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Tax conformity of earnings and the pricing of accruals

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Abstract

The primary purpose of this study is to investigate whether the market prices discretionary and non-discretionary tax accruals. Previous studies have examined the persistence of total accruals (Sloan in Account Rev 71(3):289–315, 1996) and the persistence of discretionary and non-discretionary components of total accruals (Xie in Account Rev 76(3):357–373, 2001). These studies do not investigate the tax components of accruals. We argue that tax accruals are mispriced more than book accruals because of the complexity of tax accruals in assessing future earnings. We use a sample of 6,397 firms and the Mishkin model to investigate whether the market overvalues tax accruals more than book accruals. Descriptive statistics show that firms are increasingly using more income decreasing tax accruals than income-increasing book accruals contributing to the growing divergence between tax and book earnings. Results from the Mishkin test show that the overpricing of tax accruals is more severe than that for book accruals. Finally, hedge portfolio tests show that investors can earn excess returns using a hedging strategy based on tax accruals. Interestingly, excess returns based on a hedging strategy using book accruals almost disappear.

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Notes

  1. Book accruals have relatively low tax conformity. They affect reported earnings but do not affect the firm’s taxable income. Tax accruals have higher tax conformity because the tax code allows similar or equal treatment when computing the firm’s taxable income. Thus, tax accruals affect both taxable income and reported earnings (Calegari 2000).

  2. These rules generally became effective for transactions on or after January 1, 2003. Under the regulations, six classes of reportable transactions have been created: (1) confidential transactions, (2) transactions with contractual protection, (3) loss transactions, (4) transactions with significant tax differences, (5) transactions involving a brief asset holding period and (6) IRS listed transactions.

  3. Prior studies suggest that capital market participants are unable to fully capture accounting numbers that result from complex tax rules. Nor does the market anticipate and correctly interpret income effects of tax-motivated income shifting. Shaw (1990) reports that the lack of complete disclosure of earning components impairs the analysts’ and investors’ ability to predict the earnings effects of some transactions related to taxes. Chen and Schoderbek (2000) and Chen et al. (2003) examine how investors and analysts assess the income effects of the deferred tax adjustment caused by the Omnibus Budget Reconciliation Act of 1993. They find evidence indicating that investors and analysts are fixated on reported accounting numbers and interpret accounting information without regard to the rules used to produce it. These authors suggest that the complexity of deferred tax adjustments and disclosures may have contributed to the failure of investors and analysts to properly interpret the reported earnings. Shane and Stock (2006) report that market prices and analysts’ earnings per share forecasts fail to reflect unbiased expectations regarding firms’ incentives to shift income from high to low tax rate years. In general, these studies suggest that market prices do not fully reflect the future earnings implications of current earnings components.

  4. I.R.C. 446(a) states: "Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books". I.R.C. 461(a) provides: "The amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income" (US Tax Code On-Line, http://uscode.house.gov/title_26.htm).

  5. The Schedule M-1 of Form 1120-US Corporation Income Tax Return requires a reconciliation of income (loss) per books with income per tax return.

  6. On the other hand, because tax savings are generally maximized by deferring revenues and by accelerating expenses, tax conformity may also impose significant non-tax costs on the firms. Tax conformity may depict the firm to external parties (i.e., actual and potential investors, lenders, suppliers, etc.) as relatively worse off than it would be portrayed without conformity, may increase the probability of violating some debt covenants, and it may also reduce managers’ compensation tied to book income (Cloyd et al. 1996).

  7. Hanlon (2005) uses deferred tax asset and liability accounts to classify firms into one of two groups: positive tax differences or negative tax differences. It is important to note that deferred tax accounts represent only a subset of total accruals.

  8. Graham et al. (2008) report that book-tax differences arise because of tax planning, general business conditions, earnings management, changes in financial accounting rules, changes in sales, and the level of property, plant, and equipment.

  9. All variables used in this study are defined in Table 1.

  10. Plesko (2007) computes tax accruals by taking the difference between book and taxable income. He then uses the Jones (1991) model to derive the discretionary and non-discretionary components of tax accruals.

  11. This item represents current assets that are not included in cash, cash equivalents, receivables or inventory on the balance sheet. It also includes prepaid expenses (e.g., prepaid insurance, advertising, and rent) that cause temporary differences between taxable income and book income (Dyckman et al. 1998).

  12. A similar procedure has been used by DeFond and Jiambalvo (1994), Subramanyan (1996), and Xie (2001).

  13. Nguyen et al. (2009) and Vassalou (2003) augment the CAPM and the Fama–French model (1993) with a GDP factor. Nguyen et al. (2009) found that the information about future GDP growth is not priced in equity returns in the Australian market. On the other hand, Vassalou (2003) using US data reported that premium related to the GDP growth is positive and significant.

  14. Beaver et al. (2007) find that tests of market efficiency are sensitive to the exclusion or inclusion of delisting returns. Shumway (1997) and Shumway and Walther (1999) recommend that firms with missing delisting returns should be corrected for the delisting bias. A limitation of our study is that the sample was identified using Compustat database which has a survivorship bias. As a result, it is quite possible that delisted firms were dropped in the initial sample selection process.

  15. Compared to previous related studies our median earnings scaled by total assets at the beginning of the period are similar. Our sample period runs over 1986–2001. Sloan (1996) reported scaled median earnings of 0.011 over the sample period of 1994–2000, Xie (2001) reported median scaled earnings of 0.048 over the sample period of 1971–1992, and Hanlon (2005) reports median earnings of 0.113 using the sample period of 1994–2000.

  16. Palmon et al. (2008) use a trading strategy based on the interaction of company size and accruals using raw security returns.

  17. Xie (2001) reports size-adjusted return of 11 percent for discretionary book accruals in year t + 1. The differences in returns between Xie and our study may be partly due to sample time periods used in two studies. Xie’s sample covers 1971–1992 periods whereas our sample is from 1986–2001 periods.

  18. Regression using Eq. 10a is also estimated. Untabulated results show that the sign of the coefficients for tax and book accrual coefficients are positively and negatively significant, respectively.

  19. The following steps are used in running Eq. 11: decile ranking for each firm-year is first obtained, followed by constructing ten portfolios for each year, and then computing equally weighted monthly average portfolio returns for 10 portfolios for year t + 1, finally, the risk free rate is subtracted from the portfolio returns in order to obtain excess portfolio returns. We are thankful to the reviewer for suggesting Eq. 11 and for the calculation of excess portfolio returns.

  20. http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

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Correspondence to Pervaiz Alam.

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Báez-Díaz, A., Alam, P. Tax conformity of earnings and the pricing of accruals. Rev Quant Finan Acc 40, 509–538 (2013). https://doi.org/10.1007/s11156-012-0275-2

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