative adjustment in those years. 6 Our conclusions are consistent with Hanlon et al. (2005) but they examine earnings incremental explanatory power for returns and their sample consists of exclusively of US companies, so the level of required book-tax conformity is consistent for all rms in their sample.

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with high book-tax conformity than in countries with low book-tax conformity. In contrast, Hung (2001) nds no signicant difference in the value-relevance of accounting earnings and book values of equity in countries with high book-tax conformity versus countries with low book-tax conformity. Similarly, studies examining earnings management across countries provide mixed evidence regarding the impact of book-tax conformity. Lang et al. (2009) suggest that rms in countries with lower book-tax conformity engage in less income smoothing, while Leuz et al. (2003) nd no signicant relation between book-tax conformity and earnings management. 2.2. Our contribution We contribute to the literature on the effects of book-tax conformity by introducing a new measure of book-tax conformity and by examining whether book-tax conformity is associated with cross-country differences in earnings persistence and with the association between earnings and future cash ows. The Financial Accounting Standards Boards conceptual framework suggests that the primary focus of nancial reporting is on information about an enterprises performance as provided by earnings measures, because earnings measures are generally better indicators of rm performance than is information about current cash receipts and payments (Statement of Financial Accounting Concepts No. 1, (FASB,1978, Con 1) paragraphs 43 and 44).7 Moreover, information about earnings should be helpful to users in assessing the amounts, timing, and uncertainty of future cash ows (Statement of Financial Accounting Concepts No. 1, paragraph 43). Thus, an important property of accounting earnings is its usefulness for predicting future earnings and future cash ows. We focus on cross-country differences in book-tax conformity because we are interested in the effects of required booktax conformity (i.e., the extent to which managers are allowed to report accounting earnings that differ from taxable income). Studies that focus on book-tax differences within the US (e.g., Hanlon et al., 2005; Chen et al., 2007; Ayers et al., 2009) examine cross-sectional differences in managers choices within a country where large differences between accounting earnings and taxable income are allowed. We are concerned with the effects of the amount of discretion that managers are allowed, rather than with the extent to which they use that discretion. 2.3. Hypotheses We suggest an increase in required book-tax conformity may potentially improve or reduce earnings quality. First, an increase in required book-tax conformity may result in changes to nancial accounting rules so that these rules more closely reect legislators tax policy goals. Financial accounting rules are generally based on the conservatism and matching principles whereas tax accounting rules are based on the ability-to-pay principle, with incentives for taxpayers to engage in specic economic activities. Financial accounting requires forward-looking estimates of potential losses and recognizes reserves for bad debts, warranties, self-insurance, asset write-downs, and contingent liabilities to match expenses with revenues and to reect rm performance conservatively. Tax accounting does not allow for these deductions until economic performance occurs (when services or property are provided) or losses are realized. In addition, Congress frequently makes changes to the tax laws. If increased book-tax conformity results in changes to nancial accounting rules to reect Congressional tax policies, the resulting earnings are likely to be less conservative and less consistent over time. Second, an increase in required book-tax conformity may result in a shift in the way in which managers use their discretion in applying the accounting rules, from conveying information about rm performance to minimizing taxes paid. This shift may occur even if tax rules are changed to conform to nancial accounting rules. Because of the incentive to reduce taxes, managers may estimate and record possible future losses more aggressively, potentially resulting in lower earnings quality. Third, managers may engage in fewer costly transactions that produce little or no economic benets to the rm other than exploiting differences between book and tax rules. For example, consider the case of synthetic leases. These are nancial products designed to meet the denition of an operating lease under US Generally Accepted Accounting Principles (GAAP) but they are treated as capital leases for federal income tax purposes. These nancial arrangements distort the companys earnings and balance sheets and are more costly than traditional nancing arrangements (Weidner, 2000; Bergsman, 2002; Kaikati, 2004). If the leasing and consolidation rules were the same for book and tax purposes, these and other similar types of arrangements would not exist, and nancial statements would be more comparable across rms. This would be true whether the nancial rules were conformed to the tax rules or vice versa. Finally, an increase in required book-tax conformity may result in improved earnings quality due to additional monitoring of aggressive nancial reporting by government tax auditors or because managers are unwilling to pay the tax costs of aggressive nancial reporting (Desai, 2007). The overall relation between earnings quality and the degree of book-tax conformity is an empirical question. We address this question by examining earnings persistence and the association between current earnings and future cash ows. We examine earnings persistence because it is often considered to be an indicator of earnings quality or to relate to
7

Consistent with this, Dechow (1994) nds that earnings better predict stock returns than do cash ows.

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the usefulness of earnings (Schipper and Vincent, 2003). Our focus on the association between current earnings and future cash ows is motivated by the FASBs conceptual framework, which suggests that nancial reporting should provide information helpful to users in assessing future cash ows (FASB, 1978, Con 1). Thus, all else equal, higher quality earnings numbers should be more highly associated with future cash ows. We predict that earnings persistence and the association between current earnings and future cash ows will increase with the level of required book-tax conformity if benets from reduced manager opportunism exceed the costs of reduced reporting exibility, as proponents argue. Alternatively, if the costs of restricting managers ability to communicate relevant information exceed the benets from reduced manager opportunism, as opponents argue, earnings persistence and the association between current earnings and future cash ows will decrease with the level of required book-tax conformity. 3. Research design Prior studies examining cross-country differences in the properties of accounting earnings generally do not control for the effects of book-tax conformity or follow an indicator variable approach, where the indicator variable is based on subjective assessments of each countrys book-tax conformity level (e.g., Hung, 2001; Leuz et al., 2003; Lang et al., 2009).8 We rst develop a comprehensive book-tax conformity measure that can vary across countries and within a country over time. We then examine whether a countrys current book-tax conformity level, as derived from this model, is associated with earnings persistence and with the extent to which current earnings are associated with future cash ows. We describe the book-tax conformity measure and the prediction tests below. 3.1. The book-tax conformity measure Our paper focuses on differences in required book-tax conformity (or allowed book-tax nonconformity) across countries. We dene book-tax conformity as the exibility that a rm has to report taxable income (TI) that is different from pre-tax book income (PTBI). Assume that a rm domiciled in Country A with PTBI of $100 has the exibility to report TI anywhere in the range ($90110). Now assume that the same rm if domiciled in Country B would have only the exibility to report TI in the range ($95105). The mean of the range of TIs which the rm could report for the given level of PTBI, E(TI9PTBI), is $100 in both countries. However, the allowed variation in TI for the given level of PTBI, VAR(TI9PTBI), is higher in Country A than in Country B. In other words, for a given level of PTBI, rms in Country B have less exibility to report TI that is farther away from PTBI than do rms in Country A. Assuming that rm managers have incentives to report higher earnings to investors while minimizing taxes paid (which is a basic premise maintained by proponents of increased book-tax conformity in the US), then the variation in reported TI will reect the degree of allowed variation in TI, and thus will reect the amount of required book-tax conformity. Reported TI is generally not publicly available information; however, current tax expense (CTE) in the nancial statements provides an estimate of income taxes currently payable based on expected taxable income. Thus, the allowed variation in TI for a given level of PTBI, VAR(TI9PTBI), can be estimated using the variation in reported CTE for a given level of PTBI, VAR(CTE9PTBI). Similarly, the expected level of TI for a given level of PTBI, E(TI9PTBI), can be estimated using the expected level of CTE for a given level of PTBI, E(CTE9PTBI). Our goal is to develop a measure that reects the level of required book-tax conformity in each country and a measure that is allowed to vary over time (i.e., the measure should reect the extent to which managers must report the same amounts for accounting earnings and taxable income). In a regression of CTE on PTBI, the expected level of CTE for a given level of PTBI is ECTE9PTBI y0 y1 PTBI 1

The coefcient y1 reects the average level of CTE per unit of PTBI. When required book-tax conformity is low, managers may use their discretion to report earnings in book income earlier or later than in taxable income, and the direction of these book-tax differences will vary by rm. For example, one rm may aggressively report higher book accruals to increase earnings to meet earnings expectations, while another rm may conservatively report book accruals to avoid exceeding earnings expectations (thus, banking earnings for future years). These timing differences will reverse at some point in the future. Because of the initiation and reversal of timing differences, rms will report more negative book-tax differences in some years and more positive book-tax differences in other years. In a cross-sectional regression for a given year, the y1 coefcient provides an average of the tax effects of these timing differences (i.e., it is the mean tax effect of the positives and negatives). However, the y1 coefcient does not reect the range of TIs that the rm can report (i.e., the extent to which the rm can report TI that is farther away from PTBI). Instead, the conditional variance of CTE, VAR(CTE9PTBI), provides a measure of the range of CTEs that a rm can report for a given level of PTBI.
8 Hung (2001) constructs the book-tax conformity variable using ve factors derived from international tax and accounting summaries: the existence of deferred taxes; whether additional accelerated depreciation is allowed; whether amortization periods depend on tax laws; whether lease capitalization depends on tax laws; and a subjective determination of the relation between book and tax income. These factors may be suggestive, but many other factors result in differences between accounting earnings and taxable income in countries with low required book-tax conformity.

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In a regression of CTE on PTBI, the conditional variance of CTE is calculated from the residuals as follows: Vare ECTE y0 y1 PTBI2 VARCTE9PTBI 2

The conditional variance of CTE, VAR(CTE9PTBI), is the expected variation in CTE for a given level of PTBI. The root meansquared error, RMSE, from a regression of CTE on PTBI provides an unbiased estimate of the standard error of the regression, SE(CTE9PTBI), which is the square-root of VAR(CTE9PTBI) (Weisberg, 1985, pp. 1213). For this reason, we base our book-tax conformity measure on the RMSE from the following model, estimated by country-year (country and rm subscripts are suppressed, and item numbers refer to the Compustat Global Industrial/Commercial database): CTEt y0 y1 PTBIt y2 ForPTBIt y3 DIVt et 3

where CTE is the current tax expense (Items #2325)9; t the year indicator; PTBI the pre-tax book income (Item #21); ForPTBI the estimated foreign pre-tax book income (foreign tax expense (Item #51)/total tax expense (Item #23) PTBI)10; DIV the total dividends (Item #34)11; and e the error term.12 We divide CTE, ForPTBI, and DIV by average total assets (Item #89) to control for cross-sectional scale differences. We include an estimate of foreign pre-tax book income because foreign earnings of multinationals may be taxed at rates that differ from the domestic statutory rate. We include dividends in the model to control for potential cross-sectional differences in current tax expense that are related to dividend distributions, such as those arising in countries with imputation tax systems and/or dividend surtaxes. For countries with fewer than 8 observations with nonzero values for DIV or ForPTBI in a particular year, we winsorize the nonzero values to zero for that year. The standard error of CTE for a given level of PTBI not explained by the model, SE(CTE9PTBI), provides an indication of the overall amount of discretion that managers have to report earnings that differ from taxable income (either higher or lower). We estimate Model (3) by country-year to allow for changes in tax rates and book-tax conformity across countries and within a country, over time. A higher (lower) RMSE indicates lower (higher) book-tax conformity.13 For our regression analyses, we rank countries each year, based on the Model (3) RMSEs, so that countries with higher rankings in a given year have higher book-tax conformity (i.e., we use descending ranks so that the highest RMSE in the year is ranked 0 and the lowest RMSE in the year is ranked n 1, where n is the number of included countries in that year). We then divide by n 1 to scale these rankings to range between zero and one.14 The resulting scaled rankings are labeled BTaxC. 3.2. Tests for earnings persistence and the association between earnings and future cash ows We test for differences in earnings persistence and the association between earnings and future cash ows across booktax conformity levels using the cross-section of rm-year observations. Specically, we estimate the following models (country and rm subscripts are suppressed): EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt BTaxCt a4 LOSSt a5 EARNt LOSSt a6 EVARt a7 EARNt EVARt a8 SRATEt a9 EARNt SRATEt et CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt BTaxCt b4 LOSSt b5 EARNt LOSSt b6 EVARt b7 EARNt EVARt b8 SRATEt b9 EARNt SRATEt ut 5 where EARN is the net income before extraordinary items (Item #32); t the year indicator; ayear the year xed effects in the future earnings model; BTaxC the scaled descending rank of the RMSE from Model (3); LOSS 1 if pre-tax book income is negative in year t, 0 otherwise; EVAR the scaled descending rank of the standard deviation of PTBI; SRATE the statutory tax
9 More observations in the Compustat Global Industrial/Commercial database have total tax expense (Item #23) and deferred tax expense (Item #25) than current tax expense (Item #24). When total tax expense or deferred tax expense are missing, we use current tax expense, if available. 10 The Compustat Global Industrial/Commercial database does not break pre-tax book income into its domestic and foreign components, nor does it break foreign tax expense into its current and deferred components. Thus, we estimate the foreign percentage of pre-tax book income as foreign tax expense/total tax expense. A limitation of our model is that this ratio over- (under-) estimates the percentage of foreign earnings if the foreign tax rate is higher (lower) than the domestic tax rate. However, we estimated Model (3) without ForPTBI for rms without foreign tax expense and the results are qualitatively similar. 11 For observations with missing values for total dividends (Item #34), we set DIV equal to zero. 12 Graduated tax rates and tax credits could also affect the relation between current tax expense and pre-tax book income but most countries do not have graduated rates or, like the US, the rates are graduated for very small amounts of taxable income. Since we divide CTE by average assets, the impact of graduated tax rates on the variance of CTE/Assets should be very small and we have no reason to believe that they are systematically related to future earnings or cash ows. 13 We also performed our main tests using mean absolute residuals and the difference in the mean residuals for the top and bottom quintiles of rms in each country-year. The results are quantitatively similar. 14 This transformation converts the ranks into percentiles. Because the number of included countries varies by year, this transformation is necessary to ensure that the book-tax conformity variable is scaled consistently across years.

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rate15; e the error term in the earnings persistence model; CFO the cash ows from operations; byear the year xed effects in the future cash ows model; and u the error term in the future cash ows model. We follow Pincus et al. (2007) and calculate CFO as EARN less the change in noncash current assets (Items #60 75) plus the change in current liabilities (#104) less the change in the current portion of long-term debt (#94) plus depreciation (Item #11).16 Accruals are calculated as EARN less CFO. We then scale EARN and CFO by average total assets (Item #89). Model (4) estimates one-year-ahead earnings persistence. EARN BTaxC allows earnings persistence to vary across book-tax conformity levels. A positive (negative) and signicant a3 coefcient suggests that earnings are more (less) persistent when book-tax conformity is higher. Similarly, Model (5) estimates the extent to which current earnings are associated with one-year-ahead cash ows. A positive (negative) and signicant b3 coefcient suggests that earnings are more (less) strongly associated with future cash ows when book-tax conformity is higher. In Models (4) and (5), we control for negative earnings (LOSS) and allow the coefcient on EARN to vary across positive and negative earnings. We do this to control for differences in earnings persistence and the association between earnings and future cash ows across operating gains and losses, which result from the transitory nature of losses (Hayn, 1995; Joos and Plesko, 2005). We also control for earnings variability (EVAR) and for the statutory tax rate (SRATE) to ensure that our book-tax conformity measure is not just reecting differences in the variance of PTBI or in statutory tax rates which exist across countries. To mitigate the inuence of error terms that are correlated across rms and across time, we follow the recommendation in Petersen (2009) by estimating all regression models using ordinary least squares (OLS), using standard errors clustered by rm (Rogers, 1993), and including year xed effects.17 4. Sample selection, descriptive statistics and results 4.1. Sample selection We rst obtain all rm-year observations from 1992 to 2005 with sufcient data available in the Compustat Global Industrial/Commercial le to compute the variables in Models (3)(5).18 We then delete observations in the top or bottom one-half percent of the distributions of CTE, PTBI, ForPTBI, DIV, EARN, or CFO in each year to remove potential outliers.19 We also delete all rm-year observations from countries that do not have at least 40 usable rm-year observations, which is a less stringent data availability criterion than previous research. This sample selection procedure yields 125,859 rm-year observations from 33 countries for our main tests (i.e., Models (4) and (5)). When computing country-year book-tax conformity levels, we also remove all rm-year observations with negative pre-tax book income (i.e., PTBI o 0) or with negative current tax expense (i.e., CTE o 0). In general, the current tax expense reported in loss years reects the extent to which losses may be carried backward versus forward and the amount of prots in the carryback years, as well as differences between reported losses and taxable losses for the current year. Thus, including these observations would add noise to our estimate of the relation between current tax expense (or benet) and pre-tax book income. After removing all rm-year observations with negative PTBI or negative CTE, the sample consists of 93,893 rm-year observations from 33 countries; we use this sample in Model (3) to estimate our book-tax conformity measure.20 Finally, to remove the inuence of potential outliers, we removed the top or bottom one-half percent of the distributions of residuals from Model (3) in each year; the results are robust to relaxing this truncation procedure 4.2. Descriptive statistics Table 1 lists our sample countries and country-specic averages from the results of estimating Model (3). It also presents the average RMSE for each country, as well as the number of years, N(years), that each country appears in the sample. The countries are sorted from low to high average book-tax conformity. As book-tax conformity increases, we expect y1 to approach the statutory tax rate. In other words, when book-tax conformity is very high, CTE will approach the statutory rate times PTBI. To test whether y1 approaches the statutory tax
15 We hand-collected these statutory rates from a KPMG LLP online summary, PricewaterhouseCoopers LL online information, and Coopers & Lybrand LLP s worldwide tax summary guides. We also collected statutory tax rates from the Organisation for Economic Co-operation and Development (OECD) but the latter reduces our sample to 19 countries. Untabulated analyses using the OECD data yields qualitatively similar results. 16 We also use an alternative specication where we include deferred tax expense or benet in accruals. The results from the models using this specication (not tabulated) are quantitatively similar to those reported in the paper. 17 Following the recommendation in Petersen (2009), we test for time-series and cross-sectional dependence in the data by estimating Model (4) without year xed effects and comparing the White corrected standard errors to the standard errors clustered by rm or by year. We nd (untabulated) that clustered standard errors are larger (with one exception) than the White corrected standard errors. Thus, we control for both types of dependence. 18 Since the dependent variables in Models (4) and (5) are future earnings and future cash ows, respectively, the dependent variables are from 1993 to 2005. 19 In robustness tests, we also omit all observations with absolute studentized residuals greater than three. Again, the results are qualitatively similar. 20 When we include rms with negative pre-tax book income and negative CTE and re-estimate Model (3) with an interaction term between LOSS and PTBI in untabulated sensitivity analyses, the average adjusted R2 falls for 31 of 33 sample countries, consistent with our conjecture that including rms with negative pre-tax book income or negative current tax expense adds noise to our book-tax conformity measure.

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Table 1 Book tax conformity measures by country. Model 3 : CTEt y0 y1 PTBIt y2 ForPTBIt y3 DIVt et

Country Canada South Africa Germany USA India Greece Belgium Indonesia Mexico Norway New Zealand Australia Sweden Thailand Philippines Brazil Denmark UK Italy Finland Malaysia Netherlands Taiwan Austria Singapore France Spain Switzerland Japan Korea China Hong Kong Chile

N(years) 13 7 13 13 12 7 9 8 6 12 5 13 13 13 6 10 13 13 11 8 13 13 7 7 13 13 13 13 11 7 8 10 7

Avg. y0 0.000 0.003 0.003 0.001 0.008 0.001 0.002 0.000 0.002 0.002 0.001 0.000 0.000 0.001 0.002 0.001 0.000 0.001 0.003 0.002 0.002 0.001 0.001 0.002 0.003 0.000 0.002 0.002 0.001 0.002 0.000 0.000 0.000

Avg. y1 0.238 0.221 0.342 0.326 0.314 0.254 0.254 0.215 0.272 0.231 0.287 0.238 0.213 0.215 0.177 0.250 0.269 0.253 0.336 0.244 0.193 0.305 0.122 0.211 0.171 0.331 0.256 0.186 0.398 0.242 0.195 0.121 0.140

Avg. y2 0.037 0.027 0.006 0.012 0.000 0.000 0.000 0.000 0.000 0.034 0.000 0.000 0.018 0.000 0.000 0.000 0.000 0.032 0.013 0.000 0.021 0.026 0.000 0.006 0.022 0.017 0.000 0.001 0.000 0.000 0.007 0.023 0.000

Avg. y3 0.109 0.112 0.064 0.005 0.000 0.146 0.078 0.237 0.099 0.123 0.058 0.140 0.068 0.062 0.095 0.023 0.020 0.126 0.096 0.059 0.050 0.003 0.000 0.042 0.005 0.104 0.108 0.098 0.404 0.066 0.008 0.018 0.019

Avg. RMSE 0.017 0.016 0.016 0.015 0.014 0.014 0.014 0.013 0.013 0.013 0.013 0.012 0.012 0.012 0.011 0.011 0.010 0.010 0.010 0.010 0.010 0.009 0.009 0.009 0.008 0.008 0.008 0.008 0.008 0.007 0.007 0.007 0.006

Avg. Adj. R2 0.459 0.544 0.602 0.680 0.708 0.717 0.576 0.673 0.642 0.540 0.769 0.589 0.605 0.569 0.464 0.670 0.683 0.734 0.702 0.695 0.558 0.746 0.423 0.544 0.537 0.805 0.764 0.612 0.806 0.816 0.566 0.512 0.619

Avg. N(rms) 254 60 273 1819 130 53 59 101 52 52 46 149 102 148 59 67 73 605 103 70 262 95 132 50 157 290 77 112 1630 125 965 64 67

Variable denitions: CTE is current tax expense (Items #2325); PTBI is pre-tax book income (Item #21); ForPTBI is estimated foreign pre-tax book income, calculated as foreign tax expense (Item #51) divided by total tax expense (Item #23) times PTBI; and DIV is total dividends (Item #34); N(years) is the number of years that the country appears in our sample; Avg. RMSE is the average root mean-squared error from estimating Model (3) by year for each country; Avg. Adj R2 is the average explanatory power (Adjusted R2) from the regression; Avg. N(rms) is the average number of rms, per year, entering the regression.

rate as book-tax conformity increases, we compute the absolute difference between y1 and the statutory rate, and label this difference DiffRate. We nd that DiffRate is highly correlated with RMSE, our book-tax conformity measure (r = 0.48, p o 0.01). Thus, our book-tax conformity measure increases when y1 is closer to the statutory rate.21 The presence of deferred taxes on the income statement and/or the balance sheet provides another indication of the extent to which TI can deviate from PTBI. As an additional check on the efcacy of our book-tax conformity measure, we examine the correlations between RMSE and two measures of deferred taxes. First, we divide the mean absolute deferred tax expense from the income statement by assets, and label this MabsDTE. Second, we divide the mean deferred tax liability from the balance sheet by total assets, and label this MDTL. We nd that the RMSE is positively correlated with both MabsDTE (r =0.5219, p o 0.0001) and MDTL (r = 0.2065, p o 0.0001). Thus, the RMSE increases as rms in the country report more temporary book-tax differences.22

If we scale DiffRate by the statutory rate, the correlation is still positive and signicant (r =0.27, p o 0.01). One striking difference between our book-tax conformity measure and prior measures is that Germany has a relatively high RMSE (indicating low book-tax conformity) while the conventional wisdom is that Germany has high book-tax conformity (Hung, 2001). However, the close tie between tax and book numbers in Germany applies to the individual accounts (or separate company accounts) used to assess taxes and to limit the dividends that separate companies can pay. The book-tax conformity requirement does not apply to the group accounts in the consolidated nancial statements, which may differ signicantly from those in the individual accounts (Leuz and Wustemann, 2004). German RMSEs from Model (3) suggest signicant differences between taxable income and consolidated nancial statement income. Moreover, German mean absolute deferred tax expense (scaled by assets) is similar to that of Australia where conventional wisdom suggests low book-tax conformity.
22

21

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Table 2 Descriptive statistics and correlations. Panel A: Descriptive statistics Variable Mean EARNt + 1 CFOt + 1 EARNt LOSSt N 0.010 0.051 0.012 0.23 125,859

Std. Dev 0.130 0.142 0.133 0.42

Quartile 1 0.001 0.007 0.001 0

Median 0.030 0.064 0.030 0

Quartile 3 0.066 0.120 0.068 0

Panel B: Pearson (below) and Spearman (above) correlations EARNt + 1 EARNt + 1 CFOt + 1 EARNt LOSSt 0.705 o 0.0001 0.625 o 0.0001 0.461 o 0.0001

CFOt + 1 0.583 o 0.0001

EARNt 0.691 o 0.0001 0.405 o 0.0001

LOSSt 0.472 o 0.0001 0.291 o 0.0001 0.716 o 0.0001

0.478 o 0.0001 0.326 o 0.0001

0.638 o 0.0001

Variable denitions: EARN is net income before extraordinary items (Item #32), deated by average total assets (Item #89); CFO is EARN less the change in noncash current assets (Items #75 60) plus the change in current liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets; and LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise.

Table 2, Panel A presents descriptive statistics for our sample variables, while Panel B presents the Pearson and Spearman correlations between sample variables. Correlations between future EARN, future CFO, and current earnings are all positive (p o 0.001). The correlations between the indicator variable, LOSS, and future earnings, future cash ows, and current earning are all negative (p o 0.001). Thus, we include interactions with LOSS in all association tests.

4.3. Results from tests of earnings persistence and the association between earnings and future cash ows Table 3, Panel A presents the results from Model (4). Since the Model (4) book-tax conformity measure is BTaxC, which is the scaled, descending rank of the RMSE from Model (3), higher values of BTaxC correspond to higher book-tax conformity. The overall persistence parameter from the earnings persistence model (a1) is 0.812 (p o 0.01). This is similar in magnitude to the persistence parameters in Sloan (1996). The coefcient on EARN LOSS (a5) is 0.203 (p o 0.01), conrming that accounting losses are not as persistent as prots (Hayn, 1995; Joos and Plesko, 2005). However, we nd no evidence that earnings persistence is related to earnings variability or to the statutory rate. Most importantly, the coefcient on EARN BTaxC (a3) is 0.191 (p o 0.01). Thus, earnings are less persistent as book-tax conformity increases. The magnitude of the coefcients a1 and a3 provide an indication of the economic signicance of the results. The ratio of a3 to a1 is approximately 23.5% (i.e., 0.191/0.812). Thus, all else equal, earnings persistence in countries with the highest book-tax conformity is almost one-quarter lower than earnings persistence in countries with the lowest book-tax conformity. Moreover, using US dollars as the currency, on average, 1 dollar of current earnings is associated with approximately 81 cents of future earnings in countries with the lowest book-tax conformity versus approximately 62 cents in countries with the highest book-tax conformity. Table 3, Panel B presents the results from Model (5). As in the earnings persistence model, future cash ows are positively associated with current earnings (b1 =0.625, p o 0.01).23 Furthermore, consistent with Panel A, the coefcient on EARN LOSS is negative (b5 = 0.060, p o 0.01), indicating that current prots are more informative about one-year-ahead cash ows than are current losses. Moreover, the coefcient on EARN EVAR is negative (b7 = 0.086, p o 0.01), indicating that current earnings are less informative about future cash ows when the cross-sectional standard deviation in earnings is greater. Most importantly, the coefcient on EARN BTaxC is negative (b3 = 0.201, p o 0.01), suggesting that current earnings are more highly associated with future cash ows when book-tax conformity is lower. Here, the ratio of b3b1 is approximately 32.2% (i.e., 0.201/0.625). Thus, all else equal, the association between current earnings and future cash ows in countries with the highest book-tax conformity is almost one-third lower than in countries with the lowest book-tax conformity.
23 The coefcient on current earnings is greater than that reported for US rms in Barth et al. (2001) of 0.42. This difference is likely due to the interaction of current earnings with the control variables and to differences in time period and sample composition. When we regress future cash ows on only current earnings, the coefcient for our sample (0.51) is closer to that in Barth et al. (2001).

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Table 3 Tests of earnings persistence and the association between current earnings and future cash ows. Model 4 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt BTaxCt a4 LOSSt a5 EARNt LOSSt a6 EVARt a7 EARNt EVARt a8 SRATEt a9 EARNt SRATEt et Model 5 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt BTaxCt b4 LOSSt b5 EARNt LOSSt b6 EVARt b7 EARNt EVARt b8 SRATEt b9 EARNt SRATEt ut

Variable

Panel A: Model (4) Mean coeff. t-stat. 15.37nnn 7.71nnn 5.27nnn 22.15nnn 15.55nnn 1.49 1.18 0.26 0.81

Panel B: Model (5) Mean Coeff. 0.625 0.001 0.201 0.016 0.060 0.006 0.086 0.019 0.018 Yes 0.237 125,859 t-stat. 11.58nnn 0.46 5.37nnn 10.57nnn 4.05nnn 2.57nn 2.85nnn 2.70nn 0.14

EARNt BTaxCt EARNt BTaxCt LOSSt EARNt LOSSt EVARt EARNt EVARt SRATEt EARNt SRATEt Year indicators Adjusted R2 N

0.812 0.015 0.191 0.031 0.203 0.003 0.034 0.001 0.104 Yes 0.410 125,859

n, nn, nnn indicate signicant at the p o 0.10, 0.05, 0.01 level.

Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before extraordinary items (Item #32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled descending rankings of RMSEs from Model (3); CFO is EARN less the change in noncash current assets (Item #60 75) plus the change in current liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets; LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pre-tax book income (Item #21); and SRATE is the statutory rate. Year xed effects are not reported.

Overall, these associations are consistent with claims made by opponents of increased book-tax conformitythat increased book-tax conformity will lower earnings quality (Shevlin, 2002; Hanlon et al., 2005; Plesko, 2006; Shackelford, 2006; Hanlon et al., 2008).

5. The effects of differences in institutional and accounting structures across countries 5.1. Country-level controls for institutional and accounting structures In this section, we add controls for country-level variables that may be associated with earnings persistence and with the association between earnings and future cash ows. First, we control for the countrys legal tradition using a codeversus common-law indicator variable (CommonLaw) developed by La Porta et al. (1998). Ball et al. (2000) suggest that in code-law countries, the inuence of politics on accounting is stronger, leading to a stakeholder corporate governance model. In contrast, in common-law countries, accounting practices are typically determined in the private sector, leading to a shareholder corporate governance model. Second, we control for cross-country differences in investor rights (InvRights) using the investor rights proxy developed by La Porta et al. (1998).24 All things equal, stronger investor rights reduce managements ability to exercise discretion over reported earnings (La Porta et al., 1998; Hung, 2001; Pincus et al., 2007), which potentially inuences earnings persistence and the association between earnings and future cash ows. Third, we control for ownership concentration (OwnCon) using the ownership concentration variables developed by La Porta et al. (1998) because accounting theory suggests that ownership structures affect reported earnings (Watts and Zimmerman, 1986, 1990).25 Table 4, Panel A presents data on the additional country-level variables, which are available for all sample countries other than China. The resulting sample consists of 116,902 observations from 32 countries. Table 4, Panel B reveals a high degree of collinearity among the country-level variables. The Pearson (Spearman) correlation between CommonLaw and InvRights is 0.679 (0.778) and between InvRights and OwnCon is 0.661 ( 0.668). Factor analysis (untabulated) suggests that these three variables converge to one underlying construct, which explains
24 The InvRights variable is a score ranging from 0 to 5, where a 5 implies greater minority shareholder rights. The score is based on the Anti-Director Rights index in La Porta et al. (1998). 25 The OwnCon variable is the median percentage of common shares owned by the three largest shareholders in the ten largest privately owned, nonnancial rms in the country.

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Table 4 Factor analyses with other country-level variables. Panel A: Other country-level variables Country Australia Austria Belgium Brazil Canada Chile China Denmark Finland France Germany Greece Hong Kong India Indonesia Italy Japan Korea Malaysia Mexico Netherlands New Zealand Norway Philippines Singapore South Africa Spain Sweden Switzerland Taiwan Thailand UK USA

CommonLaw 1 0 0 0 1 0 NA 0 0 0 0 0 1 1 0 0 0 0 1 0 0 1 0 0 1 1 0 0 0 0 1 1 1

InvRights 4 2 0 3 5 5 NA 2 3 3 1 2 5 5 2 1 4 2 4 1 2 4 3 3 4 5 4 3 2 3 2 5 5

OwnCon 0.28 0.51 0.62 0.63 0.24 0.38 NA 0.40 0.34 0.24 0.50 0.68 0.54 0.43 0.62 0.60 0.13 0.20 0.52 0.67 0.31 0.51 0.34 0.51 0.53 0.52 0.50 0.28 0.48 0.14 0.48 0.15 0.12

Panel B: Pearson (below) and Spearman (above) correlations BTaxC CommonLaw BTaxC CommonLaw InvRights OwnCon FACTOR 0.567 o 0.0001 0.240 o 0.0001 0.106 o 0.0001 0.360 o 0.0001 0.557 o 0.0001

InvRights 0.458 o 0.0001 0.778 o 0.0001

OwnCon 0.324 o 0.0001 0.322 o 0.0001 0.668 o 0.0001

FACTOR 0.499 o 0.0001 0.738 o 0.0001 0.940 o 0.0001 0.843 o 0.0001

0.679 o 0.0001 0.190 o 0.0001 0.757 o 0.0001

0.661 o 0.0001 0.960 o 0.0001

0.743 o 0.0001

Variable denitions: BTaxC is the book-tax conformity variable, computed as the scaled descending rankings of RMSEs derived from Model (3); CommonLaw equals one if the countrys legal tradition is common-law, zero if code-law; InvRights equals the investors rights score developed by La Porta et al. (1998); OwnCon is the ownership concentration variable developed by La Porta et al. (1998); and FACTOR is the principal factor score obtained from a factor analysis with CommonLaw, InvRights, and OwnCon as the component variables. NA indicates not available.

approximately 68% of the variation in CommonLaw, InvRights, and OwnCon.26 As expected, in Panel B, the principal factor (FACTOR) is highly correlated with its components; all correlations are greater than 0.73 in absolute magnitude. BTaxC is also correlated with FACTOR but to a lesser extent, with a Pearson (Spearman) correlation of 0.360 ( 0.499). To mitigate improper inferences (due to multicollinearity) that might result from entering the components into the models, in subsequent analyses, we include FACTOR rather than the underlying components.27 However, our results are qualitatively similar if we include the individual components.

The Eigenvalue on the principal factor is signicant at 2.05. All others are insignicant (Eigenvalues o 1). Jaccard and Turrisi (2003) state that high collinearity between main effect terms and interaction terms is generally not problematic, but high collinearity between main effect terms can be an issue. We test whether high collinearity is present in our models by estimating main effects models using OLS and by calculating the variance ination factors (VIFs). When we regress (untabulated) future earnings on current earnings, BTaxC, Loss,
27

26

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Table 5 Tests of earnings persistence and the association between current earnings and future cash ows with a factor to control for other country-level variables. Model 6 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt BTaxCt a4 LOSSt a5 EARNt LOSSt a6 EVARt a7 EARNt EVARt a8 SRATEt a9 EARNt SRATEt a10 FACTOR a11 EARNt FACTOR et Model 7 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt BTaxCt b4 LOSSt b5 EARNt LOSSt b6 EVARt b7 EARNt EVARt b8 SRATEt b9 EARNt SRATEt b10 FACTOR b11 EARNt FACTOR ut

Variable

Panel A: Model (6) Mean coeff. t-stat. 15.63nnn 9.14nnn 5.69nnn 22.37nnn 14.04nnn 4.80nnn 0.98 1.97 2.01nn 6.83nnn 4.48nnn

Panel B: Model (7) Mean coeff. 0.614 0.004 0.186 0.017 0.073 0.020 0.011 0.003 0.091 0.009 0.039 Yes 0.254 116,902 t-stat. 11.51nnn 1.64 4.86nnn 11.11nnn 4.79nnn 8.02nnn 0.32 0.39 0.71 16.46nnn 4.83nnn

EARNt BTaxCt EARNt BTaxCt LOSSt EARNt LOSSt EVARt EARNt EVARt SRATEt EARNt SRATEt FACTOR EARNt FACTOR Year indicators Adjusted R2 N

0.828 0.018 0.215 0.032 0.191 0.009 0.033 0.011 0.257 0.003 0.037 Yes 0.415 116,902

n, nn, nnn indicates signicant at the p o 0.10, 0.05, 0.01 level. Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before extraordinary items (Item #32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled descending rankings of RMSEs derived from Model (3); CFO is EARN less the change in noncash current assets (Items #60 75) plus the change in current liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets; LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pretax book income (Item #21); SRATE is the statutory rate; and FACTOR is the principal factor score obtained from the factor analysis with Common- vs. Code-Law, investors rights, and ownership concentration as the component variables. Year xed effects are not reported.

5.2. Results from tests of earnings persistence and the association between earnings and future cash ows with a country-level control for institutional and accounting structures In this section, we enter FACTOR into Models (4) and (5) and interact it with EARNt to allow for differences in earnings persistence and in the association between current earnings and future cash ows across levels of FACTOR. We estimate the following models (country and rm subscripts are suppressed): EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt BTaxCt a4 LOSSt a5 EARNt LOSSt a6 EVARt a7 EARNt EVARt a8 SRATEt a9 EARNt SRATEt a10 FACTOR a11 EARNt FACTOR et CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt BTaxCt b4 LOSSt b5 EARNt LOSSt b6 EVARt b7 EARNt EVARt b8 SRATEt b9 EARNt SRATEt b10 FACTOR b11 EARNt FACTOR ut 7

where FACTOR is the principal factor score obtained from the factor analysis with CommonLaw, InvRights, and OwnCon (as described in the previous section) as the component variables; and all other variables are as previously dened. Table 5, Panel A presents results of the earnings persistence model. EARN FACTOR is positive (a11 = 0.037, p o 0.01), suggesting that earnings are more persistent, on average, in countries with common-law legal traditions, strong investor rights, and lower ownership concentration. Moreover, the coefcient on EARNt BTaxCt remains negative (a3 = 0.215, p o 0.01). Similarly, Table 5, Panel B presents results of the future cash ows model. As in the future earnings model, EARN FACTOR is positive (b11 = 0.039, p o 0.01), suggesting that earnings are more closely associated with future cash ows, on average, in countries with common-law legal traditions, strong investor rights, and lower ownership concentration. Moreover, the coefcient on EARNt BTaxCt remains negative (b3 = 0.186, p o 0.01). Thus, our ndings,
(footnote continued) CommonLaw, InvRights, and OwnCon, the VIFs range from 1.72 to 7.37. In contrast, when we regress (untabulated) future earnings on current earnings, BTaxC, Loss, and FACTOR, the VIFs range from 1.36 to 1.78.

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that earnings persistence is lower and that current earnings are less highly associated with future cash ows when booktax conformity is higher, are robust to a control for country-level differences in legal systems, investor rights, and ownership concentration.28 Taken together, the results from Models (4) to (7) provide evidence that earnings persistence is higher and current earnings better predict future cash ows when the required level of book-tax conformity is lower. Our results suggest that, on average, even though some managers may take advantage of their reporting discretion to report accounting earnings opportunistically when book-tax-conformity is lower, the benets of allowing managers exibility in reporting accounting earnings outweigh the costs from manager opportunism (at least with respect to earnings ability to provide information about future rm performance). 6. Additional analyses In this section, we present the results of two additional tests. First, we test whether the main results are robust to controls for differential earnings persistence across industries which results from differences in product type, barriers-toentry, and/or capital intensity (Lev 1983). Second, we assess whether our book-tax conformity measure provides information beyond the traditional book-tax conformity indicator variable. 6.1. Controlling for differential earnings persistence by industry Lev (1983) nds that characteristics of a rms economic environment (e.g., product type, barriers-to-entry, capital intensity, and rm size) are associated with earnings persistence. Following Lev (1983), we control for potential differences in earnings persistence related to economic factors using industry membership by creating industry indicator variables using the Fama and French (1997) 17-industry classication scheme.29 We enter the industry variables and their interactions with EARNt into Models (4)(7) to investigate whether our results hold in the presence of industry controls. The untabulated results are qualitatively similar. 6.2. Assessing the incremental information in BTaxC beyond that in the traditional book-tax conformity indicator variable Next, we assess the incremental information in our measure, BTaxC, beyond that of the traditional book-tax conformity indicator variable in Hung (2001). Table 2 of Hung (2001) presents the level of book-tax conformity in 21 countries (where 1 indicates high conformity and 0 indicates low conformity). Countries included in the Hung (2001) sample and their respective levels of conformity are similar to those in other studies. Thus, in tests that follow, we limit the sample to 20 of the 21 countries in Hung (2001).30,31 We begin by estimating the Spearman correlation between our book-tax conformity measure, BTaxC, and the traditional book-tax conformity indicator variable, which we label TradBTC. As reported in Table 6, Panel A, BTaxC and TradBTC are positively and signicantly correlated but the Spearman correlation is only 0.565, suggesting that a substantial amount of variation between these two measures exists.32 In Panel A, we nd that relative to BTaxC, TradBTC is more highly correlated with CommonLaw, InvRights, and FACTOR, and the correlations between BTaxC and OwnCon and between TradBTC and OwnCon are quite similar in magnitude. The correlation between TradBTC and CommonLaw (r = 0.927) is particularly striking. In fact, a review of Table 2 in Hung (2001) reveals that TradBTC (labeled Tax-book conformity index) and CommonLaw (labeled Legal system) have opposite indicator values (i.e., TradBTC=1 when CommonLaw= 0, and vice versa) in 18 of the 21 countries studied, suggesting that the traditional book-tax indicator variable is picking up little more than whether the country is in a code-law legal system. The correlation between TradBTC and InvRights is also very high (r = 0.782), resulting in a high correlation between TradBTC and FACTOR (r = 0.739). Overall, results suggest that our measure contains information different from that in the traditional book-tax conformity measure and that the traditional measure is almost exclusively a function of the legal system and the strength of investor rights. Next, we enter TradBTC and the interaction of TradBTC and EARNt into Models (4) and (5), and label these Models (8) and (9), respectively, to investigate whether our book-tax conformity measure is signicant after controlling for the
28 We also remove EVAR, SRATE, FACTOR and the associated interactions from Models (6) and (7) and include country xed effects and interact country xed effects with current earnings to control for xed differences in earnings persistence across countries. Untabulated results are qualitatively similar. 29 Lev (1983) forms product type and barriers-to-entry indicator variables using industry membership. Capital intensity also likely varies across industries. We cannot directly control for rm size because our sample observations do not have a common currency but we scale earnings and cash ows by average total assets. 30 One country, Ireland, is included in the sample of Hung (2001), but is not in our sample. 31 Using this reduced sample of 20 countries, we recalculate the scaled descending rankings of the RMSEs (BTaxC) from Model (3) and of the standard deviation of PTBI (EVAR). 32 These correlations differ from those in Table 4, Panel B because they are estimated using only the 20 countries included in both our sample and in Hung (2001). However, the correlation signs and magnitudes are similar.

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Table 6 Tests of earnings persistence and the association between current earnings and future cash ows including the traditional book-tax conformity indicator variable as a control. Panel A: Spearman correlations between BTaxC, TradBTC, other country-level variables, and FACTOR TradBTC CommonLaw InvRights BTaxC TradBTC 0.565 o 0.0001 0.583 o 0.0001 0.927 o 0.0001 0.504 o 0.0001 0.782 o 0.0001

OwnCon 0.372 o 0.0001 0.357 o 0.0001

FACTOR 0.548 o 0.0001 0.739 o 0.0001

Panels B and C: Earnings persistence and the associations between current earnings and future cash ows including the traditional book-tax conformity indicator variable as a control Model 8 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt BTaxCt a4 LOSSt a5 EARNt LOSSt a6 EVARt a7 EARNt EVARt a8 SRATEt a9 EARNt SRATEt a10 TradBTC a11 EARNt TradBTC et Model 9 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt BTaxCt b4 LOSSt b5 EARNt LOSSt b6 EVARt b7 EARNt EVARt b8 SRATEt b9 EARNt SRATEt b10 TradBTC b11 EARNt TradBTC ut Variable Panel B: Model (8) Mean coeff. EARNt BTaxCt EARNt BTaxCt LOSSt EARNt LOSSt EVARt EARNt EVARt SRATEt EARNt SRATEt TradBTC EARNt TradBTC Year indicators Adjusted R2 N 0.817 0.012 0.110 0.031 0.178 0.006 0.190 0.004 0.057 0.000 0.018 Yes 0.422 100,402 t-stat 13.10nnn 5.16nnn 2.27nn 20.37nnn 12.17nnn 2.39nn 3.94nnn 0.63 0.40 0.04 0.86 Panel C: Model (9) Mean coef. 0.682 0.017 0.148 0.018 0.038 0.007 0.158 0.102 0.125 0.017 0.014 Yes 0.271 100,402 t-stat 10.60nnn 5.27nnn 3.09nnn 10.79nnn 2.33nn 2.09nn 3.33nnn 11.07nnn 0.85 9.04nnn 0.62

n, nn, nnn indicates signicant at the p o 0.10, 0.05, 0.01 level. Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before extraordinary items (Item # 32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled descending rankings of RMSEs derived from Model (3); CFO is EARN less the change in noncash current assets (Items #60 75) plus the change in current liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets; LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pretax book income (Item #21); SRATE is the statutory rate; and FACTOR is the principal factor score obtained from the factor analysis with Common- vs. Code-Law, investors rights, and ownership concentration as the component variables. Year xed effects are not reported.

traditional measure.33 Table 6, Panels B and C present the estimation results for Models (8) and (9), respectively. In Panel B, EARN BTaxC remains negative (a3 = 0.110, p o 0.05) but EARN TradBTC is not different from zero. Similarly, in Panel C, EARN BTaxC remains negative (b3 = 0.148, p o 0.01), and EARN TradBTC is not different from zero. Thus, our book-tax conformity measure subsumes the explanatory power of the traditional measure in explaining earnings persistence and associations between current earnings and future cash ows. 7. Conclusions We examine whether the required level of book-tax conformity in a country affects one-year-ahead earnings persistence and the association between current earnings and one-year-ahead cash ows. We nd that earnings persistence and the association between current earnings and future cash ows are lower when the level of required book-tax conformity is higher. Our results are robust to the inclusion of the traditional indicator variable for book-tax conformity used in prior studies, the inclusion of a control variable for differences in legal systems, investor rights, and
33 We enter TradBTC into Models (4) and (5), which do not contain FACTOR, due to the high collinearity between the TradBTC and FACTOR. However, in untabulated analyses, we enter TradBTC into Models (6) and (7), which contain FACTOR. We nd that our main result strengthens. Specically, the coefcient on EARN BTaxC is more negative and is more highly signicant in Models (6) and (7) than in Models (4) and (5).

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ownership concentration, and to controls capturing differences in earnings persistence across countries and industries. Our results imply that researchers examining cross-country differences in accounting earnings properties should consider including book-tax conformity in their models. We introduce a measure of country-wide required book-tax conformity, which can be easily estimated using publicly available data and which is more comprehensive (in that it includes more countries) and more powerful than the traditional indicator variable measure used in prior studies. Moreover, this measure allows for a continuum of book-tax conformity levels and for changes in required book-tax conformity over time. Opponents of increased book-tax conformity in the US suggest that the information required by investors is very different from that required by tax authorities, and that increasing book-tax conformity will lower (rather than increase) earnings quality. Consistent with this view, we nd that increasing the required level of book-tax conformity in the US may result in reported accounting earnings that are less persistent and less highly associated with future cash ows. Some proponents of increased book-tax conformity suggest that something less than full conformity should be considered (for example, taxable income could equal book income less explicitly allowed book-tax differences only). Since our tests are based on a continuum of book-tax conformity levels, our results suggest that any movement toward book-tax conformity (even to something less than full book-tax conformity) may result in reported accounting earnings that are less persistent and less closely associated with future cash ows. References
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