The Persistence, Forecasting, and Valuation Implications of the Tax Change Component of Earnings

Abstract

I examine whether earnings generated by changes in effective tax rates (the tax change component) persist and aid in forecasting future earnings. In addition, this study investigates to what extent investors incorporate the forecasting implications of the tax change component of earnings into stock prices. I find that there is a positive, significant association between the tax change component of earnings and future earnings. I use the interim reporting requirements of APB No. 28 (APB 1973) and FASB Interpretation No. 18 (FASB 1977) to further decompose the tax change component into an initial and a revised portion based on the first quarter estimate of the annual effective tax rates (ETR). I find that the initial tax change component is more persistent for future earnings than the revised tax change component. These results are consistent with my hypotheses that the initial and revised tax change components have differential persistence and forecasting implications, and dispute the broad notion advanced by prior literature that ETR-related earnings changes are transitory. Results from market tests indicate that the market underweights the forecasting implications of the tax change component and the mispricing appears to be driven by the transitory nature of the revised tax change component.

A review of tax research

“…He uses the interim reporting requirements of the financial accounting rules (APB 28 and SFAS 1977) to decompose the change in the ETR into an initial change (first quarter) and revised changes (quarters 2-4). Schmidt (2006) finds significant positive association between the tax change components of earnings and that the initial (Q1) change to the ETR is more persistent than a change in the other quarters. He also documents that the market underweights the forecasting ability of the tax change component of earnings but that the mispricing seems to be in all the later quarters.…”

“…The paper does not hinge on the ETR revealing information about other accounts, which then provides information about future earnings properties. Schmidt (2006) is a nice contribution to the literature but is not in the spirit of the literature above, however, and thus, is not included in the discussion. 16 The strategy of partitioning firms into those more likely to be tax planners and those more likely to be managing earnings is from where the research question is about the relative information in taxable income versus book income.…”

Accounting for Income Taxes: Primer, Extant Research, and Future Directions

“…In fact, some companies began to view the tax function as a profit center with a particular focus on managing the effective tax rate in the income statement (see Robinson et al (2010), Bryant-Kutcher et al (2009), andSchmidt (2006), among others). 3 Graham et al (2012) focus primarily on the extent to which managers use the tax accounts to manipulate earnings and whether the equity markets price the tax information in the financial statements.…”

Management Earnings Forecasts and Book Tax Differences

“…Previous studies analyze whether income tax accounts provide meaningful information about earnings quality such as growth or persistence of future returns and earnings (e.g., Lev & Nissim, 2004;Hanlon, 2005;Schmidt, 2006;Ayers, Jiang, & Laplante, 2009;Blaylock, Shevlin, & Wilson, 2012). The results imply that large BTDs provide incremental useful information and signal low earnings quality.…”