tax avoidance-large positive temporary book-tax differences and earnings persistence

THE ACCOUNTING REVIEW American Accounting Association Vol.87,No.1DOI:10.2308/accr-10158 2012pp.91–120Tax Avoidance,Large Positive Temporary Book-Tax Differences,and EarningsPersistenceBradley BlaylockOklahoma State UniversityTerry ShevlinUniversity of WashingtonRyan J.WilsonThe University of IowaABSTRACT:We investigate why temporary book-tax differences appear to serve as auseful signal of earnings persistence(Hanlon2005).We first test and show thattemporary book-tax differences provide incremental information over the magnitude ofaccruals for the persistence of earnings and accruals.We then opine that there aremultiple potential sources of large positive book-tax differences.We predict and findthat firms with large positive book-tax differences likely arising from upward earningsmanagement(tax avoidance)exhibit lower(higher)earnings and accruals persistencethan do other firms with large positive book-tax differences.Finally,we find significantvariation in current-period earnings and accruals response coefficients and insignif-icant hedge returns in period tþ1,consistent with investors being able to look through tothe source of large positive book-tax differences(earnings management and taxavoidance),allowing them to correctly price the persistence of accruals for thesesubsamples.Keywords:book-tax differences;earnings persistence;tax avoidance;earningsmanagement;earnings expectations.Data Availability:Data are available from public sources identified in this study.We acknowledge the helpful comments of Alex Edward,Michelle Hanlon,Stacie Laplante,Rick Mergenthaler,Tom Omer,Sonja Rego,and two anonymous referees.Professor Shevlin acknowledgesfinancial support from his Paul Pigott/ Paccar Professorship at the Foster School.Editor’s note:Accepted by Tom Omer.Submitted:March2010Accepted:July2011Published Online:August201191I.INTRODUCTIONP rior research suggests that the tax information contained in financial statements providesinformation about earnings persistence (e.g.,Lev and Nissim 2004;Hanlon 2005).Despite the important implications of these studies,little is known about what causes the observed link between tax information and earnings persistence.This study begins to develop an understanding of this link by first documenting that the information in temporary book-tax differences,documented by Hanlon (2005),about earnings and accruals persistence is incremental to the magnitude of accruals (i.e.,larger accruals are less persistent).We next investigate whether the implications of temporary differences between book and taxable income for the persistence of earnings vary depending on the likely source of those differences.We develop two distinct approaches for partitioning large positive temporary book-tax differences that provide meaningful information about future earnings and accruals persistence.Our analysis thus extends Hanlon (2005),who shows that for firm-years with large temporary book-tax differences,pretax income is less persistent for future earnings than it is for firm-years with small book-tax differences.1The purpose of accrual accounting is to better recognize firm performance,which often results in accruals smoothing out transitory shocks in cash flows (Dechow 1994;Dechow and Ge 2006).If accruals are recorded for book purposes but not for tax purposes,then the differences show up in deferred tax expense such that a larger deferred tax expense (hereafter,larger book-tax differences)could just be reflecting larger book accruals.Thus,the Hanlon (2005)result could just be reflecting the fact that larger accruals are less persistent,as argued by Sloan (1996)and shown by Dechow and Ge (2006).However,we argue that,when firms exhibit both large positive book-tax differences and large positive accruals,those accruals are more likely to have resulted from managerial discretion than a firm that exhibits large positive accruals and small book-tax differences.For this reason,we expect the accruals of firms with large positive book-tax differences to be less persistent than those of firms with small book-tax differences.Consistent with this expectation,we find that large book-tax differences provide incremental useful information about earnings persistence beyond the information provided by accruals.Having established that book-tax differences provide incrementally useful information about earnings and accruals persistence,we posit three primary sources of large positive book-tax differences.2First,book-tax differences can arise due to earnings management.Phillips et al.(2003)conjecture that,because tax law allows less discretion in accounting choices than GAAP,large positive differences between book and taxable income are informative about earnings management.Consistent with their assertion,they find that deferred tax expense is incrementally useful to the Jones’discretionary accruals model in detecting earnings management.In cases where book-tax differences are generated by earnings management,we expect that accruals are more likely to reverse in the next period,thus exhibiting low persistence.Second,a basic tax-planning strategy is to defer taxes as long as possible to decrease the net present value of the taxes paid.Such behavior leads to a large deferred tax expense,but does not necessarily result in accruals that reverse in the following year.We predict that,in cases where large positive book-tax differences arise primarily from extensive tax planning,these differences do not signal managerial discretion over the accruals process and,as a result,will not be associated with lower future earnings and accruals persistence.Therefore,we predict that firms with large positive 1The temporary book-tax differences examined in our study are equal to the deferred tax expense grossed-up by the applicable statutory tax rate.Consistent with Hanlon (2005),we do not include permanent differences because,as she notes,permanent differences are affected by tax rate differences,tax credits,and statutory tax breaks (e.g.,tax-exempt interest)that are not indicative of earnings persistence related to the accrual process.2Our analysis focuses on firms with large positive book-tax differences because these differences could be a signal of either earnings management or tax avoidance.92Blaylock,Shevlin,andWilsonThe Accounting ReviewJanuary 2012book-tax differences resulting primarily from tax planning will exhibit higher future earnings and accruals persistence than other large positive book-tax differencefirms.3Third,deferred tax expense can arise in the absence of tax planning and earnings management because of the normal differences in the treatment of revenue and expenses for book and tax purposes (Scholes et al.2008,39).Examples of normal temporary differences are depreciation and allowance for doubtful accounts,although both items can also be used for earnings management purposes.We use two alternative techniques to partitionfirms with large positive book-tax differences into three subsamples corresponding to the three conjectured sources of differences.Consistent with expectations,under both partitioning approaches wefind thatfirms with large positive book-tax differences that arise predominantly from upward earnings management have less persistent earnings and accruals than dofirms in the BASE subsample.Also consistent with expectations,we find thatfirms with large positive book-tax differences arising predominantly from tax avoidance exhibit significantly more persistent earnings and accruals relative to the BASE subsample under partitioning approach2,but not under partitioning approach1.We next investigate whether investors are able to identify the likely source of book-tax differences to help interpret price accruals.Hanlon(2005)notes that several accounting textbooks indicate large book-tax differences can provide information about earnings quality.4Consistent with investors heeding this lesson,Hanlon(2005)finds that investors reduce their expectations of the persistence of earnings and accruals in the presence of large positive book-tax differences and are able to efficiently price earnings and accruals for thesefirms;shefinds insignificant hedge portfolio returns in year tþ1.Despite these results,it is not clear whether investors are able to efficiently price earnings for sub-groups of large positive book-tax differencefirms partitioned on the basis of the predominant source of their book-tax differences.This question is important because we predict that the implications of large positive book-tax differences for earnings persistence vary depending on the likely source of the book-tax differences.Our analysis of different subsets of large positive book-tax differencefirms is similar in spirit to Sloan’s(1996)finding that,on average,investors correctly price the persistence of earnings for allfirms.However,Sloan(1996)also shows that there is differential persistence in the accrual and cashflow components of earnings and that the market fails to identify and correctly price this differential persistence,resulting in positive hedge portfolio returns to portfolios formed on accruals.The ability of investors to identify differences in earnings persistence is critical in valuation. Frankel and Litov(2009)point out that investors seek to identify the determinants of earnings persistence in order to better understand the relation between current earnings and permanent earnings.Ohlson(2009)discusses various theoretical models offirm valuation that all rely,to varying degrees,on earnings persistence.We conduct two market-based tests.First,wefind in regressions of current-period returns on earnings and accruals that the response coefficients vary for the subsamples,consistent with the 3We define tax planning as non-conforming tax positions that lower taxable income relative to book income in the current period.We acknowledge thatfirms could also engage in conforming tax planning that lowers reported income for both book and tax purposes.However,conforming tax planning transactions would not give rise to book-tax differences.Further,consistent with Hanlon and Heitzman(2010),we view tax avoidance as existing on a continuum.This continuum of avoidance includes clearly legal transactions,such as investments in municipal bonds that lower explicit taxes,on one end,to more aggressive forms of tax avoidance,such as tax sheltering where the legality of the transaction is less certain,on the other end.4Recent accounting textbooks continue to suggest that book-tax differences are an indicator of earnings quality.For example,Revsine et al.(2012,780)point out that‘‘deferred tax footnotes can be used to assess earnings quality.’’While their suggestion points to analysis of individualfirms,the comment is applicable to hedge funds and other investors using large sample screens to identify securities for investment.Earnings quality is difficult to define(see Dechow et al.[2010]for a discussion of this concept);consistent with Hanlon(2005),we sidestep the issue and simply focus on earnings and accruals persistence.Tax Avoidance,Large Positive Temporary Book-Tax Differences,and Earnings Persistence93The Accounting Review January2012documented variation in earnings and accruals persistence.Second,we find insignificant hedge portfolio returns in year t þ1,suggesting that investors can appropriately price accruals for tax avoidance and high earnings management subsamples under both our partitioning approaches.We contribute to the literature in three ways.First,we show that Hanlon’s (2005)finding that large book-tax differences are associated with lower earnings and accruals persistence is incremental to the effect of accruals on the persistence of earnings.Second,we provide two alternative means of partitioning firms with aggregate large positive book-tax differences that provide meaningful information about future earnings and accruals persistence.The observed differential earnings and accruals persistence of the different subsamples of large positive book-tax difference firms validate our approaches to partitioning the firms.These approaches should prove useful to researchers who want to identify the predominant source of book-tax differences for large samples of firms,as opposed to using a detailed firm-specific examination of individual line items in the tax footnotes as in Raedy et al.(2010)and Guenther (2011).Third,we provide evidence that,for the most part,investors appear to understand the differential signal about accruals persistence provided by firms that exhibit large positive book-tax differences from different sources.Section II reviews the related literature and develops our hypotheses.Section III describes the sample.Section IV presents the earnings persistence test results.Section V presents the market pricing test results,and Section VI concludes.II.RELATED LITERATURE AND HYPOTHESESEarnings PersistenceHanlon (2005)examines the implications of large book-tax differences for earnings and accruals persistence.Hanlon (2005)posits that,because discretionary accruals are less persistent than nondiscretionary accruals (Xie 2001),if large book-tax differences are a signal of increased discretion in the accruals process,then firms with large book-tax differences should exhibit lower earnings and accruals persistence.Consistent with this argument,Hanlon (2005)finds that firms with large book-tax differences exhibit lower earnings and accruals persistence than firms with small book-tax differences.However,if accruals for book purposes are not also made for tax purposes,then the differences show up in deferred tax expense,and larger deferred tax expense (equivalently larger book-tax differences)could just be reflecting larger book accruals.Thus,we first test whether large book-tax differences provide incremental useful information about earnings persistence beyond the information provided by accruals.This analysis is similar in spirit to the approach of Weber (2009),who examines whether analyst forecast errors are associated with the ratio of taxable income to net book income after controlling for accruals.He finds that analysts’forecasts of future earnings display greater optimistic bias in firm-years where book income is high relative to taxable income even after controlling for accruals.We also note that Phillips et al.(2003)find temporary book-tax differences have incremental explanatory power over discretionary accruals,estimated using the Jones model,to detect earnings management around key earnings benchmarks.Thus,we predict that book-tax differences will have incremental explanatory power for the persistence of earnings and accruals:H1a:Temporary book-tax differences provide incremental information over the magnitude ofaccruals for the persistence of earnings.H1b:Temporary book-tax differences provide incremental information over the magnitude ofaccruals for the persistence of the accruals component of earnings.Assuming book-tax differences have incremental explanatory power,we next explore why book-tax differences might indicate differences in the persistence of earnings and accruals.We extend94Blaylock,Shevlin,andWilson The Accounting ReviewJanuary 2012Hanlon(2005)by making separate predictions about the earnings and accruals persistence for different subsamples offirms with large positive book-tax differences(LPBTDs)based on the likely predominant source of those differences.We expect that the ability of LPBTDs to serve as a red-flag for low earnings quality(less persistent earnings and accruals)will be most pronounced forfirms where upward earnings management is the predominant source of the large positive book-tax differences.Phillips et al.(2003,492)argue that deferred tax expense can be used as a measure of ‘‘managers’discretionary choices under GAAP because the tax law,in general,allows less discretion in accounting choice relative to the discretion that exists under GAAP.’’As an example of this flexibility,Phillips et al.(2003)note that GAAP allows discretion in accounting for bad debts,but tax reporting requires the receivable to actually be written off.Consistent with this argument,Phillips et al.(2003)find evidence of a positive association between deferred tax expense andfirms just avoiding a loss or a decline in earnings.They conclude that the deferred tax expense is a useful indicator of earnings management incremental to a proxy for discretionary accruals.Also consistent with this reasoning,Mills and Newberry(2001)find that the magnitude of book-tax differences is positively associated withfinancial reporting incentives such asfinancial distress and bonus thresholds.We compare the earnings and accruals persistence offirms likely to have managed earnings with large positive discretionary accruals to the LPBTD BASE subsamplefirms.The above discussion leads to our second set of hypotheses:H2a:Forfirm-years with large positive book-tax differences,the persistence of earnings is lower for the earnings management subsample than for the BASE subsample.H2b:Forfirm-years with large positive book-tax differences,the persistence of the accruals component of earnings is lower for the earnings management subsample than for theBASE subsample.In November2006,the Wall Street Journal noted that public companies reported40percent higher pretax profits to Wall Street(GAAP earnings)than to tax authorities during2004(Drucker 2006).5The article went on to report that one of the biggest drivers of this gap is reportable transactions.These are transactions sold by tax advisers to companies,including some listed transactions expressly forbidden by the IRS.In addition,Mills(1998)reports that proposed IRS adjustments are positively associated with large book-tax differences.6Wilson(2009)and Lisowsky(2010)find that book-tax differences are positively associated with identified cases of tax sheltering.7Together,thesefindings suggest that tax avoidance is an important determinant of book-tax differences.We conjecture that manyfirms report LPBTDs largely as a result of tax-planning strategies associated with deferring income or accelerating deductions.5Drucker(2006)notes that thesefigures were based on IRS data for4,195U.S.public companies withfiscal years ending between June and December.6Mills(1998)uses three alternative measures of book-tax differences.Her full sample analysis utilizes IRS data and measures book-tax differences as the difference between pretax book income and taxable income.She also uses the difference between the federal tax expense for book less the declared tax on the tax return as an alternative measure of book-tax differences andfinally the deferred tax expense as a third measure.Her third measure is consistent with the measure of book-tax differences used in our study because it does not include permanent book-tax differences.7Specifically,Wilson(2009)finds that both the permanent and temporary components of book-tax differences are significantly associated with identified cases of tax sheltering.While the ideal tax shelter might generate only permanent book-tax differences,Wilson’s(2009)analysis shows that,in practice,corporate tax shelters often generate temporary book-tax differences.In addition,Lisowsky et al.(2010)examine101tax shelters reported to the IRS as listed transactions andfind that more of these transactions(38)report a related temporary book-tax difference than those(12)that report a related permanent book-tax difference.Tax Avoidance,Large Positive Temporary Book-Tax Differences,and Earnings Persistence95The Accounting Review January2012Ayers et al.(2010)examine the association between changes in credit ratings and changes in book-tax differences.They conjecture that changes in book-tax differences can have implications for credit ratings as a signal to analysts of either low earnings quality or off-balance sheet financing.However,to the extent that changes in book-tax differences arise from tax planning,they should be less useful in assessing credit worthiness.Consistent with this argument,Ayers et al.(2010)find that tax planning attenuates the relationship between changes in book-tax differences and credit ratings.Similarly,we predict that in cases for which large positive book-tax differences likely arise from tax avoidance strategies,they will not be a useful signal of low earnings persistence.The above discussion leads to our third set of hypotheses:H3a:For firm-years with large positive book-tax differences,the persistence of earnings ishigher for the tax avoider subsample than for the BASE subsample.H3b:For firm-years with large positive book-tax differences,the persistence of the accrualscomponent of earnings is higher for the tax avoider subsample than for the BASE subsample.In summary,our hypotheses imply a ranking of earnings and accruals persistence for firms with LPBTDs.Specifically,we expect that,in cases where LPBTDs are largely a function of tax avoidance,earnings and accruals persistence will be the greatest.The lowest earnings and accruals persistence will be exhibited by firms where the large book-tax differences appear to be primarily a function of upward earnings management.We expect firms with LPBTDs not specifically identified as resulting from either upward earnings management or tax avoidance (the BASE subsample)to exhibit earnings and accruals persistence between the other two subsamples of firms.For BASE subsample firms,LPBTDs likely arise from a combination of tax avoidance and discretion over accruals as well as innate firm-specific characteristics (i.e.,normal book-tax differences).Firms can have large book-tax differences simply because of differences in the timing of revenues and expenses for GAAP versus the recognition required by tax law.These differences reflect the underlying differences in the economics or business model of the firm.8As a result,LPBTDs might provide some information about subjectivity in the accruals process for the BASE firms,but not to the degree that they do for firms for which the predominant source of LPBTDs is upward earnings management.Market PricingOur next set of hypotheses examine whether stock prices reflect different investor expectations about the future of earnings for firms with LPBTDs,depending on the source of those differences.Sloan (1996)provides evidence that investors do not correctly understand the differential persistence of accruals and cash flows.Hanlon (2005)finds that,in the presence of LPBTDs,investors reduce their expectations about the persistence of earnings and accruals and appear to correctly price the accruals component of earnings.9Our market tests are intended to examine 8Seidman (2010)finds that a small subset of changes in GAAP alone explains 50.45percent of the variation in the book-tax gap between 1993and 2004.Further,she finds that removing the effects of these GAAP changes from the book-tax gap increases the association between the book-tax gap and predicted cases of tax sheltering.9Specifically,Hanlon (2005)finds that investors correctly price the persistence of the accrual component of earnings for future earnings,but actually underestimate the persistence of the cash flow component of earnings for future earnings.As a result,investors underestimate the persistence of earnings for firms with large positive book-tax differences.There is a subtle distinction between Sloan (1996)and our study,which extends Hanlon (2005).Sloan (1996)argues that investors might not recognize the differential persistence between cash flows and accruals and,thus,might misprice accruals.Hanlon (2005)and we argue that the persistence of accruals can differ across subsamples;investors might not recognize this and,thus,might misprice accruals for these subsamples.96Blaylock,Shevlin,andWilsonThe Accounting ReviewJanuary 2012whether investors recognize the difference in earnings and accruals persistence between various subsamples offirms that we predict will exhibit meaningful differences in persistence.Following the above discussion,we expect the persistence of earnings and accruals to be lowest forfirms with LPBTDs arising from upward earnings management.In contrast,we expect the persistence of earnings and accruals to be highest forfirms with LPBTDs generated by tax avoidance activity.That is,we develop our pricing predictions assuming differential accruals persistence across subsamples.If investors focus only on aggregate book-tax differences as a signal of earnings persistence and do not examine the source of those book-tax differences,then we expect that investors will not correctly understand differences in the persistence of accruals between subsamples of LPBTDfirms separated according to the source of those differences.We develop two sets of hypotheses to test whether the pricing of equities is consistent with investors looking through book-tax differences to their source.Wefirst examine whether the earnings response coefficient varies across subsamples in a manner consistent with the predicted(in H2and H3)variation in persistence across the subsamples. These tests are motivated by prior literature that shows the earnings response coefficient is positively associated with persistence(Kormendi and Lipe1986;Collins and Kothari1989).Thus, we examine the association between current-period stock returns and earnings and accruals with the following set of hypotheses:H4a:The earnings response coefficient is lower(higher)forfirms classified as earnings managers(tax avoiders)than forfirms in the BASE subsample.H4b:The accruals response coefficient is lower(higher)forfirms classified as earnings managers(tax avoiders)than forfirms in the BASE subsample.Evidence consistent with H4a and H4b does not conclusively provide evidence that investors are correctly or fully recognizing the differential persistence.If investors only partially recognize the differential persistence of accruals across subsamples,then,as earnings and accruals are reported in the subsequent year,investors will correct their estimates and portfolios formed on the sign and magnitude of accruals should generate hedge portfolio abnormal returns.This reasoning leads to the following hypotheses:H5a:Forfirms classified as earnings managers,investors overestimate the persistence of the accruals component of pretax earnings,resulting in negative abnormal returns to a hedgeportfolio formed on the sign and magnitude of pretax accruals.H5b:Forfirms classified as tax avoiders,investors underestimate the persistence of the accruals component of pretax earnings,resulting in positive abnormal returns to a hedgeportfolio formed on the sign and magnitude of pretax accruals.III.SAMPLE SELECTIONWe begin with a sample of allfirms on the Compustat and CRSP tapes with non-missing asset and stock return data for the years1993–2005.We start our sample in1993to coincide with the implementation of SFAS109,thereby ensuring consistent accounting for income taxes over the sample period.10We eliminate observations with missing regression variables,pretax accounting losses,positive net operating losses(NOL carryforward),and negative current tax expense.As noted by Hanlon(2005),the presence of accounting losses,net operating losses,and negative 10We usefive years of data to estimate the cash effective tax rate.Because cash taxes paid are not affected by SFAS 109,we are able to collect data for the calculation of the cash effective tax rate prior to1993.Tax Avoidance,Large Positive Temporary Book-Tax Differences,and Earnings Persistence97The Accounting Review January2012current tax expense can obfuscate the deferred tax expense account we use to estimate book-tax differences.11After all exclusions,our sample is composed of 21,043firm-year observations.We first estimate the book-tax difference for each firm-year as [(U.S.Deferred Taxes þForeign Deferred Taxes)/0.35]scaled by average total assets.We next rank all firms each year on book-tax differences and partition them into the quintile of largest positive book-tax differences (LPBTD,4,195observations),the quintile of largest negative book-tax differences (LNBTD,4,263),and all other observations (12,585observations),which we call the small book-tax difference group (SBTD).Table 1presents descriptive statistics for firms categorized into the SBTD,LNBTD,and LPBTD groups,respectively.Similar to Hanlon (2005),we find that the LNBTD firms are smaller in terms of median assets.This finding is consistent with smaller growth firms being more likely to be categorized in the LNBTD group.We also find that the LPBTD firms exhibit the lowest median five-year cash ETR,which we calculate as the ratio of the sum of cash taxes paid over a five-year period to the sum of pretax book income over the same five-year period (Cash5ETR ).This result is consistent with the LPBTD firms being more likely to be engaged in tax avoidance that results in positive BTDs.Consistent with LPBTDs being,in part,a function of upward earnings management,we also find that the LPBTD firms exhibit the largest median discretionary accruals of any of the three groups.We estimate discretionary accruals using the Jones model with lagged return-on-assets (Kothari et al.2005).IV .TESTS OF EARNINGS PERSISTENCEThe Basic Persistence Regression ModelThe following regression model forms the basis of all our earnings persistence tests:PTBI t þ1¼c 0þc 1PTBI t þe t þ1;ð1Þwhere PTBI is pretax accounting income scaled by average total assets for cross-sectional comparability,and the coefficient c 1is an estimate of the mapping of current-period pretax earnings into future (one-period)earnings,referred to as the persistence parameter.This model can be expanded as in Hanlon (2005)to allow persistence to vary across groups of firms based on the sign and magnitude of book-tax differences:PTBI t þ1¼c 0þc 1LPBTD t þc 2LNBTD t þc 3PTBI t þc 4PTBI t 3LPBTD tþc 5PTBI t 3LNBTD t þe t þ1;ð2Þwith the BTD groups as defined above.We next decompose PTBI in Equation (1)into pretax cash flow and pretax accruals:PTBI t þ1¼c 0þc 1PTCF t þc 2PTACC t þe t þ1;ð3Þwhere PTCF is pretax cash flow and PTACC is pretax accruals,both scaled by average total assets for cross-sectional comparability.The coefficients c 1and c 2are estimates of the mapping of current-period cash flows and accruals into future (one-period)pretax earnings.This mapping is referred to in the literature (Sloan 1996;Xie 2001;Hanlon 2005)as the persistence of cash flows and accruals into future earnings.We again allow the persistence parameters to vary as a function of the sign and magnitude of BTDs:11In addition,Hayn (1995)argues that because shareholders have a liquidation option,loss years will exhibit lower earnings persistence than profitable firm-years.The lower persistence of loss-year observations could also obscure our ability to detect differences in persistence signaled by large book-tax differences.98Blaylock,Shevlin,andWilson The Accounting ReviewJanuary 2012。