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The Interplay Between Taxes and Financial Accounting Research. Sydney G. Winter Lecture in Accounting October 2006 Terry Shevlin. Outline of talk. Academic accounting research in taxation – what does this mean?

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the interplay between taxes and financial accounting research

The Interplay Between Taxes and Financial Accounting Research

Sydney G. Winter Lecture in Accounting

October 2006

Terry Shevlin

outline of talk
Outline of talk
  • Academic accounting research in taxation – what does this mean?
  • Empirical tax research in accounting – the Shackelford/Shevlin review piece (with some updating)
  • Taxes and asset (stock) prices - dividend tax capitalization, still an important area
  • Book-tax differences and recent research
  • My objective: what can financial accounting empiricists learn from some (recent) tax research.
academic accounting research in taxation what does this mean
Academic accounting research in taxation – what does this mean?
  • All methodologies can be found in tax research
    • Archival (empirical)
    • Behavioral or JDM
    • Analytical
    • Experimental markets
    • Legal
general overview of accounting tax research
General overview of accounting tax research
  • Most tax research can be classified either as
    • Tax planning
    • Tax policy
    • Tax Compliance

(but not mutually exclusive)

tax planning vs tax policy research
Tax planning vs tax policy research
  • Tax planning vs tax policy : Descriptive vs prescriptive
  • Tax planning – how do firms react to tax law changes – or what effect do taxes have on economic entities – is descriptive.
  • Why of interest – how will economic agents react to proposed tax law/policy changes?
  • Notice the similarity to much financial accounting research – is descriptive or positive research so as to provide relevant data to policy makers so that they (FASB, SEC, Treasury) can (hopefully) make more informed choices
tax compliance research
Tax compliance research
  • Mainly JDM, but some analytical and some empirical
    • What role tax preparers in the tax return area as tax planners, as educators of taxpayers
    • What incentives do tax preparers face and what effect does this have on compliance (aggressive positions?)
    • What role IRS audits on compliance?
    • What role penalties vs increased education on compliance?
    • Hypotheses generated from equity theory, prospect theory, and more generally from psychology field
general overview summary
General overview - summary
  • Note that tax policy research is often going to be more technically tax oriented so less likely to be published in the broad-based accounting journals (TAR, JAR, JAE, CAR) and more likely in JATA, NTJ, etc.
  • Tax policy research – focus of economists so beware competing with economists
archival empirical tax research in accounting introductory comments
Archival empirical tax research in accounting- Introductory Comments
  • Micro framework used in empirical tax research (Scholes and Wolfson 1992, updated in SWEMS 2004)
  • Do taxes matter?
    • Myers (1984), Ball and Brown (1968)
  • If not, why not?
  • If so, how much?
scholes and wolfson 1992 swems 2005 framework
Scholes and Wolfson (1992), SWEMS (2005) - Framework

3 central themes

  • All parties
    • e.g., compensation
      • Matsunaga, Shevlin and Shores 1992
    • raising capital
      • Miller 1977,
      • Collins and Shackelford 1992
    • M&A Erickson 1998
  • All taxes - explicit and implicit
    • Do asset prices reflect tax treatment? An area of focus over last 5-8 years in the literature
  • All costs
    • Financial reporting, agency costs, transaction costs
overview scholes and wolfson 1992 swems 2005
Overview - Scholes and Wolfson (1992), SWEMS (2005)
  • Not a new theory
  • Is positive rather than normative
  • No paper really challenges the framework
  • Maintained assumption and used to structure tests
  • Relatively young field – although entering early maturity
    • Thus documentation
    • Not integrated empirical development
  • Changes in tax laws and data availability stimulate research questions
  • Some depth in specific areas which Shackelford and Shevlin review
swems framework tax and nontax tradeoffs
SWEMS framework - Tax and Nontax Tradeoffs
  • Taxes cannot be minimized without affecting other organizational goals
  • Taxes are not a cost that taxpayers inevitably avoid (the financial reporting cost trade-off)
  • Effects of financial reporting costs well studied
  • Quantification of nontax costs has progressed slowly
tax and nontax tradeoffs
Tax and Nontax Tradeoffs
  • Taxes andFinancial reporting trade-off
  • Inventory - LIFO adoption, LIFO liquidation and inventory management, and LIFO abandonment

e.g. Hunt, Moyer and Shevlin JAE 1996

Examined LIFO firms inventory purchases, current and noncurrent accruals as ways to manage both reported earnings and taxable income. Features of the design

  • Simultaneous equations (to allow for jointness)
  • Lagged dependent variables (to allow for reversals)
  • Current and next period earnings and tax objectives (to allow for multiperiod targets).
tax and nontax tradeoffs13
Tax and Nontax Tradeoffs


    • stock options

Matsunaga, Shevlin and Shores JAR 1992

Examined why more firms did not undertake disqualifiying dispositions of ISOs to garner the tax savings – because would have lowered reported earnings!

    • pensions
    • $1 million limit
  • Intertemporal income shifting (especially around TRA 86)
  • Divestitures and asset sales
  • Tax shelters - oil and gas, R&D
  • Regulated industries
tax and nontax tradeoffs14
Tax and Nontax Tradeoffs
  • Financial reporting tradeoffs
  • Illustrate by ‘banking’ studies - why?
  • Scholes, Wilson and Wolfson RFS 1990
  • Various tests but examined banks realized security gains
  • RSG = a + b PC + c LLP + d Tax + …
tax and nontax tradeoffs15
Tax and Nontax Tradeoffs
  • Subsequent studies
  • Beatty, Chamberlain and Magliolo JAR 1995
    • Multiple dials available to achieve multiple targets
    • Simultaneous equations
  • Shackelford, Collins and Wahlen JAR 1995
    • Multiple dials
    • Time series regression for each bank
taxes and asset prices
Taxes and Asset Prices
  • Implicit taxes versus tax capitalization?
  • Muni bond example – classic and simple

When two assets give rise to identical pretax cash flows, but the cash flows to one asset are taxed more favorably than those to the other asset, taxpayers will bid for the right to hold the tax-favored asset. Thus the price is bid up and the before-tax r/r on the tax-favored asset will decrease relative to the before-tax r/r on the tax-disfavored asset – the difference in pretax r/r is the implicit tax.

taxes and asset prices17
Taxes and Asset Prices

Accounting literature examples

  • ESOPs - Shackelford (1991)
  • R&D tax credit - Berger (1993)
  • T-Bills - Guenther (1994)
  • Dividends Received Deduction tax rule changes
  • - Erickson and Maydew (1998)

M&A literature - complex code! Act as barriers to entry

  • Stock market reaction (Hayn 1989)
  • Acquisition premiums
    • Erickson (1998)
    • Ayers, Lefanowicz and Robinson (2000)
      • goodwill amortization
shackelford 1991 esops
Shackelford 1991 ESOPS
  • Qualified lenders to ESOPS can exclude 50% of the interest they receive on ESOP loan.
  • ESOP loan agreements contain 2 interest rates
    • r/i if the interest exclusion is permitted
    • r/i if the exclusion is not permitted
  • Key: The 2 ESOP r/i are for the same loan from the same lender to the same borrower over the same time period. The only difference is the tax treatment.
shackelford 1991 esops19
Shackelford 1991 ESOPS
  • He examines the discount ratio
    • (Rb – RELA)/(Rb – REL)
    • Rb = the fully taxable rate
    • RELA = the actual ESOP loan rate
    • REL = the ESOP loan rate if all benefits passed to borrower

REL(1-.5tc) = Rb(1-tc)

    • Results
    • The lender retains about 21 – 33% of the tax benefit of the tax deduction
    • Also lenders are high-tax banks – a clientele effect.
erickson and maydew tar 1998
Erickson and Maydew TAR 1998
  • Capital market event study – effect of an unexpected proposed tax rule change
    • Reduction of the corporate DRD from 70% to 50%.
    • Firm’s security as own control – so no need to control for risk differences
    • Narrow event window
    • No confounding events
erickson and maydew tar 199821
Erickson and Maydew TAR 1998
  • If corporations are the marginal investors in preferred stock, in equilbrium
  • Rp[(1-tc(1-DRD)] = Rb(1-tc)
  • And define ti = (Rft-Rtf)/Rft
  • Given tc=35% and DRD = 70%,

max implicit tax rate = 27.4%

  • If individuals are the marginal investor, no implicit tax
erickson and maydew tar 199822
Erickson and Maydew TAR 1998
  • Assume
    • Pt = [Divs(1-tc(1-DRD))]/r

Price = PV of after-tax div in perpetuity

    • And Rt = (Pt – Pt-1)/Pt-1

= [tc(DRDt – DRDt-1)]/(1-tc(1-DRDt-1)

With tc = 35%, DRDt-1 = 70%,

and DRDt= 50%,

implies a price decrease of 7.82%

= implicit tax borne by the stock

erickson and maydew tar 199823
Erickson and Maydew TAR 1998
  • Results
  • EM preferred stock price decreased 1 to 1.5%
    • Why less than 7.8%
      • Possible capital market participants might have assessed a low probability of the proposed DRD reduction being implemented
      • Information leakage – before event window
  • No price effect for common stocks
berger jar 1993
Berger, JAR 1993
  • Interesting and somewhat overlooked paper.
  • 1981 R&D tax credit
    • Did it lead to increased R&D spending?
    • Did the increased R&D spending increase input factor prices – implicit taxes
      • Which firms benefited
      • Which firms suffered (because of increased factor prices)
berger jar 199325
Berger, JAR 1993
  • R&D became tax-favored for some firms – did they bid up the prices (and if want to examine quantity change in R&D spending need to purge price increases)
  • Event study around enactment

– to isolate price effects – firms that do not benefit from R&D tax credit suffered stock price declines

– because market expected them to face higher R&D factor input prices

berger jar 199326
Berger, JAR 1993
  • Results
    • Firms that could use the R&D credit, increased R&D spending by 2.9% on average (or$1.74 for each $1 of credit).
    • Estimates the ratio of implicit taxes to explicit taxes was between 33 to 76%. (A ratio of 100% indicates pay $1 implicit tax for each $1 of explicit tax subsidy).
taxes and stock prices
Taxes and Stock Prices
  • ‘Old’ issue in finance - Do stock returns reflect tax treatment (an after-tax CAPM)?
    • Are dividend taxes capitalized in common stock prices/returns?
    • Are capital gains taxes capitalized?
  • Multi-party - do stocks and bonds reflect taxes levied on the holders - capital structure
  • Current hot topic for some tax researchers
taxes and asset prices28
Taxes and Asset Prices
  • Based on the Brennan (1970) tax-adjusted CAPM which predicts a positive association between stock returns and dividend yields because of the higher taxes on dividends relative to capital gains.
  • Empirical studies include Litzenberger and Ramaswamy (1979), Black and Scholes (1974), Gordon and Bradford (1980), Blume (1980), Miller and Scholes (1982), Chen, Grundy and Stambaugh (1990), Fama and French (1993), and Naranjo, Nimalendran and Ryngaert (1998).
  • However, as noted by Fama and French (1998, 836) “no consensus emerges, which suggests that any tax effects are weak.”
  • Also ex div day studies
taxes and asset prices29
Taxes and Asset Prices
  • Recent accounting research utilizing Residual Income Based Valuation model.
  • Harris and Kemsley JAR 1999, Collins and Kemsley TAR 2000 and Harris, Hubbard and Kemsley JPE 2000

Argue for full dividend tax capitalization

taxes and asset prices30
Taxes and Asset Prices

Basic Research Question: Are dividend taxes capitalized into share prices?

What is tax capitalization: effect on prices of explicit taxes. The higher the explicit taxes for a given pretax income stream, the lower the price investors willing to pay (and lower the price, the higher the expected pretax return).

Why of interest (or what’s the fuss)?

If fully capitalized (at top individual tax rate) then

1. Corporate form severely tax disadvantaged

(SW: Rc(1-tc)(1-td) = Rp(1-td)

implying corporate form has to earn pretax: Rc = Rp/(1-tc)

(This is a cost of capital argument)

taxes and asset prices31
Taxes and Asset Prices

2. Debt is heavily tax-favored (when consider all parties)

3. Is dividend policy then irrelevant?

4. Are dividend tax clienteles then meaningless?

taxes and asset prices32
Taxes and Asset Prices

Implausibility of full dividend tax capitalization results

·Alternative methods to distribute value to shareholders

Share repurchases

Certain M&A

·Liquidations are not taxed as dividends (IRC 331)

·Evidence of tax clienteles – inframarginal investors

·Arbitrage opportunities for tax exempt or institutional investors

·Benefits of deferral of taxes

·Mixed and inconclusive and weak prior evidence (ex div day and return studies)

taxes and asset prices33
Taxes and Asset Prices

Harris and Kemsley Model: Based on Ohlson, and the additional assumption that all RE will be paid out as taxable dividends whereas returns of CC are tax-free

P = BVE + PV of AE

= CC + RE + PV(NI – r(CC+RE)

= CC + (1-td)RE + PV{NI(1-td) – r[CC + (1-td)RE]}

Testable implications (from HK)

1.dividend taxes reduce the value of RE

2.required R/R on RE is lower than that on CC

3.dividend taxes reduce the value of future earnings so firm value decreases as the tax rate increases.

How to test?

P = b + b1 BV + b2 BV*(RE/BV) + b3 NI + b4 NI*(RE/BV) + e

taxes and stock prices35
Taxes and Stock Prices

Hanlon, Myers and Shevlin JAE 2003

Critique HK model and results

  • Rearrange theoretical model to show little net effect of div taxes on RE and thus on prices (PV effect at most).
  • REBV interaction significant – why? Not because of dividend/shareholder-level taxes. (Via a series of analyses of Ohlson’s model and the information dynamics)
  • Correlated omitted variables – is REBV proxying for persistence, growth, other

P = b + b1 BV + b2 BV*(RE/BV) + b3 NI + b4 NI*(RE/BV) + e

  • See also Dhaliwal, Erickson, Myers, Banyi, same issue of JAE
taxes and stock prices36
Taxes and Stock Prices
  • Recent studies:
  • Invert residual income model to estimate equity cost of capital
  • Is the resulting estimate related to
    • Dividend yields - positively
    • % ownership by institutional investors
    • See Dhaliwal, Krull, Li and Moser JAR 2005
other stuff in ss
Other stuff in SS
  • SS also has discussion of some methodological issues facing tax researchers
    • Estimating marginal tax rates
    • Self-selection bias
    • Specifying trade-off regression model
    • Incremental decisions
      • - new debt versus debt levels
      • Avoids endogeneity of mtr with decision
    • Tax burdens and implicit taxes
    • Use of confidential data
updating ss interplay between taxes and financial accounting research
Updating SS: Interplay Between Taxes and Financial Accounting Research

Other questions and research that has emerged in last few years since SS 2001

  • Can we use book-tax differences to detect earnings management?
  • Can we use large book-tax differences to help interpret persistence of earnings?
  • Will firms pay taxes to boost reported earnings?
  • Calls for conforming book and taxable income?
  • Can we partition book-tax differences into “earnings management” vs “tax aggressiveness”
  • Do firms manage earnings (book-ax conformity) depending on whether managing earnings up/down?
  • What can we learn from GAAP tax footnote disclosures about tax planning, about tax shelters?
some background
Some background
  • Recent corporate financial reporting scandals have given some credence to these RQ
    • Firms reporting large book profits and low taxable income
  • Concern with abusive corporate tax shelters
    • Growing gap between book profits and taxable income
background book tax differences
Background – Book Tax Differences
  • Well known that the purpose of GAAP and Tax Rules differ
  • Gives rise to differing rules of calculation of income
  • Temporary differences – can create deferred tax assets or deferred tax liabilities
  • And Permanent differences
rq 1 using taxes to detect em
RQ 1: Using taxes to detect EM
  • Phillips, Pincus and Rego TAR 2003
  • Using the deferred tax expense account to detect EM.
  • Assumptions:
    • Assumes greater discretion under GAAP than IRS
    • Assumes managers exploit to increase book earnings BUT NOT taxable income
    • Assumes such EM will generate book-tax differences that increase deferred tax expense
    • That is, the EM is via discretionary accruals that give rise to temporary differences.
    • (Note: if 2 violated, if 3 violated)
detecting em
Detecting EM
  • All else equal, firms report higher pretax BI than TI when they have increases in their net deferred tax liabilities
  • = change in DTL – change in DTA > 0, BI > TI
  • = increase in DTE
    • Easiest to see with depreciation. Tax depn > book depn gives rise to DTL.
    • Doubtful accounts, warranty expense. Expense before deduct gives rise to DTA. If reduce doubtful accounts or warranty expense, then DTA decreases.
detecting em44
Detecting EM
  • Analyze 3 settings
    • EM to avoid an earnings decline
    • EM to avoid a loss
    • EM to avoid failure to meet or beat analysts forecasts
  • These 3 settings are popular today in light of Hayn 1995 and Burgstahler and Dichev 1997
  • Compare DTE with total accruals and modified Jones model discretionary accruals model ability to detect EM.
detecting em results 1994 2000 data fas 109
Detecting EM – Results 1994-2000 data (FAS 109)
  • EM = α + 1 DTE + 2 AC + 3 Change CFO + 4 Ind Dummies
  • EM to avoid an earnings decline
    • Increases in DTE increase the probability of EM to avoid reporting an earnings decline.
    • Total accruals and forward-looking Jones model also have incremental explanatory power.
  • EM to avoid an earnings loss
    • Increases in DTE increase the probability of EM to avoid reporting an earnings loss. And is more accurate in classifying firm-years as having successfully avoiding a loss.
  • EM to avoid failure to meet or beat analysts forecasts
    • Only total accruals seem to have any explanatory power.
rq 2 using btd to assess earnings persistence
RQ 2: Using BTD to assess earnings persistence
  • Hanlon TAR 2005 (her thesis at UW)
  • Financial accounting texts claim large book-tax differences can inform us about the persistence of current earnings
  • Assumptions
    • GAAP rules contain more discretion
    • Managers use this discretion to manage earnings
    • Most of the action is in temporary differences
    • Positive book-tax differences imply BI > TI
    • Negative book-tax differences imply BI < TI.
earnings persistence
Earnings persistence
  • If large BTD are evidence of EM, then accrual accounting implies reversals in future periods – current earnings will be less persistent.
  • But BTD arise not just because of EM but because of differences in the rules arising from the different purposes of each set of rules.
  • And BTD may be generated by tax planning rather than EM. (And some evidence consistent with this – Mills 1998 – firms more likely subject to IRS audit if have large BTD!)
  • So an empirical question.
  • Sample 1994-2000
  • Exclude book loss and NOL firms – poor data means measurement error in BTD
  • Calculate book-tax difference = DTE/top STR
  • Form 3 groups
    • Top quintile – large positive BTD
    • Bottom quintile – large negative BTD
    • Middle quintiles – small BTD
hanlon summary
Hanlon Summary
  • Firm years with large positive BTD have lower earnings persistence – both accruals AND CFFO
  • And investors appear to use these large BTD as a red flag – assign a lower persistence to accruals (but underestimate persistence of CFFO).
  • Firm years with large negative BTD have lower earnings persistence – have more special items (which tend to be negative)
  • But investors continue to over-estimate persistence of accruals
  • Large BTD appear to provide evidence useful to investors (although not completely reflected in prices).
rq 3 will firms pay taxes to boost reported earnings
RQ 3: Will firms pay taxes to boost reported earnings?
  • Erickson, Hanlon and Maydew TAR 2003
  • “The estimates in this paper represent the most direct evidence to date that firms are willing to sacrifice substantial cash to inflate their accounting earnings.”
  • So not only are some firms willing to forego cash tax savings to avoid reduced earnings (as summarized in SS 2001) but others are willing to pay taxes on inflated book earnings!
excerpt from centennial technology s 10 k a 4 18 1998
Excerpt from Centennial Technology’s 10-K/A (4/18/1998)
  • “As outlined in the criminal indictment of Centennial's former Chief Executive Officer, the Company's sales figures were inflated in previous periods. This inflation was achieved by various means, including shipping empty PC card housings; billing customers for non-existent products; using the delivery of non-product materials to generate shipping documents, which were then used to create fictitious invoices; and the payment of these invoices with funds apparently provided by the Company's former Chief Executive Officer.”
  • “As a result of the adjustments made to the Company's financial statements in connection with its financial review, previous provisions for income taxes have been reversed and the associated payments of approximately $7.4 million are classified as recoverable income taxes at March 31, 1997. Approximately $6.1 million of these tax refunds were received as of June 30, 1997, and substantially all of the remaining refunds are expected to be received by the end of August 1997.”
why pay taxes on inflated earnings
Why pay taxes on inflated earnings?
  • To avoid IRS, SEC and investor scrutiny – lowers the book-tax difference!
  • Managers of these firms believed that the inflated earnings were worth more than the cash paid to the IRS
  • Study a set of firms subject to SEC Enforcement Actions 1996-2002 where the SEC uses terms such as fraudulent, fake, nonexistent, false, in reference to revenues, net income, or assets.
paying taxes on overstated earnings
Paying taxes on overstated earnings
  • Firms were forced to restate – so can “estimate” incremental taxes paid on the fraudulent earnings. Some firms even disclosed filing for a tax refund on the earnings overstatements!
  • 27 firms (with available data) accused by SEC of fraudulent overstatement of mean earnings by $124.5 million, EHM estimate mean firm paid $11.85 million taxes to IRS on the overstated earnings or 11.3 cents per dollar of overstated earnings.
  • In aggregate, paid $320 million taxes on overstated earnings of $3.36 billion.
paying taxes on overstated earnings57
Paying taxes on overstated earnings
  • Why did these firms overstate earnings (age old question)?
  • Contracting?
  • New issuances?
  • Executive compensation – ESOs?
  • How relate to prior book-tax tradeoff literature (eg as summarized in SS and eg Matsunaga et al)?
  • How relate to recent paper by Graham, Harvey and Rajgopal JAE 2005 (Wildman Award)
rq 4 conforming book and taxable income
RQ 4: Conforming book and taxable income
  • My paper with Michelle Hanlon and Ed Maydew

Book-Tax Conformity and the Informativeness of Earnings

outline book tax conformity
Outline: Book-tax conformity
  • Background (as Motivation) and RQ
  • Prior Literature
  • Our Setting and Hypotheses
  • Sample
  • Design
  • Results
  • Recent corporate financial reporting scandals
    • Reporting large book profits and low taxable income
  • Concern with abusive corporate tax shelters
    • Growing gap between book profits and taxable income
suggestions for reform
Suggestions for Reform
  • Publicly release tax returns (Lenter, Shackelford, and Slemrod)
  • Revise M1 schedule (Mills and Plesko)
  • Revise GAAP tax disclosures (Hanlon)
  • (All 3 published in NTJ December 2003)
  • Calls for conforming
  • “to tax public corporations on their income reported for financial reporting purposes, as adjusted by tax rules authorizing specific deviations from that base” (Yin 2001, p.26).
  • suggestion by the Treasury in analyzing the corporate tax shelter problem was to impose “…book income as a floor on the corporation’s taxable income. This would eliminate the book-tax disparity, and therefore would significantly limit the allure and benefit of corporate tax shelters to public corporations” (p 116).
some quotes
Some quotes:
  • Murray (2002, October 8, A5 “Narrowing Tax Gap Should be Priority of Next Congress”) writes in the Wall Street Journal, “The gap can and should be narrowed. … The result would be a stronger incentive for companies to tell it like it is. If executives want to overstate income to fool shareholders, they’ll pay higher taxes as a result. If they are tempted to understate income in order to escape taxes, they’ll suffer with their shareholders. That kind of change in incentives would do far more to clean up corporate accounting than any amount regulatory oversight.” See also Murray (July 2 and November 19, 2002, Wall Street Journal).
  • Olson, the Treasury Assistant Secretary for Tax Policy, states “… we should also carefully consider eliminating some of the differences between book and tax reporting.”

(in Hamilton and Radziejewska, 2003 Tax Notes, March 31, 2003, p. 1935).

motivation recent sentiment
Motivation - Recent Sentiment
  • “ If you had greater book-tax conformity, Enron probably would never have happened.”

--John Buckley, Democratic council for House Ways and Means Committee

  • “...conforming the measurement of book and tax profits could provide firms with some automatic incentives to reduce tax avoidance and to be less aggressive in reporting profits to capital markets.”

--Desai (2004)

  • Desai: Declining VR of earnings, so little would be lost
conforming any costs
Conforming – Any Costs?
  • Possible costs:
  • Well known that the purpose of GAAP and Tax Rules differ
  • GAAP
    • Provide information useful to decision makers
  • Tax rules:
    • Raise revenue
    • Reallocate income/wealth
    • Encourage certain economic activities
    • Tool of macroeconomic policy
    • Political tool (re-election)
  • Gives rise to differing rules of calculation of income
conforming any costs67
Conforming – Any Costs
  • Thus our RQ:
  • Will book-tax conformity reduce the informativeness (value relevance) of reported earnings?
  • Prior (relevant) literature
international studies
International Studies
  • Ali and Hwang (JAR 2000)
  • Informativeness as function of
    • Book-tax conformity (degree to which tax rules influence financial accounting measurements)
    • Involvement of a private sector body in the standard setting process
    • Bank or market-oriented financial system
  • Find informativeness (VR) lower when higher book-tax conformity consistent with tax laws being influenced by political, social and economic objectives rather than the informational needs of investors
international studies69
International Studies
  • Ball, Kothari and Robin (JAE 2000)
    • Report that valuation in code-oriented countries (where tax and book incomes are closely aligned) is much less related to earnings.
  • Guenther and Young (JAE 2000)
    • Report evidence consistent with accounting earnings in the UK and US being more closely related to underlying economic activity than accounting earnings in France and Germany.
      • Differences in legal systems and the demand for accounting information, differences in legal protection for external stakeholders, and differences in the degree of tax conformity
but limitations to u s context
But limitations to U.S. context
  • BUT indirect evidence for US:
    • endogenous country choice reflecting institutions, markets, enforcement, etc AND
    • assumes stock markets equally liquid and efficient at information processing (unlikely given RQ).
    • And cannot say who will set rules in the US?
u s evidence
U.S. Evidence
  • Hanlon, Laplante and Shevlin JLE 2005
  • Examine U.S. firms
  • Estimate taxable income from financial statement disclosures
  • Then conduct relative information and incremental information content tests
hls but limitations
HLS – but limitations
  • Have to estimate taxable income
    • Measurement error in researcher’s estimate
    • Recognition vs disclosure – investors use and place more reliance on recognized numbers
  • Both bias towards finding results in favor of BI
  • Inferences about info loss rely on their assumption - Congress will not allow FASB or IAS to set the rules by which US raises corporate taxes
current paper hms
Current paper - HMS
  • Given limitations of HLS and international studies, research using different designs and settings can triangulate findings and contributions
  • HMS exploit a change in rules in the Tax Reform Act of 1986 TRA 86 that required a small group of firms that were using the CASH BASIS of accounting for TAX purposes to switch to the ACCRUAL BASIS for TAX purposes (no direct change for financial accounting purposes)
why this event
Why this event?
  • Guenther, Maydew and Nutter (1997)
    • Examine the impact of book-tax conformity on firms’ financial reporting and tax planning activities.
    • Use a set of firms required to change from the cash basis method of accounting for tax purposes to the accrual method—an increase in book-tax conformity.
    • Results are consistent with these firms deferring more financial accounting income after the required change.
why this event77
Why this event?
  • So given GMN results, HMS address the RQ: did the information content of book earnings decline post TRA 86 given these firms’ responses to “forced” book-tax conformity
  • Advantages of this setting:
    • Within US (so avoids problems of inferences from the prior international studies
    • Do not need to estimate TI (as HLS did with its attendant measurement error problems)
    • Studying recognized numbers – not an estimated number based on a disclosure
    • Do not have to conjecture how firms might respond – have their reported book income after “partial” conformity
    • AND can compare to firms that were on accrual basis pre/post TRA 86
basic design
Basic design
  • AN INTERRUPTED TIME-SERIES DESIGN WITH TREATMENT/CONTROL GROUPS (2 x 2 or differences-in-differences design)
  • The control group allows for any other shifts in the environment pre/post TRA 86
  • Possible control groups:
  • H1: The informativness of earnings for the converting firms decreases after TRA 86.
  • We predict a decrease because we predict that managers will report earnings to reduce taxes thereby losing a means by which to convey relevant and reliable information regarding firm performance.
    • (This is unconditional conservatism)
  • Alternative hypothesis is if firms were managing earnings upward prior to TRA 86, then increasing conformity will cause them to report earnings that are more representative of firm performance.
  • H2: Prior to TRA 86, the informativeness of earnings for the converting firms is greater than the informativeness of earnings for the accrual firms.
  • Use the set of firms from GMN that were required to switch from cash basis accounting for tax purposes to the accrual basis.
    • Test the informativeness of earnings before and after the change.
    • Five years of data before TRA 86 and five years of data after TRA 86 for 56 firms.
    • Compare to the change in informativeness for a “control” set of firms on accrual basis of accounting for tax purposes before and after TRA 86.
  • Legal environment, demand for accounting information, and other non-tax factors held constant.
descriptive stats
Descriptive stats
  • Table 2: lots of numbers
  • Converting firms smaller than the “accrual” firms (both pre and post TRA 86)
  • Converting firms exhibit higher sales growth, E/P, M/B and Leverage pre-TRA, but no difference to accrual firms post-TRA (so need to control for these differences later)
  • No difference in stock returns
  • Converting firms possibly higher (lower) ROA pre (post) TRA
empirical research design
Empirical Research Design
  • Long-window vs short-window
  • ERC vs R2
  • Prior literature’s use of long-window ERC’s and Francis and Schipper AH (1999)
empirical research design85
Empirical Research Design
  • Difference-in-differences in long-window earnings response coefficients.



+ b7CONVERTING*POSTt*DEt + e (1)

Rt = 12 month raw buy and hold return beginning in the fourth month after the fiscal year end of t-1.

DEt = change in earnings before extraordinary items from year t-1 to t, scaled by market value of equity at the end of year t-1.

alternative control sample
Alternative control sample
  • We use accrual/accrual (pre/post) firms above
  • Not enough cash/cash
  • Alternative SMALL FIRMS: Sales < $5mm
  • Small firms could remain on cash after TRA if using CASH before – however, just like GMN, we cannot tell if these firms were accrual/cash PRE TRA
  • Results and inferences unchanged with this control sample
effect of loss firms
Effect of Loss Firms
  • Hayn (1995) shows that explanatory power and ERCs are lower for loss firms.
  • How do loss observations affect our results?
  • In our sub-samples of firm-years we find loss observations constitute:
    • 18% of cash basis observations before TRA86
    • 30% of cash basis observations after TRA86
    • 20% of accrual basis observations before TRA86
    • 28% of accrual basis observations after TRA86
effect of loss firms91
Effect of Loss Firms
  • We estimate equation (1) after excluding loss observations.
  • Difference in difference coefficient, b7, is still negative and significant at a p-value of .024
sensitivity tests
Sensitivity Tests
  • Additional control variables in ERC tests
    • Size (lnTA)
    • Book-to-market ratio
    • Return on assets
    • Leverage
  • Use pre-tax earnings rather than earnings after tax.
  • Eliminate observations from 1988 to ensure income shifting around TRA86 not driving our results.
  • Results are consistent with our main results.
conclusions from hms
Conclusions from HMS
  • We use a natural experiment to investigate the effect of increased book-tax conformity on the information content of earnings in the U.S.
  • Results are consistent with the informativeness of financial accounting earnings decreasing following an increase in conformity.
  • Issue is still alive in DC.
areas of for future research in tax
Areas of For Future Research in Tax
  • Movement started but want more precise quantification of extent to which taxes matter and of nontax costs
    • see Engel, Erickson and Maydew (1999)
      • Great paper on trust preferred stock (TRUPs, MIPs)
  • Need more theory/analytical modeling
    • Transfer pricing and compliance - but not directly related to empirical literature
  • Improved econometrics (self-selection and tradeoffs modeled)
  • Do not forget finance and public economics
    • Past and present/ongoing research
future research
Future Research
  • More links to managerial accounting
    • Governance structure, management compensation and links to tax planning
    • Organizational form (decentralized vs centralized)
    • Agency conflicts with tax planning
  • Accounting for income taxes and links to tax planning (e.g., Hanlon’s UW thesis paper)
  • Do firms manage effective tax rates?
    • What does this mean?
  • What determines firms’ tax-planning aggressiveness?
future research96
Future Research
  • Corporate tax shelters
    • Which firms and why did they enter them? (what explains the choice to enter into an aggressive corporate tax shelter)
    • Can we detect the effects of corporate tax shelters in the tax footnotes?
      • Ideal shelter leads to a permanent difference
      • McGill and Outslay, NTJ 2004
      • If cannot detect, why not?
future research97
Future Research
  • Financial instruments as a tax planning device?
  • How used?
  • Which firms use?
  • Need knowledge of complex financial instruments.
future research98
Future Research
  • How can we identify/partition BTD into that related to earnings management and that related to aggressive tax planning?
  • How can we identify tax aggressive taxpayers?
    • Dyreng, Hanlon and Maydew WP – long run ETR?
  • What variables (explain) tax aggressive behavior?
    • (we have lots of evidence on the earnings management side)
  • Analysis of tax cushion (but data problems, will new disclosures help)
future research99
Future Research
  • Tax policy research
    • An area where tax accountants could have an impact
    • Effects of taxes on real decisions
    • But what is our comparative advantage over public economists?
      • Understand the data, especially if financial accounting
      • Understand the tax rules and tax data
      • Macro versus microeconomics approach
      • Willingness to make normative statements!
  • Wide-ranging talk.
  • Examples of empirical tax research
  • Draws on methodologies in empirical financial accounting
  • Need to know both taxes and financial accounting rules for income taxes
  • Lots of information in book-tax differences