The Value Relevance of Book-Tax Differences - An Empirical Study in China's Capital Market

Abstract

Book-tax differences (BTD) reflect not only the mechanical information about the divergent reporting rules for book and tax purposes, but also the opportunistic information due to the managerial choices in accounting and tax reporting. This paper investigates whether this two different information impounded in BTD can be used to evaluate firm's future earnings and value firms' equity. Using the data from Chinese B-shares listed firms, I find a significantly negative association between BTD and one-year-ahead earnings, indicating that analysts and investors rely on the information impounded in BTD to assess firms' future performance. To determine which information contributes to the predictability of BTD, I decompose the BTD measure into normal and abnormal components as in Tang (2005). Normal BTD (NBTD) reflects the mechanical information about different income reporting requirements in GAAP and tax laws and abnormal BTD (ABTD) reflects the opportunistic information about earnings management and tax management. The evidence shows that this decomposition provides incremental information to investors. The significantly negative association between NBTD and ABTD and future earnings indicate that larger (smaller) NBTD and ABTD signify that the current earnings are more (less) transitory and less (more) persistent, thereby informing on poorer (better) performance in future years. A further test shows that the predictive power of NBTD (ABTD) is relatively stronger (weaker) than that of contemporaneous EPS. I interpret this as evidence that the information content of NBTD is beyond that of EPS, and EPS has stronger predictability than ABTD because ABTD only reflects the levels of noise in reported earnings. Another possible explanation is that investors and analysts may underestimate the implications of ABTD for earnings quality. Further, I find that both NBTD and ABTD are negatively related to contemporaneous stock returns, consistent with both mechanical and opportunistic information impounded in BTD having been reflected in stock prices. On average, BTD adds approximately 44% to the explanatory power of earnings levels and earnings changes with respect to contemporaneous stock returns during 2000-2004.