Evidence for the Possible Information Loss of Conforming Book Income and Taxable Income

Abstract

Recent corporate accounting reporting scandals and aggressive corporate tax shelters have led for calls for regulatory reform. One such call is to conform (or reduce the gap between) the calculation of book and taxable income. Proponents of conformity focus on perceived benefits while ignoring possible costs. We examine one possible cost: the loss in information content to investors if one measure is removed from the information set. We provide evidence for this possible loss by examining the relative and incremental information content over the past 20 years of book and (estimated) taxable income for a large sample of firms. We find that book income exhibits significantly greater relative explanatory power, while both exhibit significant incremental explanatory power. Conforming the two measures at a minimum results in the loss of incremental explanatory power and, if book income is conformed to the tax rules, a 50 percent loss in the explanatory power of earnings.