Michelle Hanlon Presented by: IRA GERALDINA The Persistence and Pricing of Earnings, Accruals, and Cash Flows When Firms Have Large Book Tax Differences Michelle Hanlon Presented by: IRA GERALDINA

Outline Research Background Research Questions Theory & Hypothesis Development Methodology Results Conclusions

Earning , Accrual, and Cash Flow Persistence BTD Market Assessment Overview

Backgrounds The difference between pre-tax financial reporting and taxable income can provide information about current earning Book tax differences can be informative about management discretion in the accrual process - Revsine et al. (1999); Palepu et al. (2000); Penman 2001 Large differences between book and taxable income an indicator as low quality of financial reporting earning Book tax differences as an indicator of earnings management (Mills dan Newberry, 2001; Philips et al. 2003; Joos et al. 2000; dan Lev dan Nissin, 2004) Extend litelatur on book tax differences

Research Questions Q1 Q2 How is the role of book tax differences in indicating in persistence of earnings, accruals, and cash flows? How is the role of book tax differences in indicating in influencing investors’ assessments of persistence of earnings and earnings components?

Theory Accounting earnings Vs Taxable income Permanent and temporary differences SFAS No. 109 uses balance sheet approach in reporting temporary differences Future taxable Vs future deductible amounts Future taxable amounts increase deferred tax liability & recognize deferred tax expense Future deductible amounts increase deferred tax asset & recognize deferred tax benefit

Hypotheses Development FASB’s Concept Statements No. 2 Qualitative Characteristics of Accounting Information: - predictive value (part of relevance) Earning persistence as determinant of earning quality (Jonas and Blanchet, 2000) Earning persistence as a relevant-value characteristics of earnings (Ohlson, 1995) Book tax differences reflecting information about current earnings persistence.

Hypotheses Development Increase in deferred tax liability might be an indication of deteriorating of earnings quality Deferred tax assets as a way to artificially increasing earnings (Revsine et al., 1999) The objectives of financial reporting and tax reporting are differences - financial income as signal of management performance (Dechow, 1994) - IRC provides frameworks in determining tax liability (Scholes et al. 2002 Manzon dan Plesko 2002)

Hypotheses Development Book tax differences can be generated as tax planning strategies - larger book tax differences the greater the likelihood of IRS audit and adjustment (Mills, 1998) Firms with large book tax differences are suspected having lower earnings quality (Jones et.al., 2000)

Pre-tax earning persistence for firm years with large negative or positive book tax differences is lower than earning persistence for firms with small book tax differences HYPOTHESES 1

subjectivity in financial reporting accrual process HYPOTHESES 2 The persistence of the accruals component of earnings is lower for firms with years with large negative or positive book tax differences relative to firm years with small book tax differences Large book tax differences indicate low earnings quality book tax differences are indicative of subjectivity in financial reporting accrual process

HYPOTHESES 3 The expectation of pre-tax earnings persistence reflected in stock prices for the accrual component of pre-tax earnings is consistent with observed persistence of accruals for firm years with relatively large boob tax differences Lower ERC for firm- years with large book tax differences introducing possibility of manager’s opportunistic on discretion (Jones et at.,2000) If investor use book tax differences as information about persistence of accruals, they may not misprice (Sloan, 1996)

Methodology CSRP and Compustat (1994-2000) Final sample: 14,106 data-4,048 firms 47.507 observations (non financial industries) 22,242 missing variables data excluded (pre-tax financial loss) 6,447 excluded (negative current tax expense) 1,518 excluded 3,194 excluded (NOL)

Methodology Model Prediction γ4 < 0 (γ5 < 0) Consistent with H1

Methodology Model Prediction γ7 < 0 and γ8 < 0, Consistent with H2 γ6 < γ3, accrual persistence less than cash flows persistence

Methodology Model Prediction γ1* closed to γ1 γ2* closed to γ2

Methodology Model Prediction β1 < 0 β1 is not significant for LBTD

RESULTS Descriptive Statistics Panel A Mean & Median of PTACC is negative

RESULTS Descriptive Statistics Table 1 Panel B PTACC is correlated with DTE only -0,008

RESULTS LNBTD: AVETA, BM, Sales, Sales Growth LPBTD : BTD

RESULTS γ4 = -0.100 and γ5 = -0.212 Consistent with H1

RESULTS γ7 = -0.115 and γ8 = -0.187 & γ6 < γ3 consistent with H2 γ2 < γ31

See LPBTD Pre-tax earning performance RESULTS See LPBTD Pre-tax earning performance

See LPBTD Pre-tax accrual performance RESULTS See LPBTD Pre-tax accrual performance

RESULTS See LNBTD Subsample , γ1* closed to γ1 See LPBTD Subsample, ((γ1* /γ1 )) <1 See LNBTD Subsample , γ1* closed to γ1 See SmallBTD subsample, underestimate

RESULTS LPBTD, consistent with H3 LNBTD inconsistent with H3 Full sample and SmallBTD : γ2* > γ2 and γ1* < γ1 LPBTD, consistent with H3 LNBTD inconsistent with H3

RESULTS LNBTD, insignificant PTACC abnormal return= 4% LNBTD, insignificant LPBTD, significant : Rationally perception

Additional Analysis The effect of special items: Firm years with large book tax differences having lower persistence in earnings, accruals, and cash flows Firm years with large positive (negative) book tax differences having lower persistence in accruals relative to firm years small book tax differences having lower Firm years with large positive (negative) book tax differences having lower persistence in cash flows, somewhat weaker.

Additional Analysis Examination of the disclosure of changes in DTA and DTL: Only 27 out of the 60 firms does the DTE tie out to the change of DTA and DTL Change of in DTA and DTL of Firm years with large positive book tax differences is from the depreciation, bad debt reserved, pensions, postretirement benefits and others. The largest categories for LNBTD from reserves and accruals Consistent with subsample’s accruals having a lower persistence for future earnings as compared to accruals for SmallBTD.

Additional Analysis Scaler Coefficient on the accrual interaction term for LPBTD group continues to be negative and significant. Firms years with large positive (negative) book tax differences have lower persistence in earnings and accruals

Additional Analysis ROE on Equity as a correlated omitted variables The coefficient for interaction term is significantly negative (-0, 428) Consistent with higher ROE firms having more mean reverting income.

Additional Analysis Book-tax differences as a proxy for discretionary accruals: Coefficient on cash flows is 0.747, the coefficient on accruals excluding the book-tax differences is 0.481 (significantly differences) Coefficients on the book tax differences is 0.402 (significantly different than the coefficient on accruals excluding book tax differences ) Consistence with book tax differences proxying for for discretion.

Conclusions Firm years with large positive book tax differences have lower persistence in earnings than firm years with small book tax differences. Firm years with large negative book tax differences have significantly less persistent in earnings, accruals, and cash flows. Market asses a lower expectation of earning persistence for the firm years with large positive book tax differences, but underestimate the persistence of cash flows Firm years with large negative and small book tax differences, investor overestimate the persistence of the accrual component

Limitations Sample size and time period Sample partition