Book-Tax Conformity and the Information Content of Earnings

Abstract

We examine whether the information content of earnings is inversely related to the degree of conformity between financial accounting income and taxable income. Our inquiry exploits a natural experiment first examined by Guenther et al. (1997) in which a set of U.S. firms were forced to increase their book-tax conformity as a result of a change in the tax law. We find evidence consistent with the increase in book-tax conformity reducing the usefulness of financial accounting earnings. The information content of earnings as measured by the long-window earnings response coefficients and the R- squared from a regression of returns on earnings decreases for this set of firms after the tax law required greater book-tax conformity. We find that the declines are significantly larger than the changes in the same measures for an industry-matched sample of firms not required to increase conformity. These results add to the academic literature on the interaction of taxes and financial reporting as well as to the policy debate about whether the U.S. should conform the tax law to GAAP, a debate that has recently intensified. Hanlon acknowledges financial support from an Ernst & Young Faculty Fellowship. Maydew acknowledges financial assistance from the University of North Carolina Kenan- Flagler Business School. Shevlin acknowledges financial assistance from the Accounting Development Fund at the University of Washington. We thank Nader Hafzalla for research assistance and Scott Dyreng and Dave Guenther for comments on an earlier draft. We appreciate Dave Guenther and Sarah Nutter sharing the identification of the firms required to switch to accrual basis accounting for tax purposes.