Indicadores Financieros 168

This section summarises existing research studies that employ book-tax differences to determine accounting information quality of the firm. Even though prior research incorporates firm-specific and institutional factors, i.e. market-to- book ratio and legal system, to estimate earnings timeliness, it appears that book- tax differences have not yet been employed by the existing study. A review of literature is presented as follows.

Earnings informativeness and book-tax differences

Hanlon et al. (2005) estimate about the information loss if financial accounting income is conformed to taxable income. The expectation is that accounting income prepared by GAAP (or book income) should have information content relative to taxable income because of the different objectives between book income and taxable income. However, the authors suggest that if investors use taxable income as a benchmark to evaluate book income, then taxable income will have incremental information content. Based on the data during the period 1983 – 2001, they compare market returns from the change in book income and taxable income. They separate the comparison by using the sign from the change in book income and taxable income and the sign and magnitude from the change in book and taxable income. Findings suggest that book income is more useful for investors relative to taxable income because book income provides an average annual return greater than taxable income. Next, they compare the relative information content by using the explanatory power. They regress stock returns on changes in book income and taxable income separately. Their findings report that book income has higher information content than taxable income. Last, they estimate the incremental information content. They regress stock returns on book income and taxable income. They find that the coefficient estimate for book income and taxable income is .55 and .28, respectively. This suggests that the

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market appears to rely more on book income relative to taxable income. In addition, they suggest from the findings that if the same accounting rule is used for calculating both book income and taxable income, the information content would be loss.

Hanlon et al. (2008) examine a decrease in earnings informativeness if book-tax conformity increases. They use firms that are forced to convert from cash method to accrual method for tax calculation and control firms that use accrual method for tax calculation during the entire period of the study. By using the ERC model, they set an indicator variable for the converting firm and control firm. And, an indicator variable is introduced to capture the difference in the time period between pre- and post-cash and accrual method conversion. They integrate all indicator variables with changes in earnings. Stock returns are used as a dependent variable. A priori expectation is that information loss should be observed at an increase in book-tax conformity. Their findings suggest that the earnings informativeness declines after firms are forced to use accrual method for tax purposes, implying that book-tax conformity reduces the value relevance of earnings information. They also match converting firms and control firms by using sales growth. The findings remain consistent.

Ayers et al. (2009) estimate the informativeness of taxable income. They conjecture that taxable income is less informative for high tax-planning firms relative to other firms, and taxable income is more informative for firms with lower earnings quality relative to book income. They compare the information content of book income and taxable income. They regress returns on change in taxable income and on change in pre-tax book income separately. They obtain the explanatory power from the return-taxable income regression divided by the explanatory power from the return-book income regression. The higher ratio suggests that taxable income is more informative than book income. They define high tax-planning firms when those firms have low effective tax rate calculated over five-year periods, t – 4 through t. They define low earnings quality firms by

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using abnormal accruals – the difference between total accruals and modified Jones model normal accruals. The highest 20 percent of absolute abnormal accruals in each year is classified as low earnings quality. Based on 50,760 firm- years during 1983–2002, their findings are consistent with their hypotheses. Taxable income is more informative for high-tax planning firms relative to other firms, and taxable is more informative than book income for low earnings quality firms. They also estimate the incremental explanatory power of taxable income. They regress returns on change in pre-tax book income and change in taxable income. The explanatory power from return-book-taxable income regression and the explanatory power from return-book regression are compared to determine the incremental explanatory power of taxable income. They find the incremental information content of taxble income.

Financial reporting and book-tax differences

Guenther et al. (1997) investigate a shift of financial reporting preparation when firms change from cash method to accrual method according to the change in tax rules in 1986. Before 1986, firms were allowed to use cash method for tax purposes. However, accrual method was enacted for all firms after 1986. In their study, they compare the sample firm that previously used cash method pre-1986 and accrual method post-1986 and the control firm that has been used accrual method since 1986. Pre-1986, relative to the control firm, the sample firm was more likely to accelerate (defer) revenues (expenses) around the fiscal year end because taxes were paid when cash was received. However, during post-1986, the incentive of revenue (expenses) acceleration (deferral) should decline when accrual method was enacted for tax purposes for the sample firm relative to the control firm. The sample and control firm include 66 firms for each group. The control firm is matched by SIC code. According to univariate test, the higher ratio of accounts receivable divided by accounts payable and the higher ratio of sales divided by expenses suggest that the sample firm accelerates revenue recognition greater than the control firm. They employ three ratios as dependent variables, including those two ratios and the ratio of cash receipts divided by cash

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disbursements. They regress those ratios on the inventory-incentive ratio – the ratio of inventory divided by total assets. Their findings are consistent with the result from the univariate test, suggesting that firms are more likely to defer income when accrual method is used for tax purposes.

Mills and Newberry (2001) examine tax cost and non-tax cost influencing book- tax differences between public and private firms. Tax costs refer to costs associated with tax examinations. Firms that report large book income but low taxable income are more likely to have high tax costs, i.e. audit adjustments. Non-tax costs refer to costs associated with financial reporting. Firms that conform book income and taxable income to reduce tax costs incurred are more likely to confront with non-tax costs, i.e. decreasing in firm value, debt covenant violation or managers’ compensation when the compensation is tied with book income. The book-tax conformity occurs due to firms’ tendency to reduce book income to conform taxable income. They investigate the relationship between book-tax differences and some factors including profit and loss, debt constraints and bonus plan thresholds by using public and private firms. They conjecture that: 1) public firms report higher book income relative to taxable income than private firms during profit periods, 2) public firms report higher book losses relative to tax losses than private firms, and 3) in the period of profit, the relationship between book-tax differences and debt ratio is weaker for public firms relative to private firms because public firms are more likely to meet the requirement of debt obligations. Also, they investigate the relationship between book-tax differences and bonus plan among public firms only. Based on 9,187 firm-years during the period 1981–1996, they regress book-tax differences on several variables, i.e. debt, tax credit, industry, bonus threshold and size. They use an indicator variable to separate public and private firms. Their findings suggest that among income (loss) firms, public firms report larger positive (negative) book-tax differences than do private firms. They find a stronger relation between book-tax differences and debt in private firms relative to public firms. They expect that managers tend to use income-decreasing procedures when

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their bonus plans upper or lower bounds are binding, and income-increasing procedures when there is no binding for these bonus plans. Their findings support this expectation. However, the finding is sensitive to the threshold level.

Earnings persistence and book-tax differences

Hanlon (2005) investigates whether earnings persistence varies according to the scale of book-tax differences. The dataset during the period 1994–2000 is partitioned to three groups, including small, large positive and large negative book-tax differences. A priori expectation is that small book-tax difference firm- years is of higher persistence than large positive and large negative book-tax difference firm-years. By using a random walk model, indicator variables are included to estimate the difference between sample groups. Findings suggest that firm-years with large negative and positive book-tax differences have considerably less persistent earnings than firm-years with small book-tax differences. The study also decomposes earnings information to cash flows and accruals. Results from the regression of earnings on cash flows and accruals support the prior finding that earnings are of lower persistence for firm-years with large book-tax differences relative to small book-tax differences. The study further estimates the market expectation on book-tax difference information. By using Mishkin methodology, findings suggest that book-tax differences are used by investors to infer lower persistence in accruals for firm-years with large positive book-tax differences. The market overestimates the persistence of accruals attributable to earnings performance for firm-years with large negative book-tax differences. The study also examines the relationship between abnormal returns and pre-tax accruals. The relationship between large negative (positive) book-tax differences and stock returns is significant (insignificant). This finding supports the result obtained from the Mishkin test that the market perceives rationally about large positive book-tax differences but irrationally for relative to large negative book-tax differences.

Chapter III Theoretical framework and literature review

Schmidt (2006) investigates the earnings persistence when earnings are decomposed into earnings excluding tax changes and tax change component. Earnings excluding tax (ATE) changes refer to pre-tax earnings multiplied by (1 – effective tax rate). Tax change component (TCC) refers to pre-tax earnings multiplied by change in effective tax rate. He regresses the one-year-ahead earnings on ATE and TCC. He finds the positive relation between the future earnings and TCC, suggesting that tax changes are not transitory. He extends TCC component by decomposing TCC into the initial tax change (quarter 1) component of earnings and the revised tax change (quarter 2, 3 and 4) component of earnings. He finds that the relationship between the one-year-ahead earnings and the initial tax change is significantly positive. The persistence between the one-year-ahead earnings and the revised tax change component of earnings declines as the year progresses. He concludes that tax change information is not transitory, and the initial and revised tax change has differential persistence and forecasting implication.

In conclusion, the book-tax difference is a useful means to differentiate the incentive of the firm. However, the book-tax difference must be interpreted with caution. Many research studies in the well-developed market employ book-tax differences to identify accounting quality. However, research studies conducted in the emerging market have rarely used book-tax differences as the institutional factor.