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Book-tax conformity and capital structure

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Abstract

We examine the effect of increased book-tax conformity on corporate capital structure. Prior studies document a decrease in the informativeness of accounting earnings for equity markets resulting from higher book-tax conformity. We argue that the decrease in earnings informativeness impacts equity holders more than debt holders because of the differences in payoff structures between debt and equity investments such that increases in book-tax conformity lead to increases in firms’ reliance on debt capital. We exploit a natural experiment in the U.S. and find that firms facing an increase in required book-tax conformity increase leverage relative to other firms. We also provide evidence of an increase in the cost of equity (but not of debt) capital for firms facing an increase in required book-tax conformity, relative to control firms, and show that these increases in cost of equity capital are positively associated with an increase in leverage. Our findings are consistent with firms substituting away from equity and toward more debt in the presence of higher book-tax conformity.

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Notes

  1. Desai (2003, 2005, 2006), Yin (2001), and Whitaker (2005) all suggest moving the taxable income calculation closer to the book income calculation, that is, conforming or basing tax more on the book rules, which is the setting we study.

  2. Exceptions are McClelland and Mills (2007) and Hanlon and Maydew (2009), who examine tax revenue implications of increased book-tax conformity.

  3. Hanlon et al. (2008) were motivated by the findings in Guenther et al. (1997) that firms required to conform taxable income toward accounting income, relative to firms not required to conform, changed their financial reporting behavior in response to the altered tax incentives by deferring more accrual revenue, accelerating more accrual expenses, or both in the post-TRA ‘86 period.

  4. See Graham (2003) for a review of the literature on capital structure and taxes.

  5. According to Hanlon and Heitzman (2010), the EU considered a common consolidated corporate tax base (CCCTB) to be used by all members. One proposal was to link the CCCTB to the common adoption by all EU members of IFRS. However, this proposal met opposition by members who did not want to cede control of their tax base to a foreign entity such as the International Accounting Standards Board.

  6. We use the Blouin et al. (2010) estimates of marginal tax rates to maximize sample size but obtain similar results using pre-interest marginal tax rate estimates from John Graham’s website (see Graham 1996).

  7. The terms “converting firms” and “nonconverting firms” relate specifically to the computation of taxable income. A key benefit of our setting is that all firms (i.e., converting and nonconverting) use the accrual method of accounting to compute book income, regardless of the tax regime. Thus, while book-tax conformity increases for converting firms and stays the same for nonconverting firms, the accrual method of accounting is used for all firms both before and after TRA ‘86.

  8. The five-year pre and post periods reflect a trade-off of wanting sufficient sample observations with concern over confounding events as the sample period increases.

  9. To ensure our regression results are not driven by influential observations, we also eliminate influential observations using the DFFITS statistic (Belsley et al., 1980). After doing so, we find nearly identical results for our leverage and cost of capital tests. We also find similar results after using robust regressions and after eliminating observations with large studentized residuals.

  10. Guenther et al. (1997) report means and medians of sales, assets, and inventory/assets separately across the converting and control firms but pooled across pre and post. Guenther et al. report mean assets for the converting firms of $191 million, which is comparable to our pooled mean of assets. However, the mean assets of $199 million of Guenther et al. for the control firms is much smaller than in Hanlon et al. and our sample.

  11. Unscaled aggregate debt increases from $8.820 billion to $23.467 billion for converting firms and from $350.464 billion to $518.563 billion for nonconverting firms. We note that there are nine times as many firms in the nonconverting sample, compared to the converting sample, and that nonconverting firms are generally larger, which explains the scale difference in aggregate debt.

  12. We use the following model to calculate propensity scores:Converting i = β 1 1/Assets it + β 2 Book−to−market it + β 3 PP&E it + β 4 Return on assets it + β 5 Annual stock return it + β 6 Marginal tax rate it + ε it .

    Following matching, we find no differences in means between converting and nonconverting groups for the included covariates indicating covariate balance.

  13. We thank Jennifer Blouin for supplying us with kink data.

  14. Unconditionally, the mean for Kink equals 0.784 for converting firms before TRA ‘86 and 0.942 afterward. The mean for Kink equals 1.255 for nonconverting firms before TRA ‘86 and 1.235 afterward.

  15. We note the general economic stability of our post-TRA ‘86 period complicates the interpretation of this “no result,” as it becomes more difficult to observe increases in bankruptcy in the absence of negative economic shocks.

  16. We obtain 7.6% by dividing the increase in cost of equity for treatment firms relative to control firms (i.e., 1.1%) divided by pre-TRA cost of equity for treatment firms (i.e., 14.4%).

  17. For comparison purposes, we examine the magnitude of a change in the implied cost of equity capital surrounding an increase in noise as proxied by an internal control deficiency. Ashbaugh-Skaife et al. (2009) document an increase in the implied cost of equity of 93 basis points for firms first disclosing an internal control deficiency. They also find a decrease in the average cost of equity of 116 basis points around the release date of an unqualified SOX 404 opinion for firms most likely to report ICDs. We document a 111 basis point increase on average for our converting firms.

  18. We acknowledge that, because measures of cost of debt derived from interest expense capture interest on all debt, rather than new debt, such proxies result in tests that are lower in power relative to tests using interest rates on new debt (which we do not have). However, we try to increase the power of the cost of debt test by limiting our post-TRA ‘86 sample to its last year and find very similar results.

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Acknowledgements

We are thankful for helpful comments from Patricia Dechow, the editor, and two anonymous referees, Kriss Allee, T.J. Atwood, James Chyz, Shane Dikolli, Mike Drake, Alex Edwards, Joseph Gerakos (discussant), Erin Henry, Stacie Laplante, Terry Warfield, Ryan Wilson, workshop participants at the University of Tennessee-Knoxville and the University of Wisconsin-Madison, and participants at the HKUST Accounting Research Symposium. We thank David Guenther, Ed Maydew, and Sarah Nutter for sharing the identification of the firms required to switch to accrual basis accounting for tax purposes in the Tax Reform Act of 1986 and Jennifer Blouin for sharing kink data, and Hye Seung (Grace) Lee for providing implied cost of capital estimates. Blaylock acknowledges financial support from the Spears School of Business at Oklahoma State University. Gaertner acknowledges financial support from the Wisconsin School of Business at the University of Wisconsin-Madison. Shevlin acknowledges financial support from the Paul Merage School of Business at the University of California, Irvine.

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Authors and Affiliations

  1. Price College of Business, University of Oklahoma, Norman, OK, 73019-4004, USA

    Bradley Blaylock

  2. Wisconsin School of Business, University of Wisconsin-Madison, Madison, WI, 53706, USA

    Fabio B. Gaertner

  3. Merage School of Business, University of California-Irvine, Irvine, CA, 92697-3125, USA

    Terry Shevlin

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  1. Bradley Blaylock
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  2. Fabio B. Gaertner
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  3. Terry Shevlin
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Correspondence to Terry Shevlin.

Appendices

Appendix A

Table 8

Appendix B. Cost of Equity Capital Measures

Gebhardt et al. (2001) estimate a residual income model using analyst earnings forecasts in years t + 1 and t + 2, long-term growth forecasts for year t + 3 earnings, and terminal value estimates. Earnings forecasts beyond year three are estimated assuming the year t + 3 return on equity (ROE) reverts to the industry median ROE by year t + T (T = 12).

\( {P}_t={B}_t+\frac{FROE_{t+1}-{r}_g}{\left(1+{r}_g\right)}{B}_t+\frac{FROE_{t+2}-{r}_g}{{\left(1+{r}_g\right)}^2}{B}_{t+1}+ TV \), where FROEt+i is forecasted ROE in period t + i and equals FEPSt+i/Bt+i-1 for years one through three, and Bt+i is year t + i book value of equity divided by the number of common shares outstanding in June of year t + i. Using clean surplus accounting, Bt+i = Bt+i-1 + FEPSt+I×(1-k). FEPS is forecasted earnings per share and FEPS1 and FEPS2 equal the one-year- and two-year-ahead consensus EPS forecasts in I/B/E/S in June of year t. FEPS3 equals the three-year-ahead EPS forecast, if available; otherwise FEPS3 is FEPS2 × (1 + long-term growth forecast). k is expected dividend payout ratio (dividends per share divided by earnings per share in year t – 1). If EPS ≤ 0, then k equals 6% of total assets at the beginning of year t. TV, the terminal value, is calculated as:

$$ TV=\sum_{i=3}^{T-1}\frac{FROE_{t+ i}-{r}_g}{{\left(1+{r}_g\right)}^i}{B}_{t+ i-1}+\frac{FROE_{t+ T}-{r}_g}{r_g{\left(1+{r}_g\right)}^{T-1}}{B}_{t+ T-1} $$

Claus and Thomas (2001) use the following residual income model:

$$ {P}_0={B}_0+\frac{ae_1}{\left(1+{r}_{ct}\right)}+\frac{ae_2}{{\left(1+{r}_{ct}\right)}^2}+\frac{ae_3}{{\left(1+{r}_{ct}\right)}^3}+\frac{ae_4}{{\left(1+{r}_{ct}\right)}^4}+\frac{ae_5}{{\left(1+{r}_{ct}\right)}^5}+\frac{ae_5\left(1+ g\right)}{\left({r}_{ct}- g\right){\left(1+{r}_{ct}\right)}^5} $$

ae t is year t expected abnormal earnings equal to FEPSt - rct × Bt-1. For years three through five, FEPSt+i equals the consensus EPS forecast, if available; otherwise FEPSt+i = FEPSt+i-1 × (1 + long-term growth forecast). Bt+i equals Bt+i-1 + k × FEPSt+i, assuming k = 0.5. g, the growth in abnormal earnings beyond t + 5, equals the yield on the 10-year Treasury note minus 3%.

Gode and Mohanram (2003) use a model based on Ohlson and Juettner-Narouth (2005):

$$ {r}_{oj}= A+\sqrt{A^2+\frac{EPS_t}{P_{t-1}}\left( g-\left({r}_f-0.03\right)\right)}, $$

where \( A=0.5\left(\left({r}_f-0.03\right)\kern-7pt +\frac{DPS_{t+1}}{P_t}\right)\kern-6pt , \) \( g=\frac{\left({FEPS}_{t+2}-{FEPS}_{t+1}\right)}{FEPS_{t+1}}, \) r f  = yield on a 10-year Treasury note, and DPS = dividends per share (DPSt+1 = DPS0). This model assumes that g (short-term growth) decays asymptotically to a perpetual growth rate (r f – 0.03) and requires that FEPSt+1 and FEPSt+2 be positive.

Easton (2004) uses a modified PEG ratio (PE ratio divided by the short-term rate of earnings growth, modified to include expected dividends in the estimate of short-term growth):

\( {P}_0=\frac{\left({EPS}_{t+2}+{r}_{mpeg}{DPS}_{t+1}-{EPS}_{t+1}\right)}{{r_{mpeg}}^2}, \) where EPS2 ≥ EPS1 > 0 and DPSt+1 = DPS0. This model constrains EPS2 ≥ EPS1 > 0 so the solution has two real roots, one of which is positive.

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Blaylock, B., Gaertner, F.B. & Shevlin, T. Book-tax conformity and capital structure. Rev Account Stud 22, 903–932 (2017). https://doi.org/10.1007/s11142-017-9386-2

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