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Tax Avoidance, Large Positive Book-tax Differences, and Earnings Persistence

Bradley Blaylock Ph.D. Candidate University of Washington Foster School of Business Box 353200 Seattle, WA 98195

Terry Shevlin Paul Pigott/PACCAR Professor of Business Administration University of Washington Foster School of Business Box 353200 Seattle, WA 98195

Ryan Wilson Tippie School of Business University of Iowa W280 Pappajohn Business Building Iowa City, IA 52242-1994

March 29, 2010

Abstract:

We investigate why book-tax temporary differences appear to serve as a useful signal of earnings persistence. We maintain that there are multiple potential sources of large positive book-tax differences and examine the differing implications of large positive book-tax differences for earnings and accruals persistence depending on the source of those differences. We expect and observe that firms with large positive book-tax differences likely arising from tax avoidance exhibit greater accruals persistence than other firms with large positive book-tax differences. We also expect and observe that firms with large positive book-tax differences likely arising from upward earnings management exhibit lower earnings and accruals persistence than other firms with large positive book-tax differences. Further, we provide evidence that investors are able to look through to the source of large positive book-tax differences allowing them to correctly price the persistence of accruals. Together, our results illustrate the importance of considering the source of book-tax differences when using them as a signal of earnings quality.

We acknowledge the helpful comments of Alex Edwards, Michelle Hanlon, Stacie Laplante, Rick Mergenthaler, and Sonja Olhoft Rego. Shevlin acknowledges financial support from his Paul Pigott/Paccar Professorship at the Foster School.

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Electronic copy available at: http://ssrn.com/abstract=1524298

I. Introduction

Existing research suggests the tax information contained in the financial statements

provides information about earnings quality (e.g. Lev and Nissim 2004; Hanlon 2005). Despite

the important implications of these studies little is known about what causes the observed link

between tax information and earnings quality. This study begins to develop an understanding of

this link by investigating whether the implications of differences between book and taxable

income for the persistence of earnings vary depending on the likely source of those differences.

Our analysis extends Hanlon (2005) who shows that for firm-years with large book-tax

temporary differences, pre-tax income is less persistent for future earnings than firm-years with

small book-tax differences.

We also investigate whether investors are able identify the likely source of book-tax

differences to help interpret and price accruals. Hanlon (2005) notes that several accounting

textbooks indicate large book-tax differences can provide information about earnings quality. 1

Consistent with investors heeding this lesson, Hanlon (2005) finds investors reduce their

expectations of the persistence of earnings and accruals in the presence of large positive book-tax

differences and are able to efficiently price earnings and accruals for these firms. Despite the

results in Hanlon, it is not clear whether investors are able to efficiently price earnings for sub-

groups of large positive book-tax difference firms partitioned on the basis of the predominant

source of their book-tax differences. This question is important because we predict the

implications of large positive book-tax differences for earnings persistence vary depending on

the likely source of the book-tax differences. Our analysis of different sub-sets of large positive

book-tax difference firms is similar in spirit to Sloan (1996) who finds that on average investors

1 Recent accounting textbooks continue to suggest that book-tax differences are an indicator of earnings quality. For example, Revsine, Collins, and Johnson (2005) point out that increases in the deferred tax expense could be an indication of deteriorating earnings quality. Earnings quality is a difficult concept to define; consistent with Hanlon (2005) we define earnings quality as earnings persistence.

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Electronic copy available at: http://ssrn.com/abstract=1524298

correctly price the persistence of earnings for all firms. However, Sloan also shows that there is

differential persistence in the accrual and cash flow components of earnings and that the market

fails to identify and correctly price this differential persistence, resulting in positive hedge

portfolio returns to portfolios formed on accruals.

The ability of investors to identify differences in earnings persistence is critical in

valuation. If earnings are permanent investors do not need to make cash-flow predictions to

value equity; they can simply divide permanent earnings by the risk-free rate (Beaver and Morse

1978). As a result, Frankel and Litov (2009) point out investors have sought to identify the

determinants of earnings persistence in order to better understand the relation between current

earnings and permanent earnings. Ohlson (2007) discusses various theoretical models of firm

valuation that all rely to varying degrees on the persistence of earnings. Hanlon (2005)

demonstrates that large book-tax differences are an important signal about earnings persistence

and we extend her analysis by investigating whether the underlying likely source of book-tax

differences should also be considered when evaluating the implication of large positive book-tax

differences for earnings persistence.

We posit there are three primary sources of large positive book-tax differences. First,

book-tax differences can arise due to earnings management. Phillips, Pincus, and Rego (2003)

conjecture that because tax law allows less discretion in accounting choices than GAAP, large

positive differences between book and taxable income are informative about earnings

management. Consistent with their assertion, they find the deferred tax expense is useful in

detecting earnings management. 2 In cases where book-tax differences are generated by earnings

2 Consistent with Hanlon (2005) we do not include permanent differences in our measure of book-tax differences. Hanlon (2005) notes that permanent differences are affected by tax rate differences, tax credits, and statutory tax breaks (e.g. tax-exempt interest) that are not indicative of earnings quality related to the accrual process. The temporary book-tax differences examined in this study are equal to the deferred tax expense grossed-up by the applicable statutory tax rate.

management we expect accruals are more likely to reverse in the next period thus exhibiting low

persistence.

Second, a basic tax planning strategy is to defer taxes as long as possible to decrease the

net present value of the taxes paid. Such behavior also leads to a large deferred tax expense, but

does not necessarily result in accruals that will reverse in the following year. Wilson (2009) finds

that for a sample of 33 identified tax shelter firms the tax shelter activity increased the firms’

book-tax differences by an average of 102%. 3 We predict that in cases where large positive

book-tax differences arise primarily from extensive tax planning these differences do not signal

managerial discretion over the accruals process and, as a result, will not be associated with lower

future earnings and accruals persistence. Therefore, we predict that firms with large positive

book-tax differences resulting primarily from tax planning will exhibit higher future earnings and

accruals persistence than other large positive book-tax difference firms.

Third, deferred tax expense can arise in the absence of tax planning and earnings

management because of the normal differences in the treatment of revenue and expenses for

book and tax purposes (Scholes et al. 2008, p.39). Examples of normal temporary differences

are depreciation and allowance for doubtful accounts (although both items can also be used for

earnings management purposes).

We initially focus on firms with large positive book-tax differences but in sensitivity

analysis we also examine firms with large negative book-tax differences. We partition our

sample of large positive book tax difference firm-year observations into three groups

corresponding to the conjectured three sources of differences. A subsample of firms where the

large positive book tax differences likely arise from earnings management (the EM subsample), a

3 It should be noted that in his analysis Wilson (2009) examines total book-tax differences. The identified tax shelters in his study generate a mix of permanent and temporary book-tax differences. However, Wilson (2009) finds that the association between temporary book-tax differences and actual cases of tax sheltering is more significant than the association between permanent book-tax differences and incidence of sheltering.

subsample of firms where the large positive book tax differences likely arise from tax planning

(the TAXAVOIDER subsample), 4 and a remaining (non-overlapping) subsample where the

differences likely arise from the innate characteristics or normal book tax differences of the firms

(the BASE subsample). We compare the earnings and accruals persistence of the earnings

management and tax planning subsamples to the BASE subsample.

We identify tax avoidance firms using the cash effective tax rate developed by Dyreng et

al. (2008). The cash effective tax rate is calculated as the ratio of the sum of cash taxes paid over

a five-year period to the sum of pre-tax book income over the same five-year period. 5 We

identify high earnings management firm-year observations using a cross-sectional modified

Jones Model with lagged return-on-assets (Kothari et al. 2005). Our analysis of the differential

earnings and accruals persistence of these three groups of large book-tax difference firms

represents a joint test of the predictions discussed above and our method of partitioning the

firms.

Consistent with expectations, we find firms with large positive book-tax differences

(large deferred tax expense) that primarily result from tax avoidance have more persistent

accruals than firm-year observations in the BASE group. 6 Also consistent with expectations, we

find that firms with large positive book-tax differences that arise predominantly from upward

earnings management have less persistent earnings and accruals than firm-year observations in

the BASE group. Further, when we remove the 26% of firm-year observations classified as

4 We define tax planning as non-conforming tax positions that lower taxable income relative to book income in the current period. It is possible firms could also engage in conforming tax planning where they lower reported income for both book and tax purposes. Conforming tax planning transactions would not give rise to book-tax differences.

5 Throughout this study we refer to firms in the bottom quintile of the five-year Cash ETR measure as tax avoiders. We expect firms in the bottom quintile were able to lower their tax burden through standard tax planning practices that do not necessarily violate income tax rules, as well as fraudulent tax avoidance, including tax shelter transactions considered abusive by the IRS and the Treasury Department. A synonym for tax planning is tax avoidance, and we use the two terms interchangeably.

6 In supplemental tests, we continue to find the tax avoider firms exhibit higher persistence for the accrual component of earnings than the base group firms when we calculate Cash ETR using operating cash flow as a scalar instead of pre-tax book income and when we use a three-year measure of Cash ETR instead of a five-year measure.

earnings managers from the LPBTD (leaving the BASE and TAX AVOIDERS in the LPBTD

group) we find that the cash flow and accruals persistence of the remaining LPBTD firms is

larger than the persistence of these components for the small book-tax difference firms. This

finding is important because it demonstrates that the lower overall earnings and accrual

persistence of large positive book-tax difference firms documented in Hanlon (2005) is driven

primarily by the relatively high concentration of high discretionary accrual firms within the large

positive book-tax difference group (26% of firm-year observations in our sample). 7

We find investors are able to appropriately price accruals for both sub-samples of tax

avoidance and high earnings management firms. This finding is consistent with investors being

relatively sophisticated in their ability to identify and understand the implications of different

sources of book-tax differences. Investors appear to go beyond the suggestion of accounting texts

to examine differences between book and taxable income as a signal of earnings quality and

actually examine the likely source of those differences.

Our analysis focuses primarily on firms with large positive book-tax differences because

these differences could be a signal of either earnings management or tax avoidance. In

supplemental tests we examine the earnings persistence of large negative book-tax difference

firms. Because of interpretation problems associated with losses (discussed below), we restrict

this group to positive income firms and our descriptive statistics show that the mean pretax

return on assets in this group exceeds that of the LPBTD. However, if managers of highly

profitable firms use discretion in accounting for accruals to smooth earnings they might have an

incentive to manage earnings downward. Significant downward earnings management would

7 In a contemporaneous working paper, Seidman (2010) examines the total (permanent and temporary) book-tax gap as a function of GAAP changes, macroeconomic conditions, earnings management, and tax planning. She also

examines the Hanlon persistence result across large negative, small and large positive total BTD groups and finds that after removing the effects of earnings management, the earnings persistence of the large positive BTD is

attenuated.

differences on a measure of discretionary accruals and using the residual from that regression as an adjusted measure of the book-tax gap.

Seidman removes the effect of earnings management on book-tax differences by regressing book-tax

likely result in large negative book-tax differences. We partition the large negative book-tax

difference firms into a downward earnings management group and a base group. While large

negative discretionary accruals might generally be expected to result in lower levels of earnings

and accruals persistence than the base group of firms (as extreme accruals tend to reverse), if the

accruals are motivated by smoothing it is possible than earnings persistence is no different or is

increased relative to the base group for these superior performing firms. We observe no

significant difference in earnings persistence between these two groups of large negative book-

tax difference firms.

We contribute to the literature in three ways. First, our analysis provides an important

caveat to researchers and investors using large-positive book-tax differences as a signal about

earnings persistence. Specifically, the usefulness of this signal is contingent upon the source of

the book-tax differences. Large positive book-tax differences are not a useful signal of lower

earnings or accrual persistence except in cases where those differences arise primarily from

upwards earnings management. Second, we provide evidence that despite the complex nature of

many differences between book and taxable income investors are able to look through to the

source of those differences and appropriately price accruals for different sub-samples of large

positive book-tax difference firms. Third, the observed differential earnings and accruals

persistence of the three groups of large positive book-tax difference firms validates our approach

to partitioning these firms into sub-groups. This approach should prove useful to researchers in

future studies that want to identify the predominant source of book-tax differences for large

samples of firms.

The remainder of the paper proceeds as follows. In section II, we review the related

literature and develop our hypotheses. In section III, we describe the sample used. Section IV

presents the earnings persistence test results. Section V presents the market pricing test results.

Section VI presents our supplemental analysis. In section VII we examine earnings persistence

for groups of large negative book-tax difference firms and the final section concludes.

II. Related Literature and Hypotheses

a. Earnings Persistence

Phillips et al. (2003, p.492) argue that the deferred tax expense can be used as a measure

of “managers’ discretionary choices under GAAP because the tax law, in general, allows less

discretion in accounting choice relative to the discretion that exists under GAAP.” As an

example of this flexibility, Phillips et al. (2003) note that GAAP allows discretion in accounting

for bad debts, but tax reporting requires the receivable to actually be written-off. Consistent with

this argument, Phillips et al. (2003) find evidence of a positive association between the deferred

tax expense and firms just avoiding a loss or a decline in earnings. They conclude the deferred

tax expense is a useful indicator of earnings management. Also consistent with this reasoning,

Mills and Newberry (2001) find the magnitude of book-tax differences is positively associated

with financial reporting incentives such as financial distress and bonus thresholds.

Hanlon (2005) examines the implications of large book-tax differences for earnings and

accruals persistence. Hanlon (2005) posits that because discretionary accruals are less persistent

than nondiscretionary accruals (Xie 2001), then if large book-tax differences are a signal of

increased discretion in the accruals process, firms with large book-tax differences should exhibit

lower earnings and accruals persistence. Consistent with this argument, Hanlon (2005) finds that

firms with large book-tax differences do exhibit lower earnings and accruals persistence than

firm with small book-tax differences. 8

8 The theory developed in Phillips et al. (2003) and Hanlon (2005) suggests only temporary book-tax differences provide insight into managerial discretion over the accruals process and therefore serve as a signal of pre-tax earnings and accruals persistence. Consistent with this theory, Jackson (2009) finds the temporary component of book-tax differences provides information about pre-tax earnings growth while the permanent component of book- tax differences does not. Because our study focuses on the information provided by book-tax differences about pre- tax earnings and accruals persistence we limit our analysis to temporary book-tax differences.

However, not all large positive book-tax differences are a reflection of increased

managerial discretion over the accruals process. Firms can have large book-tax differences

simply because of differences in the timing of revenues and expenses for GAAP versus the

recognition required by tax law. These differences reflect the underlying differences in the

economics or business model. Seidman (2010) finds a small subset of changes in GAAP alone

explain 50.45% of the variation in the book-tax gap between 1993 and 2004. Further, she finds

that removing the effects of these GAAP changes from the book-tax gap increases the

association between the book-tax gap and predicted cases of tax sheltering.

We extend the analysis in Hanlon (2005) by making separate predictions about the

earnings and accrual persistence for different groups of firms with large positive book-tax

differences based on the likely predominant source of those differences. We expect the ability of

large positive book-tax differences to serve as a red-flag for low earnings quality (less persistent

earnings and accruals) will be most pronounced for firms where upward earnings management is

the predominant source of the large positive book-tax differences. We compare the earnings

persistence of these firms to firms in the BASE group (firm-year observations with large positive

book-tax differences not classified into either the earnings management or tax avoidance

subsamples). This leads to our first hypothesis:

H1a: For firm-years with large positive book-tax differences, the persistence of earnings

is lower for the earnings management (EM) subsample compared to the BASE group.

Consistent with Hanlon (2005) we assume that cases where large positive book-tax

differences indicate low earnings quality are a result of subjectivity in the accruals process for

financial reporting purposes. If large positive book-tax differences are indicative of opportunistic

managerial discretion in the accruals process then we expect the accruals component of earnings

will be less persistent for firms with large positive book-tax differences arising from upward

earnings management. This leads to our next hypothesis:

H1b: For firm-years with large positive book-tax differences, the persistence of the

accrual component of earnings is lower for the earnings management (EM) subsample compared

to the BASE group.

In November of 2006 the Wall Street Journal noted that public companies reported 40%

higher pretax profits to Wall Street (GAAP earnings) than to tax authorities during 2004

(Drucker 2006). 9 The article went on to report that one of the biggest drivers of this gap is

reportable transactions. These are transactions sold by tax advisers to companies and include

some listed transactions expressly forbidden by the IRS. In addition, Mills (1998) reports that

proposed IRS adjustments are positively associated with large book-tax differences. 10 Desai

(2003) asserts that the divergence between book and tax income during the 1990s was

attributable to increased levels of tax sheltering. Consistent with this assertion, Wilson (2009)

finds that book-tax differences are positively associated with identified cases of tax sheltering. 11

Together these findings suggest tax avoidance is an important determinant of book-tax

differences. It is reasonable to assume that many firms report large positive book-tax differences

largely as a result of tax planning strategies associated with deferring income or accelerating

deductions.

9 The Wall Street Journal article noted these figures were based on IRS data for 4,195 U.S. public companies with fiscal years ending between June and December.

10 Mills (1998) uses three alternative measures of book-tax differences. Her full sample analysis utilizes IRS data and measures book-tax differences as the difference between pre-tax book income and taxable income. She also uses the difference between the federal tax expense for book less the declared tax on the tax return as an alternative measure of book-tax differences and finally the deferred tax expense as a third measure. Her third measure is consistent with the measure of book-tax differences used in this study because it does not include permanent book- tax differences.

11 Specifically, Wilson (2009) finds both the permanent and temporary components of book-tax differences are significantly associated with identified cases of tax sheltering. While the ideal tax shelter might generate only permanent book-tax differences, Wilson’s analysis shows that in practice corporate tax shelters often generate temporary book-tax differences. In addition, Lisowsky et al. (2010) examine 101 tax shelters reported to the IRS as listed transactions and find that more of these transactions (38) report a related temporary book-tax difference than (12) that report a related permanent book-tax difference.

An example of a tax avoidance strategy that attempts to accelerate tax deductions which

results in large positive book-tax differences is the contested liability acceleration strategy

(CLAS) developed by KPMG. According to the Wall Street Journal (2004), the IRS reported this

shelter generated $1.7 billion in tax savings for several dozen companies. KPMG devised the

CLAS shelter to help clients accelerate the timing of tax deductions for settlements of lawsuits

and other claims against the corporation. In most cases, tax deductions for these claims are not

allowable until the claim is paid. However, one exception to this rule involves transferring

money or other property to a contested liability trust before the claims are resolved. A firm

would establish a trust with itself as the beneficiary, and then transfer noncash assets such as

company stock or some type of intercompany note to the trust. The transferred items were

intended to correspond to amounts owed related to a particular claim, and the firm would then

take a tax deduction when the items were transferred to the trust. To the extent the firm had not

yet met the requirements under SFAS No. 5 to accrue the claim for financial reporting purposes,

the CLAS shelter would lower taxable income for that period relative to book income. In a

subsequent period when the contingent claim is accrued under SFAS No. 5 then the temporary

book-tax difference would be reversed. The CLAS shelter is an example of a tax planning

transaction where the legality of the transaction is uncertain. In this study our intent is to identify

book-tax differences arising from all types of tax planning activity from clearly legal transactions

to those characterized by significant uncertainty.

Ayers, Laplante, and McGuire (2010) examine the association between changes in credit

ratings and changes in book-tax differences. They conjecture that changes in book-tax

differences can have implications for credit ratings as a signal to analysts of either low earnings

quality or off-balance sheet financing. However, they note that to the extent changes in book-tax

differences arise from tax planning they should be less useful in assessing credit worthiness.

Consistent with this argument, they find that tax planning attenuates the relationship between

changes in book-tax differences and credit ratings. 12 Similarly, we predict that in cases where

large positive book-tax differences likely arise from tax avoidance strategies they will not be a

useful signal of low earnings quality. Of the three groups of large positive book-tax difference

firms that we examine, we expect the TAXAVOIDERS group represents the firm-year

observations with the lowest level of earnings management. 13 The large positive book-tax

differences exhibited by these firms likely arise primarily as a result of their tax planning

strategies. In contrast, we expect that firms categorized into the BASE group exhibit large

positive book-tax differences because of a combination of management discretion over the

accruals process, innate firm characteristics, and tax avoidance. Because we believe management

discretion over the accrual process in the BASE group firms is higher than in the

TAXAVOIDERS firms we expect that the future earnings and accrual persistence for these firms

will be greater than that of the BASE group firms. This leads to our next hypotheses:

H2a: For firm-years with large positive book-tax differences, the persistence of earnings

is higher for the TAXAVOIDERS subsample compared to the BASE group.

H2b: For firm-years with large positive book-tax differences, the persistence of the

accrual component of earnings is higher for the TAXAVOIDERS subsample compared to the

BASE group.

12 Ayers et al. (2010) use changes in book-tax differences in their primary analysis. We use levels of book-tax differences to be consistent with Hanlon (2005) and because the implications of large changes in book-tax differences for earnings persistence are more difficult to predict. For example, a firm could exhibit large negative book-tax differences in year t-1 and no book-tax differences in year t resulting in a large positive change in book-tax differences. It is not clear what this change would signal about management discretion over the accrual process and therefore about earnings and accruals persistence. See Wilson (2010) for further discussion of this issue. 13 Consistent with Hanlon and Heitzman (2010), we view tax avoidance as existing on a continuum. This continuum of avoidance includes clearly legal transactions, such as investments in municipal bonds that lower explicit taxes, on one end, to more aggressive forms of tax avoidance, such as tax sheltering where the legality of the transaction is less certain, on the other end. We select a general measure of tax avoidance (Cash ETR) to partition our sample because we want to identify all types of tax avoidance activity that lead to large positive book-tax differences.

In summary, the two sets of hypotheses above imply a ranking of earnings and accrual

persistence for firms with large positive book-tax differences. Specifically, we expect that in

cases where large positive book-tax differences are largely a function of tax avoidance, earnings

and accrual persistence will be the greatest. The lowest earnings and accrual persistence will be

exhibited by firms where the large book-tax differences appear to be largely a function of

upward earnings management. We expect firms with large positive book-tax differences not

specifically identified as resulting from either upward earnings management or tax avoidance

(the BASE group) to exhibit earnings and accrual persistence between the other two subsets of

firms. For these firms their large positive book-tax differences likely arise from a combination of

tax avoidance and discretion over accruals as well as innate firm specific characteristics (i.e.

normal book tax differences). As a result, large positive book-tax differences might provide

some information about subjectivity in the accruals process, but not to the degree that they do for

firms where the predominant source of large positive book-tax differences is upward earnings

management.

As an additional test, we compare the persistence of earnings and accruals from the small

book tax difference group (SBTD) to the observations in the LPBTD group after excluding firm-

year observations classified as earnings managers (26% of observations). Recall from Table 2

and Hanlon (2005) that the persistence of earnings and accruals is substantially lower for the

LPBTD firms compared to the SBTD group. We expect the lower earnings and accruals

persistence of large positive book-tax difference firms documented in Hanlon (2005) is driven by

the firms where their large positive book-tax differences primarily reflect earnings management

activity. Consequently, we predict that when these observations are excluded from the LPBTD

group that the persistence of earnings and accruals will no longer be lower for the LPBTD group

then the SBTD group. This leads to our third set of hypotheses:

H3a: The persistence of earnings for the LPBTD subsample excluding earnings

managers is the same or greater compared to the SBTD group.

H3b: The persistence of the accruals component of earnings for the LPBTD subsample

excluding earnings managers is the same or greater compared to the SBTD group.

b. Market Pricing

Our final set of hypotheses examine whether stock prices reflect different investor

expectations about the future of earnings for firms with large positive book-tax differences

depending on the source of those differences. Sloan (1996) provides evidence investors do not

correctly understand the differential persistence of accruals and cash flows. Hanlon (2005) finds

that in the presence of large positive book-tax differences investors reduce their expectations

about the persistence of earnings and accruals and appear to correctly price the accrual

component of earnings. 14 We extend this analysis by examining whether investors look through

to the source of the book-tax differences in assessing their implications for earnings persistence.

Following our discussion above we expect the persistence of earnings and accruals to be

lowest for firms with large positive book-tax differences arising from upward earnings

management. In contrast, we expect the persistence of earnings and accruals to be highest for

firms with large positive book-tax differences generated by tax avoidance activity. Existing

research suggests investors should focus on book-tax differences as a signal of earnings

persistence. This point is further emphasized in financial accounting textbooks (e.g. Revsine et

al. 2005). However, there is no evidence that investors look through to the source of those

differences and correctly incorporate the information signaled by different types/sources of

14 Specifically, Hanlon (2005) finds that investors correctly price the persistence of the accrual component of earnings for future earnings, but actually underestimate the persistence of the cash flow component of earnings for future earnings. As a result, investors underestimate the persistence of earnings for firms with large positive book- tax differences.

book-tax differences. If investors focus only on aggregate book-tax differences as a signal of

earnings persistence and do not examine the source of those book-tax differences then we expect

investors will not correctly understand difference in the persistence of accruals between sets of

large positive book-tax difference firms separated based on the source of those differences. If

investors miss-estimate the persistence of accruals, then as earnings and accruals are reported in

the subsequent year, investors will correct their estimates and portfolios formed on the sign and

magnitude of accruals should generate hedge portfolio abnormal returns. Our analysis is

motivated by Sloan (1996) who finds that while investors correctly price earnings (in our setting

all firms within the LPBTD group), the CFO and accrual subcomponents of earnings exhibit

differential persistence which investors fail to fully appreciate resulting in mispricing (in our

setting, the sub-partitions of the LPBTD group based on EM and TAXAVOIDERS). This leads

to our final set of hypotheses:

H4a: For firms classified as tax avoiders, investors under-estimate the persistence of the

accrual component of pre-tax earnings resulting in positive abnormal returns to a hedge portfolio

formed on the sign and magnitude of pretax accruals.

H4b: For firms classified as managing earnings, investors over-estimate the persistence

of the accrual component of pre-tax earnings resulting in negative abnormal returns to a hedge

portfolio formed on the sign and magnitude of pretax accruals.

III. Sample Selection and Descriptive Statistics

We begin with a sample of all firms on the Compustat and CRSP tapes with non-missing

asset and stock return data for the years 1993-2005. We start our sample in 1993 to coincide with

the implementation of SFAS 109 to ensure consistent accounting for income taxes over the

sample period. 15 Consistent with Hanlon (2005), we remove firms with foreign incorporation

codes and firms in the financial services and utility industries since they have different

accounting requirements. In addition, we eliminate observations with missing regression

variables, pre-tax accounting losses, positive net operating losses (NOL carryforwards), and

negative current tax expense. As noted in Hanlon (2005), the presence of accounting losses, net

operating losses and negative current tax expense can obscure the deferred tax expense account

which we use to estimate book-tax differences. 16 After all exclusions, our sample is composed of

21,205 firm-year observations.

We rank all firms each year on book-tax differences 17 and partition them into the quintile

of largest positive book-tax differences (4,178 observations), the quintile of largest negative

book-tax differences (4,263), and all other observations (12,585 observations), which we call the

small book-tax difference group. As discussed above, our analysis focuses principally on the

large positive book-tax difference firms. However, we do begin by using all three groups of

firms to replicate the results in Hanlon (2005) over this extended sample period. Consequently,

we provide descriptive statistics for each of the three groups of firms.

Table 1 presents descriptive statistics for each of the three groups of firms. 18

All financial statement variables are scaled by lagged total assets. The results in Table 1 indicate

the large positive book-tax difference firms have the lowest median Cash ETRs and the highest

median levels of discretionary accruals of any of the three groups of firms. This result is

consistent with these firms being more aggressive for both financial reporting and tax purposes

15 We use 5 years of data to estimate the cash effective tax rate. Because cash taxes paid are not affected by SFAS 109 we are able to collect data for the calculation of the cash effective tax rate prior to 1993.

16 In addition, Hayn (1995) argues that because shareholders have a liquidation option, loss years will exhibit lower earnings persistence than profitable firm years. The lower persistence of loss year observations could also obscure our ability to detect differences in persistence signaled by large book-tax differences.

17 Estimated as (US Deferred Taxes + Foreign Deferred Taxes)/.35 scaled by lagged total assets.

18 All accounting variables are winsorized at the 1 st and 99 th percentiles to reduce the effect of outliers.

than the other groups of firms. Both the large positive and the large negative BTD groups are

composed of smaller and more profitable firms than the small BTD group. The large positive

BTD group exhibits the lowest median size-adjusted returns of the three groups.

IV. Tests of Earnings Persistence

Following Hanlon (2005), we use equation (1) to estimate one-year ahead earnings

persistence. This equation permits the coefficient on earnings to vary depending on the level of

book-tax differences by including indicator variables for both the large positive and large

negative book-tax difference firms.

PTBI t+1 = γ 0 + γ 1 LNBTD t + γ 2 LPBTD t + γ 3 PTBI t + γ 4 PTBI t × LNBTD t + γ 5 PTBI t × LPBTD t + ε t+1

(1)

In equation (1), PTBI is pre-tax accounting income scaled by average total assets for cross-

sectional comparability. LNBTD is an indicator variable set equal to 1 for firm-years with scaled

book-tax differences in the lowest quintile of firms in each year, and 0 otherwise. LPBTD is an

indicator variable set equal to 1 for firm-years with scaled book-tax differences in the highest

quintile of firms in each year, and 0 otherwise. Panel A of Table 2 presents the results from

estimating equation (1). The results indicate the findings in Hanlon (2005) hold for this extended

sample period. We find that firm-years with large positive or large negative book-tax differences

both exhibit significantly lower earnings persistence than firm-years with small book-tax

differences.

Consistent with Hanlon (2005), we also decompose earnings into cash flows and accruals

in order to examine whether the persistence of accruals and cash flows varies as a function of the

level of book-tax differences. We partition earnings into pre-tax accruals and pre-tax cash flows

and estimate the following equation 19 :

19 Pre-tax cash flows are calculated as Compustat Item 308 (Cash from Operations) – Compustat Item 124 (Extraordinary Income and Discontinued Operations from cash flow statement) + Compustat Item 317 (Cash taxes paid). Pre-tax accruals are calculated as pre-tax income minus pre-tax cash flows.

PTBI t+1 = γ 0 + γ 1 LNBTD t + γ 2 LPBTD t + γ 3 PTCF t + γ 4 PTCF t × LNBTD t + γ 5 PTCF t ×

LPBTD t + γ 6 PTACC t + γ 7 PTACC t × LNBTD t + γ 8 PTACC t × LPBTD t + ε t+1

(2)

The coefficients γ 3 and γ 6 are estimates of the mapping of current period of cash flows

and accruals into future (one-period) earnings for the base group. This mapping is referred to in

the extant literature (Sloan 1996, Xie 2001 and Hanlon 2005) as the persistence of cash flows

and accruals into future earnings. The coefficients on the interaction terms allow for differences

in the persistence estimates across groups. Panel B of Table 2 presents the results from

estimating equation (2). As expected, consistent with Sloan (1996) and Hanlon (2005), we find

the accrual component of earnings is significantly less persistent than the cash flow component.

Also consistent with Hanlon, we find that both the accruals and cash flow components of

earnings are significantly less persistent for both the LPBTD and LNBTD subsamples. The

results in Table 2 are important because they show that even for this extended sample period, the

results in Hanlon (2005) continue to hold and that, on average, firms with large positive book tax

differences exhibit lower earnings and accruals persistence in comparison to small book-tax

difference firms.

In order to examine whether the implications of large positive book-tax differences for

earnings persistence vary as a function of the most likely source of those differences we must

first calculate measures of tax avoidance and earnings management.

We use the cash effective

tax rate (Cash ETR) developed by Dyreng et al. (2008) to identify tax avoidance firms. The Cash

ETR is the ratio of the five-year sum of cash taxes paid to the five-year sum of pretax financial

accounting income. As discussed in Dyreng et al. (2008), this measure of tax avoidance has

several advantages over the traditional effective tax rate measures. First, the Cash ETR measure

is not affected by the recording of contingencies for uncertain tax benefits. Regardless of

whether a firm recognizes the benefit associated with a tax planning position in earnings, the

reduced cash tax payments that result from that position will be reflected in a lower Cash ETR.

In addition, to the extent firms accelerate expenses or defer income for tax purposes this will be

reflected in a lower Cash ETR provided that those timing differences do not reverse within the

five-year period over which Cash ETR is measured. 20 We classify firms as tax avoiders

(TAXAVOIDER) if they have a five-year Cash ETR in the lowest quintile within the pooled

sample of all firms. 21 See Appendix 1 for a discussion of additional examples of tax planning

transactions that some readers might be consider as being entered into for earnings management

purposes but which we argue are properly classified as tax planning and which are captured by

our partitioning variable - Cash ETR.

We identify upward earnings management using discretionary accruals calculated from a

cross-sectional modified Jones Model with lagged return-on-assets (Kothari et al. 2005). We

classify firm-year observations as earnings management firm-years (EM) if the observation’s

discretionary accruals are in the top quintile of all firms. 22

Our tests are joint tests of our predictions and the ability of our partitioning variables (Cash

ETR and discretionary accruals) to correctly partition or identify the underlying likely source for

why the observations is in the LPBTD group.

Note that the denominator of the Cash ETR is

20 We use a 5-year Cash ETR for this analysis because we believe it is the broadest measure in the literature of tax avoidance. We are agnostic about the legality of the tax avoidance, we are simply trying to partition firms based on the most likely source of the temporary book-tax difference. Measures designed to capture only the most aggressive forms of tax avoidance, such as models of tax sheltering are too narrow for this purpose. Additionally, tax avoidance measures based only on permanent differences such as the traditional ETR by definition should not cause large positive temporary book tax differences. Finally, there is insufficient time series data to perform meaningful persistence tests using uncertain tax benefits as defined under FIN 48 as an alternative tax avoidance measure. These data are only available for 2 years and the economic upheaval in 2007 and 2008 likely makes any inferences based on UTBs over this sample period less generalizable.

21 In supplemental tests (not tabulated) we categorize firms as TAXAVOIDER within the LPBTD group by year. The results are consistent with those reported in Tables 4 and 5 using this alternative classification.

22 As with our tax avoidance proxy, we use a broad measure of earnings management because we are trying to determine the most likely source of a firm’s large positive book-tax difference regardless of the legality of the earnings manipulation. Both within GAAP upwards earnings management and fraudulent upwards earnings management could lead to a large positive temporary book tax difference so we attempt to capture both with our measure. We do not use measures that capture the most aggressive earnings management, such as restatements or AAERs because the sample would likely be too small to conduct a meaningful analysis of persistence or equity pricing and because we are not trying to capture management’s intent in reporting large positive accruals. Furthermore, just meeting or beating earnings benchmarks does not necessarily result in large positive book-tax differences.

pretax book income which is affected by earnings management activities. Thus it is possible that

a low Cash ETR arises because of a higher (managed) pretax book income. We argue however

that the firm did not pay cash taxes on these earnings otherwise it would not have reported a low

Cash ETR. Further, if Cash ETR is really only picking up earnings management activities then

the persistence results should not differ between the EM and TAXAVOIDER partitions.

Panel A of Table 3 presents statistics on the proportion of firms classified as EM and

TAXAVOIDERs within the SBTD, LNBTD, and LPBTD groups. To reiterate, we classify firms

as EM and TAXAVOIDER firms based on their ranking across the entire sample of 21,205 firm-

year observations. Firms in the bottom 20% of Cash ETR are classified as TAXAVOIDERS.

Firms in the top 20% of discretionary accruals are classified as upward EM (+) firms and firms

in the bottom 20% of discretionary accruals are classified as downward EM (-) firms.

If the

distribution of EM and TAXAVOIDER firms is random between each group (SBTD, LPBTD,

and LNBTD) we would observe that 20% of the firms in each group would be categorized as EM

(+) firms, 20% as EM (-) firms, and 20% as TAXAVOIDERS. However, it is notable that the

results in Panel A indicate a significant difference in the number of EM and TAXAVOIDER

firms within each group. Specifically, we observe significantly more EM (+) firms and

TAXAVOIDER firms in the LPBTD group. This result is consistent with prior studies

suggesting that large positive book-tax differences can serve as a useful signal of earnings

management and as a signal of tax avoidance activity and with our maintained assumption that

both EM and TAXAVOIDANCE activities can lead firms to end up in the LPBTD group

Table 3 also provides descriptive statistics for the sub-samples of large positive book-tax

difference firms categorized as EM or TAXAVOIDER firms. The TAXAVOIDER group has

lower median current period pre-tax earnings and lower median pre-tax accruals, but higher

median pre-tax cash flows than the EM firms. The TAXAVOIDER firms also have higher

median average total assets and higher median size-adjusted returns in period t+1 than the EM

firms. Not surprisingly, the EM firms exhibit higher median discretionary accruals and higher

Cash5ETRs than the TAXAVOIDER firms. Significance tests of differences are not provided

because these data are intended as purely descriptive.

We estimate equation (3) below to examine whether the earnings persistence of large positive

book-tax difference firms varies as a function of whether those book-tax differences are likely

largely a result of upward earnings management or tax planning.

PTBI t+1 = γ 0 + γ 1 TAXAVOIDER t + γ 2 EM + γ 3 PTBI t + γ 4 PTBI t × TAXAVOIDER t +

γ 5 PTBI t × EM t + ε t+1

(3)

Equation (3) is estimated only on the subset of firms with large-positive book-tax

differences. The coefficient on PTBI t , γ 3 , represents the earnings persistence of firm-years with

large positive book-tax differences that are in the BASE group – that is, firm-years that are not

categorized as upward earnings management or tax planning/avoidance firms. For these firms we

believe their large positive book-tax differences are likely a result of some combination of tax

avoidance, earnings management, and innate firm characteristics. Consequently, we expect the

earnings persistence for this subset of large positive book-tax difference firms to fall between the

other two subsets of firms. We expect that if large positive book-tax differences resulting from

earnings management are a signal of discretion in accruals then the coefficient on the interaction

term (PTBI × EM), γ 5 , will be negative. In contrast, if the positive book-tax differences are

primarily a result of tax planning we expect this will mitigate the extent to which large positive

book-tax differences serve as a signal of lower earnings persistence. Consequently, we expect

earnings persistence will be higher for this subset of firms (γ 4 > 0) than for the BASE group of

firms.

The results reported in Panel A of Table 4 indicate that firm-years designated as upward

earnings management (EM) exhibit significantly lower earnings persistence than other large

positive book-tax difference firms. This finding is consistent with hypothesis (1) and suggests

that when large book tax differences are largely a result of upward earnings management they

are a particularly useful signal of low earnings persistence. The results also indicate that firm-

years designated as TAXAVOIDER exhibit higher earnings persistence than the BASE group of

firms although the difference is not significant.

Next, we decompose earnings into pre-tax cash flows and pre-tax accruals for our sub-

sample of large positive book-tax difference firms to examine the implications of being

designated as a TAXAVOIDER or EM for the persistence of these two earnings components.

Panel B of Table 4 reports the results of estimating equation (4) below:

PTBI t+1 = γ 0 + γ 1 TAXAVOIDER t + γ 2 EM t + γ 3 PTCF t + γ 4 PTCF t × TAXAVOIDER t + γ 5 PTCF t ×

EM t + γ 6 PTACC t + γ 7 PTACC t × TAXAVOIDER t + γ 8 PTACC t × EM t + ε t+1

(4)

Consistent with Hypothesis (2), the results indicate the pre-tax accrual component of

earnings has lower persistence for future earnings for the firm-years designated as EM as

compared to the BASE group of LPBTD firms. This finding suggests that in the cases where

large positive book-tax differences are largely a function of upward earnings management they

serve as a useful signal of subjectivity in the accruals process and therefore of lower quality

earnings. Consistent with hypothesis (4), the results in Panel B also show that the accrual

component of earnings for the firm-years designated as TAXAVOIDERS is significantly more

persistent than for the BASE group firms. This result suggests that when large positive book-tax

differences arise primarily from tax planning they are a less useful signal of discretion in the

accruals process. We do not make a prediction about the persistence of cash flows between

groups of large positive book-tax difference firms. The results in Panel B of Table 4 indicate the

persistence of cash flows are not significantly different for the EM and TAXAVOIDER firms

compared to the BASE group of firms. Panel B of Table 4 also sums the coefficients reported in

the top part of panel B to provide a direct estimate of the persistence of cash flows and accruals

for each group within the LPBTD sample. As expected, the persistence of accruals is highest for

the TAXAVOIDER firms while the EM firms exhibit the lowest persistence of accruals. 23

Because we observe significant differences in the persistence of earnings and accruals for the

EM and TAXAVOIDER groups, concerns that the Cash ETR measure (used to partition LPBTD

into TAXAVOIDERS) is largely picking up the effects of earnings management rather than tax

avoidance appear unwarranted.

There are 349 firm-year observations in our large positive book-tax difference sample

classified into both the TAXAVOIDER and EM groups. These observations exhibit both high

levels of discretionary accruals and low Cash ETRs. It is notable that we do not observe a high

correlation between tax avoidance and financial reporting aggressiveness (as measured by the

level of discretionary accruals). In other words, the number of firm-years categorized as both EM

firms and TAXAVOIDER firms is roughly what would be expected to occur by chance. 24,25

The purpose of categorizing firm-year observations as either EM or TAXAVOIDER is to

identify cases where the predominant source of the large positive book-tax differences is either

earnings management or tax avoidance. We do not have clear predictions for the earnings or

accruals persistence of the firm-year observations that exhibit both aggressive earnings

23 In supplemental tests (untabulated) we re-estimate equations (3) and (4) including a measure of the variance of taxable income (based on the prior 5 years of data or 3 years if there are not 5 years of data available) and its interaction with pre-tax book income. We include the variance of taxable income to control for differences in the variability of taxable income across firms. The results are qualitatively similar to those reported in Table 4.

24 The 349 firm-year observations categorized in both the TAXAVOIDER and EM group represents 27.2% (349 / 1281) of firms in the TAXAVOIDER group, or 32.1% (349/1085) of firms in the EM group. By chance we would expect 26% of the TAXAVOIDER group and 30.7% of the EM group to be categorized in both groups. Neither of these differences is statistically significant at conventional levels.

25 This result contrasts with Frank et al. (2009) who find aggressive financial reporting firms are more likely to also pursue aggressive tax reporting strategies. However, our measure, Cash ETR, is a more broad measure of tax avoidance whereas their measure, adjusted permanent book tax differences, is more towards the tax aggressiveness end of the spectrum so the results are not directly comparable.

management and tax avoidance. Consequently, in supplemental analysis we re-estimate

equations (3) and (4) removing the firm-year observations categorized as both EM and

TAXAVOIDERS from our sample. The results of this re-estimation (not tabulated) indicate both

the earnings and accruals persistence of the remaining EM observations continue to be

significantly lower than the BASE group of LPBTD firms. The accruals persistence of the

TAXAVOIDER firms also continues to be significantly higher than the accruals persistence of

the BASE group firms. However, the overall earnings persistence of the TAXAVOIDER group

is not significantly greater than that of the BASE group firms once the firms categorized as both

EM and TAXAVOIDER firms are removed.

Table 5 presents the test results for our third set of hypotheses comparing the persistence

across BTD firms after removing EM observations from the LPBTD group. The results in Panel

A indicate that when the EM firms are removed from the LPBTD group, the LPBTD group no

longer exhibits significantly different earnings persistence from the SBTD group. Further, the

results in Panel B of Table 5 indicate that when the EM firms are removed from the LPBTD

group, the LPBTD group actually exhibits higher persistence of accruals into future period

earnings in comparison to the SBTD group. These results are consistent with our prediction that

the lower earnings and accruals persistence of the LPBTD group is driven by the sub-sample of

firms where the predominant source of their LPBTDs is upward earnings management. 26

V. Market Pricing Tests

Table 6 presents the results of our market pricing tests. We estimate the two-equation

Mishkin approach and hedge portfolio returns. These tests allow us to examine whether

investors correctly infer the persistence of accruals for each group and to examine whether there

26 In untabulated analysis, we also remove high discretionary accrual firms from the SBTD group and continue to find that LPBTD firms have comparable cash flow and accrual persistence as SBTD firms, although LPBTD firms accrual persistence is no longer significantly greater than the accrual persistence of SBTD firms.

is any deviation from market efficiency in the pricing of the persistence of the accrual

component of earnings. We estimate the relation between future returns and ranked accruals and

other control variables using the following equation (5):

SAR t+1 = β 0 + β 1 PTACC t + β 2 MVE t + β 3 BM t + β 4 BETA t + β 5 EP t + β 6 SAR t + ε t+1

(5)

Each of the variables in Equation (5) is converted to a rank variable scaled from 0 to 1.

Specifically, we sort each variable into deciles, and then the decile rank (1-10) is transformed to

between 0 and 1 by ((Decile rank – 1)/9). The estimated coefficient on each transformed

variable can be interpreted as the hedge portfolio return to positions taken on that variable.

PTACC t is pre-tax accruals for period t, MVE t is the market value of equity at the end of period

t, BM t is the book value of equity at the end of period t divided by MVE, BETA t is the common

stock beta calculated using a market model run over the 24-month period ending at the start of

the current fiscal year, EP t is earnings per share in the current fiscal year divided by price at the

end of the current fiscal year, and SAR t is size adjusted annual returns beginning on the first day

of the fourth month of the current fiscal year. Fama and French (1992) argue these variables

represent unknown risk factors, and consequently, are associated with future expected returns.

The coefficient, β 1 , represents the size-adjusted abnormal return to a zero-investment portfolio

based on taking long positions in firm-years with positive weights and short positions in firm-

years with negative weights. We begin the calculation of size-adjusted abnormal returns three

months after the fiscal year-end to allow for the determination of the portfolio weights used to

take these investment positions.

In equation (5), β 1 will equal 0 if investors correctly infer the persistence of accruals, β 1

<0 (>0) if investors overestimate (underestimate) the persistence of accruals. In fact, β 1 is an

estimate of the difference in the actual time-series persistence of accruals and the market’s

implied persistence. This result can be shown as follows using the two-equation framework in

Mishkin (and used by Sloan 1996 and Hanlon 2005. Ball and Kothari 1996 and Kraft, Leone

and Wasley 2007 develop a similar reconciliation). This analysis helps interpret the hedge

portfolio return results. The two equation system is (simplifying equation (2) to only PTACC t )

as follows:

PTBI t+1 = γ 0 + γ 1 PTACC t + ε t+1

(S1)

SAR t+1 = δ 0 + δ 1 UPTBI t+1 + ν t+1

(S2)

where UPTBI t+1 is unexpected pretax book income in t+1. We can substitute from S1 for UPTBI (which equals ε t+1 ) in S1 and get

SAR t+1 = δ 0 + δ 1 (PTBI t+1 - γ 0 * - γ 1 *PTACC t ) + ν t+1

(S3)

Consistency between coefficient estimates in equations (S1) and (S2) is tested using the Mishkin approach. 27

Now substitute the RHS of equation (S1) for PTBI t+1 in (S2).

SAR t+1 = δ 0 + δ 1 (γ 0 + γ 1 PTACC t + ε t+1 γ 0 * - γ 1 *PTACC t ) + ν t+1

Expanding and collecting terms:

(S4)

SAR t+1 = (δ 0 + δ 1 (γ 0 γ 0 *)) + δ 1 (γ 1 - γ 1 *) PTACC t + δ 1 ε t+1 + ν t+1

SAR t+1 = β 0 + β 1 PTACC t + η

(S5)

where β 0 = (δ 0 + δ 1 (γ 0 γ 0 *)) and β 1 = δ 1 (γ 1 - γ 1 *). Equation (S5) is simply equation (5) without the

additional control variables. Thus β 1 will equal zero if the markets’ estimate of the persistence of

accruals, γ 1 *, is the same as the actual time series persistence of accruals γ 1 . If the market

overestimates the persistence of accruals (γ 1 < γ 1 *), β 1 will be < 0 indicating negative hedge

27 One can also estimate SAR t+1 = δ 0 + δ 1 PTBI t+1 + δ 2 PTACC t + ν t+1 using OLS, noting that δ 2 = δ 1 γ 1 * so that we

can solve for γ 1 * = -δ 2 / δ 1.

Consistent with Hanlon (2005), we correct for missing delisted returns by using delisting returns of -35 percent for NYSE/AMEX firms and -55 percent for NASDAQ firms for delisting codes 500 and 520-584.

See Burgstahler, Jiambalvo and Shevlin (2002) who use both OLS and the Mishkin test.

portfolio returns. Intuitively, the returns are negative because there are predictable negative accrual

surprises because investors are over-estimating the persistence of accruals. The predictions are

reversed if the market underestimates the persistence of accruals, (γ 1 > γ 1 *) and β 1 will be > 0

indicating positive hedge portfolio returns. We present the results of both the Mishkin (1983) and

hedge portfolio tests in Table 6. The Mishkin test allows us to directly estimate the markets implied

persistence estimates and, using these implied persistence estimates, hedge portfolio returns. We

also directly estimate hedge portfolio returns using equation (5) because this approach allows us to

include additional controls for risk and to estimate the model using annual return regressions to

mitigate concerns with cross-sectional correlation in returns (Fama and Macbeth 1973).

Panel A of Table 6 presents the results of the Mishkin (1983) test of market rationality to

compliment the hedge portfolio tests. The results do not indicate a significant difference between

investor expectations for accruals persistence for the TAXAVOIDER group and the actual

accruals persistence for that group. However, we do observe a significant (p 0.01) difference

between investor expectations of accruals persistence for the EM group and actual accruals

persistence for that group. Investors do not appear to correctly anticipate the lower accruals

persistence exhibited by the EM group relative to the BASE group of firms. While the Mishkin

tests appear to indicate investors overestimate the persistence of accruals for the EM firms, we

also estimate the hedge portfolio tests which have the important advantage of allowing us to

include additional controls for risk.

For our hedge portfolio tests, we estimate equation (5) separately for four samples of

firms. We begin by estimating equation (5) for all firms with large positive book-tax differences.

Hanlon (2005) finds that investors correctly price the persistence of accruals for firms with large

positive book-tax differences. Panel B of Table 6 presents the result of estimating equation (5) on

the full sample of large positive book-tax difference firms. The results in Panel B indicate that β 1 ,

is marginally significantly different from 0 (p 0.10) in a one-sided test indicating that investors

overestimate the persistence of accruals for the entire LPBTD group. Furthermore, the

coefficient on β 1 is negative in 9 of the 13 years that we estimate the hedge portfolio regression.

Overall, the results in Panel B do provide some weak evidence that investors consistently

overestimate accruals persistence for the LPBTD group. Panel C of Table 6 presents the results

of estimating equation (5) on the sub-sample of firm years designated as TAXAVOIDERs. If,

consistent with hypothesis 4a, investors underweight the persistence of accruals then we expect

β 1 will be significantly positive. The results in Panel C indicate that β 1 is actually negative but is

not significantly different from 0 for the TAXAVOIDER sub-sample. This result suggests

investors are able to identify large positive book-tax differences that have been generated

predominantly as a result of tax planning and adjust their expectations for the persistence of

accruals accordingly.

Panel D of Table 6 presents the results of estimating equation (5) on the sub-sample of

earnings management firms. If, consistent with hypothesis 4b, investors overweight the

persistence of accruals for this sub-sample then we expect β 1 will be significantly negative. The

results in Panel D show that β 1 is actually positive but not significant for the sub-sample of

earnings management firms. This finding is consistent with investors being able to identify large

positive book-tax differences generated by upward earnings management and correctly pricing

the persistence of accruals for those firms. While these results are consistent with Hanlon (2005),

we note that they are opposite the findings of Xie (2001) who finds that the mispricing

documented by Sloan (1996) is concentrated in firms with high discretionary accruals. Thus, our

finding that firms with high discretionary accruals in the LPBTD group have lower earnings and

accrual persistence is similar to Xie (2001), but our finding that market participants appear to

price accruals in a rational manner provides a stark contrast to the findings in Xie (2001), at least

for our large positive book-tax difference subsample. Our results suggest that investors might be

using large positive book-tax differences as a signal about the quality of accruals for these firms.

For completeness, Panel E presents the results of estimating equation (5) on the

remaining, BASE group, of large positive book-tax difference firms. The results indicate β 1 is

also not significant for this sample of firms. In summary, we do not observe mispricing for any

of the sub-samples of LPBTD firms despite the significant differences in the persistence of

earnings and accruals between these sub-samples of firms. The differing results between the

hedge portfolio tests and the Mishkin tests are the result of the inclusion of additional controls

for risk in the hedge portfolio tests. Because the hedge portfolio tests allow us to more fully

control for risk we place more emphasis on those tests and conclude that overall investors appear

to correctly price accruals persistence for each sub-sample of LPBTD firms.

VI. Supplemental Analysis on the Large Positive Book Tax Difference Firms

Table 7 presents the results of our supplemental analysis using alternative measures to

identify the TAXAVOIDER firms among the large positive book-tax difference group. Because

the denominator of our five-year Cash ETR measure is pre-tax book income it is possible that

this measure of tax avoidance is also identifying firms that have managed pre-tax earnings

upward resulting in a lower Cash ETR. If true, this could confound attempts to use Cash ETR to

identify cases of LPBTDs arising from tax avoidance rather than upward earnings management.

But note that our earlier results in Tables 4 and 5 mitigate some of this concern: we do observe

differences in the persistence of earnings and accruals using Cash ETR to identify likely TAX

AVOIDERS. However, as an alternative measure of tax avoidance we calculate five-year Cash

ETR scaled by cash flow from operations rather than pre-tax earnings. The results reported in

Panel A of Table 7 indicate that using this alternative measure the TAXAVOIDER firms exhibit

significantly higher earnings persistence than the BASE Group. Further, the results reported in

Panel B indicate that the TAXAVOIDER firms continue to exhibit significantly higher

persistence for the accrual component of earnings. Not surprisingly, because the EM group is not

really affected by the TAXAVOIDER classification, although the BASE group to which the EM

group is compared does change as a result of the revised TAXAVOIDER classification, the

results from the EM group remain consistent with our prior findings: EM firms exhibit lower

persistence of earnings and accruals.

Next, we calculate an alternative 3-year measure of Cash ETR. We do this in an effort to

better identify whether current year book-tax differences are a direct result of tax avoidance

activity. It is possible that a low Cash ETRs based on a five-year measure could be a function of

prior period tax avoidance and unrelated to the current year book-tax differences. However,

Dyreng et al. (2008) point out that Cash ETR suffers from measurement error and this

measurement error is greater for short-term, especially one-year, measures of Cash ETR.

Specifically, cash taxes paid represents the actual taxes paid by the firm during a given year and,

as a result, could include estimated tax payments associated with the prior year’s income. Using

longer-term measures of Cash ETR helps to minimize this measurement error. We use a three-

year measure of Cash ETR as a compromise between the desire to identify current year book-tax

differences arising from tax avoidance and the measurement error that exists in short-term Cash

ETR measures. The results reported in Panel C of Table 7 indicate that using this alternative

measure the TAXAVOIDER firms do not exhibit significantly higher earnings persistence than

the BASE Group. However, the results reported in Panel D indicate that the TAXAVOIDER

firms continue to exhibit significantly higher persistence for the accrual component of

earnings. 28

28 Other common measures of tax aggressiveness include the traditional ETR (total income tax expense over pre-ta x book income), permanent book-tax differences, and discretionary permanent book-tax differences (DTAX) developed by Frank, Lynch, and Rego (2008). Because each of these measures only detect aggressive tax reporting

VII. Large Negative Book-Tax Differences

In addition to documenting lower earnings persistence for large positive book-tax

difference firms, Hanlon (2005) also finds firms with large negative book-tax differences exhibit

lower earnings persistence. Because large negative book-tax differences are not likely to be

reflective of tax avoidance this group of firms does not lend itself to the same partitioning as our

analysis of large positive book-tax differences. We conjecture that large negative book-tax

differences likely arise from a combination of normal book-tax differences and downward

earnings management (negative discretionary accruals). Managers might use discretion over the

accrual process to manage earnings downward for purposes of smoothing earnings. We extend

the analysis of large negative book-tax differences (LNBTDs) in Hanlon (2005) by partitioning

the LNBTD firms into a downward earnings management group (EM) and a BASE group. The

EM firms are identified as LNBTD firms with modified Jones model discretionary accruals in

the bottom quintile of all firms. If LNBTDs result from downward earnings management we

would expect these firms to exhibit lower levels of earnings and accruals persistence than the

BASE group of firms.

Panels A and B of Table 8 present the descriptive statistics for the EM and BASE groups

of LNBTD firms respectively. Because we exclude loss firms from our analysis, we do not

believe the LNBTD firms reflect traditional “big bath” firms. In fact, it is interesting to note that

both groups of LNBTD firms report very high pretax profits and the EM firms are actually more

profitable than the BASE group. It is possible the EM firms exhibit large negative discretionary

accruals because managers are using their discretion to smooth earnings downward during very

profitable years. In Panel C of Table 8 we directly examine the earnings persistence of the EM

and BASE groups of LNBTD firms. The results do not indicate a significant difference in the

earnings persistence between the BASE group of LNBTD firms and the EM group. However, the

results reported in P anel D of Table 8 indicate the accrual component of earnings is significantly

more persistent for the EM group of LNBTD firms for which we have no ex post explanation.

VIII. Conclusion

This study provides insight into why large positive book-tax differences serve as a us eful

signal of future earnings and accruals persistence. Our findings suggest that in some ca ses large

positive book-tax differences do reflect discretion in the accrual process that leads to lower

earnings and accruals persistence. For this reason, on average, large positive book-tax

differences are a useful signal of earnings quality. However, we provide evidence that the

usefulness of this signal is contingent upon the predominant source of the book-tax difference s.

In cases where large positive book-tax differences arise primarily from tax reporting strate gies

the persistence of accruals is significantly greater than that of other firms with large po sitive

book-tax differences. In contrast, when large positive book-tax differences are generated

primarily by upward earnings management the persistence of earnings and accruals is

significantly less than that of other large positive book-tax difference firms. Furthermore, the

lower overall earnings and accrual persistence of large positive book-tax difference firms is th e

result of the relatively high number of high accrual firms (26%) within this group. After

removing high discretionary accru al firms from the large positive book-tax difference, we no

longer

find lower persistence of earnings and accruals for this group compared to the firms in

small book tax difference group.

the

Recent debate by policy makers has centered on the issue of improving disclosures of

differences in book income and taxable income. In the wake of several prominent accounting

scandals, Senator Charles Grassley sent a letter to President Bush on October 7, 2002 asking th e

administration to consider whether action was warranted to improve disclosures of book-tax

differences. McGill and Outslay (2004) provide a detailed analysis of identified corporate tax

shelter participants and show that their tax footnote disclosures provide little information on

these transactions. However, despite concerns over the limited information provided to investo rs

regarding differences between a firm’s book and taxable income we find investors are able to us e

these disclosures to look through to the source of book-tax differences and correctly price the

persistence of accruals. This result compliments the findings of Ayers, LaPlante, and McGuir e

(2010) who show that credit analysts also appear able to look through to the source of book-tax

differences in assessing credit-worthiness. Together these results suggest financial statement

users are fairly sophisticated in their ability to understand the implications of different types of

book-tax differences.

Appendix 1: The Cash Effective Tax Rate as a Measure of Tax Avoidance

The purpose of using Cash ETR to partition firms with large positive book-tax differences is to identify those cases where the differences likely arise from tax planning. As such, we use a general measure of tax avoidance designed to reflect both clearly legal tax planning activity and cases where the legality of the transaction is less certain. As Hanlon, Dyreng, and Maydew (2008) point out, the Cash ETR is affected by tax deferral strategies, but has the advantage (relative to traditional ETR measures) of not being affected by changes in the tax accounting accruals (tax cushion or reserve). To minimize the possibility that the Cash ETR may mismatch cash taxes paid in one period on earnings from a different period, we follow the recommendation of Dyreng et al. and use a five-year aggregate measure. Below we discuss examples of tax planning transactions that would be reflected by this measure. The list is not meant to be exhaustive but rather an illustration of why we think cash ETR is a reasonable proxy for our broad definition of tax avoidance.

Example A: Leasing transaction – lessor perspective

Consider a firm that manufactures and leases electronic equipment. It writes lease contracts that qualify as sales-type leases for financial reporting purposes but operating leases for tax purposes. For financial reporting purposes, the company reports the gross profit on each new lease as a “sale” but for tax purposes, only the monthly rental payments are included in taxable income while MACRS deductions are claimed on the equipment. This lowers Cash ETRs by creating large temporary book-tax differences that are sustainable as long as the lease base continues to expand. It is possible for the firm to write lease contracts that qualify as operating leases for both book and tax purposes without changing the timing of the taxes paid. Since this structure enables the firm to accelerate pretax book income without accelerating the corresponding taxes paid one could argue that this transaction and the corresponding book-tax differences primarily reflect earnings management. However, it is equally plausible that the firm could sell the equipment and record the gain for tax purposes immediately. If the firm structured the transaction to be a sale for both tax and financial reporting purposes, the book-tax difference would not exist. Since the firm deliberately structured the transaction to defer income for tax purposes (relative to simply selling the equipment), this transaction fits our definition of tax planning.

Example B: Synthetic lease – lessee perspective

As a second example, consider synthetic leases. These leases are structured to be treated as operating leases for financial reporting purposes but are treated as a purchase and collateralized borrowings for tax purposes. The firm essentially borrows money to acquire real property but structures the transaction so that only a small rental payment decreases GAAP income each year while MACRS deductions and interest expense on the loan reduce taxable income. One could argue that the firm would be allowed the same tax deductions by just borrowing money and purchasing the property outright and that the lease structure was created to defer expenses for financial reporting purposes. However, the firm could also structure the transaction so that the tax treatment is also an operating lease rather than a purchase. The book-tax difference would not exist if the firm were not accelerating deductions for tax purposes (relative to structuring the transaction as an operating lease for tax purposes). This also fits our definition of tax planning.

Example C: Multinational Tax Planning

Finally, consider a multinational firm that invests in a subsidiary in a country with a statutory tax rate below the U.S. tax rate and reinvests the profits in the subsidiary to fund continued growth in that market. This reinvestment results in a low Cash ETR that may persist for many years. One could argue that reinvesting in such a foreign subsidiary is not tax planning but simply a reflection of a firm taking advantage of growth opportunities abroad. However, Hartman (1985) develops a model demonstrating that whether a firm repatriates foreign earnings or reinvests those earnings in the foreign jurisdiction is a function of the after tax rates of return in both jurisdictions which in turn are functions of foreign and domestic tax rates. Therefore, a lower foreign tax rate, ceteris paribus, leads to a higher likelihood that the firm will reinvest the earnings in the subsidiary. Consequently, we would view this type of investment in a low tax foreign jurisdiction as another form of tax planning. 29

Each of these transactions lowers a firm’s Cash ETR. In each case, the transaction structuring and the existence of the temporary book-tax difference reflect some amount of tax planning. Consequently, we believe that long-term Cash ETR is a reasonable proxy for tax avoidance. It is possible that if a firm manages financial earnings upward and does not pay taxes on those earnings the Cash ETR will be driven lower by the earnings management activity. In some respects, this would still reflect tax planning because the firm was able to avoid paying taxes on the overstated earnings. Nonetheless, to address this concern we follow the recommendation of Dyreng et al. (2008) and conduct supplemental tests using an alternative specification of Cash ETR where cash flows from operations are the scalar rather than pretax earnings.

29 It is important to note that in cases where managers designate earnings from a low-tax foreign jurisdiction as permanently reinvested abroad this would not result in a deferred tax liability (temporary book-tax difference) for the firm but does increase after tax net income. Graham, Hanlon and Shevlin (2009) report survey evidence indicating the importance of this effect in firm’s location and repatriation decisions.

References

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Table 1 Descriptive Statistics on Sample Firms Partitioned on Book-Tax Differences Sample Period 1993-2005

Large Positive Book-Tax Difference Group

Firm-Year Observations: 4,178

Variable

Mean

Median

Std Dev

Minimum

Maximum

Avg. Assets t

2,513.60

376.10

13,787.30

4.634

684,794

PTBI t+1

0.089

0.086

0.114

-0.291

0.433

PTBI t

0.130

0.108

0.087

0.004

0.465

PTCF t

0.140

0.138

0.113

-0.146

0.497

PTACC t

-0.010

-0.028

0.088

-0.213

0.305

SAR t+1

-0.010

-0.077

0.618

-1.522

13.257

Disc. Acc.

0.010

0.007

0.069

-0.283

0.344

Cash5ETR

0.303

0.277

0.199

0.000

1.000

Large Negative Book-Tax Difference Group

Firm-Year Observations: 4,263

Variable

Mean

Median

Std Dev

Minimum

Maximum

Avg. Assets t

2,178.90

232.300

11,472.80

4.822

409,644

PTBI t+1

0.120

0.114

0.129

-0.291

0.433

PTBI t

0.149

0.125

0.108

0.004

0.465

PTCF t

0.174

0.161

0.125

-0.146

0.497

PTACC t

-0.024

-0.038

0.097

-0.213

0.305

SAR t+1

0.038

-0.043

0.697

-1.545

15.742

Disc. Acc.

-0.014

-0.016

0.076

-0.366

0.306

Cash5ETR

0.347

0.334

0.171

0.000

1.000

Table 1 (Continued)

Small Book-Tax Difference Group

Firm-Year Observations: 12,764

Variable

Mean

Median

Std Dev

Minimum

Maximum

Avg.

         

Assets t

6,572.00

450.500

44,802.60

2.445

1,489,069

PTBI t+1

0.082

0.072

0.104

-0.291

0.433

PTBI t

0.105

0.083

0.084

0.004

0.465

PTCF t

0.123

0.111

0.102

-0.146

0.497

PTACC t

-0.017

-0.026

0.075

-0.213

0.305

SAR t+1

-0.002

-0.045

0.540

-1.583

9.587

Disc. Acc. t

0.002

0.000

0.060

-0.259

0.345

Cash5ETR t

0.329

0.321

0.167

0.000

1.000

Avg. Assets t = Assets t-1 (Compustat item 6) plus Assets t divided by 2 PTBI t+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assets t PTBI t = Pre-tax book income for the current year divided by average assets t (an estimate of pretax ROA) PTCF t = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assets t PTACC t = Pre-tax accruals for the current year calculated as PTBI t -PTCF t SAR t+1 = Size-adjusted return calculated as the buy-and-hold return on the security (including dividends) beginning at the start of the fourth month after fiscal year end and ending at the end of the third month the following year less the buy-and-hold return on a size-matched portfolio over the same period. Disc. Acc. t = Modified Jones Model discretionary accruals by 2-digit SIC industry Cash5ETR t = Sum of cash taxes paid over the previous 5 years divided by the sum of PTBI over the previous 5 years (or 3 years if 5 years of data are unavailable). Cash5ETRs greater than one are reset to one. Negative cash5ETR are reset to 35%

Observations in the top (bottom) quintile of book-tax differences by year are characterized as large positive (negative) book-tax difference firm-years. All other observations are characterized as small book- tax difference firm-years. PTBI t+1 , PTBI t , PTCF t , and PTACC t are winsorized at the 1 st and 99 th percentiles.

Table 2 Replication of Hanlon (2005)

Panel A: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings with Coefficients Allowed to Vary for Firm-Years with Large Book-Tax Differences (N=21,205)

PTBI t+1 = γ 0 + γ 1 LNBTD + γ 2 LPBTD t + γ 3 PTBI t + γ 4 PTBI t × LNBTD t + γ 5 PTBI t × LPBTD t + ε t+1

Variables

γ

0

γ

1

γ

2

γ

3

γ

4

γ

5

Adj

Pre-tax Earnings Persistence by Group

           

R2

Predicted

?

?

?

+

-

-

 

LPBTD

SBTD

LNBTD

sign

Estimate

0.001

0.016

0.005

0.772

-0.071

-0.122

0.363

0.650

0.772

0.701

t-statistic

0.39

5.93***

1.77*

81.70***

-4.48***

-6.49***

       

Panel B: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components with Coefficients Allowed to Vary for Firm-Years with Large Book-Tax Differences (N=21,205)

PTBI t+1 = γ 0 + γ 1 LNBTD t + γ 2 LPBTD t + γ 3 PTCF t + γ 4 PTCF t × LNBTD t + γ 5 PTCF t × LPBTD t + γ 6 PTACC t + γ 7 PTACC t × LNBTD t + γ 8 PTACC t × LPBTD t + ε t+1

Variables

γ

0

γ

1

γ

2

 

γ

3

 

γ

4

 

γ

5

γ

6

γ

7

γ

8

Adj

                 

R2

Predicted

?

?

?

 

+

 

?

 

?

+

-

-

 

sign

     

Estimate

-0.007

 

0.007

-0.001

0.802

-0.046

 

-0.080

0.579

-0.098

-0.099

0.384

t-statistic

-4.55***

 

-2.71***

-0.41

85.90***

-2.93***

-4.13***

45.40***

-4.75***

-4.31***

 

By

 

LPBTD

       

SBTD

     

LNBTD

 

Group

     
 

PTCF

 

PTACC

 

PTCF

PTACC

PTCF

 

PTACC

 

0.722

 

0.477

 

0.802

 

0.579

0.756

 

0.478

Table 2 (Continued)

PTBI t+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assets t PTBI t = Pre-tax book income for the current year divided by average assets t PTCF t = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assets t PTACC t = Pre-tax accruals for the current year calculated as PTBI-PTCF LNBTD t = Indicator variable equal to 1 for firm-year observations in the lowest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35) LPBTD t = Indicator variable equal to 1 for firm-year observations in the highest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35)

All variables except for indicator variables are scaled by average total assets. T-tests are one-sided if a directional prediction is made, two-sided * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. PTBI t+1 , PTBI t , PTCF t , and PTACC t are winsorized at the 1 st and 99 th percentiles.

Table 3 Descriptive Statistics For Selected Variables

Panel A: Proportions of Groups Classified as Earnings Managers and Tax Avoiders

 

SBTD

LNBTD

LPBTD