Tax Avoidance, Large Positive Book-tax Differences, and Earnings Persistence Bradley Blaylock Ph.D.

Candidate University of Washington Foster School of Business Box 353200 Seattle, WA 98195 Terry Shevlin Paul Pigott/PACCAR Professor of Business Administration University of Washington Foster School of Business Box 353200 Seattle, WA 98195 Ryan Wilson Tippie School of Business University of Iowa W280 Pappajohn Business Building Iowa City, IA 52242-1994 March 29, 2010 Abstract: We investigate why book-tax temporary differences appear to serve as a useful signal of earnings persistence. We maintain that there are multiple potential sources of large positive book-tax differences and examine the differing implications of large positive book-tax differences for earnings and accruals persistence depending on the source of those differences. We expect and observe that firms with large positive book-tax differences likely arising from tax avoidance exhibit greater accruals persistence than other firms with large positive book-tax differences. We also expect and observe that firms with large positive book-tax differences likely arising from upward earnings management exhibit lower earnings and accruals persistence than other firms with large positive book-tax differences. Further, we provide evidence that investors are able to look through to the source of large positive book-tax differences allowing them to correctly price the persistence of accruals. Together, our results illustrate the importance of considering the source of book-tax differences when using them as a signal of earnings quality.

We acknowledge the helpful comments of Alex Edwards, Michelle Hanlon, Stacie Laplante, Rick Mergenthaler, and Sonja Olhoft Rego. Shevlin acknowledges financial support from his Paul Pigott/Paccar Professorship at the Foster School.

Electronic copy available at: http://ssrn.com/abstract=1524298

I. Introduction Existing research suggests the tax information contained in the financial statements provides information about earnings quality (e.g. Lev and Nissim 2004; Hanlon 2005). Despite the important implications of these studies little is known about what causes the observed link between tax information and earnings quality. This study begins to develop an understanding of this link by investigating whether the implications of differences between book and taxable income for the persistence of earnings vary depending on the likely source of those differences. Our analysis extends Hanlon (2005) who shows that for firm-years with large book-tax temporary differences, pre-tax income is less persistent for future earnings than firm-years with small book-tax differences. We also investigate whether investors are able identify the likely source of book-tax differences to help interpret and price accruals. Hanlon (2005) notes that several accounting textbooks indicate large book-tax differences can provide information about earnings quality. 1 Consistent with investors heeding this lesson, Hanlon (2005) finds investors reduce their expectations of the persistence of earnings and accruals in the presence of large positive book-tax differences and are able to efficiently price earnings and accruals for these firms. Despite the results in Hanlon, it is not clear whether investors are able to efficiently price earnings for subgroups of large positive book-tax difference firms partitioned on the basis of the predominant source of their book-tax differences. This question is important because we predict the implications of large positive book-tax differences for earnings persistence vary depending on the likely source of the book-tax differences. Our analysis of different sub-sets of large positive book-tax difference firms is similar in spirit to Sloan (1996) who finds that on average investors
Recent accounting textbooks continue to suggest that book-tax differences are an indicator of earnings quality. For example, Revsine, Collins, and Johnson (2005) point out that increases in the deferred tax expense could be an indication of deteriorating earnings quality. Earnings quality is a difficult concept to define; consistent with Hanlon (2005) we define earnings quality as earnings persistence.
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Electronic copy available at: http://ssrn.com/abstract=1524298

correctly price the persistence of earnings for all firms. However, Sloan also shows that there is differential persistence in the accrual and cash flow components of earnings and that the market fails to identify and correctly price this differential persistence, resulting in positive hedge portfolio returns to portfolios formed on accruals. The ability of investors to identify differences in earnings persistence is critical in valuation. If earnings are permanent investors do not need to make cash-flow predictions to value equity; they can simply divide permanent earnings by the risk-free rate (Beaver and Morse 1978). As a result, Frankel and Litov (2009) point out investors have sought to identify the determinants of earnings persistence in order to better understand the relation between current earnings and permanent earnings. Ohlson (2007) discusses various theoretical models of firm valuation that all rely to varying degrees on the persistence of earnings. Hanlon (2005) demonstrates that large book-tax differences are an important signal about earnings persistence and we extend her analysis by investigating whether the underlying likely source of book-tax differences should also be considered when evaluating the implication of large positive book-tax differences for earnings persistence. We posit there are three primary sources of large positive book-tax differences. First, book-tax differences can arise due to earnings management. Phillips, Pincus, and Rego (2003) conjecture that because tax law allows less discretion in accounting choices than GAAP, large positive differences between book and taxable income are informative about earnings management. Consistent with their assertion, they find the deferred tax expense is useful in detecting earnings management. 2 In cases where book-tax differences are generated by earnings

Consistent with Hanlon (2005) we do not include permanent differences in our measure of book-tax differences. Hanlon (2005) notes that permanent differences are affected by tax rate differences, tax credits, and statutory tax breaks (e.g. tax-exempt interest) that are not indicative of earnings quality related to the accrual process. The temporary book-tax differences examined in this study are equal to the deferred tax expense grossed-up by the applicable statutory tax rate.

management we expect accruals are more likely to reverse in the next period thus exhibiting low persistence. Second, a basic tax planning strategy is to defer taxes as long as possible to decrease the net present value of the taxes paid. Such behavior also leads to a large deferred tax expense, but does not necessarily result in accruals that will reverse in the following year. Wilson (2009) finds that for a sample of 33 identified tax shelter firms the tax shelter activity increased the firms book-tax differences by an average of 102%. 3 We predict that in cases where large positive book-tax differences arise primarily from extensive tax planning these differences do not signal managerial discretion over the accruals process and, as a result, will not be associated with lower future earnings and accruals persistence. Therefore, we predict that firms with large positive book-tax differences resulting primarily from tax planning will exhibit higher future earnings and accruals persistence than other large positive book-tax difference firms. Third, deferred tax expense can arise in the absence of tax planning and earnings management because of the normal differences in the treatment of revenue and expenses for book and tax purposes (Scholes et al. 2008, p.39). Examples of normal temporary differences are depreciation and allowance for doubtful accounts (although both items can also be used for earnings management purposes). We initially focus on firms with large positive book-tax differences but in sensitivity analysis we also examine firms with large negative book-tax differences. We partition our sample of large positive book tax difference firm-year observations into three groups corresponding to the conjectured three sources of differences. A subsample of firms where the large positive book tax differences likely arise from earnings management (the EM subsample), a
It should be noted that in his analysis Wilson (2009) examines total book-tax differences. The identified tax shelters in his study generate a mix of permanent and temporary book-tax differences. However, Wilson (2009) finds that the association between temporary book-tax differences and actual cases of tax sheltering is more significant than the association between permanent book-tax differences and incidence of sheltering.
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subsample of firms where the large positive book tax differences likely arise from tax planning (the TAXAVOIDER subsample), 4 and a remaining (non-overlapping) subsample where the differences likely arise from the innate characteristics or normal book tax differences of the firms (the BASE subsample). We compare the earnings and accruals persistence of the earnings management and tax planning subsamples to the BASE subsample. We identify tax avoidance firms using the cash effective tax rate developed by Dyreng et al. (2008). The cash effective tax rate is calculated as the ratio of the sum of cash taxes paid over a five-year period to the sum of pre-tax book income over the same five-year period. 5 We identify high earnings management firm-year observations using a cross-sectional modified Jones Model with lagged return-on-assets (Kothari et al. 2005). Our analysis of the differential earnings and accruals persistence of these three groups of large book-tax difference firms represents a joint test of the predictions discussed above and our method of partitioning the firms. Consistent with expectations, we find firms with large positive book-tax differences (large deferred tax expense) that primarily result from tax avoidance have more persistent accruals than firm-year observations in the BASE group. 6 Also consistent with expectations, we find that firms with large positive book-tax differences that arise predominantly from upward earnings management have less persistent earnings and accruals than firm-year observations in the BASE group. Further, when we remove the 26% of firm-year observations classified as
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We define tax planning as non-conforming tax positions that lower taxable income relative to book income in the current period. It is possible firms could also engage in conforming tax planning where they lower reported income for both book and tax purposes. Conforming tax planning transactions would not give rise to book-tax differences. 5 Throughout this study we refer to firms in the bottom quintile of the five-year Cash ETR measure as tax avoiders. We expect firms in the bottom quintile were able to lower their tax burden through standard tax planning practices that do not necessarily violate income tax rules, as well as fraudulent tax avoidance, including tax shelter transactions considered abusive by the IRS and the Treasury Department. A synonym for tax planning is tax avoidance, and we use the two terms interchangeably. 6 In supplemental tests, we continue to find the tax avoider firms exhibit higher persistence for the accrual component of earnings than the base group firms when we calculate Cash ETR using operating cash flow as a scalar instead of pre-tax book income and when we use a three-year measure of Cash ETR instead of a five-year measure.

earnings managers from the LPBTD (leaving the BASE and TAX AVOIDERS in the LPBTD group) we find that the cash flow and accruals persistence of the remaining LPBTD firms is larger than the persistence of these components for the small book-tax difference firms. This finding is important because it demonstrates that the lower overall earnings and accrual persistence of large positive book-tax difference firms documented in Hanlon (2005) is driven primarily by the relatively high concentration of high discretionary accrual firms within the large positive book-tax difference group (26% of firm-year observations in our sample). 7 We find investors are able to appropriately price accruals for both sub-samples of tax avoidance and high earnings management firms. This finding is consistent with investors being relatively sophisticated in their ability to identify and understand the implications of different sources of book-tax differences. Investors appear to go beyond the suggestion of accounting texts to examine differences between book and taxable income as a signal of earnings quality and actually examine the likely source of those differences. Our analysis focuses primarily on firms with large positive book-tax differences because these differences could be a signal of either earnings management or tax avoidance. In supplemental tests we examine the earnings persistence of large negative book-tax difference firms. Because of interpretation problems associated with losses (discussed below), we restrict this group to positive income firms and our descriptive statistics show that the mean pretax return on assets in this group exceeds that of the LPBTD. However, if managers of highly profitable firms use discretion in accounting for accruals to smooth earnings they might have an incentive to manage earnings downward. Significant downward earnings management would
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In a contemporaneous working paper, Seidman (2010) examines the total (permanent and temporary) book-tax gap as a function of GAAP changes, macroeconomic conditions, earnings management, and tax planning. She also examines the Hanlon persistence result across large negative, small and large positive total BTD groups and finds that after removing the effects of earnings management, the earnings persistence of the large positive BTD is attenuated. Seidman removes the effect of earnings management on book-tax differences by regressing book-tax differences on a measure of discretionary accruals and using the residual from that regression as an adjusted measure of the book-tax gap.

likely result in large negative book-tax differences. We partition the large negative book-tax difference firms into a downward earnings management group and a base group. While large negative discretionary accruals might generally be expected to result in lower levels of earnings and accruals persistence than the base group of firms (as extreme accruals tend to reverse), if the accruals are motivated by smoothing it is possible than earnings persistence is no different or is increased relative to the base group for these superior performing firms. We observe no significant difference in earnings persistence between these two groups of large negative booktax difference firms. We contribute to the literature in three ways. First, our analysis provides an important caveat to researchers and investors using large-positive book-tax differences as a signal about earnings persistence. Specifically, the usefulness of this signal is contingent upon the source of the book-tax differences. Large positive book-tax differences are not a useful signal of lower earnings or accrual persistence except in cases where those differences arise primarily from upwards earnings management. Second, we provide evidence that despite the complex nature of many differences between book and taxable income investors are able to look through to the source of those differences and appropriately price accruals for different sub-samples of large positive book-tax difference firms. Third, the observed differential earnings and accruals persistence of the three groups of large positive book-tax difference firms validates our approach to partitioning these firms into sub-groups. This approach should prove useful to researchers in future studies that want to identify the predominant source of book-tax differences for large samples of firms. The remainder of the paper proceeds as follows. In section II, we review the related literature and develop our hypotheses. In section III, we describe the sample used. Section IV presents the earnings persistence test results. Section V presents the market pricing test results. 6

Section VI presents our supplemental analysis. In section VII we examine earnings persistence for groups of large negative book-tax difference firms and the final section concludes. II. Related Literature and Hypotheses a. Earnings Persistence Phillips et al. (2003, p.492) argue that the deferred tax expense can be used as a measure of managers discretionary choices under GAAP because the tax law, in general, allows less discretion in accounting choice relative to the discretion that exists under GAAP. As an example of this flexibility, Phillips et al. (2003) note that GAAP allows discretion in accounting for bad debts, but tax reporting requires the receivable to actually be written-off. Consistent with this argument, Phillips et al. (2003) find evidence of a positive association between the deferred tax expense and firms just avoiding a loss or a decline in earnings. They conclude the deferred tax expense is a useful indicator of earnings management. Also consistent with this reasoning, Mills and Newberry (2001) find the magnitude of book-tax differences is positively associated with financial reporting incentives such as financial distress and bonus thresholds. Hanlon (2005) examines the implications of large book-tax differences for earnings and accruals persistence. Hanlon (2005) posits that because discretionary accruals are less persistent than nondiscretionary accruals (Xie 2001), then if large book-tax differences are a signal of increased discretion in the accruals process, firms with large book-tax differences should exhibit lower earnings and accruals persistence. Consistent with this argument, Hanlon (2005) finds that firms with large book-tax differences do exhibit lower earnings and accruals persistence than firm with small book-tax differences. 8
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The theory developed in Phillips et al. (2003) and Hanlon (2005) suggests only temporary book-tax differences provide insight into managerial discretion over the accruals process and therefore serve as a signal of pre-tax earnings and accruals persistence. Consistent with this theory, Jackson (2009) finds the temporary component of book-tax differences provides information about pre-tax earnings growth while the permanent component of booktax differences does not. Because our study focuses on the information provided by book-tax differences about pretax earnings and accruals persistence we limit our analysis to temporary book-tax differences.

However, not all large positive book-tax differences are a reflection of increased managerial discretion over the accruals process. Firms can have large book-tax differences simply because of differences in the timing of revenues and expenses for GAAP versus the recognition required by tax law. These differences reflect the underlying differences in the economics or business model. Seidman (2010) finds a small subset of changes in GAAP alone explain 50.45% of the variation in the book-tax gap between 1993 and 2004. Further, she finds that removing the effects of these GAAP changes from the book-tax gap increases the association between the book-tax gap and predicted cases of tax sheltering. We extend the analysis in Hanlon (2005) by making separate predictions about the earnings and accrual persistence for different groups of firms with large positive book-tax differences based on the likely predominant source of those differences. We expect the ability of large positive book-tax differences to serve as a red-flag for low earnings quality (less persistent earnings and accruals) will be most pronounced for firms where upward earnings management is the predominant source of the large positive book-tax differences. We compare the earnings persistence of these firms to firms in the BASE group (firm-year observations with large positive book-tax differences not classified into either the earnings management or tax avoidance subsamples). This leads to our first hypothesis: H1a: For firm-years with large positive book-tax differences, the persistence of earnings is lower for the earnings management (EM) subsample compared to the BASE group. Consistent with Hanlon (2005) we assume that cases where large positive book-tax differences indicate low earnings quality are a result of subjectivity in the accruals process for financial reporting purposes. If large positive book-tax differences are indicative of opportunistic managerial discretion in the accruals process then we expect the accruals component of earnings

will be less persistent for firms with large positive book-tax differences arising from upward earnings management. This leads to our next hypothesis: H1b: For firm-years with large positive book-tax differences, the persistence of the accrual component of earnings is lower for the earnings management (EM) subsample compared to the BASE group. In November of 2006 the Wall Street Journal noted that public companies reported 40% higher pretax profits to Wall Street (GAAP earnings) than to tax authorities during 2004 (Drucker 2006). 9 The article went on to report that one of the biggest drivers of this gap is reportable transactions. These are transactions sold by tax advisers to companies and include some listed transactions expressly forbidden by the IRS. In addition, Mills (1998) reports that proposed IRS adjustments are positively associated with large book-tax differences. 10 Desai (2003) asserts that the divergence between book and tax income during the 1990s was attributable to increased levels of tax sheltering. Consistent with this assertion, Wilson (2009) finds that book-tax differences are positively associated with identified cases of tax sheltering. 11 Together these findings suggest tax avoidance is an important determinant of book-tax differences. It is reasonable to assume that many firms report large positive book-tax differences largely as a result of tax planning strategies associated with deferring income or accelerating deductions.
The Wall Street Journal article noted these figures were based on IRS data for 4,195 U.S. public companies with fiscal years ending between June and December. 10 Mills (1998) uses three alternative measures of book-tax differences. Her full sample analysis utilizes IRS data and measures book-tax differences as the difference between pre-tax book income and taxable income. She also uses the difference between the federal tax expense for book less the declared tax on the tax return as an alternative measure of book-tax differences and finally the deferred tax expense as a third measure. Her third measure is consistent with the measure of book-tax differences used in this study because it does not include permanent booktax differences. 11 Specifically, Wilson (2009) finds both the permanent and temporary components of book-tax differences are significantly associated with identified cases of tax sheltering. While the ideal tax shelter might generate only permanent book-tax differences, Wilsons analysis shows that in practice corporate tax shelters often generate temporary book-tax differences. In addition, Lisowsky et al. (2010) examine 101 tax shelters reported to the IRS as listed transactions and find that more of these transactions (38) report a related temporary book-tax difference than (12) that report a related permanent book-tax difference.
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An example of a tax avoidance strategy that attempts to accelerate tax deductions which results in large positive book-tax differences is the contested liability acceleration strategy (CLAS) developed by KPMG. According to the Wall Street Journal (2004), the IRS reported this shelter generated $1.7 billion in tax savings for several dozen companies. KPMG devised the CLAS shelter to help clients accelerate the timing of tax deductions for settlements of lawsuits and other claims against the corporation. In most cases, tax deductions for these claims are not allowable until the claim is paid. However, one exception to this rule involves transferring money or other property to a contested liability trust before the claims are resolved. A firm would establish a trust with itself as the beneficiary, and then transfer noncash assets such as company stock or some type of intercompany note to the trust. The transferred items were intended to correspond to amounts owed related to a particular claim, and the firm would then take a tax deduction when the items were transferred to the trust. To the extent the firm had not yet met the requirements under SFAS No. 5 to accrue the claim for financial reporting purposes, the CLAS shelter would lower taxable income for that period relative to book income. In a subsequent period when the contingent claim is accrued under SFAS No. 5 then the temporary book-tax difference would be reversed. The CLAS shelter is an example of a tax planning transaction where the legality of the transaction is uncertain. In this study our intent is to identify book-tax differences arising from all types of tax planning activity from clearly legal transactions to those characterized by significant uncertainty. Ayers, Laplante, and McGuire (2010) examine the association between changes in credit ratings and changes in book-tax differences. They conjecture that changes in book-tax differences can have implications for credit ratings as a signal to analysts of either low earnings quality or off-balance sheet financing. However, they note that to the extent changes in book-tax differences arise from tax planning they should be less useful in assessing credit worthiness. 10

Consistent with this argument, they find that tax planning attenuates the relationship between changes in book-tax differences and credit ratings. 12 Similarly, we predict that in cases where large positive book-tax differences likely arise from tax avoidance strategies they will not be a useful signal of low earnings quality. Of the three groups of large positive book-tax difference firms that we examine, we expect the TAXAVOIDERS group represents the firm-year observations with the lowest level of earnings management. 13 The large positive book-tax differences exhibited by these firms likely arise primarily as a result of their tax planning strategies. In contrast, we expect that firms categorized into the BASE group exhibit large positive book-tax differences because of a combination of management discretion over the accruals process, innate firm characteristics, and tax avoidance. Because we believe management discretion over the accrual process in the BASE group firms is higher than in the TAXAVOIDERS firms we expect that the future earnings and accrual persistence for these firms will be greater than that of the BASE group firms. This leads to our next hypotheses: H2a: For firm-years with large positive book-tax differences, the persistence of earnings is higher for the TAXAVOIDERS subsample compared to the BASE group. H2b: For firm-years with large positive book-tax differences, the persistence of the accrual component of earnings is higher for the TAXAVOIDERS subsample compared to the BASE group.

Ayers et al. (2010) use changes in book-tax differences in their primary analysis. We use levels of book-tax differences to be consistent with Hanlon (2005) and because the implications of large changes in book-tax differences for earnings persistence are more difficult to predict. For example, a firm could exhibit large negative book-tax differences in year t-1 and no book-tax differences in year t resulting in a large positive change in book-tax differences. It is not clear what this change would signal about management discretion over the accrual process and therefore about earnings and accruals persistence. See Wilson (2010) for further discussion of this issue. 13 Consistent with Hanlon and Heitzman (2010), we view tax avoidance as existing on a continuum. This continuum of avoidance includes clearly legal transactions, such as investments in municipal bonds that lower explicit taxes, on one end, to more aggressive forms of tax avoidance, such as tax sheltering where the legality of the transaction is less certain, on the other end. We select a general measure of tax avoidance (Cash ETR) to partition our sample because we want to identify all types of tax avoidance activity that lead to large positive book-tax differences.

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In summary, the two sets of hypotheses above imply a ranking of earnings and accrual persistence for firms with large positive book-tax differences. Specifically, we expect that in cases where large positive book-tax differences are largely a function of tax avoidance, earnings and accrual persistence will be the greatest. The lowest earnings and accrual persistence will be exhibited by firms where the large book-tax differences appear to be largely a function of upward earnings management. We expect firms with large positive book-tax differences not specifically identified as resulting from either upward earnings management or tax avoidance (the BASE group) to exhibit earnings and accrual persistence between the other two subsets of firms. For these firms their large positive book-tax differences likely arise from a combination of tax avoidance and discretion over accruals as well as innate firm specific characteristics (i.e. normal book tax differences). As a result, large positive book-tax differences might provide some information about subjectivity in the accruals process, but not to the degree that they do for firms where the predominant source of large positive book-tax differences is upward earnings management. As an additional test, we compare the persistence of earnings and accruals from the small book tax difference group (SBTD) to the observations in the LPBTD group after excluding firmyear observations classified as earnings managers (26% of observations). Recall from Table 2 and Hanlon (2005) that the persistence of earnings and accruals is substantially lower for the LPBTD firms compared to the SBTD group. We expect the lower earnings and accruals persistence of large positive book-tax difference firms documented in Hanlon (2005) is driven by the firms where their large positive book-tax differences primarily reflect earnings management activity. Consequently, we predict that when these observations are excluded from the LPBTD group that the persistence of earnings and accruals will no longer be lower for the LPBTD group then the SBTD group. This leads to our third set of hypotheses: 12

H3a: The persistence of earnings for the LPBTD subsample excluding earnings managers is the same or greater compared to the SBTD group. H3b: The persistence of the accruals component of earnings for the LPBTD subsample excluding earnings managers is the same or greater compared to the SBTD group.

b. Market Pricing Our final set of hypotheses examine whether stock prices reflect different investor expectations about the future of earnings for firms with large positive book-tax differences depending on the source of those differences. Sloan (1996) provides evidence investors do not correctly understand the differential persistence of accruals and cash flows. Hanlon (2005) finds that in the presence of large positive book-tax differences investors reduce their expectations about the persistence of earnings and accruals and appear to correctly price the accrual component of earnings. 14 We extend this analysis by examining whether investors look through to the source of the book-tax differences in assessing their implications for earnings persistence. Following our discussion above we expect the persistence of earnings and accruals to be lowest for firms with large positive book-tax differences arising from upward earnings management. In contrast, we expect the persistence of earnings and accruals to be highest for firms with large positive book-tax differences generated by tax avoidance activity. Existing research suggests investors should focus on book-tax differences as a signal of earnings persistence. This point is further emphasized in financial accounting textbooks (e.g. Revsine et al. 2005). However, there is no evidence that investors look through to the source of those differences and correctly incorporate the information signaled by different types/sources of
Specifically, Hanlon (2005) finds that investors correctly price the persistence of the accrual component of earnings for future earnings, but actually underestimate the persistence of the cash flow component of earnings for future earnings. As a result, investors underestimate the persistence of earnings for firms with large positive booktax differences.
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book-tax differences. If investors focus only on aggregate book-tax differences as a signal of earnings persistence and do not examine the source of those book-tax differences then we expect investors will not correctly understand difference in the persistence of accruals between sets of large positive book-tax difference firms separated based on the source of those differences. If investors miss-estimate the persistence of accruals, then as earnings and accruals are reported in the subsequent year, investors will correct their estimates and portfolios formed on the sign and magnitude of accruals should generate hedge portfolio abnormal returns. Our analysis is motivated by Sloan (1996) who finds that while investors correctly price earnings (in our setting all firms within the LPBTD group), the CFO and accrual subcomponents of earnings exhibit differential persistence which investors fail to fully appreciate resulting in mispricing (in our setting, the sub-partitions of the LPBTD group based on EM and TAXAVOIDERS). This leads to our final set of hypotheses: H4a: For firms classified as tax avoiders, investors under-estimate the persistence of the accrual component of pre-tax earnings resulting in positive abnormal returns to a hedge portfolio formed on the sign and magnitude of pretax accruals. H4b: For firms classified as managing earnings, investors over-estimate the persistence of the accrual component of pre-tax earnings resulting in negative abnormal returns to a hedge portfolio formed on the sign and magnitude of pretax accruals. III. Sample Selection and Descriptive Statistics We begin with a sample of all firms on the Compustat and CRSP tapes with non-missing asset and stock return data for the years 1993-2005. We start our sample in 1993 to coincide with the implementation of SFAS 109 to ensure consistent accounting for income taxes over the

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sample period. 15 Consistent with Hanlon (2005), we remove firms with foreign incorporation codes and firms in the financial services and utility industries since they have different accounting requirements. In addition, we eliminate observations with missing regression variables, pre-tax accounting losses, positive net operating losses (NOL carryforwards), and negative current tax expense. As noted in Hanlon (2005), the presence of accounting losses, net operating losses and negative current tax expense can obscure the deferred tax expense account which we use to estimate book-tax differences. 16 After all exclusions, our sample is composed of 21,205 firm-year observations. We rank all firms each year on book-tax differences 17 and partition them into the quintile of largest positive book-tax differences (4,178 observations), the quintile of largest negative book-tax differences (4,263), and all other observations (12,585 observations), which we call the small book-tax difference group. As discussed above, our analysis focuses principally on the large positive book-tax difference firms. However, we do begin by using all three groups of firms to replicate the results in Hanlon (2005) over this extended sample period. Consequently, we provide descriptive statistics for each of the three groups of firms. Table 1 presents descriptive statistics for each of the three groups of firms. 18 All financial statement variables are scaled by lagged total assets. The results in Table 1 indicate the large positive book-tax difference firms have the lowest median Cash ETRs and the highest median levels of discretionary accruals of any of the three groups of firms. This result is consistent with these firms being more aggressive for both financial reporting and tax purposes
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We use 5 years of data to estimate the cash effective tax rate. Because cash taxes paid are not affected by SFAS 109 we are able to collect data for the calculation of the cash effective tax rate prior to 1993. 16 In addition, Hayn (1995) argues that because shareholders have a liquidation option, loss years will exhibit lower earnings persistence than profitable firm years. The lower persistence of loss year observations could also obscure our ability to detect differences in persistence signaled by large book-tax differences. 17 Estimated as (US Deferred Taxes + Foreign Deferred Taxes)/.35 scaled by lagged total assets. 18 All accounting variables are winsorized at the 1st and 99th percentiles to reduce the effect of outliers.

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than the other groups of firms. Both the large positive and the large negative BTD groups are composed of smaller and more profitable firms than the small BTD group. The large positive BTD group exhibits the lowest median size-adjusted returns of the three groups. IV. Tests of Earnings Persistence Following Hanlon (2005), we use equation (1) to estimate one-year ahead earnings persistence. This equation permits the coefficient on earnings to vary depending on the level of book-tax differences by including indicator variables for both the large positive and large negative book-tax difference firms. PTBIt+1 = 0 + 1LNBTDt + 2LPBTDt + 3PTBIt + 4PTBIt LNBTDt + 5PTBIt LPBTDt + t+1 (1) In equation (1), PTBI is pre-tax accounting income scaled by average total assets for crosssectional comparability. LNBTD is an indicator variable set equal to 1 for firm-years with scaled book-tax differences in the lowest quintile of firms in each year, and 0 otherwise. LPBTD is an indicator variable set equal to 1 for firm-years with scaled book-tax differences in the highest quintile of firms in each year, and 0 otherwise. Panel A of Table 2 presents the results from estimating equation (1). The results indicate the findings in Hanlon (2005) hold for this extended sample period. We find that firm-years with large positive or large negative book-tax differences both exhibit significantly lower earnings persistence than firm-years with small book-tax differences. Consistent with Hanlon (2005), we also decompose earnings into cash flows and accruals in order to examine whether the persistence of accruals and cash flows varies as a function of the level of book-tax differences. We partition earnings into pre-tax accruals and pre-tax cash flows and estimate the following equation 19 :

Pre-tax cash flows are calculated as Compustat Item 308 (Cash from Operations) Compustat Item 124 (Extraordinary Income and Discontinued Operations from cash flow statement) + Compustat Item 317 (Cash taxes paid). Pre-tax accruals are calculated as pre-tax income minus pre-tax cash flows.

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PTBIt+1 = 0 + 1LNBTDt + 2LPBTDt + 3PTCFt + 4PTCFt LNBTDt + 5PTCFt LPBTDt + 6PTACCt + 7PTACCt LNBTDt + 8PTACCt LPBTDt + t+1 (2) The coefficients 3 and 6 are estimates of the mapping of current period of cash flows and accruals into future (one-period) earnings for the base group. This mapping is referred to in the extant literature (Sloan 1996, Xie 2001 and Hanlon 2005) as the persistence of cash flows and accruals into future earnings. The coefficients on the interaction terms allow for differences in the persistence estimates across groups. Panel B of Table 2 presents the results from estimating equation (2). As expected, consistent with Sloan (1996) and Hanlon (2005), we find the accrual component of earnings is significantly less persistent than the cash flow component. Also consistent with Hanlon, we find that both the accruals and cash flow components of earnings are significantly less persistent for both the LPBTD and LNBTD subsamples. The results in Table 2 are important because they show that even for this extended sample period, the results in Hanlon (2005) continue to hold and that, on average, firms with large positive book tax differences exhibit lower earnings and accruals persistence in comparison to small book-tax difference firms. In order to examine whether the implications of large positive book-tax differences for earnings persistence vary as a function of the most likely source of those differences we must first calculate measures of tax avoidance and earnings management. We use the cash effective tax rate (Cash ETR) developed by Dyreng et al. (2008) to identify tax avoidance firms. The Cash ETR is the ratio of the five-year sum of cash taxes paid to the five-year sum of pretax financial accounting income. As discussed in Dyreng et al. (2008), this measure of tax avoidance has several advantages over the traditional effective tax rate measures. First, the Cash ETR measure is not affected by the recording of contingencies for uncertain tax benefits. Regardless of whether a firm recognizes the benefit associated with a tax planning position in earnings, the reduced cash tax payments that result from that position will be reflected in a lower Cash ETR. 17

In addition, to the extent firms accelerate expenses or defer income for tax purposes this will be reflected in a lower Cash ETR provided that those timing differences do not reverse within the five-year period over which Cash ETR is measured. 20 We classify firms as tax avoiders (TAXAVOIDER) if they have a five-year Cash ETR in the lowest quintile within the pooled sample of all firms. 21 See Appendix 1 for a discussion of additional examples of tax planning transactions that some readers might be consider as being entered into for earnings management purposes but which we argue are properly classified as tax planning and which are captured by our partitioning variable - Cash ETR. We identify upward earnings management using discretionary accruals calculated from a cross-sectional modified Jones Model with lagged return-on-assets (Kothari et al. 2005). We classify firm-year observations as earnings management firm-years (EM) if the observations discretionary accruals are in the top quintile of all firms. 22 Our tests are joint tests of our predictions and the ability of our partitioning variables (Cash ETR and discretionary accruals) to correctly partition or identify the underlying likely source for why the observations is in the LPBTD group. Note that the denominator of the Cash ETR is

We use a 5-year Cash ETR for this analysis because we believe it is the broadest measure in the literature of tax avoidance. We are agnostic about the legality of the tax avoidance, we are simply trying to partition firms based on the most likely source of the temporary book-tax difference. Measures designed to capture only the most aggressive forms of tax avoidance, such as models of tax sheltering are too narrow for this purpose. Additionally, tax avoidance measures based only on permanent differences such as the traditional ETR by definition should not cause large positive temporary book tax differences. Finally, there is insufficient time series data to perform meaningful persistence tests using uncertain tax benefits as defined under FIN 48 as an alternative tax avoidance measure. These data are only available for 2 years and the economic upheaval in 2007 and 2008 likely makes any inferences based on UTBs over this sample period less generalizable. 21 In supplemental tests (not tabulated) we categorize firms as TAXAVOIDER within the LPBTD group by year. The results are consistent with those reported in Tables 4 and 5 using this alternative classification. 22 As with our tax avoidance proxy, we use a broad measure of earnings management because we are trying to determine the most likely source of a firms large positive book-tax difference regardless of the legality of the earnings manipulation. Both within GAAP upwards earnings management and fraudulent upwards earnings management could lead to a large positive temporary book tax difference so we attempt to capture both with our measure. We do not use measures that capture the most aggressive earnings management, such as restatements or AAERs because the sample would likely be too small to conduct a meaningful analysis of persistence or equity pricing and because we are not trying to capture managements intent in reporting large positive accruals. Furthermore, just meeting or beating earnings benchmarks does not necessarily result in large positive book-tax differences.

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pretax book income which is affected by earnings management activities. Thus it is possible that a low Cash ETR arises because of a higher (managed) pretax book income. We argue however that the firm did not pay cash taxes on these earnings otherwise it would not have reported a low Cash ETR. Further, if Cash ETR is really only picking up earnings management activities then the persistence results should not differ between the EM and TAXAVOIDER partitions. Panel A of Table 3 presents statistics on the proportion of firms classified as EM and TAXAVOIDERs within the SBTD, LNBTD, and LPBTD groups. To reiterate, we classify firms as EM and TAXAVOIDER firms based on their ranking across the entire sample of 21,205 firmyear observations. Firms in the bottom 20% of Cash ETR are classified as TAXAVOIDERS. Firms in the top 20% of discretionary accruals are classified as upward EM (+) firms and firms in the bottom 20% of discretionary accruals are classified as downward EM (-) firms. If the distribution of EM and TAXAVOIDER firms is random between each group (SBTD, LPBTD, and LNBTD) we would observe that 20% of the firms in each group would be categorized as EM (+) firms, 20% as EM (-) firms, and 20% as TAXAVOIDERS. However, it is notable that the results in Panel A indicate a significant difference in the number of EM and TAXAVOIDER firms within each group. Specifically, we observe significantly more EM (+) firms and TAXAVOIDER firms in the LPBTD group. This result is consistent with prior studies suggesting that large positive book-tax differences can serve as a useful signal of earnings management and as a signal of tax avoidance activity and with our maintained assumption that both EM and TAXAVOIDANCE activities can lead firms to end up in the LPBTD group.. Table 3 also provides descriptive statistics for the sub-samples of large positive book-tax difference firms categorized as EM or TAXAVOIDER firms. The TAXAVOIDER group has lower median current period pre-tax earnings and lower median pre-tax accruals, but higher median pre-tax cash flows than the EM firms. The TAXAVOIDER firms also have higher 19

median average total assets and higher median size-adjusted returns in period t+1 than the EM firms. Not surprisingly, the EM firms exhibit higher median discretionary accruals and higher Cash5ETRs than the TAXAVOIDER firms. Significance tests of differences are not provided because these data are intended as purely descriptive. We estimate equation (3) below to examine whether the earnings persistence of large positive book-tax difference firms varies as a function of whether those book-tax differences are likely largely a result of upward earnings management or tax planning. PTBIt+1 = 0 + 1TAXAVOIDERt + 2EM + 3PTBIt + 4PTBIt TAXAVOIDERt + 5PTBIt EMt + t+1 (3) Equation (3) is estimated only on the subset of firms with large-positive book-tax differences. The coefficient on PTBIt, 3, represents the earnings persistence of firm-years with large positive book-tax differences that are in the BASE group that is, firm-years that are not categorized as upward earnings management or tax planning/avoidance firms. For these firms we believe their large positive book-tax differences are likely a result of some combination of tax avoidance, earnings management, and innate firm characteristics. Consequently, we expect the earnings persistence for this subset of large positive book-tax difference firms to fall between the other two subsets of firms. We expect that if large positive book-tax differences resulting from earnings management are a signal of discretion in accruals then the coefficient on the interaction term (PTBI EM), 5, will be negative. In contrast, if the positive book-tax differences are primarily a result of tax planning we expect this will mitigate the extent to which large positive book-tax differences serve as a signal of lower earnings persistence. Consequently, we expect earnings persistence will be higher for this subset of firms (4 > 0) than for the BASE group of firms.

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The results reported in Panel A of Table 4 indicate that firm-years designated as upward earnings management (EM) exhibit significantly lower earnings persistence than other large positive book-tax difference firms. This finding is consistent with hypothesis (1) and suggests that when large book tax differences are largely a result of upward earnings management they are a particularly useful signal of low earnings persistence. The results also indicate that firmyears designated as TAXAVOIDER exhibit higher earnings persistence than the BASE group of firms although the difference is not significant. Next, we decompose earnings into pre-tax cash flows and pre-tax accruals for our subsample of large positive book-tax difference firms to examine the implications of being designated as a TAXAVOIDER or EM for the persistence of these two earnings components. Panel B of Table 4 reports the results of estimating equation (4) below: PTBIt+1 = 0 + 1 TAXAVOIDERt + 2 EMt + 3PTCFt + 4PTCFt TAXAVOIDERt + 5PTCFt EMt + 6PTACCt + 7PTACCt TAXAVOIDERt + 8PTACCt EMt + t+1 (4) Consistent with Hypothesis (2), the results indicate the pre-tax accrual component of earnings has lower persistence for future earnings for the firm-years designated as EM as compared to the BASE group of LPBTD firms. This finding suggests that in the cases where large positive book-tax differences are largely a function of upward earnings management they serve as a useful signal of subjectivity in the accruals process and therefore of lower quality earnings. Consistent with hypothesis (4), the results in Panel B also show that the accrual component of earnings for the firm-years designated as TAXAVOIDERS is significantly more persistent than for the BASE group firms. This result suggests that when large positive book-tax differences arise primarily from tax planning they are a less useful signal of discretion in the accruals process. We do not make a prediction about the persistence of cash flows between groups of large positive book-tax difference firms. The results in Panel B of Table 4 indicate the 21

persistence of cash flows are not significantly different for the EM and TAXAVOIDER firms compared to the BASE group of firms. Panel B of Table 4 also sums the coefficients reported in the top part of panel B to provide a direct estimate of the persistence of cash flows and accruals for each group within the LPBTD sample. As expected, the persistence of accruals is highest for the TAXAVOIDER firms while the EM firms exhibit the lowest persistence of accruals. 23 Because we observe significant differences in the persistence of earnings and accruals for the EM and TAXAVOIDER groups, concerns that the Cash ETR measure (used to partition LPBTD into TAXAVOIDERS) is largely picking up the effects of earnings management rather than tax avoidance appear unwarranted. There are 349 firm-year observations in our large positive book-tax difference sample classified into both the TAXAVOIDER and EM groups. These observations exhibit both high levels of discretionary accruals and low Cash ETRs. It is notable that we do not observe a high correlation between tax avoidance and financial reporting aggressiveness (as measured by the level of discretionary accruals). In other words, the number of firm-years categorized as both EM firms and TAXAVOIDER firms is roughly what would be expected to occur by chance. 24,25 The purpose of categorizing firm-year observations as either EM or TAXAVOIDER is to identify cases where the predominant source of the large positive book-tax differences is either earnings management or tax avoidance. We do not have clear predictions for the earnings or accruals persistence of the firm-year observations that exhibit both aggressive earnings
In supplemental tests (untabulated) we re-estimate equations (3) and (4) including a measure of the variance of taxable income (based on the prior 5 years of data or 3 years if there are not 5 years of data available) and its interaction with pre-tax book income. We include the variance of taxable income to control for differences in the variability of taxable income across firms. The results are qualitatively similar to those reported in Table 4. 24 The 349 firm-year observations categorized in both the TAXAVOIDER and EM group represents 27.2% (349 / 1281) of firms in the TAXAVOIDER group, or 32.1% (349/1085) of firms in the EM group. By chance we would expect 26% of the TAXAVOIDER group and 30.7% of the EM group to be categorized in both groups. Neither of these differences is statistically significant at conventional levels. 25 This result contrasts with Frank et al. (2009) who find aggressive financial reporting firms are more likely to also pursue aggressive tax reporting strategies. However, our measure, Cash ETR, is a more broad measure of tax avoidance whereas their measure, adjusted permanent book tax differences, is more towards the tax aggressiveness end of the spectrum so the results are not directly comparable.
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management and tax avoidance. Consequently, in supplemental analysis we re-estimate equations (3) and (4) removing the firm-year observations categorized as both EM and TAXAVOIDERS from our sample. The results of this re-estimation (not tabulated) indicate both the earnings and accruals persistence of the remaining EM observations continue to be significantly lower than the BASE group of LPBTD firms. The accruals persistence of the TAXAVOIDER firms also continues to be significantly higher than the accruals persistence of the BASE group firms. However, the overall earnings persistence of the TAXAVOIDER group is not significantly greater than that of the BASE group firms once the firms categorized as both EM and TAXAVOIDER firms are removed. Table 5 presents the test results for our third set of hypotheses comparing the persistence across BTD firms after removing EM observations from the LPBTD group. The results in Panel A indicate that when the EM firms are removed from the LPBTD group, the LPBTD group no longer exhibits significantly different earnings persistence from the SBTD group. Further, the results in Panel B of Table 5 indicate that when the EM firms are removed from the LPBTD group, the LPBTD group actually exhibits higher persistence of accruals into future period earnings in comparison to the SBTD group. These results are consistent with our prediction that the lower earnings and accruals persistence of the LPBTD group is driven by the sub-sample of firms where the predominant source of their LPBTDs is upward earnings management. 26 V. Market Pricing Tests Table 6 presents the results of our market pricing tests. We estimate the two-equation Mishkin approach and hedge portfolio returns. These tests allow us to examine whether investors correctly infer the persistence of accruals for each group and to examine whether there

In untabulated analysis, we also remove high discretionary accrual firms from the SBTD group and continue to find that LPBTD firms have comparable cash flow and accrual persistence as SBTD firms, although LPBTD firms accrual persistence is no longer significantly greater than the accrual persistence of SBTD firms.

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is any deviation from market efficiency in the pricing of the persistence of the accrual component of earnings. We estimate the relation between future returns and ranked accruals and other control variables using the following equation (5): SARt+1 = 0 + 1PTACCt + 2MVEt + 3BMt + 4BETAt + 5EPt + 6SARt + t+1 (5)

Each of the variables in Equation (5) is converted to a rank variable scaled from 0 to 1. Specifically, we sort each variable into deciles, and then the decile rank (1-10) is transformed to between 0 and 1 by ((Decile rank 1)/9). The estimated coefficient on each transformed variable can be interpreted as the hedge portfolio return to positions taken on that variable. PTACCt is pre-tax accruals for period t, MVEt is the market value of equity at the end of period t, BMt is the book value of equity at the end of period t divided by MVE, BETAt is the common stock beta calculated using a market model run over the 24-month period ending at the start of the current fiscal year, EPt is earnings per share in the current fiscal year divided by price at the end of the current fiscal year, and SARt is size adjusted annual returns beginning on the first day of the fourth month of the current fiscal year. Fama and French (1992) argue these variables represent unknown risk factors, and consequently, are associated with future expected returns. The coefficient, 1, represents the size-adjusted abnormal return to a zero-investment portfolio based on taking long positions in firm-years with positive weights and short positions in firmyears with negative weights. We begin the calculation of size-adjusted abnormal returns three months after the fiscal year-end to allow for the determination of the portfolio weights used to take these investment positions. In equation (5), 1 will equal 0 if investors correctly infer the persistence of accruals, 1 <0 (>0) if investors overestimate (underestimate) the persistence of accruals. In fact, 1 is an estimate of the difference in the actual time-series persistence of accruals and the markets 24

implied persistence. This result can be shown as follows using the two-equation framework in Mishkin (and used by Sloan 1996 and Hanlon 2005. Ball and Kothari 1996 and Kraft, Leone and Wasley 2007 develop a similar reconciliation). This analysis helps interpret the hedge portfolio return results. The two equation system is (simplifying equation (2) to only PTACCt) as follows: PTBIt+1 = 0 + 1PTACCt + t+1 SAR t+1 = 0 + 1 UPTBIt+1 + t+1 (S1) (S2)

where UPTBIt+1 is unexpected pretax book income in t+1. We can substitute from S1 for UPTBI (which equals t+1) in S1 and get SAR t+1 = 0 + 1 (PTBIt+1 - 0* - 1*PTACCt) + t+1 (S3)

Consistency between coefficient estimates in equations (S1) and (S2) is tested using the Mishkin approach. 27 Now substitute the RHS of equation (S1) for PTBIt+1 in (S2). SAR t+1 = 0 + 1 (0 + 1PTACCt + t+1 0* - 1*PTACCt) + t+1 (S4) Expanding and collecting terms: SAR t+1 = (0 + 1(0 0*)) + 1(1 - 1*) PTACCt + 1t+1 + t+1 SARt+1 = 0 + 1PTACCt + (S5)

where 0 = (0 + 1(0 0*)) and 1 = 1(1 - 1*). Equation (S5) is simply equation (5) without the additional control variables. Thus 1 will equal zero if the markets estimate of the persistence of accruals, 1*, is the same as the actual time series persistence of accruals 1. If the market overestimates the persistence of accruals (1 < 1*), 1 will be < 0 indicating negative hedge

One can also estimate SAR t+1 = 0 + 1 PTBIt+1 + 2 PTACCt + t+1 using OLS, noting that 2 = 1 1* so that we can solve for 1* = -2 / 1. See Burgstahler, Jiambalvo and Shevlin (2002) who use both OLS and the Mishkin test. Consistent with Hanlon (2005), we correct for missing delisted returns by using delisting returns of -35 percent for NYSE/AMEX firms and -55 percent for NASDAQ firms for delisting codes 500 and 520-584.

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portfolio returns. Intuitively, the returns are negative because there are predictable negative accrual surprises because investors are over-estimating the persistence of accruals. The predictions are reversed if the market underestimates the persistence of accruals, (1 > 1*) and 1 will be > 0 indicating positive hedge portfolio returns. We present the results of both the Mishkin (1983) and hedge portfolio tests in Table 6. The Mishkin test allows us to directly estimate the markets implied persistence estimates and, using these implied persistence estimates, hedge portfolio returns. We also directly estimate hedge portfolio returns using equation (5) because this approach allows us to include additional controls for risk and to estimate the model using annual return regressions to mitigate concerns with cross-sectional correlation in returns (Fama and Macbeth 1973). Panel A of Table 6 presents the results of the Mishkin (1983) test of market rationality to compliment the hedge portfolio tests. The results do not indicate a significant difference between investor expectations for accruals persistence for the TAXAVOIDER group and the actual accruals persistence for that group. However, we do observe a significant (p 0.01) difference between investor expectations of accruals persistence for the EM group and actual accruals persistence for that group. Investors do not appear to correctly anticipate the lower accruals persistence exhibited by the EM group relative to the BASE group of firms. While the Mishkin tests appear to indicate investors overestimate the persistence of accruals for the EM firms, we also estimate the hedge portfolio tests which have the important advantage of allowing us to include additional controls for risk. For our hedge portfolio tests, we estimate equation (5) separately for four samples of firms. We begin by estimating equation (5) for all firms with large positive book-tax differences. Hanlon (2005) finds that investors correctly price the persistence of accruals for firms with large positive book-tax differences. Panel B of Table 6 presents the result of estimating equation (5) on the full sample of large positive book-tax difference firms. The results in Panel B indicate that 1, 26

is marginally significantly different from 0 (p 0.10) in a one-sided test indicating that investors overestimate the persistence of accruals for the entire LPBTD group. Furthermore, the coefficient on 1 is negative in 9 of the 13 years that we estimate the hedge portfolio regression. Overall, the results in Panel B do provide some weak evidence that investors consistently overestimate accruals persistence for the LPBTD group. Panel C of Table 6 presents the results of estimating equation (5) on the sub-sample of firm years designated as TAXAVOIDERs. If, consistent with hypothesis 4a, investors underweight the persistence of accruals then we expect 1 will be significantly positive. The results in Panel C indicate that 1 is actually negative but is not significantly different from 0 for the TAXAVOIDER sub-sample. This result suggests investors are able to identify large positive book-tax differences that have been generated predominantly as a result of tax planning and adjust their expectations for the persistence of accruals accordingly. Panel D of Table 6 presents the results of estimating equation (5) on the sub-sample of earnings management firms. If, consistent with hypothesis 4b, investors overweight the persistence of accruals for this sub-sample then we expect 1 will be significantly negative. The results in Panel D show that 1 is actually positive but not significant for the sub-sample of earnings management firms. This finding is consistent with investors being able to identify large positive book-tax differences generated by upward earnings management and correctly pricing the persistence of accruals for those firms. While these results are consistent with Hanlon (2005), we note that they are opposite the findings of Xie (2001) who finds that the mispricing documented by Sloan (1996) is concentrated in firms with high discretionary accruals. Thus, our finding that firms with high discretionary accruals in the LPBTD group have lower earnings and accrual persistence is similar to Xie (2001), but our finding that market participants appear to price accruals in a rational manner provides a stark contrast to the findings in Xie (2001), at least 27

for our large positive book-tax difference subsample. Our results suggest that investors might be using large positive book-tax differences as a signal about the quality of accruals for these firms. For completeness, Panel E presents the results of estimating equation (5) on the remaining, BASE group, of large positive book-tax difference firms. The results indicate 1 is also not significant for this sample of firms. In summary, we do not observe mispricing for any of the sub-samples of LPBTD firms despite the significant differences in the persistence of earnings and accruals between these sub-samples of firms. The differing results between the hedge portfolio tests and the Mishkin tests are the result of the inclusion of additional controls for risk in the hedge portfolio tests. Because the hedge portfolio tests allow us to more fully control for risk we place more emphasis on those tests and conclude that overall investors appear to correctly price accruals persistence for each sub-sample of LPBTD firms. VI. Supplemental Analysis on the Large Positive Book Tax Difference Firms Table 7 presents the results of our supplemental analysis using alternative measures to identify the TAXAVOIDER firms among the large positive book-tax difference group. Because the denominator of our five-year Cash ETR measure is pre-tax book income it is possible that this measure of tax avoidance is also identifying firms that have managed pre-tax earnings upward resulting in a lower Cash ETR. If true, this could confound attempts to use Cash ETR to identify cases of LPBTDs arising from tax avoidance rather than upward earnings management. But note that our earlier results in Tables 4 and 5 mitigate some of this concern: we do observe differences in the persistence of earnings and accruals using Cash ETR to identify likely TAX AVOIDERS. However, as an alternative measure of tax avoidance we calculate five-year Cash ETR scaled by cash flow from operations rather than pre-tax earnings. The results reported in Panel A of Table 7 indicate that using this alternative measure the TAXAVOIDER firms exhibit significantly higher earnings persistence than the BASE Group. Further, the results reported in 28

Panel B indicate that the TAXAVOIDER firms continue to exhibit significantly higher persistence for the accrual component of earnings. Not surprisingly, because the EM group is not really affected by the TAXAVOIDER classification, although the BASE group to which the EM group is compared does change as a result of the revised TAXAVOIDER classification, the results from the EM group remain consistent with our prior findings: EM firms exhibit lower persistence of earnings and accruals. Next, we calculate an alternative 3-year measure of Cash ETR. We do this in an effort to better identify whether current year book-tax differences are a direct result of tax avoidance activity. It is possible that a low Cash ETRs based on a five-year measure could be a function of prior period tax avoidance and unrelated to the current year book-tax differences. However, Dyreng et al. (2008) point out that Cash ETR suffers from measurement error and this measurement error is greater for short-term, especially one-year, measures of Cash ETR. Specifically, cash taxes paid represents the actual taxes paid by the firm during a given year and, as a result, could include estimated tax payments associated with the prior years income. Using longer-term measures of Cash ETR helps to minimize this measurement error. We use a threeyear measure of Cash ETR as a compromise between the desire to identify current year book-tax differences arising from tax avoidance and the measurement error that exists in short-term Cash ETR measures. The results reported in Panel C of Table 7 indicate that using this alternative measure the TAXAVOIDER firms do not exhibit significantly higher earnings persistence than the BASE Group. However, the results reported in Panel D indicate that the TAXAVOIDER firms continue to exhibit significantly higher persistence for the accrual component of earnings. 28

Other common measures of tax aggressiveness include the traditional ETR (total income tax expense over pre-tax book income), permanent book-tax differences, and discretionary permanent book-tax differences (DTAX) developed by Frank, Lynch, and Rego (2008). Because each of these measures only detect aggressive tax reporting

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VII. Large Negative Book-Tax Differences In addition to documenting lower earnings persistence for large positive book-tax difference firms, Hanlon (2005) also finds firms with large negative book-tax differences exhibit lower earnings persistence. Because large negative book-tax differences are not likely to be reflective of tax avoidance this group of firms does not lend itself to the same partitioning as our analysis of large positive book-tax differences. We conjecture that large negative book-tax differences likely arise from a combination of normal book-tax differences and downward earnings management (negative discretionary accruals). Managers might use discretion over the accrual process to manage earnings downward for purposes of smoothing earnings. We extend the analysis of large negative book-tax differences (LNBTDs) in Hanlon (2005) by partitioning the LNBTD firms into a downward earnings management group (EM) and a BASE group. The EM firms are identified as LNBTD firms with modified Jones model discretionary accruals in the bottom quintile of all firms. If LNBTDs result from downward earnings management we would expect these firms to exhibit lower levels of earnings and accruals persistence than the BASE group of firms. Panels A and B of Table 8 present the descriptive statistics for the EM and BASE groups of LNBTD firms respectively. Because we exclude loss firms from our analysis, we do not believe the LNBTD firms reflect traditional big bath firms. In fact, it is interesting to note that both groups of LNBTD firms report very high pretax profits and the EM firms are actually more profitable than the BASE group. It is possible the EM firms exhibit large negative discretionary accruals because managers are using their discretion to smooth earnings downward during very profitable years. In Panel C of Table 8 we directly examine the earnings persistence of the EM

strategies that lead to permanent book-tax differences we do not use them in our study. Our analysis is focused on identifying cases of aggressive tax reporting that result in large temporary book-tax differences that could cause a firm to be categorized into the LPBTD group.

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and BASE groups of LNBTD firms. The results do not indicate a significant difference in the earnings persistence between the BASE group of LNBTD firms and the EM group. However, the results reported in Panel D of Table 8 indicate the accrual component of earnings is significantly more persistent for the EM group of LNBTD firms for which we have no ex post explanation. VIII. Conclusion This study provides insight into why large positive book-tax differences serve as a useful signal of future earnings and accruals persistence. Our findings suggest that in some cases large positive book-tax differences do reflect discretion in the accrual process that leads to lower earnings and accruals persistence. For this reason, on average, large positive book-tax differences are a useful signal of earnings quality. However, we provide evidence that the usefulness of this signal is contingent upon the predominant source of the book-tax differences. In cases where large positive book-tax differences arise primarily from tax reporting strategies the persistence of accruals is significantly greater than that of other firms with large positive book-tax differences. In contrast, when large positive book-tax differences are generated primarily by upward earnings management the persistence of earnings and accruals is significantly less than that of other large positive book-tax difference firms. Furthermore, the lower overall earnings and accrual persistence of large positive book-tax difference firms is the result of the relatively high number of high accrual firms (26%) within this group. After removing high discretionary accrual firms from the large positive book-tax difference, we no longer find lower persistence of earnings and accruals for this group compared to the firms in the small book tax difference group. Recent debate by policy makers has centered on the issue of improving disclosures of differences in book income and taxable income. In the wake of several prominent accounting scandals, Senator Charles Grassley sent a letter to President Bush on October 7, 2002 asking the 31

administration to consider whether action was warranted to improve disclosures of book-tax differences. McGill and Outslay (2004) provide a detailed analysis of identified corporate tax shelter participants and show that their tax footnote disclosures provide little information on these transactions. However, despite concerns over the limited information provided to investors regarding differences between a firms book and taxable income we find investors are able to use these disclosures to look through to the source of book-tax differences and correctly price the persistence of accruals. This result compliments the findings of Ayers, LaPlante, and McGuire (2010) who show that credit analysts also appear able to look through to the source of book-tax differences in assessing credit-worthiness. Together these results suggest financial statement users are fairly sophisticated in their ability to understand the implications of different types of book-tax differences.

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Appendix 1: The Cash Effective Tax Rate as a Measure of Tax Avoidance The purpose of using Cash ETR to partition firms with large positive book-tax differences is to identify those cases where the differences likely arise from tax planning. As such, we use a general measure of tax avoidance designed to reflect both clearly legal tax planning activity and cases where the legality of the transaction is less certain. As Hanlon, Dyreng, and Maydew (2008) point out, the Cash ETR is affected by tax deferral strategies, but has the advantage (relative to traditional ETR measures) of not being affected by changes in the tax accounting accruals (tax cushion or reserve). To minimize the possibility that the Cash ETR may mismatch cash taxes paid in one period on earnings from a different period, we follow the recommendation of Dyreng et al. and use a five-year aggregate measure. Below we discuss examples of tax planning transactions that would be reflected by this measure. The list is not meant to be exhaustive but rather an illustration of why we think cash ETR is a reasonable proxy for our broad definition of tax avoidance. Example A: Leasing transaction lessor perspective Consider a firm that manufactures and leases electronic equipment. It writes lease contracts that qualify as sales-type leases for financial reporting purposes but operating leases for tax purposes. For financial reporting purposes, the company reports the gross profit on each new lease as a sale but for tax purposes, only the monthly rental payments are included in taxable income while MACRS deductions are claimed on the equipment. This lowers Cash ETRs by creating large temporary book-tax differences that are sustainable as long as the lease base continues to expand. It is possible for the firm to write lease contracts that qualify as operating leases for both book and tax purposes without changing the timing of the taxes paid. Since this structure enables the firm to accelerate pretax book income without accelerating the corresponding taxes paid one could argue that this transaction and the corresponding book-tax differences primarily reflect earnings management. However, it is equally plausible that the firm could sell the equipment and record the gain for tax purposes immediately. If the firm structured the transaction to be a sale for both tax and financial reporting purposes, the book-tax difference would not exist. Since the firm deliberately structured the transaction to defer income for tax purposes (relative to simply selling the equipment), this transaction fits our definition of tax planning. Example B: Synthetic lease lessee perspective As a second example, consider synthetic leases. These leases are structured to be treated as operating leases for financial reporting purposes but are treated as a purchase and collateralized borrowings for tax purposes. The firm essentially borrows money to acquire real property but structures the transaction so that only a small rental payment decreases GAAP income each year while MACRS deductions and interest expense on the loan reduce taxable income. One could argue that the firm would be allowed the same tax deductions by just borrowing money and purchasing the property outright and that the lease structure was created to defer expenses for financial reporting purposes. However, the firm could also structure the transaction so that the tax treatment is also an operating lease rather than a purchase. The book-tax difference would not exist if the firm were not accelerating deductions for tax purposes (relative to structuring the transaction as an operating lease for tax purposes). This also fits our definition of tax planning.

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Example C: Multinational Tax Planning Finally, consider a multinational firm that invests in a subsidiary in a country with a statutory tax rate below the U.S. tax rate and reinvests the profits in the subsidiary to fund continued growth in that market. This reinvestment results in a low Cash ETR that may persist for many years. One could argue that reinvesting in such a foreign subsidiary is not tax planning but simply a reflection of a firm taking advantage of growth opportunities abroad. However, Hartman (1985) develops a model demonstrating that whether a firm repatriates foreign earnings or reinvests those earnings in the foreign jurisdiction is a function of the after tax rates of return in both jurisdictions which in turn are functions of foreign and domestic tax rates. Therefore, a lower foreign tax rate, ceteris paribus, leads to a higher likelihood that the firm will reinvest the earnings in the subsidiary. Consequently, we would view this type of investment in a low tax foreign jurisdiction as another form of tax planning. 29 Each of these transactions lowers a firms Cash ETR. In each case, the transaction structuring and the existence of the temporary book-tax difference reflect some amount of tax planning. Consequently, we believe that long-term Cash ETR is a reasonable proxy for tax avoidance. It is possible that if a firm manages financial earnings upward and does not pay taxes on those earnings the Cash ETR will be driven lower by the earnings management activity. In some respects, this would still reflect tax planning because the firm was able to avoid paying taxes on the overstated earnings. Nonetheless, to address this concern we follow the recommendation of Dyreng et al. (2008) and conduct supplemental tests using an alternative specification of Cash ETR where cash flows from operations are the scalar rather than pretax earnings.

It is important to note that in cases where managers designate earnings from a low-tax foreign jurisdiction as permanently reinvested abroad this would not result in a deferred tax liability (temporary book-tax difference) for the firm but does increase after tax net income. Graham, Hanlon and Shevlin (2009) report survey evidence indicating the importance of this effect in firms location and repatriation decisions.

29

34

References Ayers, B., J. Jiang and S. Laplante, 2008. Taxable income as a performance measure: The effects of tax planning and earnings quality. Contemporary Accounting Research, 26(1): 15 54. Ayers, B., S. Laplante and S. McGuire. 2010. Credit ratings and taxes: The effect of book-tax differences on ratings changes. Contemporary Accounting Research, forthcoming. Ball, R. and A. Bartov, 1996. How nave is the stock markets use of earnings information? Journal of Accounting and Economics 21(3): 319-337. Beaver, W., and D. Morse. 1978. What determines price-earnings ratios? Financial Analysts Journal (July/August), 65-76. Burgstahler, D., J. Jiambalvo and T. Shevlin, 2002. Do stock prices fully reflect the implications of special items for future earnings? Journal of Accounting Research 40(3): 585-612. Desai, M., and D. Dharmapala, 2006. Corporate tax avoidance and high-powered incentives, Journal of Financial Economics 79: 145-179. Dyreng, S., M. Hanlon, and E. Maydew. 2008. Long-run corporate tax avoidance. The Accounting Review 83(1): 61-82. Fama, E., and J. MacBeth. 1973. Risk, return, and equilibrium: Empirical tests. Journal of Political Economy 81(May/June): 608 636. Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance 47: 427465. Frank., M., and S. Rego, 2006. Do managers use the valuation allowance account to manage earnings around certain earnings targets? Journal of the American Taxation Association 28(1): 43-65. Frank, M., L. Lynch, and S. Rego. 2009. Are financial and tax reporting aggressiveness reflective of broader corporate policies. The Accounting Review, forthcoming 2009. Frankel R., and L. Litov. 2009. Earnings persistence. Journal of Accounting and Economics. 47(1): 182 190. Graham, J., M. Hanlon and T. Shevlin. 2009. Real effects of accounting rules: Evidence from multinational firms investment location and profit repatriation decisions, Working paper, MIT. Grassley, Sen. Charles E. U.S. Senator Grassley calls for review of corporate return disclosure requirements. Tax Notes Today, October 11, 2002, 30.

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Hanlon, M. 2005. The persistence and pricing of earnings, accruals, and cash flows when firms have large book-tax differences. The Accounting Review 80(1): 137-167. Hanlon, M., and S. Heitzman. 2009. A review of tax research. Working paper, Massachusetts Institute of Technology and University of Rochester. Jackson, M. 2009. Book-tax differences and earnings growth. Working Paper, University of Oregon. Hayn, C. 1995. The information content of losses. Journal of Accounting and Economics 20: 125-153. Kraft, A., A. Leone, and C. Wasley, 2006. An analysis of the theories and explanations offered for the mispricing of accruals and accrual components. Journal of Accounting Research 44(2): 297-339. Kraft, A., A. Leone and C. Wasley, 2007. Regression-based tests of the market pricing of accounting numbers: The Mishkin test and ordinary least squares: Journal of Accounting Research 45(5): 1081-1114. Lev, B., and D. Nissim, 2004. Taxable income, future earnings, and equity values. The Accounting Review 79(4): 1039-1074. Lisowsky, P., L. Robinson, and A. Schmidt, 2009. An examination of FIN 48: Tax shelters, auditor independence, and corporate governance. Working paper, University of Illinois at Urbana-Champaign, Dartmouth University, and Columbia University. McGill, G., and E. Outslay. 2004. Lost in translation: Detecting tax shelter activity in financial statements National Tax Journal 57: 739-756. Mills, L., M. Erickson, and E. Maydew, 1998. Investments in tax planning. Journal of the American Taxation Association 20(1): 1-20. Ohlson, J.A., 2007. Accounting data and value: The basic results. Working paper (presented at the 2008 Contemporary Accounting Research Conference). Phillips, J., M. Pincus and S. Rego. 2003. Earnings management: new evidence based on deferred tax expense. Accounting Review 78(2): 491. Schmidt, A., 2006. The persistence, forecasting ability, and valuations implications of the tax change components of earnings. The Accounting Review 81(3): 589-616. Scholes, M., M. Wolfson, M. Erickson, E. Maydew, and T. Shevlin, 2004. Taxes and business strategy: a planning approach, Third edition, Prentice Hall, Upper Saddle River, NJ. Seidman, J.K. 2010. Interpreting the book-tax gap as earnings management or tax sheltering. Working Paper, University of Texas. 36

Wilson, R. 2009. An examination of corporate tax shelter participations. The Accounting Review, 84(3): 969-999. Wilson, R. 2010. A discussion of credit ratings and taxes: The effect of book/tax differences on ratings changes. Contemporary Accounting Research, forthcoming.

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Table 1 Descriptive Statistics on Sample Firms Partitioned on Book-Tax Differences Sample Period 1993-2005 Large Positive Book-Tax Difference Group Variable Avg. Assetst PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Disc. Acc. Cash5ETR Mean 2,513.60 0.089 0.130 0.140 -0.010 -0.010 0.010 0.303 Median 0.086 0.108 0.138 -0.028 -0.077 0.007 0.277 Std Dev 0.114 0.087 0.113 0.088 0.618 0.069 0.199 Firm-Year Observations: 4,178 Minimum 4.634 -0.291 0.004 -0.146 -0.213 -1.522 -0.283 0.000 Maximum 684,794 0.433 0.465 0.497 0.305 13.257 0.344 1.000

376.10 13,787.30

Large Negative Book-Tax Difference Group Variable Avg. Assetst PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Disc. Acc. Cash5ETR Mean 2,178.90 0.120 0.149 0.174 -0.024 0.038 -0.014 0.347 Median 0.114 0.125 0.161 -0.038 -0.043 -0.016 0.334 Std Dev 0.129 0.108 0.125 0.097 0.697 0.076 0.171

Firm-Year Observations: 4,263 Minimum 4.822 -0.291 0.004 -0.146 -0.213 -1.545 -0.366 0.000 Maximum 409,644 0.433 0.465 0.497 0.305 15.742 0.306 1.000

232.300 11,472.80

38

Table 1 (Continued) Small Book-Tax Difference Group Variable Avg. Assetst PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Disc. Acc.t Cash5ETRt Mean 6,572.00 0.082 0.105 0.123 -0.017 -0.002 0.002 0.329 Median Std Dev Firm-Year Observations: 12,764 Minimum 2.445 -0.291 0.004 -0.146 -0.213 -1.583 -0.259 0.000 Maximum 1,489,069 0.433 0.465 0.497 0.305 9.587 0.345 1.000

450.500 44,802.60 0.072 0.083 0.111 -0.026 -0.045 0.000 0.321 0.104 0.084 0.102 0.075 0.540 0.060 0.167

Avg. Assetst = Assetst-1 (Compustat item 6) plus Assetst divided by 2 PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst (an estimate of pretax ROA) PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBIt-PTCFt SARt+1 = Size-adjusted return calculated as the buy-and-hold return on the security (including dividends) beginning at the start of the fourth month after fiscal year end and ending at the end of the third month the following year less the buy-and-hold return on a size-matched portfolio over the same period. Disc. Acc.t = Modified Jones Model discretionary accruals by 2-digit SIC industry Cash5ETRt = Sum of cash taxes paid over the previous 5 years divided by the sum of PTBI over the previous 5 years (or 3 years if 5 years of data are unavailable). Cash5ETRs greater than one are reset to one. Negative cash5ETR are reset to 35% Observations in the top (bottom) quintile of book-tax differences by year are characterized as large positive (negative) book-tax difference firm-years. All other observations are characterized as small booktax difference firm-years. PTBIt+1, PTBIt, PTCFt, and PTACCt are winsorized at the 1st and 99th percentiles.

39

Table 2 Replication of Hanlon (2005) Panel A: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings with Coefficients Allowed to Vary for Firm-Years with Large Book-Tax Differences (N=21,205) PTBIt+1 = 0 + 1LNBTD + 2LPBTDt + 3PTBIt + 4PTBIt LNBTDt + 5PTBIt LPBTDt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.001 0.39 1 ? 0.016 2 ? 0.005 3 + 0.772 4 -0.071 -4.48*** 5 -0.122 -6.49*** 0.363 Adj R2 Pre-tax Earnings Persistence by Group LPBTD SBTD LNBTD 0.650 0.772 0.701

5.93*** 1.77* 81.70***

Panel B: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components with Coefficients Allowed to Vary for Firm-Years with Large Book-Tax Differences (N=21,205) PTBIt+1 = 0 + 1LNBTDt + 2LPBTDt + 3PTCFt + 4PTCFt LNBTDt + 5PTCFt LPBTDt + 6PTACCt + 7PTACCt LNBTDt + 8PTACCt LPBTDt + t+1 Variables Predicted sign Estimate t-statistic By Group 0 ? -0.007 -4.55*** 1 ? 0.007 -2.71*** 2 ? -0.001 -0.41 3 + 0.802 85.90*** 4 ? -0.046 -2.93*** SBTD PTCF 0.802 PTACC 0.579 PTCF 0.756 5 ? -0.080 -4.13*** 6 + 0.579 45.40*** 7 -0.098 -4.75*** 8 -0.099 -4.31*** LNBTD PTACC 0.478 0.384 Adj R2

LPBTD PTCF 0.722 PTACC 0.477

40

Table 2 (Continued) PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBI-PTCF LNBTDt = Indicator variable equal to 1 for firm-year observations in the lowest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35) LPBTDt = Indicator variable equal to 1 for firm-year observations in the highest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35) All variables except for indicator variables are scaled by average total assets. T-tests are one-sided if a directional prediction is made, two-sided otherwise. . * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. PTBIt+1, PTBIt, PTCFt, and PTACCt are winsorized at the 1st and 99th percentiles.

41

Table 3 Descriptive Statistics For Selected Variables Panel A: Proportions of Groups Classified as Earnings Managers and Tax Avoiders SBTD Tax Avoider Earnings Manager (+) Earnings Manager (-) 17.9%*** 18.5%*** 17.0%*** LNBTD 15.9%*** 18.6%** 32.9%*** LPBTD 30.7%*** 26.0%*** 15.9%***

*A chi-squared test rejects the equivalence of the LPBTD and SBTD, of the LPBTD and LNBTD groups and the LNBTD and SBTD groups at a less than .01 level.

Panel B: Large Positive Book-Tax Difference Group (N = 4,178) Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.089 0.130 0.140 -0.010 -0.010 2,514 0.011 0.303 Median 0.086 0.108 0.138 -0.028 -0.077 376 0.007 0.277 Std Dev 0.114 0.087 0.114 0.088 0.618 13,787 0.069 0.199 Minimum -0.291 0.004 -0.146 -0.213 -1.522 4.640 -0.283 0.000 Maximum 0.433 0.465 0.497 0.305 13.26 684,794 0.344 1.0000

Panel C: Tax Avoiders in Large Positive Book-Tax Difference Group (N = 1,281) Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.088 0.124 0.148 -0.024 0.000 2,509 0.011 0.126 Median 0.080 0.103 0.137 -0.030 -0.061 476.9 0.008 0.133 Std Dev 0.109 0.084 0.105 0.085 0.538 9,202 0.063 0.070 Minimum -0.290 0.004 -0.146 -0.213 -1.522 5.260 -0.271 0.000 Maximum 0.431 0.467 0.498 0.305 5.722 167,813 0.337 0.232

42

Table 3 (Continued) Panel C: Earnings Managers in Large Positive Book-Tax Difference Group (N = 1,085) Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.073 0.140 0.069 0.071 -0.074 1,743 0.090 0.312 Median 0.078 0.116 0.066 0.047 -0.127 283.8 0.070 0.334 Std Dev 0.128 0.095 0.102 0.094 0.619 6,218 0.054 0.184 Minimum -0.290 0.004 -0.146 -0.131 -1.479 7.215 0.039 0.001 Maximum 0.431 0.467 0.498 0.306 7.146 151,790 0.345 1.000

Panel D: All Other Firms Large Positive Book-Tax Difference Group (N = 2,161) Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.096 0.127 0.175 -0.048 -0.004 2,732 -0.018 0.379 Median 0.089 0.108 0.105 -0.042 -0.060 391.4 0.008 0.350 Std Dev 0.104 0.083 0.098 0.057 0.609 10,198 0.044 0.143 Minimum -0.290 0.004 -0.146 -0.213 -1.149 4.640 -0.277 0.232 Maximum 0.431 0.467 0.498 0.306 13.257 207,861 0.038 1.000

43

Table 3 (Continued) PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBIt-PTCFt SARt+1 = Size-adjusted return calculated as the buy-and-hold return on the security (including dividends) beginning at the start of the fifth month after fiscal year end (e.g., April 1 for a Dec. 31 fiscal year-end firm) and ending at the end of the fourth month the following year (e.g., March 31) less the buy-and-hold return on a size-matched portfolio over the same period. Avg. Assetst = Assetst-1 (Compustat item 6) plus Assetst divided by 2 Disc. Acc.t = Modified Jones Model discretionary accruals by 2-digit SIC industry Cash5ETRt = Sum of cash taxes paid over the previous 5 years divided by the sum of PTBI over the previous 5 years (or 3 years if 5 years of data are unavailable). Cash5ETRs greater than one are reset to one. Negative cash5ETR are reset to 35%. Observations are characterized as tax avoiders if the firm-year cash5ETR is in the bottom quintile of cash5ETR for all firm-years in the sample (pooled). Observations are characterized as earnings managers if the firm-year discretionary accrual is in the top quintile of discretionary accruals of all firm years in the sample (pooled). 349 firm-year observations are classified as both earnings managers and tax avoiders. PTBIt+1, PTBIt, PTCFt, and PTACCt are winsorized at the 1st and 99th percentiles.

44

Table 4 Panel A: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1TAXAVOIDERt + 2EMt + 3PTBIt + 4PTBIt TAXAVOIDERt + 5PTBIt EMt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.002 0.44 1 ? -0.006 -0.70 2 ? 0.007 0.65 3 + 0.728 25.30*** 4 + 0.076 1.13 5 -0.284 -2.90*** 0.275 Adj R2 Pre-tax Earnings Persistence by Group Base Tax Avoider EM 0.728 0.804 0.444

Panel B: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1 TAXAVOIDERt + 2 EMt+ 3PTCFt + 4PTCFt TAXAVOIDERt + 5PTCFt EMt + 6PTACCt + 7PTACCt TAXAVOIDERt + 8PTACCt EMt + t+1 0 1 2 3 4 5 6 7 8 ? -0.003 -0.53 Base PTCF 0.740 PTACC 0.647 ? -0.001 -0.20 ? 0.008 0.95 + 0.740 27.12*** ? 0.040 0.77 ? -0.060 -1.01 + 0.647 12.84*** + 0.138 2.44** -0.394 -3.91*** Earnings Manager PTCF 0.680 PTACC 0.253 0.312

Variables Predicted sign Estimate t-statistic By Group

Adj R2

Tax Avoider PTCF 0.780 PTACC 0.785

PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBI-PTCF divided by average assetst TAXAVOIDERt = Indicator variable equal to 1 for firm-year observations within the LPBTD group and with a 5year cash effective tax rate (see Dyreng et al 2008) in the lowest quintile of all firm-years in the sample. EMt = Indicator variable equal to 1 for firm-year observations within the LPBTD group and with modified Jones model discretionary accruals in the top quintile of all firm-years in the sample. All variables except for indicator variables are scaled by average total assets over the current and prior year. T-tests are one-sided if a directional prediction is made, two-sided otherwise. . * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. PTBIt+1, PTBIt, PTCFt, and PTACCt are winsorized at the 1st and 99th percentiles. Standard errors are clustered by year.

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Table 5 Panel A: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings with Earnings Managers Removed from LPBTD Group PTBIt+1 = 0 + 1LNBTD + 2LPBTDt + 3PTBIt + 4PTBIt LNBTDt + 5PTBIt LPBTDt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.000 0.12 1 ? 0.016 4.17*** 2 ? 0.000 0.09 3 + 0.772 38.17*** 4 -0.070 -3.43*** 5 -0.023 -0.68 0.387 Adj R2 Pre-tax Earnings Persistence by Group SBTD LNBTD LPBTD 0.772 0.702 0.749

Panel BC: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components with Earnings Managers Classified on the Entire Sample Removed from All Groups PTBIt+1 = 0 + 1LNBTDt + 2LPBTDt + 3PTCFt + 4PTCFt LNBTDt + 5PTCFt LPBTDt + 6PTACCt + 7PTACCt LNBTDt + 8PTACCt LPBTDt + t+1 Variables Predicted sign Estimate t-statistic By Group PTCF 0.802 0 ? -0.007 -3.17*** SBTD PTACC 0.578 1 ? 0.007 1.73* 2 ? 0.004 1.11 3 + 0.802 45.27*** 4 ? -0.046 -2.29** LNBTD PTCF 0.756 PTACC 0.483 PTCF 0.752 5 ? -0.050 -1.71* 6 + 0.578 17.82*** 7 -0.095 -3.26*** 8 ? 0.114 1.81* LPBTD PTACC 0.692 0.410 Adj R2

PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBI-PTCF LNBTDt = Indicator variable equal to 1 for firm-year observations in the lowest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35) LPBTDt = Indicator variable equal to 1 for firm-year observations in the highest quintile of book-tax differences by year (calculated as Compustat items 269+270/0.35) All variables except for indicator variables are scaled by average total assets. T-tests are one-sided if a directional prediction is made, two-sided otherwise. . * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. The binomial distribution is used to test significance in panel A with a null hypothesis of 20%. PTBIt+1, PTBIt, PTCFt, and PTACCt are winsorized at the 1st and 99th percentiles. Standard errors are clustered by year.

46

Table 6 Market Pricing Tests Panel A: Mishkin Equations Tests Persistence Equation: PTBIt+1 = 0 + 1 TAXAVOIDERt + 2 EMt+ 3PTCFt + 4PTCFt TAXAVOIDERt + 5PTCFt EMt + 6PTACCt + 7PTACCt TAXAVOIDERt + 8PTACCt EMt + t+1 Pricing Equation: SARt-1 = 0 + (PTBIt+1 [0* + 1* TAXAVOIDERt + 2* EMt+ 3*PTCFt + 4*PTCFt TAXAVOIDERt + 5*PTCFt EMt + 6*PTACCt + 7*PTACCt TAXAVOIDERt + 8*PTACCt EMt]) + t+1

Variables

2 0.216 -0.106 0.322

3 0.792 0.618 0.174*

4 -0.011 0.034

5 -0.183 0.207

8 -0.174 0.198 -0.372* 0.066

Persistence Estimate Pricing Estimate Difference Significance of Difference (one-tailed) Base PTCF 3 Actual Implied 0.792 0.618 0.582

-0.104 -0.028 0.001 -0.074 -0.105 0.046

0.408 0.089 0.416 0.058 -0.008 0.031 0.432

-0.045 -0.390**

Tax Avoider PTCF PTACC 3 + 4 0.781 0.652 6 + 7 0.497 0.474

Earnings Manager PTCF 3 + 5 0.609 0.825 PTACC 6 + 8 0.234 0.614

PTACC 6 0.408 0.416

Panel B-E: Hedge Portfolio Returns SARt+1 = 0 + 1PTACCt + 2MVEt + 3BMt + 4BETAt + 5EPt + 6SARt + t+1 Panel B: Hedge Portfolio Returns Large Positive Book Tax Difference Group (N=4,178) Variables Predicted Sign Estimate T-stat Years +/0 ? 0.035 0.43 8/5 1 -0.079 -1.46* 4/9 2 -0.045 -0.7 6/7 3 + 0.000 0.00 6/7 4 + 0.080 0.77 7/6 5 + -0.008 -0.13 6/7 6 ? -0.008 -0.12 7/6

47

Table 6 (Continued) SARt+1 = 0 + 1PTACCt + 2MVEt + 3BMt + 4BETAt + 5EPt + 6SARt + t+1

Panel C: Hedge Portfolio Returns Tax Avoiders in LPBTD Group (N=1,281) Variables Predicted Sign Estimate T-stat Years +/0 ? 0.061 0.60 5/8 1 + -0.050 -0.81 6/7 2 -0.095 -0.74 8/5 3 + -0.095 -1.15 5/8 4 + 0.105 1.58* 9/4 5 + 0.034 0.73 7/6 6 ? 0.028 0.53 7/6

Panel D: Hedge Portfolio Returns Earnings Managers in LPBTD Group (N=1,085) Variables Predicted Sign Estimate T-stat Years +/0 ? -0.221 -1.34 4/9 1 0.040 0.27 5/8 2 0.051 0.79 6/7 3 + 0.196 1.94** 8/5 4 + 0.179 1.77** 10/3 5 + -0.077 -0.89 7/6 6 ? -0.057 -0.68 6/7

Panel E: Hedge Portfolio Returns LPBTD Base Group (N=2,161) Variables Predicted Sign Estimate T-stat Years +/0 ? 0.007 0.10 5/8 1 -0.043 -0.64 6/7 2 -0.011 -0.16 6/7 3 + -0.026 -0.56 9/4 4 + 0.035 0.39 8/5 5 + 0.058 0.75 5/8 6 ? -0.032 -0.34 8/5

All variables except SARt+1 are deciles ranks with the lowest decile having a value of zero and the highest decile having a value of one. As a result, the persistence coefficients are not directly comparable to the coefficients shown in Table 4. MVEt is defined as shares outstanding times price at the end of the current fiscal year. BMt is defined as book value of equity at the end of the current fiscal year divided by MVEt. BETAt is calculated using daily returns over the 24-month period ending at the start of the current fiscal year. EPt is calculated as earnings per share in the current fiscal year divided by price at the end of the current fiscal year. SARt is the size-adjusted return beginning on the first day of the fourth month of the current fiscal year and ending on the last day of the third month of the following fiscal year. SARt+1 is the size-adjusted return beginning on the first day of the fourth month after the end of the current fiscal year and ending on the last day of the third month of the following fiscal year. 349 observations are catergorized as both tax avoiders and earnings managers. T-tests are one-sided if a directional prediction is made, two-sided otherwise. * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. T-statistics are calculated as the ratio of the mean of the annual coefficients to the standard error calculated from the distribution of annual coefficients.

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Table 7 Additional Sensitivity Analysis Cash From Operations Used as Denominator in Cash ETR Calculation Panel A: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1TAXAVOIDERt + 2EMt + 3PTBIt + 4PTBIt TAXAVOIDERt + 5PTBIt EMt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.001 0.30 1 ? -0.005 -1.02 2 ? 0.007 0.65 3 + 0.730 22.94*** 4 + 0.092 2.14** 5 -0.283 -2.86*** 0.275 Adj R2 Pre-tax Earnings Persistence by Group Base 0.730 Tax Avoider 0.822 EM 0.447

Panel B: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1 TAXAVOIDERt + 2 EMt+ 3PTCFt + 4PTCFt TAXAVOIDERt + 5PTCFt EMt + 6PTACCt + 7PTACCt TAXAVOIDERt + 8PTACCt EMt + t+1 Variables Predicted sign Estimate t-statistic By Group PTCF 0.750 0 ? -0.004 -0.85 Base PTACC 0.628 PTCF 0.765 1 ? 0.004 0.84 2 ? 0.008 0.88 3 + 0.750 24.41*** 4 ? 0.015 0.43 5 ? -0.066 -1.06 6 + 0.628 11.20*** 7 + 0.192 4.52*** 8 -0.359 -3.48*** Earnings Manager PTCF 0.684 PTACC 0.269 0.313 Adj R2

Tax Avoider PTACC 0.820

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Table 7 (Continued) Cash ETR Calculated over Prior 3 Years Panel C: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1TAXAVOIDERt + 2EMt + 3PTBIt + 4PTBIt TAXAVOIDERt + 5PTBIt EMt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.001 0.27 1 ? -0.003 -0.45 2 ? 0.007 0.65 3 + 0.741 24.30*** 4 + 0.035 0.51 5 -0.283 -2.94*** 0.274 Adj R2 Pre-tax Earnings Persistence by Group Base Tax Avoider EM 0.741 0.776 0.458

Panel D: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components Within the Large Positive Book-Tax Difference Group (N=4,178) PTBIt+1 = 0 + 1 TAXAVOIDERt + 2 EMt+ 3PTCFt + 4PTCFt TAXAVOIDERt + 5PTCFt EMt + 6PTACCt + 7PTACCt TAXAVOIDERt + 8PTACCt EMt + t+1 Variables Predicted sign Estimate t-statistic By Group PTCF 0.737 0 ? -0.002 -0.42 1 ? -0.006 -0.96 Base PTACC 0.640 2 ? 0.009 1.01 3 + 0.737 25.58*** 4 ? 0.062 1.14 5 ? -0.062 -1.04 6 + 0.640 12.38*** 7 + 0.172 2.83*** 8 -0.398 -3.93*** Earnings Manager PTCF 0.675 PTACC 0.242 0.313 Adj R2

Tax Avoider PTCF 0.799 PTACC 0.812

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Table 7 (Continued) Avg. Assetst = Assetst-1 (Compustat item 6) plus Assetst divided by 2 PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBI-PTCF divided by average assetst SARt+1 = Size-adjusted return calculated as the buy-and-hold return on the security (including dividends) beginning at the start of the fourth month after fiscal year end and ending at the end of the third month the following year less the buy-and-hold return on a size-matched portfolio over the same period. Disc. Acc.t = Modified Jones Model discretionary accruals by 2-digit SIC industry Cash5ETRt = Sum of cash taxes paid over the previous 5 years divided by the sum of PTBI over the previous 5 years (or 3 years if 5 years of data are unavailable). Cash5ETRs greater than one are reset to one. Negative cash5ETR are reset to 35% TAXAVOIDERt = Indicator variable equal to 1 for firm-year observations within the LPBTD group and with a 5year cash effective tax rate (see Dyreng et al 2008) in the lowest quintile of all firms. EMt = Indicator variable equal to 1 for firm-year observations within the LPBTD group and with modified Jones model discretionary accruals in the top quintile of all firms. All variables except for indicator variables are scaled by average total assets over the current and prior year. T-tests are one-sided if a directional prediction is made, two-sided otherwise. * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. Standard errors are clustered by year.

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Table 8 Large Negative Book-tax Difference Group Earnings Persistence

Panel A: Earnings Managers in Large Negative Book-Tax Difference Group N = 1,404 Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.142 0.156 0.254 -0.096 0.082 1566.9 -0.091 0.344 Median 0.135 0.132 0.238 -0.096 -0.010 202.9 -0.079 0.350 Std Dev 0.131 0.114 0.111 0.062 0.705 5401.3 0.044 0.145 Minimum -0.291 0.004 0.003 -0.213 -1.241 5.0 -0.366 0.010 Maximum 0.433 0.465 0.496 0.157 7.294 84073.0 -0.043 1.000

Panel B: All Other Firms in Large Negative Book-Tax Difference Group N = 2,859 Variable PTBIt+1 PTBIt PTCFt PTACCt SARt+1 Avg. Assetst Disc. Acc.t Cash5ETRt Mean 0.110 0.145 0.134 0.012 0.014 2849.5 0.023 0.349 Median 0.102 0.121 0.124 -0.011 -0.055 255.6 -0.009 0.350 Std Dev Minimum 0.126 0.105 0.111 0.091 0.692 13546.3 0.057 0.156 -0.291 0.004 -0.146 -0.213 -1.545 4.82 -0.043 0.000 Maximum 0.433 0.465 0.496 0.305 15.742 409644.5 0.306 1.000

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Table 8 (Continued) Panel C: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Within the Large Negative Book-Tax Difference Group (N=4,263) PTBIt+1 = 0 + 1EMt + 2PTBIt + 3PTBIt EMt + t+1 Variables Predicted sign Estimate t-statistic 0 ? 0.010 2.16** 1 ? 0.020 4.28*** 2 + 0.688 21.97*** 3 0.026 0.71 0.357 From SBTD (T-stat) Adj R2 Pre-tax Earnings Persistence by Group EM Base 0.714 -0.058 -1.58* 0.688 -0.084 -2.68***

Panel D: OLS Regressions of Future Pre-Tax Earnings on Current Pre-Tax Earnings Components Within the Large Negative Book-Tax Difference Group (N=4,263) PTBIt+1 = 0 + 1EMt + 2PTCFt + 3PTCFt EMt + 4PTACCt + 5PTACCt EMt + t+1 Variables Predicted sign Estimate t-statistic By Group PTCF 0.769 From SBTD (T-stat) 0 ? 0.001 0.19 1 ? -0.003 -0.41 Base PTACC 0.449 -0.130 -4.06*** PTCF 0.763 2 + 0.769 30.00*** 3 ? -0.006 -0.17 4 + 0.449 10.88*** EM PTACC 0.516 -0.063 -1.13 5 0.067 1.61* 0.389 Adj R2

PTBIt+1 = Pre-tax book income (Compustat item 170) one-year ahead divided by average assetst PTBIt = Pre-tax book income for the current year divided by average assetst PTCFt = Pre-tax cash from operations for the current year calculated as Compustat items 308+317-124 divided by average assetst PTACCt = Pre-tax accruals for the current year calculated as PTBI-PTCF divided by average assetst EMt = Indicator variable equal to 1 for firm-year observations for firm-year observations within the LPBTD group and with modified Jones model discretionary accruals in the bottom quintile of all firms. from SBTD is the difference between the coefficient estimate and the corresponding estimate of .772 (Panel A) or .579 (Panel B) for the small book-tax difference group as reported in Table 2. All variables except for indicator variables are scaled by average total assets over the current and prior year. T-tests are one-sided if a directional prediction is made, two-sided otherwise. * indicates significance at the 10% level; ** indicates significance at the 5% level; *** indicates significance at the 1% level. Standard errors are clustered by year.

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