Book-Tax Conformity of Earnings and the Pricing of Accruals

Abstract

We examine managerial incentives underlying book accruals and tax accruals affecting stock prices. Due to the differential incentives underlying tax and financial reporting systems differences between book and tax earnings are likely to exist despite the requirements of tax conformity. It is widely argued in the literature that tax conformity will likely reduce opportunistic behavior. However, recent findings of Hanlon et al. (2006) indicate that tax conformity leads to tax-induced conservatism which in turn reduces the information content of earnings. Hanlon (2005) demonstrates the association between tax differences and the persistence of earnings. We decompose total accruals into discretionary tax accruals and non-discretionary tax accruals, discretionary book accruals and non-discretionary book accruals to examine how the market prices book versus tax accruals. As predicted, the evidence shows that during the period of 1986-2001 firms had increased the use of income decreasing discretionary tax accruals in an effort to reduce their tax liability. In contrast with prior studies, a test of equality of multivariate regression coefficients reveals that the persistence of the nondiscretionary book accruals is not significantly different than the cash flow component of earnings. This implies that by taking into account the tax incentives embedded in tax accruals provides a more transparent measure of book accruals that better reflects changes in earnings and firm value. The market's inability to correctly assess the persistence of accruals is more severe for tax accruals than for book accruals. In addition, a trading strategy of portfolios with high levels of discretionary tax accruals yields positive size-adjusted abnormal returns. These results suggest that the market has difficulty interpreting tax accruals either because of lack of sufficient disclosure regarding these accruals or lack of understanding of their tax consequences.