Book Income Research Articles

Incoming Books for Review

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Valuation of Tax Expense

Both intuition and evidence suggest that tax expense reflects value lost to taxes paid. Inconsistent with this traditional valuation role for tax expense, some recent research finds that tax expense surprise, especially its current component, is positively associated with stock returns. Holding pre-tax income surprise constant, a higher tax expense surprise is associated with higher returns, even though net income is lower. To reconcile this apparent conflict, we propose that a) tax expense can reflect both value lost to taxes paid and underlying profitability, and b) the proxy-for-profitability role is more important when profitability is weakly related to pre-tax book income and strongly related to tax expense. As a result, the coefficient on tax expense in valuation regressions varies across samples and specifications based on the relative ability of pre-tax book income and tax expense to reflect profitability. While the conditions that favor the proxy-for-profitability role may appear restrictive and not frequently encountered, in fact that role generally dominates the traditional value-lost-to-taxes role because pre-tax book income reflects profitability poorly for most samples and specifications. The main implication is that inferences based on the valuation coefficients associated with different tax variables should be made with caution, as they could be affected substantially by other correlated factors.

Conservatism and Book-Tax Differences

I investigate the relation between conservatism and book-tax differences (BTDs), where “conservatism” refers to conservatism in the financial statement context (as opposed to the taxable income context). Specifically, “conservatism” refers to conditional and unconditional conservatism per Basu (1997). The primary objective of my study is to further the use of BTDs in financial statement analysis. I find that, on average, the conditional and unconditional financial statement conservatism of firm-years with large positive BTDs (book income is greater than taxable income) is similar to that of other sample firm-years, while the conditional and unconditional conservatism in taxable income of firm-years with large positive BTDs is greater than that of other sample firm-years. Thus, contrary to teachings in popular accounting textbooks, my main findings suggest that large positive BTDs do not, on average, reveal information about a firm's relative level of financial statement conservatism. I additionally find that, on average, the unconditional financial statement conservatism among firm-years with large negative BTDs (LNBTDs, taxable income is greater than book income) is greater than that of other sample firm-years, and, at the same time, the conditional and unconditional conservatism in taxable income among firm-years with large negative BTDs is less than that of other sample firm-years. Because the increased financial statement conservatism among firm-years with LNBTDs is unconditional in nature, and is not conditional in nature, the increased conservatism among firm-years in this subsample does not translate into higher earnings quality.

Incoming Books for Review

Incoming Books for Review

Discussion of "Taxable Income as a Performance Measure: The Effects of Tax Planning and Earnings Quality"*

Ayers, Jiang and Laplante (2008) provide evidence that the association between taxable income and market returns is a function of the level of noise in taxable income. Their study extends the nascent but growing literature which documents a correlation between taxable income and market returns - a result which holds up in multivariate analyses that properly control for book income (e.g., Hanlon, 2005; Hanlon, Laplante and Shevlin, 2005; Lev and Nissim, 2004; and Shevlin, 2002). Ayers et al. (2008) partition their sample firms based on the extent of tax planning and provide evidence that the noise introduced by this activity weakens the association between taxable income and returns. This result provides a useful contribution to the literature because it strengthens the body of evidence which suggests that taxable income incorporates elements of economic income. The paper also provides evidence which addresses whether the association between taxable income and market returns is a function of the noise in book income. This discussion will focus on three issues: (1) hypothesis development, (2) research design, and (3) directions for future research.

The Influence of Differences in Taxable Income and Book Income on the Bond Credit Market

ABSTRACT: We examine the importance of information pertaining to the relationship between taxable income and reported book income to bond rating analysts. Specifically, using a relatively large sample of new bond issues over an extended period of time, we examine information related to deferred taxes as well as the overall tax-to-book position in the assessment of a firm's default risk. Our results are consistent with the existence of a U-shaped relationship, with firms falling in the extreme upper or lower quintiles of their industry-year group receiving lower bond ratings than firms that are nearer to their industry average. Additional analyses suggest this effect is partially diminished for firms identified as highly effective tax planners. Finally, examination of investors' bond yields provides further corroborating evidence with respect to the importance and treatment of the information provided by the firm's overall tax-to-book position.

DISCUSSION OF The Influence of Differences in Taxable Income and Book Income on the Bond Credit Market

DISCUSSION OF The Influence of Differences in Taxable Income and Book Income on the Bond Credit Market

Book-Tax Conformity: Implications for Multinational Firms

This paper examines the implications for multinational firms of recent proposals to conform tax and financial reporting (i.e., book-tax conformity). Proponents of book-tax conformity argue that the current dual system in the U.S. allows firms to simultaneously manage their taxable income downward while managing their book income upward. By requiring book-tax conformity, they contend that firms will be forced to trade off reporting high earnings numbers to shareholders and reporting low earnings to the taxing authority, resulting in improved financial reporting and less tax avoidance. Reduced compliance costs and easier auditing have also been cited as potential benefits of book-tax conformity. However, before one can evaluate the costs and benefits of book-tax conformity it is necessary to understand international implications of conformity, particularly regarding the foreign operations of U.S. multinationals. We describe several possible approaches to implementing book-tax conformity for firms that have both domestic and foreign operations. We discuss issues likely to arise with each approach and conjecture at the behavioral responses to each. Using firm-level financial data from Compustat, we simulate the effects of book-tax conformity on publicly traded U.S. firms. Specifically, we simulate the effects of book-tax conformity on the level and variability of tax payments/collections.

Inferring U.S. Tax Liability from Financial Statement Information

Abstract: Using a multi-year matched tax return-financial statement data set, this study builds empirical models that infer U.S. tax liability on the corporate tax return from publicly available financial statement disclosures, including those of Statement on Financial Accounting Standards No. 109, Accounting for Income Taxes. Results show that current U.S. tax expense, the tax benefit from stock options, current-year tax cushion accrual, consolidation book-tax differences, and R&D are informative in inferring actual tax, while intraperiod tax allocation is not. Additionally, the sign of pretax book income and the existence of net operating loss carryforwards are useful partitioning variables in estimating actual tax. In general, for every dollar of current U.S. tax expense reported on the financial statements, approximately $0.70 is reported in U.S. tax liability on the tax return. The models are validated using a holdout sample, providing support for the notion that public parties can reliably use these results to estimate a firm's tax position. Additional tests reveal a hierarchy of subsamples that researchers may employ when maximizing the usefulness of tax-related disclosures in inferring U.S. tax liability.

Incoming Books for Review

Incoming Books for Review

Interpretability of Empirical Valuation Models in the Value Relevance Literature

This paper proposes an alternative formulation of the information dynamics that can serve as a foundation for the linear valuation models tested in empirical research. The models tested in the literature express market value either as a function of earnings and equity book value (net income form) or residual income and equity book value (residual income form). The net income form deviates from its theoretical development by excluding either current dividends or prior equity book value. The current formulation is consistent with the valuation models tested in the literature, and without the need to include a discount rate. The current study provide expectations on the regression coefficients produced from the empiricist's tests. Finally, since model selection is fundamentally an empirical question, we propose a model specification test for choosing among modeling alternatives.

The Provision of Tax Services by Incumbent Auditors and Earnings Management: Evidence from Korea

AbstractThis study examines the associations between the provision of tax services by incumbent auditors and earnings management. We investigate whether three different effects of tax service provision play different roles in accounting practices. The three effects include the audit independence effect, the knowledge spillover effect, and the tax avoidance effect. If the provision of tax services by incumbent auditors harms auditor independence, firms may exercise greater earnings management (audit independence effect). However, if incumbent auditors gain incremental knowledge by offering tax services, the quality of their audit services could be enhanced, and therefore, reported earnings could be more conservative (knowledge spillover effect). If tax service fee leads to low taxable income, it could depress book income when book‐tax conformity is high (tax avoidance effect). We find that the provision of tax services generally improves earnings quality by curtailing opportunistic accounting practices. The results also suggest that the negative association between the provision of tax services and discretionary accruals seems to be primarily driven by the knowledge spillover effect as opposed to the tax avoidance effect. Additional analysis is conducted in examining whether the tax avoidance effect exists in a sub‐sample.

Incoming Books for Review

Incoming Books for Review

Four Core Principles of Tax System Design: Introduced and Applied to the Taxation of Multinationals

Although optimal tax theory dominates both tax economics and tax law scholarship in the upper academic ranks, legal academics make remarkably little use of it in their day-to-day work. This is unfortunate. Although I am unwilling to accord efficiency the primacy that optimal tax theory gives it, the behaviorally distortive effects of tax rules should be of concern regardless of one’s normative perspective. Distortive effects are not merely inefficient; they affect fairness and administrability as well. We know, for example, that if the relevant supply or demand curve of a nominal taxpayer is elastic, she is unlikely to bear the ultimate burden of a tax or rule. If so, the burden of a tax or rule that is supposed to be borne by one group may in fact be shifted to another. Tax shelters and the administrative problems they create similarly cannot be understood without taking into account the behaviorally distortive effects of the rules on which they rely.The paper proposes four nonmathematical principles that, consistently applied, should result in rules that minimize such distortion:1. Tax liability should not turn on factors as to which taxpayer is relatively indifferent (“relative indifference”).2. The least distortive tax base for any taxpayer is whatever that taxpayer would seek to maximize in the absence of taxation (“taxing the maximand”).3. If what taxpayer would seek to maximize in the absence of taxation is a number already computed for non-tax purposes, tax administrative costs will be minimized if the tax base equals that reported number (“taxing the reported maximand”).4. Taxpayers should be classified for tax purposes by reference to whatever it is they would seek to maximize in the absence of taxation (“classification by maximand”).All else being equal, rules consistent with these four principles are more likely to be efficient, more likely to effect intended distributive goals, and less likely to invite tax avoidance than rules that are not.The paper then illustrates the power of these principles by applying them to a problem that has long resisted solution: design of a minimally distortive system for taxing corporations, particularly multinational groups. Such a minimally distortive system, it concludes, would tax all publicly-reporting corporate groups, domestic and foreign alike, on their adjusted book income, computed on a consolidated basis and allocated among jurisdictions using a single factor formula based on sales adjusted by industry-average profit-to-sales ratios.

Incoming Books for Review

Incoming Books for Review

Book/Tax Conformity and Equity Compensation

Should we require companies to report the same amount of income to the IRS as they report to their shareholders? The idea behind is that managers' desire to increase reported earnings would act as a check on their desire to minimize taxable income, and vice versa. Some scholars have proposed a comprehensive approach, adopting financial income as the basis for corporate taxation. Legislators, meanwhile, have offered a targeted approach that singles out equity compensation, which has historically been a significant source of the gap between book income and taxable income.This Article argues that book/tax conformity carries unexplored costs that reduce its attractiveness, at least in the context of equity compensation (and quite possibly in other areas as well). Conforming the employer's tax treatment of stock and options with the accounting rules creates a paradox for employee-level taxation. Either employee taxation is also conformed to book, which raises liquidity, fairness, and other concerns, or we must diverge from section 83(h), which limits the employer's deduction to the amount included by the employee as income. Severing this link between the employer's deduction and the employee's inclusion would eliminate an important check on tax gamesmanship that is analogous to the check that book/tax conformity proponents seek to create. Conforming tax deductions for options with book, in other words, may simply trade one form of gamesmanship for another.More broadly, book/tax conformity must be evaluated in light of (1) the cost of other gamesmanship that may result from conformity, (2) the availability of other means of combating manipulation, (3) potential distortions in compensation design, and (4) effects on the decision to be a private or public company. We conclude that equity compensation should be excluded from comprehensive book/tax conformity regimes, and one-off proposals to conform employer taxation of stock and options with book are probably misguided. On the other hand, we suggest that if targeted conformity of equity compensation is desired, revising the accounting rules for options to match those of stock appreciation rights, which would yield conformity at the tax end of the spectrum, possibly could improve upon the status quo.

Incoming Books for Review

Incoming Books for Review

Discussion of: 'Taxable Income as a Performance Measure: The Effects of Tax Planning and Earnings Quality'

Ayers, Jiang and Laplante (2008) provide evidence that the association between taxable income and market returns is a function of the level of noise in taxable income. Their study extends the nascent but growing literature which documents a correlation between taxable income and market returns - a result which holds up in multivariate analyses that properly control for book income (e.g., Hanlon, 2005; Hanlon, Laplante and Shevlin, 2005; Lev and Nissim, 2004; and Shevlin, 2002). Ayers et al. (2008) partition their sample firms based on the extent of tax planning and provide evidence that the noise introduced by this activity weakens the association between taxable income and returns. This result provides a useful contribution to the literature because it strengthens the body of evidence which suggests that taxable income incorporates elements of economic income. The paper also provides evidence which addresses whether the association between taxable income and market returns is a function of the noise in book income. This discussion will focus on three issues: (1) hypothesis development, (2) research design, and (3) directions for future research.

Incoming Books for Review

Incoming Books for Review

Incoming Books for Review

Incoming Books for Review