Book-tax conformity and capital structure

Abstract

We examine the effect of increased book-tax conformity on corporate capital structure. Prior studies document a decrease in the informativeness of accounting earnings for equity markets resulting from higher book-tax conformity. We argue that the decrease in earnings informativeness impacts equity holders more than debt holders because of the differences in payoff structures between debt and equity investments such that increases in book-tax conformity lead to increases in firms' reliance on debt capital. We exploit a natural experiment in the U.S. and find that firms facing an increase in required book-tax conformity increase leverage relative to other firms. We also provide evidence of an increase in the cost of equity (but not of debt) capital for firms facing an increase in required book-tax conformity relative to control firms and that these increases in cost of equity capital are positively associated with an increase in leverage. Our findings are consistent with firms substituting away from equity and towards more debt in the presence of higher book-tax conformity.

Book-Tax Differences and Capital Structure

“…Most studies in these areas consider only the effects of taxes on the capital structure (Graham, 2002). This work extends the study of Blaylock et al (2017), using BTD as a book-tax conformity measure and examining the change of accounting standards in a legalistic environment.…”

“…This group requires high-quality information because they are mainly based on financial statements to make decisions concerning investments (Dalmácio & Rezende, 2008). Blaylock et al (2017) argue that reducing the quality of earnings will result in an increase of informational asymmetry since the book-tax conformity will lead to an increase in financial leverage. Since the creditors mainly worry whether the value of the assets will be sufficient to cover the liabilities and whether the company has current and future cash flow to honor its obligations, they're probably less concerned about the loss of earnings quality in an environment of low BTD than investors.…”

“…Companies probably respond to informational quality loss (derived from the informational asymmetry) resulting from the reduction of BTD using more debt in their capital structures (Blaylock et al, 2017). In this line of thought, after the adoption of IFRS, the following is expected: reduction of the book-tax conformity, BTD, reduction of informational asymmetry, increase the quality of accounting information, reduction of financial leverage and the cost of equity and debt.…”

“…The creditors are probably less concerned about the quality loss of earningswhich results in low BTD level -than investors (Easton, Monahan, & Vasvari, 2009). In fact, they may prefer an accounting system that is closer to cash-basis because they do not participate in the company's future growth (Blaylock, Gaertner, & Shevlin, 2017).…”

“…An empirical observation in this direction was made by Blaylock et al (2017), which identified that, in the presence of major book-tax conformity, companies replace financing through the issuance of shares with creditors' financing. This survey was conducted with a sample of American companies, with non-legalistic origins (common law).…”