Reassessing the Role of Book-Tax Conformity

Abstract

Book-tax conformity refers to the legal link between financial and tax accounts, and is an institutional feature of many continental European countries and countries like Japan that follow continental European traditions. Many studies argue that book-tax conformity impedes earnings informativeness. However, book-tax-conformity is required for single accounts but not for group accounts, which are used to inform capital markets. Previous research has not properly used this distinction. The absence of a formal link between group income and taxable income makes a causal empirical relationship between legal book-tax conformity and resulting cross-country differences in group earnings properties much less compelling. We argue that studies documenting this relationship suffer either from an omitted variable problem (i.e., failure to sufficiently control for differences in reporting incentives) or sample selection bias (inclusion/noninclusion of single accounts in the test sample). We reassess cross-country differences in asymmetric earnings timeliness and find that legal book-tax conformity does not affect cross-country differences in group earnings properties when the institutional environment is adequately controlled for. Instead, group accounting follows typical reporting incentives even in countries where there is high book-tax conformity for single accounts. Furthermore, we show that even tax-dominated single accounts are responsive to nontax reporting incentives.