Disclosure of Managers' Forecasts in Interim Financial Statements: A Study of Effective Tax Rate Changes

Abstract

This study examines whether managerial forecasts of annual effective tax rates, disclosed in interim financial statements, are useful in predicting future quarterly earnings, are incorporated in financial analysts' forecasts of quarterly earnings, or are impounded in stock prices. The integral view of interim financial reporting requires managers to make their best estimate of the effective income tax rate (ETR) to be in effect for the full fiscal year. Thus, the ETR reflected in interim financial statements represents the disclosure of certain private information regarding management's expectations for forthcoming earnings. Auditors review the income tax provision in conjunction with the release of interim financial statements, arguably lending credibility to management's ETR forecast. Our empirical analyses show that interim effective tax rate disclosures are useful in predicting next-quarter earnings. However, financial analysts generally under-utilize this information when firms report large decreases in ETR. Surprisingly, small ETR increases are related to higher future earnings, and a zeroinvestment strategy based on small ETR increases yields significant abnormal returns. In sum, although interim ETRs are useful in predicting future earnings, both financial analysts and stock market investors fail to fully impound the earnings implications of interim effective tax rate changes in their decisions.