Blaylock (2002)

Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings
Persistence
Author(s): Bradley Blaylock, Terry Shevlin and Ryan J. Wilson
Source: The Accounting Review , JANUARY 2012, Vol. 87, No. 1 (JANUARY 2012), pp.
91-120
Published by: American Accounting Association
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THE ACCOUNTING REVIEW American Accounting Association
Vol. 87, No. 1 DOI: 10.2308/accr-10158
2012
pp. 91-120
Tax Avoidance, Large Positive Temporary

Book-Tax Differences, and Earnings
Persistence
Bradley Blaylock
Oklahoma State University
Terry Shevlin
University of Washington
Ryan J. Wilson
The University of Iowa
ABSTRACT: We investigate why temporary book-tax differences appear to serve as a

useful signal of earnings persistence (Hanlon 2005). We first test and show that
temporary book-tax differences provide incremental information over the magnitude of
accruals for the persistence of earnings and accruals. We then opine that there are
multiple potential sources of large positive book-tax differences. We predict and find
that firms with large positive book-tax differences likely arising from upward earnings
management (tax avoidance) exhibit lower (higher) earnings and accruals persistence
than do other firms with large positive book-tax differences. Finally, we find significant
variation in current-period earnings and accruals response coefficients and insignif-
icant hedge returns in period ř+1 , consistent with investors being able to look through to
the source of large positive book-tax differences (earnings management and tax
avoidance), allowing them to correctly price the persistence of accruals for these
subsamples.
Keywords: book-tax differences; earnings persistence; tax avoidance ; earnings

management; earnings expectations.
Data Availability: Data are available from public sources identified in this study.
We acknowledge the helpful comments of Alex Edward, Michelle Hanlon, Stacie Laplante, Rick Mergenthaler, Tom
Omer, Sonja Rego, and two anonymous referees. Professor Shevlin acknowledges financial support from his Paul Pigott/
Paccar Professorship at the Foster School.
Editor's note: Accepted by Tom Omer.
Submitted: March 2010
Accepted: July 201 1
Published Online: August 2011
91

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92 В lay lock, Shevlin, and Wilson
I. INTRODUCTION
information about earnings persistence (e.g., Lev and Nissim 2004; Hanlon 2005). Despite
Prior the informationtheimportant
importantresearch aboutof suggests
implications implications
these studies, earningsaboutthatwhatof causes
little is known the persistence
the observedthese tax information studies, (e.g., little Lev contained is and known Nissim in about financial 2004; what Hanlon causes statements 2005). the observed provides Despite
link between tax information and earnings persistence. This study begins to develop an
understanding of this link by first documenting that the information in temporary book-tax
differences, documented by Hanlon (2005), about earnings and accruals persistence is incremental
to the magnitude of accruals (i.e., larger accruals are less persistent). We next investigate whether
the implications of temporary differences between book and taxable income for the persistence of
earnings vary depending on the likely source of those differences. We develop two distinct
approaches for partitioning large positive temporary book-tax differences that provide meaningful
information about future earnings and accruals persistence. Our analysis thus extends Hanlon
(2005), who shows that for firm-years with large temporary book-tax differences, pretax income is
less persistent for future earnings than it is for firm-years with small book-tax differences.1
The purpose of accrual accounting is to better recognize firm performance, which often results
in accruals smoothing out transitory shocks in cash flows (Dechow 1994; Dechow and Ge 2006). If
accruals are recorded for book purposes but not for tax purposes, then the differences show up in
deferred tax expense such that a larger deferred tax expense (hereafter, larger book-tax differences)
could just be reflecting larger book accruals. Thus, the Hanlon (2005) result could just be reflecting
the fact that larger accruals are less persistent, as argued by Sloan (1996) and shown by Dechow
and Ge (2006). However, we argue that, when firms exhibit both large positive book-tax differences
and large positive accruals, those accruals are more likely to have resulted from managerial
discretion than a firm that exhibits large positive accruals and small book-tax differences. For this
reason, we expect the accruals of firms with large positive book-tax differences to be less persistent
than those of firms with small book-tax differences. Consistent with this expectation, we find that
large book-tax differences provide incremental useful information about earnings persistence
beyond the information provided by accruals.
Having established that book-tax differences provide incrementally useful information about
earnings and accruals persistence, we posit three primary sources of large positive book-tax
differences.2 First, book-tax differences can arise due to earnings management. Phillips et al. (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 that deferred tax expense is incrementally useful to the
Jones' discretionary accruals model in detecting earnings management. In cases where book-tax
differences are generated by earnings management, we expect that 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 leads to a large deferred tax expense, but does not
necessarily result in accruals that reverse in the following year. 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
1 The temporary book-tax differences examined in our study are equal to the deferred tax expense grossed-up by
the applicable statutory tax rate. Consistent with Hanlon (2005), we do not include permanent differences
because, as she notes, 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 persistence related to the accrual process.
2 Our analysis focuses on firms with large positive book-tax differences because these differences could be a signal
of either earnings management or tax avoidance.
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Tax Avoidance , Large Positive Temporary Book-Tax Differences, and Earnings Persistence 93
book-tax differences resulting primarily from tax planning will exhibit higher future earnings and
accruals persistence than other large positive book-tax difference firms.3
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, 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 use two alternative techniques to partition firms with large positive book-tax differences
into three subsamples corresponding to the three conjectured sources of differences. Consistent with
expectations, under both partitioning approaches we find that firms with large positive book-tax
differences that arise predominantly from upward earnings management have less persistent
earnings and accruals than do firms in the BASE subsample. Also consistent with expectations, we
find that firms with large positive book-tax differences arising predominantly from tax avoidance
exhibit significantly more persistent earnings and accruals relative to the BASE subsample under
partitioning approach 2, but not under partitioning approach 1 .
We next investigate whether investors are able to identify the likely source of book-tax
differences to help interpret price accruals. Hanlon (2005) notes that several accounting textbooks
indicate large book-tax differences can provide information about earnings quality.4 Consistent with
investors heeding this lesson, Hanlon (2005) finds that 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; she finds insignificant hedge portfolio
returns in year t+ 1. Despite these results, it is not clear whether investors are able to efficiently price
earnings for sub-groups 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
that 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 subsets of large positive
book-tax difference firms is similar in spirit to Sloan's (1996) finding that, on average, investors
correctly price the persistence of earnings for all firms. However, Sloan (1996) 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.
Frankel and Litov (2009) point out that investors seek to identify the determinants of earnings
persistence in order to better understand the relation between current earnings and permanent
earnings. Ohlson (2009) discusses various theoretical models of firm valuation that all rely, to
varying degrees, on earnings persistence.
We conduct two market-based tests. First, we find in regressions of current-period returns on
earnings and accruals that the response coefficients vary for the subsamples, consistent with the
3 We define tax planning as non-conforming tax positions that lower taxable income relative to book income in the
current period. We acknowledge that firms could also engage in conforming tax planning that lowers reported
income for both book and tax purposes. However, conforming tax planning transactions would not give rise to
book-tax differences. Further, 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.
4 Recent accounting textbooks continue to suggest that book-tax differences are an indicator of earnings quality.
For example, Revsine et al. (2012, 780) point out that "deferred tax footnotes can be used to assess earnings
quality. " While their suggestion points to analysis of individual firms, the comment is applicable to hedge funds
and other investors using large sample screens to identify securities for investment. Earnings quality is difficult
to define (see Dechow et al. [2010] for a discussion of this concept); consistent with Hanlon (2005), we sidestep
the issue and simply focus on earnings and accruals persistence.
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94 Blaylock, Shevlin, and Wilson
documented variation in earnings and a

portfolio returns in year f+l, suggestin
avoidance and high earnings manageme
We contribute to the literature in thre
large book-tax differences are assoc
incremental to the effect of accruals o
alternative means of partitioning firm
provide meaningful information about
differential earnings and accruals persis
difference firms validate our approache
useful to researchers who want to identi
samples of firms, as opposed to using a
in the tax footnotes as in Raedy et al. (2
for the most part, investors appear to u
provided by firms that exhibit large pos
Section II reviews the related literatur
sample. Section IV presents the earning
pricing test results, and Section VI con
II. RELATED LITERATURE AND HYPOTHESES
Earnings Persistence
Hanlon (2005) examines the implications of large book-tax differences fo

accruals persistence. Hanlon (2005) posits that, because discretionary accruals are
than nondiscretionary accruals (Xie 2001), if large book-tax differences are a sig
discretion in the accruals process, then firms with large book-tax differences sho
earnings and accruals persistence. Consistent with this argument, Hanlon (2005)
with large book-tax differences exhibit lower earnings and accruals persistence
small book-tax differences. However, if accruals for book purposes are not also
purposes, then the differences show up in deferred tax expense, and larger def
(equivalently larger book-tax differences) could just be reflecting larger book ac
first test whether large book-tax differences provide incremental useful informati
persistence beyond the information provided by accruals.
This analysis is similar in spirit to the approach of Weber (2009), who exami
analyst forecast errors are associated with the ratio of taxable income to net bo
controlling for accruals. He finds that analysts' forecasts of future earning
optimistic bias in firm-years where book income is high relative to taxable inco
controlling for accruals. We also note that Phillips et al. (2003) find temporary boo
have incremental explanatory power over discretionary accruals, estimated using
to detect earnings management around key earnings benchmarks. Thus, we predic
differences will have incremental explanatory power for the persistence of earni
Hla: Temporary book-tax differences provide incremental information over th

accruals for the persistence of earnings.
Hlb: Temporary book-tax differences provide incremental information over th

accruals for the persistence of the accruals component of earnings.
Assuming book-tax differences have incremental explanatory power, we next ex

tax differences might indicate differences in the persistence of earnings and accr
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Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings Persistence 95
Hanlon (2005) by making separate predictions about the earnings and accruals persistence for
different subsamples of firms with large positive book-tax differences (LPBTDs) based on the likely
predominant source of those differences. We expect that the ability of LPBTDs 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. Phillips et al. (2003, 492) argue that 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 deferred tax expense and firms just avoiding
a loss or a decline in earnings. They conclude that the deferred tax expense is a useful indicator of
earnings management incremental to a proxy for discretionary accruals. Also consistent with this
reasoning, Mills and Newberry (2001) find that the magnitude of book-tax differences is positively
associated with financial reporting incentives such as financial distress and bonus thresholds.
We compare the earnings and accruals persistence of firms likely to have managed earnings
with large positive discretionary accruals to the LPBTD BASE subsample firms. The above
discussion leads to our second set of hypotheses:
H2a: For firm-years with large positive book-tax differences, the persistence of earnings is
lower for the earnings management subsample than for the BASE subsample.
H2b: For firm-years with large positive book-tax differences, the persistence of the accruals
component of earnings is lower for the earnings management subsample than for the
BASE subsample.
In November 2006, the Wall Street Journal noted that public companies reported 40 percent
higher pretax profits to Wall Street (GAAP earnings) than to tax authorities during 2004 (Drucker
2006). 5 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, including some listed
transactions expressly forbidden by the 1RS. In addition, Mills (1998) reports that proposed 1RS
adjustments are positively associated with large book-tax differences.6 Wilson (2009) and
Lisowsky (2010) find that book-tax differences are positively associated with identified cases of tax
sheltering.7 Together, these findings suggest that tax avoidance is an important determinant of
book-tax differences. We conjecture that many firms report LPBTDs largely as a result of tax-
planning strategies associated with deferring income or accelerating deductions.
5 Drucker (2006) notes that these figures were based on 1RS data for 4,195 U.S. public companies with fiscal years
ending between June and December.
6 Mills (1998) uses three alternative measures of book-tax differences. Her full sample analysis utilizes 1RS data
and measures book-tax differences as the difference between pretax 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 our study because it does not include
permanent book-tax differences.
7 Specifically, Wilson (2009) finds that 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, Wilson's (2009) 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 1RS as listed transactions and find that more of these transactions (38) report a related temporary book-tax
difference than those (12) that report a related permanent book-tax difference.
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Ayers et al. (2010) examine the associ

book-tax differences. They conjecture
for credit ratings as a signal to analysts
However, to the extent that changes in
less useful in assessing credit worthine
that tax planning attenuates the relat
ratings. Similarly, we predict that in ca
from tax avoidance strategies, they wi
The above discussion leads to our thi
H3a: For firm-years with large posit

higher for the tax avoider subsam
H3b: For firm-years with large positi

component of earnings is higher f
subsample.
In summary, our hypotheses imply a ra

LPBTDs. Specifically, we expect that
avoidance, earnings and accruals persist
persistence will be exhibited by firms w
function of upward earnings manageme
as resulting from either upward earni
exhibit earnings and accruals persisten
subsample firms, LPBTDs likely arise
accruals as well as innate firm-specific
have large book-tax differences simply b
for GAAP versus the recognition requ
differences in the economics or business
information about subjectivity in the acc
they do for firms for which the predo
Market Pricing
Our next set of hypotheses examine w

about the future of earnings for firms
Sloan (1996) provides evidence that
persistence of accruals and cash flow
investors reduce their expectations ab
correctly price the accruals componen
8 Seidman (2010) finds that a small subset of

book-tax gap between 1993 and 2004. Further
the book-tax gap increases the association b
9 Specifically, Hanlon (2005) finds that inv
earnings for future earnings, but actually un
for future earnings. As a result, investors un
book-tax differences. There is a subtle dist
(2005). Sloan (1996) argues that investors m
and accruals and, thus, might misprice accru
differ across subsamples; investors might
subsamples.
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whether investors recognize the difference in earnings and accruals persistence between various
subsamples of firms that we predict will exhibit meaningful differences in persistence.
Following the above discussion, we expect the persistence of earnings and accruals to be
lowest for firms with LPBTDs arising from upward earnings management. In contrast, we expect
the persistence of earnings and accruals to be highest for firms with LPBTDs generated by tax
avoidance activity. That is, we develop our pricing predictions assuming differential accruals
persistence across subsamples. 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
that investors will not correctly understand differences in the persistence of accruals between
subsamples of LPBTD firms separated according to the source of those differences. We develop
two sets of hypotheses to test whether the pricing of equities is consistent with investors looking
through book-tax differences to their source.
We first examine whether the earnings response coefficient varies across subsamples in a
manner consistent with the predicted (in H2 and H3) variation in persistence across the subsamples.
These tests are motivated by prior literature that shows the earnings response coefficient is
positively associated with persistence (Kormendi and Lipe 1986; Collins and Kothari 1989). Thus,
we examine the association between current-period stock returns and earnings and accruals with the
following set of hypotheses:
H4a: The earnings response coefficient is lower (higher) for firms classified as earnings
managers (tax avoiders) than for firms in the BASE subsample.
H4b: The accruals response coefficient is lower (higher) for firms classified as earnings
managers (tax avoiders) than for firms in the BASE subsample.
Evidence consistent with H4a and H4b does not conclusively provide evidence that investors
are correctly or fully recognizing the differential persistence. If investors only partially recognize
the differential persistence of accruals across subsamples, 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. This reasoning
leads to the following hypotheses:
H5a: For firms classified as earnings managers, investors overestimate the persistence of the
accruals component of pretax earnings, resulting in negative abnormal returns to a hedge
portfolio formed on the sign and magnitude of pretax accruals.
H5b: For firms classified as tax avoiders, investors underestimate the persistence of the
accruals component of pretax earnings, resulting in positive abnormal returns to a hedge
portfolio formed on the sign and magnitude of pretax accruals.
III. SAMPLE SELECTION
We begin with a sample of all firms on the Compustat and CRSP tapes with n
and stock return data for the years 1993-2005. We start our sample in 1993 to
implementation of SFAS 109, thereby ensuring consistent accounting for incom
sample period.10 We eliminate observations with missing regression variables, p
losses, positive net operating losses (NOL carryforward), and negative current t
noted by Hanlon (2005), the presence of accounting losses, net operating los
10 We use five years of data to estimate the cash effective tax rate. Because cash taxes paid are
109, we are able to collect data for the calculation of the cash effective tax rate prior to 199
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current tax expense can obfuscate the

differences.11 After all exclusions, our
We first estimate the book-tax differe
Deferred Taxes)/0.35] scaled by average
differences and partition them into the
4,195 observations), the quintile of larg
other observations (12,585 observatio
(SBTD).
Table 1 presents descriptive statistics for firms categorized into the SBTD, LNBTD, and
LPBTD groups, respectively. Similar to Hanlon (2005), we find that the LNBTD firms are smaller
in terms of median assets. This finding is consistent with smaller growth firms being more likely to
be categorized in the LNBTD group. We also find that the LPBTD firms exhibit the lowest median
five-year cash ETR, which we calculate as the ratio of the sum of cash taxes paid over a five-year
period to the sum of pretax book income over the same five-year period ( Cash5ETR ). This result is
consistent with the LPBTD firms being more likely to be engaged in tax avoidance that results in
positive BTDs. Consistent with LPBTDs being, in part, a function of upward earnings management,
we also find that the LPBTD firms exhibit the largest median discretionary accruals of any of the
three groups. We estimate discretionary accruals using the Jones model with lagged return-on-assets
(Kothari et al. 2005).
IV. TESTS OF EARNINGS PERSISTENCE
The Basic Persistence Regression Model
The following regression model forms the basis of all our earnings persistence t
PTBIt+ 1 =}'() + yxPTBIt + £t+' i (1)

where PTBI is pretax accounting income scaled
comparability, and the coefficient yx is an estimate of
into future (one-period) earnings, referred to as th
expanded as in Hanlon (2005) to allow persistence to
and magnitude of book-tax differences:
PTBIt+] = y0 + yxLPBTDt + y2LNBTDt + y3PTBIt

+ y5PTBIt X LNBTDt + e/+1 , (2)
with the BTD groups as defined above. We next decom
flow and pretax accruals:
PTBIt+ 1 = }'() + yxPTCFt -f y2PTACCt + 8t+ 1, (3)

where PTCF is pretax cash flow and PTACC is pretax accruals, both scaled
for cross-sectional comparability. The coefficients y x and y2 are estimates of
period cash flows and accruals into future (one-period) pretax earnings. Thi
in the literature (Sloan 1996; Xie 2001; Hanlon 2005) as the persistence of
into future earnings. We again allow the persistence parameters to vary as a
magnitude of BTDs:
11 In addition, Hayn (1995) argues that because shareholders have a liquidation option, l
earnings persistence than profitable firm-years. The lower persistence of loss-ye
obscure our ability to detect differences in persistence signaled by large book-tax dif

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TABLE 1
Descriptive Statistics for Selected Variables
Panel A: Small Positive Book-Tax Difference Group (n = 12,585)

Variable Mean Median Std. Dev. Minimum Maximum
BTDt 0.004 0.002 0.010 -0.016 0.037

PTBI,+ l 0.082 0.072 0.104 -0.291 0.431
PTBIt 0.105 0.083 0.084 0.004 0.467
PTCFt 0.123 0.111 0.102 -0.146 0.498
PTACCt -0.017 -0.026 0.075 -0.213 0.305
SARt+l -0.002 -0.045 0.540 -1.583 9.587
Avg. Assets, 4,611 444.5 20,765 1.680 409,417
Disc. Acc, 0.002 0.000 0.060 -0.259 0.345
Cash5ETRt 0.324 0.321 0.167 0.000 1.000
Panel B: Large Negative Book-Tax Differ

BTDt -0.039 -0.028 0.037 -0.763 -0.005

PTBIt+l 0.120 0.113 0.129 -0.291 0.431
PTBIt 0.149 0.125 0.108 0.004 0.467
PTCFt 0.174 0.161 0.125 -0.146 0.498
PTACCt -0.024 -0.038 0.097 -0.213 0.306
SAR,+ i 0.038 -0.043 0.695 -1.545 15.74
Avg. Assets, 2,163 232.3 11,430 4.822 409,644
Disc. Acc, -0.015 -0.016 0.076 -0.362 0.306
Cash5ETR, 0.349 0.350 0.131 0.000 1.000
Panel C: Large Positive Book-Tax Differe

BTD, 0.059 0.045 0.049 0.021 0.742

PTBI,+ l 0.089 0.086 0.114 -0.291 0.433
PTBI, 0.130 0.108 0.087 0.004 0.465
PTCF, 0.140 0.138 0.114 -0.146 0.497
PTACC, -0.010 -0.028 0.088 -0.213 0.305
SAR,+ l -0.010 -0.077 0.618 -1.522 13.26
Avg. Assets, 2,514 376 13,787 4.640 684,794
Disc. Acc, 0.011 0.007 0.069 -0.283 0.344
Cash5ETR, 0.303 0.277 0.199 0.000 1.0000
PTBI,+U PTBI„ PTCF,, and PTACC, are winsorized at t
Variable Definitions:
LNBTD = large negative book-tax differences (bottom quintile);
SBTD = small book-tax differences (middle three quintiles);
LPBTD = large positive book-tax differences (top quintile);
BTD, = book-tax differences estimated as [(U.S. Deferred Tax + Foreign Deferred Tax)/0.35]/Average Total Assets;
PTBI,+l = pretax book income (Compustat item 170) one-year ahead divided by Avg. Assets,;
PTBI, = pretax book income for the current year divided by Avg. Assets,.
PTCF, = pretax cash from operations for the current year calculated as Compustat items 308 + 317- 1 24 divided by Avg. Assets,',
PTACC, = pretax accruals for the current year calculated as PTBI, - PTCF,-,
(continued on next page )
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100 В lay lock, Shevlin , and Wilson
TABLE 1 (continued)
SAR,+ 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 (e.g., April 1 for a December 3 1 fiscal year-end firm) and ending at the
end of the third month the following year (e.g., March 31) less the buy-and-hold return on a size-matched portfolio
over the same period;
Avg. Assets, - Assets ,_j (Compustat item 6) plus Assets, divided by 2;
Disc. Acc, = modified Jones Model discretionary accruals by two-digit SIC industry; and
Cash5ETR, = sum of cash taxes paid over the previous five years divided by the sum of PTBI over the previous five years
(or three years if five years of data are unavailable); Cash5ETRs greater than 1 are reset to 1 .
PTBIt+] = 70 + yxLPBTDt + y2LNBTDt + y3PTCFt + y4PTACCt + y5PTCFt X LPBTDt

+ y6PTACCt X LPBTDt + у -j PTC F t X LNBTDt + y%PTACCt X LNBTDt
+ ČM-1- (4)
Equations (2) and (4
replicating Hanlon (20
available upon request
and 4) for our exten
exhibit significantly
To test whether Han
the persistence of ac
also vary as a functio
test Hla and Hlb:
PTBIt+' = y0 + yxLPBTDt + y2LNBTDt + y3ABSACCt + y4PTBIt + y5PTBIt X LPBTD ,

+ y6PTBIf X LNBTDt + У 7 PTBI, X ABS ACC t + et+] , (5)
PTBIt+{ = 7o + yxLPBTDt + y2LNBTDt + y3ABSACCt + y4PTCFt + y5PTACCt

+ y6PTCFt X LPBTDt + y1PTACCt X LPBTD t + ysPTCFt X LNBTDt
+ y9PTACCt X LNBTDt + 7 к }PTCFt X ABS ACC t + yuPTACCt X ABS ACC t
+ fy+b (6)
where ABSACC is
(1996) hypothesi
accruals is decrea
accruals persisten
the absolute value of accruals.
Table 2 reports the results of estimating these two models. In Panel A, the estimated coefficients
on the PTBI interaction terms are all significant in their predicted directions. The significance of the
absolute value of the accruals interaction term is the highest of the three interaction terms. However,
the results in Panel A show that both LPBTDs and LNBTDs provide incrementally useful information
about earnings persistence. In Panel B, we report the results for the persistence of pretax cash flows
and pretax accruals. After controlling for accruals, the persistence of pretax accruals is lower for both
the LNBTD and LPBTD firms, indicating that BTDs contain incremental information about accruals
persistence. Again the significance of the accruals interaction term is higher than for the BTD terms,
but the BTD terms clearly provide incremental information. Also note that, consistent with the results
in Dechow and Ge (2006), cash flows are less persistent as the magnitude of absolute accruals
increases. We believe this result arises through the normal process of accrual accounting smoothing
out transitory shocks in cash flows (Dechow 1994).

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Partitioning BTDs
Having established that book-tax differences have incremental ability to explain cross-sectional
variation in the persistence of earnings and accruals, we now proceed to test H2a, H2b, H3a, and
H3b. As previously noted, our hypotheses relate to why firms might appear in the LPBTD group
and why we might expect differences in persistence of earnings and accruals within this group. H2a
and H3a predict differences in yx in Equation (1) across the subsamples of firms in the LPBTD
group. To conduct tests of differences across the subsamples, we expand Equation (1) to examine
whether the earnings persistence of LPBTD firms varies as a function of whether those book-tax
differences are likely largely a result of upward earnings management (labeled EM observations) or
tax avoidance (labeled TAXAVOIDER observations).
PTBIt+i = 70 + yxEMt + y2TAXAVOIDERt + y3PTBIt

+ y4PTBIt X EMt + y5PTBIt X TAXAVOIDER t + e,+i . (7)
The coefficient on PTBIt , y3, represents the earnings persistence of firm-years with LPBT
that are in the BASE subsample - that is, firm-years that are not categorized as upward earn
management or tax avoidance firms. For these firms, LPBTDs are likely a result of som
combination of tax avoidance, earnings management, and innate firm characteristics.
Consequently, we expect the earnings persistence for this subset of LPBTD firms to fall between
the other two subsets of firms. We expect that if LPBTDs resulting from earnings management are
a signal of discretion in accruals, then the coefficient on the interaction term ( PTBI X EM ), y4, will
be negative. In contrast, if the positive book-tax differences are primarily a result of tax planning,
then we expect that earnings persistence will be higher for this subset of firms than for the BASE
subsample, and that the coefficient on the interaction term ( PTBI X TAXAVOIDER ), y5, will be
positive.
H2b and H3b predict differences in the persistence of accruals across the subsamples of firms
in the LPBTD group (EM, BASE, and TAXAVOIDER). To test accruals persistence across
subsamples, we expand Equation (3) as follows:
PTBIt+x = 7o + yxEMt + у 2 TAXA V О I DER t + y3PTCFt + y4PTCFt X EMt + y5PTCFt
X TAXAVOIDERf + y6PTACCt + y^TACCt X EMt + y^PTACCt

X TAXAVOIDERf + £,+ ,. (8)
H2b predicts that y7 will be negative and H3

hypotheses, we must partition firms into subsam
(EM and TAXAVOIDER)}2 We use the two ap
12 Partitioning large book-tax difference firms into sub

tax differences raises the question of why we do not
differences. After all, we are not predicting that defe
underlying event that caused the deferred tax. Our m
deferred tax expense (or book-tax differences) prov
accounting choices. For hedge funds or other investor
summary measure that provides useful information ab
individual transactions at numerous firms. In contra
and examine individual line-items from the tax foot
methods of partitioning LPBTDs to provide addition
persistence that are relatively easy to implement
transactions that give rise to book-tax differences.
The Accounting Review A™"nt"ng

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First Partitioning Approach of LPBTD Firms

We identify upward earnings management using discretionary accruals calculated from a cross-
sectional modified Jones model with lagged return-on-assets (Jones 1991; Kothari et al. 2005). We
classify firm-year observations as earnings management firm-years {EM) if the observation's
discretionary accruals are in the top quintile of all firms.13
We use the cash effective tax rate ( Cash5ETR ) developed by Dyreng et al. (2008) to identify tax
avoidance firms. The Cash5ETR is the ratio of the five-year sum of cash taxes paid to the five-year
sum of pretax financial accounting income. As discussed by Dyreng et al. (2008), this measure of tax
avoidance has several advantages over the traditional effective tax rate measures. First, the Cash5ETR
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 Cash5ETR.]4 In addition,
if firms accelerate expenses or defer income for tax purposes, then this will be reflected in a lower
Cash5ETR , provided that those timing differences do not reverse within the five-year period over
which Cash5ETR is measured.15 We classify firms as tax avoiders (TAXAVOIDER) if they have a
five-year Cash5ETR in the lowest quintile within the pooled sample of all firms.16
There are 349 firm-year observations in our LPBTD group classified into both the
TAXAVOIDER and EM subsamples. These observations exhibit both high levels of discretionary
accruals and low Cash5ETRs .17 To maintain consistency with partitioning approach 2 below, we
13 We use a broad measure of earnings management because we are trying to determine the most likely source of a
firm's large positive book-tax difference regardless of the legality of the earnings manipulation. Both within
GAAP upward earnings management and fraudulent upward 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 management's intent in reporting large positive accruals. Furthermore, just meeting or beating
earnings benchmarks does not necessarily result in large positive book-tax differences.
14 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 year's income or settlement payments to the 1RS associated
with past tax years. We expect that the effect of the timing of estimated tax payments will add only limited noise
to our measure of Cash5ETR , since we use a five-year measure. However, we acknowledge that the
appropriateness of the five-year Cash5ETR measure depends on the consistency of these timing issues from year
to year and that a five-year Cash5ETR is not an exact measure of a firm's tax avoidance activities in the current
year. When we use a three-year measure of Cash5ETR instead of a five-year measure, the results are unchanged.
1 5 We use a five-year Cash5ETR for this analysis because we believe it is the broadest measure in the literature of tax avoidance.
We are indifferent to 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 available for only two years, and the economic upheaval
in 2007 and 2008 likely makes any inferences based on uncertain tax benefits over this sample period less generalizable.
16 In supplemental tests (not tabulated) we categorize firms as TAXAVOIDER within the LPBTD group by year. The
results are consistent with those reported in Table 3 using this alternative classification.
17 The 349 firm-year observations categorized in both the TAXAVOIDER subsample and the EM subsample
represent 26.9 percent (349/1299) of firms in the TAXAVOIDER subsample (before we exclude the 349 EM
firm-year observations), or 32.2 percent (349/1084) of firms in the EM subsample. We would expect that, by
chance, 25.8 percent of the TAXAVOIDER subsample and 31.0 percent of the EM subsample would be
categorized in both subsamples. Neither of these differences is statistically significant at conventional levels.
Thus, 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). This result contrasts with that of Frank et al.
(2009), who find that aggressive financial reporting firms are more likely to also pursue aggressive tax reporting
strategies. However, our measure, Cash5ETR, is a broad measure of tax avoidance, whereas their measure,
adjusted permanent book-tax differences, tends more toward the tax aggressiveness end of the spectrum. Thus,
the results are not directly comparable.
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exclude the 349 firm-years classified

subsample and treat them as EM observ
Our tests are joint tests of our pred
(discretionary accruals and CashSETR) to
the observation is in the LPBTD group.
income, which is affected by earning
Cash5ETR arises because of a higher (ma
firm did not pay cash taxes on these
Cash5ETR. Further, if Cash5ETR is really
persistence results should not differ bet
supplemental tests, we find that the TAX
component of earnings than the BASE g
cash flow as a scalar instead of preta
TAXAVOIDER using the partitioning va
only for tax avoidance, but also for other
accruals are more persistent than in othe
is aimed at identifying useful/available
exhibit different earnings persistence. T
Panel A of Table 3 presents statistic
TAXAVOIDER within the SBTD, LNBTD,
EM and TAXAVOIDER firms based on th
observations. Firms in the bottom 20
provided that they are also not in the E
accruals are classified as upward EM (+) f
accruals are classified as downward EM (-
the EM variable used in our analysis of L
of EM and TAXAVOIDER firms were random between each group (SBTD, LPBTD, and
LNBTD), then we would observe that 20 percent of the firms in each group would be categorized as
EM (+) firms, 20 percent as EM (- ) firms, and 16 percent as TAXAVOIDER firms (we would
expect 20 percent in the TAXAVOIDER subsample if we did not reclassify the overlapping
observations in EM and TAXAVOIDER subsamples into the EM subsample only). 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 LPBTDs serve as a useful signal of upward earnings management and as a signal of
tax avoidance activities (Phillips et al. 2003; Badertscher et al. 2009; Wilson 2009; Lisowsky
2010). This result is also consistent with our maintained assumption that both earnings management
and tax avoidance activities can lead firms to end up in the LPBTD group.
Table 3 also provides descriptive statistics for the three subsamples of LPBTD firms. Median
BTDs (0.041, 0.048, and 0.051) are similar for the BASE, EM, and TAXAVOIDER groups,
respectively. The TAXAVOIDER subsample has lower median current-period pretax earnings and
18 Omitting these 349 firm-year observations altogether yields almost exactly the same results reported in Table 3.
Including these observations in both groups and adding an interaction EM X TAXAVOIDER (to separately
identify these observations) results in the same inferences for the EM and TAXAVOIDER subsamples as
reported in Table 3. The coefficient on the interaction term for both earnings and cash flows persistence is
positive and significant. The estimate for the interaction term for accruals persistence is positive but insignificant.
Including these observations in both groups with no interaction term results in the TAXAVOIDER accruals being
more persistent than the BASE group, with no change in the results for EM earnings and accruals persistence.
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TABLE 3
Descriptive Statistics for Selected Variables and Persistence of Earnings and Ear
Components within LPBTD Group
Partitioning Approach 1
Panel A: Proportions of Groups Classified as EM and TAXAVOIDER

SBTD LNBTD LPBTD
n 12,585 4,263 4,195

EM (+) 18.5%*** 18.6%** 26.0%***
EM (-) 17.0%*** 32.9%*** 15.9%***
TAXAVOIDER 14.2%*** 12.7%*** 22.6%***
A Chi-squared test rejects the equivalence of t

the LNBTD and SBTD groups at a less than 0
Panel B: BASE Subsample in Large P

BTDt 0.053 0.041 0.040 0.021 0.566

PTBIt+x 0.096 0.089 0.104 -0.290 0.431
PTBIt 0.127 0.108 0.083 0.004 0.467
PTCFt 0.175 0.105 0.098 -0.146 0.498
PTACCf -0.048 -0.042 0.057 -0.213 0.306
SAR,+ i -0.004 -0.060 0.609 -1.149 13.257
Avg. Assets, 2,732 391.4 10,198 4.640 207,861
Disc. Accf -0.018 0.008 0.044 -0.277 0.038
С ash5ETRt 0.379 0.350 0.143 0.232 1.000
Panel C: EM in Large Positive Book-Tax D

BTDt 0.067 0.048 0.063 0.021 0.742

PTBIt+i 0.073 0.078 0.128 -0.290 0.431
PTBlt 0.140 0.116 0.095 0.004 0.467
PTCFt 0.069 0.066 0.102 -0.146 0.498
/ТАСС, 0.071 0.047 0.094 -0.131 0.306
SAR,+ X -0.074 -0.127 0.619 -1.479 7.146
Avg. Assets, 1,743 283.8 6,218 7.215 151,790
Disc. Acc, 0.090 0.070 0.054 0.039 0.345
Cash5ETR, 0.312 0.334 0.184 0.001 1.000
Panel D: Tax Avoiders in Large Positive

BTD, 0.065 0.051 0.045 0.021 0.348

PTBI,+ l 0.091 0.083 0.103 -0.290 0.431
PTBI, 0.121 0.102 0.078 0.004 0.467
PTC F , 0.173 0.157 0.095 -0.066 0.498
PT ACC, -0.052 -0.047 0.060 -0.213 0.305
SAR,+ l 0.013 -0.048 0.556 -1.522 5.722
( continued on ne
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TABLE 3 (continued)
Avg. Assets, 2,583 524.0 9,194 5.260 167,813

Disc. Accf -0.015 -0.005 0.042 -0.271 0.039
Ccish5ETRt 0.126 0.132 0.070 0.000 0.232
Panel E: OLS Regressions of Future Pretax

Large Positive Book-Tax Difference Grou
PTBIf+l = 7o + Vi EMt + У 2 TAXA VOIDE

+ y5PTBlt X TAXAVOIDERf +
Pretax Earning
Persistence by G
Variables y0 7i У 2 Уз У 4 У 5 Adj. R2 BASE EM Tax Avoider

Predicted sign ? ? ? + - +
Estimate -0.001 0.008 0.004 0.759 -0.291 -0.035 0.275 0.759 0.468 0.724
t-statistic -0.12 0.69 0.48 21.39*** -2.91*** -0.55
Panel F: OLS Regressions of Future Pretax Earnings on Current

Components within the Large Positive Book-Tax Difference Gro
PTBI[+i = y0 + yxEMt + у 2 TAXA VOlDERt + y3PTCFt + y4PTCFt X

X TAXAVOIDERt + y6PTACCt + y7 PTACCt X EMt + y^PTACC
+ 1 •
Variables y» Vi У2 Уз У4 Ys Уб У7 У8 Adj. R2
Predicted sign ? ? ? + ? ? + - +
Estimate -0.006 0.010 0.009 0.759 -0.062 -0.026 0.659 -0.366 0.095 0.312
t-statistic -1.09 1.16 1.53 23.57*** -0.96 -0.55 14.62*** -3.90*** 1.04
Panel G: Persistence of Earnings Components by Group

BASE EM TAX AVOIDER
PTCF PTACC PTCF PTACC PTCF PTACC
0.759 0.659 0.697 0.293 0.733 0.754
*, **, *** Indicates significance at th

All variables except for indicator var
PTBIf, PTCF „ and PTACC, are winsori
is made, two-sided otherwise. Standar
Partitioning Approach 1:
EM, - 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;
TAX AVOIDER, = indicator variable equal to 1 for firm-year observations within the LPBTD group and with a five-year
cash effective tax rate (see Dyreng et al. 2008) in the lowest quintile of all firm-years in the sample and not part of
the EM subsample;
PTBI,+ 1 = pretax book income (Compustat item 170) one-year ahead divided by Avg. Assets,;
PTB I, = pretax book income for the current year divided by Avg. Assets,;
PTCF, = pretax cash from operations for the current year calculated as Compustat items 308 + 317- 1 24 divided by A vg.
Assets,;
(continued on next page)

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TABLE 3 (continued)
PTACCf = pretax accruals for the current year calculated as PTBI - PTCF divided by Avg. Assets
BTDt = book-tax differences estimated as [(U.S. Deferred Tax -I- Foreign Deferred Tax)/0.35]/Average Total Assets;
SA/?,+i = 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 (e.g., April 1 for a December 31 fiscal year-end firm) and ending at the
Avg. Assets t = Assets t_ ' (Compustat item 6) plus Assets t divided by 2;
Disc. Acct - modified Jones Model discretionary accruals by two-digit SIC industry; and
Cash5ETRt = sum of cash taxes paid over the previous five years divided by the sum of PTBI over the previous five years
lower median pretax accruals, but higher median pretax cash flows, than the EM firms. The
TAX A VOIDER firms also have higher median average total assets and higher median size-adjusted
returns in period t- hi than the EM firms. Not surprisingly, the EM firms exhibit higher median
discretionary accruals and higher Cash5ETRs than the TAXAVOIDER firms.
We also note that pretax cash from operations scaled by average assets is less than half as large
for the EM subsample as for the other two subsamples (0.069 versus 0.173 and 0.175). This result is
consistent with prior studies that document a strong negative correlation between cash flows and
accruals (e.g., Dechow 1994; Sloan 1996; Xie 2001). Dechow (1994) notes that accruals are
intended to reduce timing and matching problems and could be used to smooth temporary
fluctuations in cash flows. The result is a strong negative correlation between accruals and cash
flows. We further note that the mean and median discretionary accruals are close to zero for both the
BASE and TAXAVOIDER subsamples, suggesting that there is no more earnings management in
the BASE subsample than in the TAXAVOIDER subsample, which might lead to no difference in
the persistence of accruals between these two subsamples (H2b). Significance tests of differences in
the descriptive statistics in Table 3 are not provided because these data are intended as purely
descriptive.
Table 3 also presents the regression results under partition approach 1. Panel E of Table 3
reports the results of estimating Equation (7). The results indicate that firm-years designated as
upward earnings managers (EM) exhibit significantly lower earnings persistence than the BASE
subsample of the LPBTD firms: y4 is significantly negative at the (p < 0.01) level. This finding is
consistent with H2a and suggests that, when large book-tax differences result primarily from
upward earnings management, they are a particularly useful signal of low earnings persistence. For
firm-years in the TAXAVOIDER subsample, inconsistent with H3a, y5 is negative but is not
significant at conventional levels.
Panels F and G of Table 3 reports the results of estimating Equation (8). Consistent with H2b,
the results indicate that the pretax accruals component of earnings exhibits significantly lower
persistence for future earnings for the firm-years designated as EM than for the BASE subsample of
LPBTD firms. This finding suggests that, in the cases for which LPBTDs 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. While the results in Panel E also show that the accruals
component of earnings for the TAXAVOIDER subsample is more persistent than for the BASE
subsample, the difference is not significant. We do not make a prediction about the persistence of
cash flows between subsamples of LPBTD firms. The results in Panels F and G indicate that the
persistence of cash flows is not significantly different for the EM and TAXAVOIDER firms than for
the BASE subsample firms. Panel G of Table 3 sums the coefficients reported in Panel F to provide
a direct estimate of the persistence of cash flows and accruals for each subsample within the
LPBTD group. As expected, the persistence of accruals is highest for the TAXAVOIDER firms
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108 Blaylock , Shevlin, and Wilson
(although as noted, the difference is not

while the EM firms exhibit the lowest pe
find the differences in the persistenc
TAXAVOIDER subsamples are significan
that concerns that the Cash5ETR mea
largely picking up the effects of earnings
Second Partitioning of LPBTD Firms
In our second partitioning of LPBTD firm

the LPBTD group in both the current an
LPBTD group in the current but not prev
we need to eliminate the first year of s
sample. We next exclude and separately c
managers (from approach 1) from both
to label these earnings managers as EM fi
forms the BASE subsample in this partiti
MULTIPLE subsample, we argue that the r
exhibiting large positive BTDs due to eithe
We make this prediction because tax avoid
because firm characteristics are unlikely
Panels A through С of Table 4 present d
second partitioning approach. We find t
MULTIPLE subsample and 25.9 percent
descriptive statistics subs across the three
flows and higher discretionary accruals t
these firms managing earnings when pre
have lower Cash5ETRs than firms in the
a more likely source of large positive BT
difference in the level of discretionary
difference in Cash5ETRs between the BA
Table 4 also presents the regression res
TAXAVOIDER label with the MULTIPLE l
partitioning approaches 1 and 2). The resu
of upward earnings managers (EM) exhibi
years of the LPBTD firms in the BASE s
that firm-years designated as MULTIP
subsample of firms, significant at p < 0.
the results of estimating Equation (8) test
subsamples. Consistent with H2b, the EM
the BASE firms. Consistent with H3b, th
accruals persistence than the BASE firm
persistence of cash flows across the th
partitioning are consistent with those repo
19 We pool all observations in the MULTIPLE su

exhibit the same persistence of earnings and ac
years. We validate this assumption by testing
subsample for two years compared to firms in t
accruals is not significantly different between
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TABLE 4
Descriptive Statistics for Selected Variables and Persistence of Earnings and Ear
Components within LPBTD Group
Panel A: BASE Subsample (n = 1,799)

BTDt 0.055 0.043 0.044 0.021 0.566

PTBIt+x 0.097 0.088 0.110 -0.290 0.431
PTBIt 0.128 0.107 0.086 0.004 0.467
PTCFt 0.175 0.158 0.102 -0.128 0.498
PTACCf -0.047 -0.042 0.086 -0.213 0.306
SARt+] 0.007 -0.042 0.584 -1.489 5.946
Avg. Assets t 2,572 379.0 9,560 4.640 207,861
Disc. Acct -0.019 -0.009 0.045 -0.273 0.039
Cash5ETRt 0.327 0.350 0.172 0.000 1.000
Panel B: EM Subsample (n = 987)

BTDt 0.068 0.049 0.065 0.021 0.742

PTBIt+l 0.072 0.079 0.129 -0.290 0.431
PTBIf 0.140 0.117 0.095 0.004 0.467
PTCFf 0.070 0.069 0.102 -0.146 0.498
PTACCt 0.070 0.047 0.092 -0.131 0.306
SARt+i -0.073 -0.130 0.638 -1.479 7.146
Avg. Assets, 1,853 296.4 6,493 8.698 151,791
Disc. Acct 0.089 0.070 0.054 0.039 0.344
Cash5ETRt 0.310 0.331 0.184 0.000 1.000
Panel C: MULTIPLE Subsample (n = 1,027)

BTDt 0.059 0.047 0.039 0.021 0.430

PTBIt+i 0.089 0.086 0.196 -0.290 0.431
PTBIt 0.122 0.106 0.073 0.004 0.467
PTCFt 0.176 0.161 0.091 -0.066 0.498
PTACCt -0.053 -0.048 0.055 -0.213 0.215
SARt+l -0.008 -0.067 0.658 -1.522 13.25
Avg. Assets, 3,231 591.5 11,391 10.51 167,813
Disc. Acc, -0.013 -0.005 0.039 -0.240 0.039
Cash5ETRt 0.252 0.250 0.165 0.000 1.000
( continued on ne
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1 10 Blaylock, Shevlin, and Wilson
TABLE 4 (continued)
Panel D: OLS Regressions of Future Pretax Earnings on Current Pretax Earnings;

Partitions Based on Discretionary Accruals and Number of Consecutive Years in LPBTD
Group (n = 3,813)
PTBIt+ 1 = y0 + yxEMt + y2MULTIPLEt + y^PTBIt + y4PTBIt X EMt + y5PTBI, X MULTIPLEt

I
't+ Pretax Earnings
Persistence by
Variables y0 7i У 2 Уз У 4 У 5 Adj. R2 BASE EM MULTIPLE

Predicted sign ? ? ? + - +
Estimate 0.004 0.004 -0.016 0.727 -0.271 0.099 0.273 0.727 0.456 0.826
t-statistic 0.94 0.38 -2.10* 18.83*** -2.61** 1.72*
Panel E: OLS Regressions of Future Pretax Earnings on Current

Components; Partitions Based on Number of Consecutive Years
PTBIt+ 1 = y0 + y , EMt + y2 MULTIPLEt + y3PTCFt + yAPTCFt*EM

+ y6PTACCt + ynPTACCt X EMt + y%PTACCt X MULTIPLEt
Variables
Predicted sign ? ? ? + ? ? + - +
Estimate -0.004 0.009 -0.003 0.735 -0.053 0.088 0.590 -0.305 0.327 0.309
t-statistic -1.08 0.97 -0.34 21.10*** -0.92 1.58 10.25*** -2.82*** 3.88***
Panel F : Persistence of Earnings Components by Group

BASE EM MULTIPLE
PTCF PTACC PTCF PTACC PTCF PTACC
0.735 0.590 0.682 0.285 0.823 0.917
*, **, *** Indicates significance at th

All variables except for indicator var
PTBI,, PTCF „ and PTACC, are winsori
is made, two-sided otherwise. Standa
Partitioning Approach 2:
Base , = firms in the LPBTD group in year t that were not in the LPBTD group in the prior year t- 1 and are not part of the
EM subsample;
EM, - indicator variable equal to 1 for firm-year observations with modified Jones Model discretionary accruals in the
top quintile of all firm-years in the sample;
Multiplet = indicator variable equal to 1 for firm-year observations within the LPBTD group in year t that were in the
LPBTD sample in the prior year t- 1 and are not part of the EM subsample;
PTBIt+i = pretax book income (Compustat item 170) one-year ahead divided by Avg. Assets,;
PTB I, = pretax book income for the current year divided by Avg. Assets,;
PTCF, = pretax cash from operations for the current year calculated as Compustat items 308 + 317- 124 divided by Avg.
Assets ,;
PTACC, = pretax accruals for the current year calculated as PTBI - PTCF divided by Avg. Assets,;
BTD, = book-tax differences estimated as [(U.S. Deferred Tax + Foreign Deferred Tax)/0.35]/Average Total Assets;
SAR,+ 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 (e.g., April 1 for a December 3 1 fiscal year-end firm) and ending at the
Avg. Assets, = Assets i (Compustat item 6) plus Assets, divided by 2;
Disc. Act, = modified Jones Model discretionary accruals by two-digit SIC industry; and
Cash5ETR, = sum of cash taxes paid over the previous five years divided by the sum of PTBI over the previous five years

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Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings Persistence 1 1 1
MULTIPLE subsample exhibits significantly higher earnings and accruals persistence than the
BASE subsample in partitioning approach 2, but TAXAVOIDERs in approach 1 do not.
V. MARKET PRICING TESTS
Do Investors Use BTDs and Their Source in Pricing Current Earnings?
We first examine whether investors appear to recognize and utilize the dif
persistence in earnings and accruals (as documented in Tables 3 and 4) in the current
of earnings and accruals. To conduct this analysis, we allow the earnings response coe
Equation (9) below to vary across subsamples:
RETt = ô0 + ái Д PTBIt + e,+ i . (9)

Kormendi and Lipe (1986) and Collins and Kotha
response coefficient is positively associated with
(H4b) that the earnings (accruals) response coeffic
LPBTD group that are classified as earnings manag
estimate the following two equations:
RETt = ¿o + <5 1 APTBIt 4- Ô2A PTBIt X EMt
RET, = ôo + ô'APTCFt -h ö2APTACCt + ô3APT

+ ô5APTCFt X TAXAVOIDERt + ô6APT
The results of estimating Equation (10) are repo

expectations, we find a negative and significan
This result is consistent with the earnings respon
variation in earnings persistence for the EM
interaction term is not significant. Next, we e
estimating Equation (11) with results reported
find that the accruals response coefficient is sign
TAXAVOIDER firms, than for the BASE group. The insignificant results on the
TAXAVOIDER interaction term in both panels are consistent with the earlier persistence
results: these firms did not exhibit significantly different earnings and accruals persistence
relative to the BASE group in Table 3.
In Panel A of Table 6 we test whether the earnings response coefficient varies across
subsamples using our second partitioning approach. Recall from Table 4 that the EM firms
exhibit significantly lower earnings and accruals persistence than the BASE firms, and the
MULTIPLE firms exhibit significantly higher earnings and accruals persistence than the BASE
firms. Consistent with investors incorporating this variation in persistence between subgroups
into their pricing, the earnings response coefficient is significantly higher for the MULTIPLE
firms than for the BASE firms. Also consistent with expectations, we find that the earnings
response coefficient is significantly lower for the EM firms than for the BASE group firms.
Finally, in Panel В of Table 6 we examine the accruals response coefficients on the subgroups
using our second partitioning. The results in Panel В are also consistent with investors
recognizing the differences in the persistence of accruals between subgroups and pricing
accruals accordingly. Overall, the results in Tables 5 and 6 are consistent with investors
incorporating variation in persistence across the subsamples (as documented in Tables 3 and 4)
in the current pricing of earnings and accruals.
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1 12 В lay lock, Shevlin, and Wilson
TABLE 5
Earnings Response Coefficient Tests

Panel A: OLS Regressions of Current Size-Adjusted Returns on Current Pretax E

Changes within the Large Positive Book-Tax Difference Group (n = 3,243)
RETt = ô0 + ¿i A PTBIt + ¿2 A PTBIt X EMt + 0ЪА PTBIt X TAXAVOIDERt + et+i .
Variables A0 <5i ô2 ô3 Adj. R2

Predicted sign ? + - +
Estimate -0.015 0.884 -0.376 -0.203 0.043
t-statistic -0.54 732*** -4.08*** -0.81
Panel B: OLS Regressions of Current S

Components Changes within the Larg
RETt = ¿o + S'APTCFt + ö2A PTACCt

+ ô5APTCFt X TAXAVOIDERt + ô6A
Variables <50 <5i S2 S3 ô4 S5 S6 Adj. R2

Predicted sign ? -f + ? - ? +
Estimate -0.016 0.967 0.779 -0.331 -0.282 -0.268 -0.191 0.045
t-statistic -0.59 6.39*** 7.54*** -2.58** -2.36** -1.02 -0.63
* ** *** indicates significance at the 10 percent, 5 percent, and 1 percen

For the above test we restrict the sample to firms with greater than $10 mi
all firm-year observations in the top or bottom 1 percent of earnings, cas
Partitioning Approach 1 : EM, = indicator variable equal to 1 for firm-yea
with modified Jones Model discretionary accruals in the top quintile of a
= indicator variable equal to 1 for firm-year observations within the
effective tax rate (see Dyreng et al. 2008) in the lowest quintile of all fir
EM group.
t-tests are one-sided if a directional prediction is made, two-sided otherwise. Standard errors are clustered by year.
RET, = size-adjusted buy and hold returns for the 12-month period beginning in the fourth month after the fiscal year-end
of year t-' and ending in the third month following the year-end of fiscal year /;
PTBIt - pretax book income for the current year divided by beginning of the year price;
PTCF, = pretax cash from operations for the current year calculated as Compustat items 308 + 317 - 124 divided by
beginning of the year price; and
PTACC, = pretax accruals for the current year calculated as PTBI - PTCF divided by beginning of the year price.
Hedge Portfolio Tests
Table 7 presents the results of our market pricing tests using hedge portfolio returns. These
tests allow us to examine whether investors correctly infer the persistence of accruals for each
subsample and to examine whether there is any deviation from market efficiency in the pricing of
the persistence of the accruals component of earnings. We estimate the relation between future
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Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings Persistence 1 13
TABLE 6
Earnings Response Coefficient Tests

Panel A: Regressions of Current Size- Adjusted Returns on Current Pretax Earnings

Changes; Partitions Based on Discretionary Accruals and Number of Consecutive Ye
LPBTD Group (n = 2,980)
RETt = öo + ¿i A PTBlt + Ô2A PTBIt X EMt + ô3APTBIt X MULTIPLE, + вж .
Variables <50 <5i ô2 ô3 Adj. R2

Predicted sign ? + - +
Estimate -0.014 0.782 -0.280 0.579 0.046
t-statistic -0.47 5.63*** -2.63** 2.23**
Panel B: OLS Regressions of Current Si

Components Changes; Partitions Based
Consecutive Years in LPBTD Group (n =
RETt = öo + ¿i A PTCFt + <S2 A PTACCt
+ ¿5 A PTCFt X MULTIPLE t + ô6APT
Variables <50 <5i ô2 ^3 ^4 à5 <56 Adj. R2

Predicted sign ? + + ?-? +
Estimate -0.014 0.856 0.671 -0.246 -0.187 0.505 0.719 0.048
t-statistic -0.47 5.30*** 4.83*** 1.66* -1.51* 1.84* 2.13**
* **5 *** indicates significance at the 10 percent, 5 percent, and 1 perc

For the above test we restrict the sample to firms with greater than $10 m
all firm-year observations in the top or bottom 1 percent of earnings, c
Partitioning Approach 2: BASEt are firms in the LPBTD group in year t
year t-' and are not part of the EM subsample. EM, = indicator variable
modified Jones Model discretionary accruals in the top quintile of all fir
variable equal to 1 for firm-year observations within the LPBTD group i
prior year t- 1 and that are not part of the EM subsample.
t-tests are one-sided if a directional prediction is made, two-sided other
RET, = size-adjusted buy and hold returns for the 12-month period beginning in the fourth month after the fiscal year-end
of year t- 1 and ending in the third month following the year-end of fiscal year t;
PTBI, = pretax book income for the current year divided by beginning of the year price;
PTC F , = pretax cash from operations for the current year calculated as Compustat items 308 + 317 - 124 divided by
beginning of the year price; and
PTACC, = pretax accruals for the current year calculated as PTBI - PTCF divided by beginning of the year price.
returns and ranked accruals and other control variables using the following equation:
SARt+l =ß0 + ßxPTACCt + ß2MVEt + ß3BMt + ß4BETAt + ß5EPt + ß6SARt + еж . (12)
Each of the independent variables in Equation (12) is converted to a rank variable scaled from
0 to 1. Specifically, we sort each variable into deciles by year, and then transform the decile rank (1
to 10) to be between 0 and 1 by ((Decile rank - l)/9). The estimated coefficient on each
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TABLE 7

SARt+l = ß0 + ßxPTACCt + ß2MVE, -h ß3BMt + ß4BETAt + ß5EPt + ß6SARt + et+x.
Panel A: Hedge Portfolio Returns Large Positive Book Tax Difference Group (n =
Variables ßa /?i ß2 ßi ßs ße
Predicted sign ? - - + + + ?
Estimate 0.035 -0.079 -0.045 0.000 0.080 -0.008 -0.008
t-statistic 0.43 -1.46* -0.7 0.00 0.77 -0.13 -0.12
Years +/- 8/5 4/9 6/7 6/7 7/6 6/7 7/6
Panel B: Hedge Portfolio Returns BAS

Variables ß0 ßx ß2 ß3 ß4 ß5 ß6
Estimate 0.007 -0.043 -0.011 -0.026 0.035 0.058 -0.032
t-statistic 0.10 -0.64 -0.16 -0.56 0.39 0.75 -0.34
Years +/- 5/8 6/7 6/7 9/4 8/5 5/8 8/5
Panel C: Hedge Portfolio Returns EM

Variables ß0 ßt ß2 ß3 ß4 ßs ß(,
Predicted sign ?- - + + + ?
Estimate -0.221 0.040 0.051 0.196 0.179 -0.077 -0.057
t-statistic -1.34 0.27 0.79 1.94** 1.77** -0.89 -0.68
Years +/- 4/9 5/8 6/7 8/5 10/3 7/6 6/7
Panel D: Hedge Portfolio Returns TAX

Variables ß0 ßx ß2 ß3 ß 4 ßs ße
Predicted Sign? + - + + + ?
Estimate 0.077 -0.027 -0.110 -0.119 0.099 0.019 0.043
t-statistic 0.77 -0.34 -1.09 -1.52 1.45* 0.27 0.80
Years +/- 7/6 8/5 7/6 4/9 9/4 6/7 7/6
*, ** Indicates significance at the 10 percent and

All variables except SARt+l are decile ranks with
value of 1.
Partitioning Approach 1 : We place observations in the EM subsample if the firm-year discretionary accrual is in the top
quintile of discretionary accruals of all firm-years in the sample (pooled). We place observations in the tax avoider
subsample if the firm-year Cash5ETR is in the bottom quintile of Cash5ETR for all firm-years in the sample (pooled) and
the firm-year is not part of the EM subsample.
MVEt = shares outstanding times price at the end of the current fiscal year;
BMt = book value of equity at the end of the current fiscal year divided by MVEt'
BETA, = calculated using daily returns over the 24-month period ending at the start of the current fiscal year;
EPt = calculated as earnings per share in the current fiscal year divided by price at the end of the current fiscal year;
SAR, = 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; and
SARH i = 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.
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transformed variable can be interpreted as the hedge portfolio return to positions taken on that
variable. PTACCt is pretax 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. We include these variables as controls because Fama
and French (1992) argue that these variables represent unknown risk factors and, consequently, are
associated with future expected returns. The coefficient, /Jb 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 firm-years 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.20
In Equation (12), ß' will equal 0 if investors correctly infer the persistence of accruals, ß' < 0 (>
0) if investors overestimate (underestimate) the persistence of accruals. In fact, ß{ is an estimate of the
difference in the actual time-series persistence of accruals and the market's implied persistence.21
For our hedge portfolio tests, we estimate Equation (12) for all firms in the LPBTD group and
separately for the three subsamples in each partitioning approach, which results in the panels in
Tables 7 and 8. We begin by estimating Equation (12) for all firms with LPBTDs. Hanlon (2005)
finds that investors correctly price the persistence of accruals for firms with LPBTDs. Panel A of
Tables 7 and 8 present the result of estimating Equation (12) on the full sample of LPBTD firms.
The results show that ß' = -0.079 (a hedge return of -7.9 percent) 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.22 Furthermore, the coefficient on ßi is negative in nine of
the three years that we estimate the hedge portfolio regression. Overall, the results in Panel A in
Tables 7 and 8 provide some weak evidence that investors overestimate accruals persistence for the
LPBTD group during our sample period.
Panels B-D of Table 7 present the results of estimating Equation (12) on the subsamples
formed using partitioning approach 1. Panel В presents the hedge returns for the BASE subsample.
The returns are not significant at conventional levels. Panel С presents the hedge returns for the
subsample of firm-years designated as EM. If, consistent with H5a, investors overweight the
persistence of accruals, then we expect ß' to be significantly negative. The results in Panel С for the
EM subsample indicate that ß' is actually positive but is not significantly different from zero. If,
consistent with H5b, investors underweight the persistence of accruals for firm-years designated as
TAXAVOIDERs , then we expect ßx to be significantly positive. The results for TAXAVOIDERs in
Panel D indicate that ßi is actually negative but is not significantly different from zero.
20 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. Note that
subsamples are formed on pooled samples, so these tests are not strictly a test of market efficiency because we are
using data not available to investors in real time to form our groups. We note that the foresight bias (if any)
would favor finding significant hedge returns. Further, if the cutoffs used to form portfolios are relatively
stationary through time, then one would end up with sample compositions similar to those that one would obtain
using the pooled results. We have no reason to believe the cutoffs changed through time. We use the pooled
approach because we are more interested in understanding whether mispricing exists ex post than we are in
creating a trading strategy.
21 See Ball and Bartov (1996) and Kraft et al. (2007) for an illustration of this result.
22 Hanlon (2005) documents a coefficient of -0.041 and a t-statistic of - 1.61 on PTACC in her regression examining the
relation between abnormal stock returns and scaled deciles of accruals for LPBTD firms. Hanlon (2005) uses a two-tailed
test of significance. We report a t-statistic of - 1.46 on PTACC and, because we predict a sign on PTACC , we use a one-
tailed test of significance. We view our results as being consistent with those of Hanlon (2005).
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1 16 В lay lock, Shevlin, and Wilson
Panels B-D of Table 8 present the results

formed using partitioning approach 2. The
is negative and marginally significant. The
positive (expected negative) but not sign
subsample are positive, as expected, but not
Under both partitioning approaches, the
subsample are consistent with investors
earnings management and correctly pricing
results are consistent with those of Hanlon
that the mispricing documented by Sloan (
accruals. Thus, our finding that firms wit
lower earnings and accruals persistence is si
market participants appear to price accruals
(2001), at least for our LPBTD subsample.23
LPBTDs as a signal about the quality of acc
Under both partitioning approaches, t
TAX A VOIDER and MULTIPLE subsamples
LPBTDs generated by tax avoidance or othe
and correctly pricing the persistence of acc
investors are able to identify large posi
predominantly through tax avoidance and e
the persistence of accruals accordingly.24
persistence of cash flows and accruals with
Consequently, an alternative explanation fo
Sloan (1996), we might not expect mispricin
market is applying the same correct multip
It is reasonable to ask how it is that investors are too naïve to understand accruals but are
sophisticated enough not only to understand book-tax differences, but also to understand the sou
of the book-tax difference. Our results certainly suggest a higher level of investor sophisticatio
than the results in Sloan (1996). Given that most of our sample is dated after Sloan (1996) was
published, the most likely explanation for the apparently contradictory evidence on investor
sophistication is that investors paid more attention to accounting-based signals over our samp
period. Related to this point, Green et al. (2011) argue and find that the accrual anomaly
decayed in the 2000s, in part because activity by hedge funds has increased (likely exploiting
anomaly). Because our sample period covers 1993-2005, some of our years overlap with the per
in which Green et al. (201 1) display diminished hedge portfolio returns to the accrual strategy. W
find that in the LPBTD group overall, three out of the four positive returns to accruals (i.e., lon
23 In untabulated tests we examine hedge returns to the accrual strategy in the SBTD subsample. We find that t
accrual anomaly still exists in our sample period in the SBTD firms. We find a hedge return of -7.6 percent w
at statistic of -3.60. The hedge return to accruals is negative in every year except 2004. These results are
consistent with the proposition that LPBTDs do help investors identify differential accrual persistence, which
helps hedge funds arbitrage the anomaly.
24 The lack of significant hedge portfolio returns for 5 of the 6 subsamples of LPBTD firms examined in Tables
and 8 could be a result of low power in our market-based tests. From the standard errors, we can infer the leve
abnormal returns necessary to produce a significant result in any of the subsamples. For example, in Panel B,
order for ßi to be significant at the (p < 0.05) level, we would have to observe an 1 1.9 percent return to accrual
However, the fact that the coefficient on ß' is the opposite of the predicted direction in three of the si
subsamples, combined with the fact that the sign on the coefficient is not consistent across years in many of t
subsamples, suggests that investors are not consistently mispricing accruals in a manner consistent with o
hypotheses.

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TABLE 8

SARt+ 1 = ß0 + ß{PTACCt + ß2MVEt + ß3BMt + ß4BETAt + ß5EPt + ß6SARt + e,+ 1
Panel A: Hedge Portfolio Returns Large Positive Book Tax Difference Group (n
Variables ß0 ßl ß2 ß3 ß4 ß5 ß6
Predicted Sign? - - + + + ?
Estimate 0.035 -0.079 -0.045 0.000 0.080 -0.008 -0.008
t-statistic 0.43 -1.46* -0.7 0.00 0.77 -0.13 -0.12
Years +/- 8/5 4/9 6/7 6/7 7/6 6/7 7/6
Panel B: Hedge Portfolio Returns BAS

Variables ß0 ßx ß2 ß3 ß4 ßs ße
Predicted sign ? - - + + +?
Estimate -0.018 -0.075 0.012 -0.006 0.086 0.044 -0.014
t-statistic -0.35 -1.49* 0.16 -0.09 1.23 0.70 -0.20
Years +/- 4/8 3/9 6/6 7/5 8/4 6/6 5/7
Panel C: Hedge Portfolio Returns EM Subsample in LPBTD Group (n = 987)

Variables ß0 ßx ß2 fe ß4 ßs ße
Estimate 0.015 0.023 -0.056 -0.024 -0.026 0.071 -0.022
t-statistic 0.12 0.21 -0.48 -0.25 0.24 0.65 -0.19
Years +/- 7/5 8/4 6/6 5/7 4/8 5/7 9/3
Panel D: Hedge Portfolio Returns MU

Variables ß0 ßx ß2 fe ß 4 ßs ße
Predicted sign ?+ - + + + ?
Estimate -0.234 0.030 0.057 0.205 0.196 -0.076 -0.042
t-statistic -1.27 0.19 0.90 1.80** 1.73* -0.72 -0.51
Years +/- 3/9 5/7 6/6 7/5 8/4 7/5 6/6
*, ** Indicates significance at the 10 percent and

All variables except SARt+' are decile ranks with
value of 1.
Partitioning Approach 2: We place observations in the BASE subsample if the firm is in the LPBTD group in year t, the
firm was not in the LPBTD group in the prior year t- 1 , and the firm is not in the EM subsample. We place observations
in the EM subsample if the firm-year discretionary accrual is in the top quintile of discretionary accruals of all firm-years
in the sample (pooled). We place observations in the MULTIPLE subsample if the firm is within the LPBTD group in
year t, the firm was in the LPBTD group in the prior year t- 1, and the firm-year is not in the EM subsample.
MVE, = shares outstanding times price at the end of the current fiscal year;
BMt = book value of equity at the end of the current fiscal year divided by MVEt'
BETAt = calculated using daily returns over the 24-month period ending at the start of the current fiscal year;
EP, = calculated as earnings per share in the current fiscal year divided by price at the end of the current fiscal year;
SARt = 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; and
SARt+i = 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.
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high accruals, short low accruals when t

investors overestimate the persistence o
examined in Panel С of Tables 7 and 8, th
2001. These results are generally consisten
Green et al. (201 1). However, we find tha
with actual earnings and accruals persiste
consistent with investors using the info
earnings and accruals persistence.
VI. CONCLUSION
This study extends Hanlon (2005) to provide further evidence on the role of book-tax
in identifying differences in the persistence of earnings and accruals. We first docu
information in temporary book-tax differences about earnings and accruals persistence i
to the magnitude of accruals (i.e., larger accruals are less persistent). We next provide
methods for partitioning large positive book-tax differences to provide additional
information about future earnings and accruals persistence. We find that, in cases where
book-tax temporary differences arise predominantly as a result of earnings management
accruals persistence is significantly lower than in cases where either tax avoidance o
firm characteristics are the primary source of large positive book-tax differences.
We examine whether investors appear to use book-tax differences to help i
persistence of earnings and accruals. We find in regressions of current-period retur
and accruals that the response coefficient varies for the subsamples, consistent with t
variation in earnings and accruals persistence. Furthermore, we find insignificant he
returns for tax avoidance and earnings management subsamples under both partitioni
These findings are consistent with investors using book-tax differences to incorpora
persistence in the current pricing of earnings and accruals, such that there are no su
returns in period H-l.
While this study provides useful insight into how large positive BTDs can be part
subgroups to obtain additional incremental information about earnings and accrual
many questions remain about BTDs as a signal of earnings quality. For example, it re
which specific book-tax differences are useful signals of earnings persistence. Rece
Raedy et al. (2010) and Guenther (2011) investigate this question by examining indi
within firms' tax footnotes. Raedy et al. (2010) hand-collect tax footnote data from th
firms from 1993 to 2007 and examine whether these disclosure data provide investor
incremental information. When they include the individual components of BTDs (bot
and permanent) in addition to total BTDs, as linear additive terms in a regression on c
returns, few individual components exhibit significant regression coefficients. Th
book-tax differences do not appear to provide incremental information content. T
somewhat surprising in light of our results; however, our research design is based o
that large temporary differences tell us something about the underlying persistence o
accruals. Guenther (201 1) examines 1 13 influential observations in the observed link
BTDs and earnings persistence. He finds that these 1 13 firms are younger and small
higher levels of pretax ROA, and have larger transitory items.25 Studies such as these
25 Guenther (201 1) discusses why his analysis of these 1 13 observations does not invalidate Hanlon
thus ours by extension). He concludes that the "results of this study do not suggest that Hanlon'
driven by a trivially small number of extreme observations, and can therefore be disregarded" (H
^Hl Accounting The Accounting Review

V january 2012
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Tax Avoidance, Large Positive Temporary Book-Tax Differences , and Earnings Persistence 1 19
the details of firms' tax footnotes have the potential to make an important contribution to our
understanding of the link between large BTDs and earnings persistence.
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T5 Accounting The Accounting Review

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Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings

Stable URL: https://www.jstor.org/stable/41408062

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Tax Avoidance, Large Positive Temporary

ABSTRACT: We investigate why temporary book-tax differences appear to serve as a

Keywords: book-tax differences; earnings persistence; tax avoidance ; earnings

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О Accounting The Accounting Review

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The Accounting Review O ÂSSlnung

documented variation in earnings and a

II. RELATED LITERATURE AND HYPOTHESES

Hanlon (2005) examines the implications of large book-tax differences fo

Hla: Temporary book-tax differences provide incremental information over th

Hlb: Temporary book-tax differences provide incremental information over th

Assuming book-tax differences have incremental explanatory power, we next ex

XQ Accounting The Accounting Review

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The Accounting Review ^ íSõínttae

Ayers et al. (2010) examine the associ

H3a: For firm-years with large posit

H3b: For firm-years with large positi

In summary, our hypotheses imply a ra

Our next set of hypotheses examine w

8 Seidman (2010) finds that a small subset of

Accounting The Accounting Review

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III. SAMPLE SELECTION

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current tax expense can obfuscate the

IV. TESTS OF EARNINGS PERSISTENCE

The Basic Persistence Regression Model

PTBIt+ 1 =}'() + yxPTBIt + £t+' i (1)

PTBIt+] = y0 + yxLPBTDt + y2LNBTDt + y3PTBIt

PTBIt+ 1 = }'() + yxPTCFt -f y2PTACCt + 8t+ 1, (3)

Accounting The Accounting Review

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Descriptive Statistics for Selected Variables

Panel A: Small Positive Book-Tax Difference Group (n = 12,585)

BTDt 0.004 0.002 0.010 -0.016 0.037

Panel B: Large Negative Book-Tax Differ

BTDt -0.039 -0.028 0.037 -0.763 -0.005

Panel C: Large Positive Book-Tax Differe

BTD, 0.059 0.045 0.049 0.021 0.742

PTBI,+U PTBI„ PTCF,, and PTACC, are winsorized at t

The Accounting Review NQ iSnZg

PTBIt+] = 70 + yxLPBTDt + y2LNBTDt + y3PTCFt + y4PTACCt + y5PTCFt X LPBTDt

PTBIt+' = y0 + yxLPBTDt + y2LNBTDt + y3ABSACCt + y4PTBIt + y5PTBIt X LPBTD ,

PTBIt+{ = 7o + yxLPBTDt + y2LNBTDt + y3ABSACCt + y4PTCFt + y5PTACCt

Accounting The Accounting Review

PTBIt+i = 70 + yxEMt + y2TAXAVOIDERt + y3PTBIt

PTBIt+x = 7o + yxEMt + у 2 TAXA V О I DER t + y3PTCFt + y4PTCFt X EMt + y5PTCFt

X TAXAVOIDERf + y6PTACCt + y^TACCt X EMt + y^PTACCt

H2b predicts that y7 will be negative and H3

12 Partitioning large book-tax difference firms into sub

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Accounting The Accounting Review

First Partitioning Approach of LPBTD Firms

The Accounting Review A«S¡nt"n9

exclude the 349 firm-years classified

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Panel A: Proportions of Groups Classified as EM and TAXAVOIDER

n 12,585 4,263 4,195

A Chi-squared test rejects the equivalence of t

, , Indicates significance at th

, , Indicates significance at th

* * indicates significance at the 10 percent, 5 percent, and 1 percen

* 5 * indicates significance at the 10 percent, 5 percent, and 1 perc