Does Firm Life Cycle Inform the Relation between Book-Tax Differences and Earnings Persistence?

Abstract

Existing literature consistently documents a relation between book-tax differences and future financial performance. Specifically, Hanlon (2005) finds that large book-tax differences are associated with lower earnings persistence. I contend that one reason the tax information contained in financial statements is informative about future earnings is that the relation between book income and taxable income captures information about a firm’s life cycle stage. Using life cycle measures from the accounting literature, I use fundamental analysis to group firm-year observations into life cycle stages and document a link between book-tax differences and firm life cycle. I find that controlling for firm life cycle stage weakens the association between large book-tax differences and lower earnings persistence. I also find that life cycle explains a portion of investor valuation of earnings persistence for firms with large book-tax differences. My results offer an explanation grounded in economic theory for a portion of the relation between book-tax differences and earnings persistence documented in prior research.