Hanlon (2010)

The Persistence and Pricing of Earnings, Accruals, and Cash Flows When Firms Have Large
Book-Tax Differences
Author(s): Michelle Hanlon
Source: The Accounting Review, Vol. 80, No. 1 (Jan., 2005), pp. 137-166
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol.80, No. 1
2005
pp. 137-166
The Persistence and Pricing of Earnings,

Accruals, and Cash Flows When Firms
Have Large Book-Tax Differences
Michelle Hanlon
University of Michigan
ABSTRACT:I investigate the role of book-tax differences in indicatingthe persistence
of earnings, accruals, and cash flows for one-period-ahead earnings. I also examine
whether the level of book-tax differences influences investors' assessments of future
earnings persistence. I find that firm-yearswith large book-tax differences have earn-
ings that are less persistent than firm-yearswith small book-tax differences. Further,
the evidence is consistent with investorsinterpretinglargepositive book-taxdifferences
(book income greater than taxable income) as a "redflag" and reducingtheir expec-
tation of future earnings persistence for these firm-years.I then investigate potential
sources of the lower persistence for firm-yearswith large book-tax differences. I find
that special items contributein partto the results but that firm-yearswith large book-
tax differences continue to have lower persistence in earnings aftercontrollingfor the
effect of the special items.
Keywords: book-taxdifferences;earningspersistence; accruals;earningsexpectations.
I. INTRODUCTION
investigatethe role of book-tax differencesin indicatingthe persistenceof earnings,
I accruals, and cash flows for one-period-aheadearnings. I also examine whether the
level of book-tax differencesinfluences investors'assessmentsof futureearningsper-
sistence. Financialaccountingtexts claim that the differencebetween pre-taxfinancialre-
porting earnings and taxable income (i.e., book-tax differences)can provide information
aboutcurrentearnings.The underlyingmaintainedhypothesisis thatbecauseless discretion
is allowed in the computationof taxable income, book-tax differencescan be informative
I appreciatethe helpfulcommentsandsuggestionsfrommy dissertationcommittee-Bob Bowen,DaveBurgstahler,

JenniferKoski,ShivaRajgopal,andTerryShevlin(Chair)-as well as those from HelenAdams,MichaelBamber,
MaryBarth,Bill Beaver,WaltBlacconiere,MaryMargaretFrank,RichardFrankel,FrankHodge,JimJiambalvo,
KathrynKadous,Dawn Matsumoto,MaureenMcNichols,JamesMyers,MarkPeecher,MortPincus,JamiePratt,
D. Shores,Jim Wahlen,and two anonymousreferees.The paperalso benefitedfrom the commentsof workshop
participantsat IndianaUniversity,MassachusettsInstituteof Technology,StanfordUniversity,the Universityof
Chicago,the Universityof Georgia,the Universityof Illinois at Urbana-Champaign, The Universityof Iowa, the
Universityof Michigan,the Universityof Pennsylvania,the Universityof Rochester,the Universityof Washington,
and WashingtonUniversityin St. Louis. I am gratefulfor fundingfromthe AmericanInstituteof CertifiedPublic
Accountants,the Deloitte & ToucheFoundation,and an Ernst& YoungFacultyFellowship.This paperwon the
2003 ATA/PricewaterhouseCoopers Best Tax DissertationAwardand the 2003 AAA FinancialAccountingand
ReportingSectionBest DissertationAward.
Editor'snote: This paperwas acceptedby MaureenMcNichols,SpecialEditor.
Submitted January 2003
Accepted March 2004
137

138 Hanlon
about managementdiscretionin the accrualsprocess. For example, Revsine et al. (1999,

638) suggest the ratio of pre-taxbook income to taxableincome can be used as a measure
of accountingconservatismor aggressiveness.Palepuet al. (2000, 3-11) point out that an
increasinggap between a firm'sreportedincome and its taxableincome is a potential"red
flag."Penman(2001, 612) includesthe differencebetweenbook income andtaxableincome
as a diagnostic to detect manipulationof core expenses. He states "if a firm is using
estimatesto generatehigher GAAP income, it must recognize more deferredtaxes."1
In the wake of recent accounting scandals, some are wondering whether the large
differencesbetweenbook and taxableincomes shouldhave been an indicatorof low-quality
financialreportingearnings.For example, Seida (2003) in his analysis of Enron'stax dis-
closures calculatesthat Enron'staxableincome over the years 1996-1999 was $5.8 billion
below financialreportingincome. He asks whethertaxable income is a useful alternative
measureof income, or at least a benchmarkto evaluatebook income. Whetherbook-tax
differencesprovideinformationabout the qualityof earningshas attractedthe attentionof
policy makersas well.2 For example, SenatorCharlesGrassleywrote a letter to President
Bush on October7, 2002 calling for additionaldisclosureof book-tax differencesbecause
"the minimal disclosureis a breedinggroundfor the manipulationof financialstatements
and abusivetax shelterschemes."Further,RepresentativeLloyd Doggett has stated, "When
investorshear only of rosy earningswhile at tax time Uncle Sam only hears of regretsand
red ink, somethingis very wrong. A corporatecultureof creativeaccountingand reporting
abuses weakens our economy" (Weisman2002, A01). The press has also takennote of the
potential association of book-tax differences with earningsquality. For example, a CFO
Magazine article claims that the recent scandals have shifted the focus of the book-tax
reconciliationdiscussionfrom rootingout tax sheltersto rootingout financialfraud(Reason
2002).
Recent academicliteratureinvestigatesbook-taxdifferencesas an indicatorof earnings
management.Mills and Newberry(2001) reportevidence consistentwith the magnitudeof
book-taxdifferencesbeing positively associatedwith financialreportingincentives such as
priorearningspatterns,financialdistress,andbonus thresholds.Phillipset al. (2003) extend
this researchand reportthat firm-yearswith small earningsincreaseshave a largeraverage
deferredtax expense (indicativeof book income in excess of taxable income) than firm-
years with small earningsdecreases and conclude that the deferredtax expense is infor-
mative about firms' earnings managementactivities. Joos et al. (2000) report that the
earnings-returnrelationis weaker when book-tax differences(in absolutevalue) are large
and interpretthis as evidence that firms with large book-tax differenceshave opportunist-
ically managedearningsand investorsrecognize these actions and attacha lower weight to
earnings.Finally,in concurrentresearch,Lev andNissim (2004) findthatthe ratioof taxable
income to book income predicts subsequent five-year earnings growth and is strongly
(weakly) related to futurereturnsin the pre- (post-) 1993 sample period (i.e., before and
after the implementationof the Statementof Financial Accounting StandardsNo. 109,
Accountingfor Income Taxes)(SFAS No. 109, FASB 1992).
My examinationcontributesto two lines of research.First, I extend the literaturethat
examines the informationin book-tax differences. Though recent research reports that
1 These statementsdo not imply that taxableincome is

a bettermeasureof economicperformanceof the firm
thanis financialreportingincome.Rather,the statementssuggestthatin contextswherethe divergencebetween
tax and financialreportingincome is large, earningsmanagementis more likely and additionalscrutinyis
warranted.
2 I discuss the link betweenqualityof earningsand earningspersistencebelow.
TheAccountingReview,January2005

The Persistenceand Pricing of Earnings,Accruals,and Cash Flows 139
earnings managementincentives and lower earnings response coefficients are associated

with book-tax differences,there is no direct evidence that large book-tax differencesare
indicativeof earningsthat are less persistent.I also examine whetherlarge book-tax dif-
ferencesare associatedwith less persistentaccrualsor cash flows. Prioraccountingresearch
reports evidence consistent with accrual earnings being more relevant in reflecting firm
performanceas comparedto cash flows (Dechow 1994; Dechow et al. 1998). However,
researchalso reportsevidence consistentwith the accrualcomponentof earningsbeing less
persistentfor futureearningsthan the cash flow component(Sloan 1996). Because discre-
tionary accrualsare less persistentthan nondiscretionaryaccruals(Xie 2001), if book-tax
differencesindicate discretionin the accrualsprocess, firm-yearswith large book-tax dif-
ferences will have less persistentaccrualsthan firm-yearswith small book-taxdifferences.
Second, I contributeto the literaturethat investigates investors' assessments of the
persistence of earnings (e.g., Sloan 1996; Xie 2001; Barth and Hutton 2004). I examine
whetherlarge book-tax differencesinfluence investors'expectationsabout the persistence
of earningsand its components.Prior studies such as Joos et al. (2000) and Chaney and
Jeter (1994) reportthat returnsare less associatedwith earningswhen the firm'sbook-tax
differencesare large or highly variable.3These tests implicitly assume that earningsare of
lower quality when book-tax differences are large and that the marketprices the shares
accordingly.I extend this analysis and more directlytest this link by investigatingwhether
the market'sassessmentof earningspersistencefor firm-yearswith large book-tax differ-
ences is consistentwith the observedpersistencein earnings.
My results indicate that for firm-yearswith large positive book-tax differences (i.e.,
book income in excess of taxable income), pre-tax financial reportingincome and the
accrualscomponentof earningsare less persistentfor one-year-aheadearningsas compared
to firm-yearswith small book-taxdifferences.4In addition,the cash flow componentis also
less persistentfor these firm-years,suggestingthatbook-taxdifferencescontaininformation
about the underlyingcash flow stream as well as accruals."These results are consistent
with the conjecturethat large book-taxdifferencesare associatedwith lower earningsper-
sistence. When I investigate investor expectationsof future earnings for firm-yearswith
large positive book-tax differences,the evidence suggests that investorsreduce the expec-
tation of the persistenceof earningsresultingin the accrualscomponentof earningsbeing
priced in a mannerconsistent with its lower persistence.However, investors reduce the
expectationof the persistenceof cash flows in excess of thatrequired,thus underestimating
the persistenceof total earningsfor these firm-years.
For firm-yearswith large negative book-tax differences (i.e., book income less than
taxableincome), againI find evidence consistentwith the accrualandcash flow components
of earnings being less persistentfor one-year-aheadearnings relative to firm-yearswith
small book-taxdifferences.Thus, while most claims regardingthe informationin book-tax
differencesfocus on firms that have book income in excess of taxable income, my results
indicate that book-tax differences where book income is less than taxable income also
provideinformationaboutthe persistenceof earnings.When I investigateinvestors'expec-
tations of persistence for these firm-years, I find evidence consistent with prior research;
the persistence of accruals is overestimated. Thus, large differences between book and
3 Chaneyand Jeter's(1994) studyis pre-SFASNo. 109 when only deferredtax liabilities(not deferredtax assets)
were requiredto be recorded.
4 In my sample,the scaled deferredtax expense and scaled total accrualsare not highly correlated(correlation
of -0.008); thus, the deferredtax expense does not simply equal accrualsbut rathera subsetof total accruals.
5 I discuss the possible implicationsof the cash flow resultsbelow.

140 Hanlon
taxable incomes for these firm-yearsdo not appearto aid investorsin estimatingaccruals
persistence.
I performseveral additionalanalyses. First, I investigatethe effect of special items on
my results. I assume that all special items create a book-tax difference and remove the
special items from my measuresof book-taxdifferences,earnings,and accruals.I find that
while the resultsare somewhatweaker,firm-yearswith largebook-taxdifferencesstill have
significantlylower persistencein both accrualsand cash flows.
Second, I investigatewhetherthe book-taxdifferenceshave lower persistencefor one-
year-aheadearningsthan accrualsexcluding the book-taxdifferences.Specifically,I parti-
tion total pre-taxaccrualsinto the book-taxdifferences(a proxy for discretionaryaccruals)
and the remainingportionof accruals(a proxy for nondiscretionaryaccruals)and include
both of these separatelyin the regression of future earnings on currentcash flows and
accruals.I find that the book-taxdifferencesare less persistentfor futureearningsthan are
accrualsexcludingthe book-taxdifferences.Thus,using the book-taxdifferencesas a proxy
for discretionaryaccruals,as in Phillips et al. (2003), I find that the discretionaryaccruals
have lower persistencethan nondiscretionaryaccruals,consistentwith Xie (2001).
The rest of the paperproceedsas follows. The next section providesinstitutionaldetail
about book-tax differences. The third section contains common argumentsboth for and
against the book-tax differencescontaininginformationabout earningspersistence and a
statementof my hypotheses.The fourthsection providesa descriptionof the sample selec-
tion and data used for the tests, and the fifth explains the empiricalmethods used. The
sixth section describes the results and discusses sensitivity tests and additionalanalyses,
and the final section concludes.
II. BOOK-TAX DIFFERENCES

Management calculates corporateincome for two purposeseach year. The first is for
financialreportingpurposesunderGenerallyAccepted AccountingPrinciples(GAAP) and
the second is done in accordancewith the InternalRevenue Code (IRC) to determinethe
corporation'stax liabilities.IRC Section 446(a) states, "Taxableincome shall be computed
underthe methodof accountingon the basis of which the taxpayerregularlycomputeshis
income in keeping his books." Thus, for most corporations,taxable income is computed
on the accrualbasis ratherthan the cash method.6
Despite both book and taxable income being preparedon an accrualbasis, differences
between book and taxable incomes can be large. Some differences,known as permanent
differences,are items includedin one measureof income but never includedin the other.7
I do not incorporatepermanentdifferencesinto my primaryanalysis for several reasons.
First, permanentdifferences are extremely difficult to measure. For example, permanent
book-tax differencesare generallyinferredfrom the currenttax expense and the effective
tax rate (total tax expense divided by pre-taxfinancialaccountingearnings).However,tax
rate differences (for foreign-sourcedearnings or state income taxes) and tax credits are
mixed with permanentdifferences in the calculationof the effective tax rate and current
6 In fact, some prior studies rely on the consistencies in tax and book accruals to formulate empirical tests. For
examples, see Guenther (1994), Manzon (1992), Maydew (1997), and Guenther et al. (1997). An exception to
the requirement of accrual tax accounting is in IRC Section 448, which provides that a corporation with average
annual gross receipts of $5 million or less for its three most recent taxable years may use the cash method for
tax purposes.
7 Technically, the term "permanent difference" is not used in SFAS No. 109. The concept of permanent differences
under SFAS No. 109 is limited to events recognized in the financial statements that do not have tax consequences,
such as tax-exempt interest. This type of permanent difference continues to impact the calculation of current
tax expense under SFAS No. 109 (KPMG 1992).

income tax expense.8In addition, statutorytax breaks (e.g., tax-exemptinterest and the
dividendreceived deduction)are often includedin these calculationsand are not indicative
of earningsqualityrelatedto the accrualsprocess.9Thus, due to the difficultyin measuring
true permanentbook-tax differencesand the financialaccountingtextbook suggestions to
exclude the effects of permanentdifferences I do not examine the relation between per-
manentdifferencesand earningspersistence.
The remainingbook-taxdifferencesare temporarydifferencesand constitutethe focus
of this study.SFAS No. 109 uses a balancesheet approach.Temporarydifferencesbetween
book and taxable incomes each year are changes in the firm's book-basis balance sheet
relative to its tax-basisbalance sheet. Basis differencesarise because of differingrequire-
ments for the timing of recognition of income and expense items. For book purposes,
revenue is recognized when earnedand expense recognitionis either matchedagainstthe
related revenue or recorded in the accountingperiod in which the expense is incurred.
However, GAAP provides managers with considerablediscretion in their choice of ac-
counting procedures(Wattsand Zimmerman1986, 215). Managersmay choose between
differentaccountingmethods,use varyingperiodsand estimatesfor cost amortization(e.g.,
for depreciationand goodwill) and exercise judgment with respect to recordingreserve
allowances(e.g., bad debt allowances,warrantyreserves,accruedcompensation,etc.) (Mills
and Newberry2001).
For tax purposes,however,firmsmust "clearlyreflectincome."'oRevenueis generally
recordedwhen cash is received;thus, deferred(or unearned)revenue does not exist under
the IRC. In addition,for tax purposesconservatismis not an objective (for the Treasury)
and thus an item may not be deducteduntil more stringentconditionsare satisfied,reducing
the level of discretionin the calculationof taxable income."
Temporarybook-taxdifferencesinclude futuretaxable and futuredeductibleamounts.
Futuretaxableamountscreate or increasedeferredtax liabilitiesand requirerecognitionof
a deferredtax expense. In contrast,future deductibleamountscreate or increase deferred
tax assets and require the recognition of a deferred tax benefit (credit to deferred tax
expense). All else equal, an increase in deferredtax liabilities is consistent with a firm
currentlyrecognizing revenue and/or deferringexpense for book purposes relative to its
tax reporting(book income in excess of taxable income). All else equal, an increase in
deferredtax assets is consistentwith a firm currentlyrecognizingexpense and/or deferring
8 See Hanlon(2003) for a moredetaileddiscussionof problemsusing the ratereconciliationor effectivetax rate

to infertotal book-taxdifferencesor taxableincome.
9 Revsine et al. (1999, 638) also advocateexcludingthe effect of permanentdifferencesbecausethese are "un-
relatedto quality-of-earnings choices."Thereare notableexceptions,however,wherepermanentdifferencesare
indicativeof earningsquality.One such exampleis nondeductiblein-processresearchanddevelopment(IPRD)
in acquisitions.For financialreportingpurposesthis amountis often writtenoff immediately(perhapsto provide
for higherreportingof futureearnings);however,for tax purposes,the amountis not deductibleif no tax basis
exists. Thus, it generallyconstitutesa permanentdifferencethat is potentiallyindicativeof pre-taxearnings
persistencesince the write-offof the IPRD is presumablytransitoryin nature.Thereare otherpermanenttype
differencesthatmay be indicativeof earningsquality,but due to the measurementproblemsI discuss above,I
exclude these from my tests. However,I performa sensitivityanalysis using an estimateof total book-tax
differencesbelow. In addition,I note that despitethese concerns,Schmidt(2003) and Lev and Nissim (2004)
investigateinformationin totalbook-taxdifferencesusing the effectivetax rateandthe ratioof estimatedtaxable
income to book income,respectively.
1o IRC Section 446 (b).
" First,underthe "all events"test, all of the events that determinethe taxpayer'sliabilityfor the expensemust
have occurredand, second,the amountof the taxpayer'sliabilitymustbe determinedwith reasonableaccuracy.
Third,beforean item of expensemay be accruedfor tax purposes,"economicperformance" musthaveoccurred.
In the case of a liabilityof a taxpayerthatrequiresa paymentfor propertyor services,economicperformance
is deemedto occur as the propertyor servicesare providedto the taxpayer(Guenther1994).

142 Hanlon
revenue for book relativeto tax income (book income less than taxable income) (Phillips
et al. 2003).
III. HYPOTHESIS DEVELOPMENT

While the persistenceof earningsis likely not a completedefinitionof earningsquality,
it is often considereda qualitativecharacteristicof earnings.12 For example, FASB's Con-
cepts Statement No. 2, Qualitative Characteristics of Accounting Information, includes the
predictivevalue of earningsas a componentof relevance.Jonas and Blanchet (2000) spe-
cifically add earningspersistenceas a descriptorof the predictivevalue of earningsin their
proposed frameworkfor determiningearnings quality. Further,earnings persistence is a
value-relevantcharacteristicof earnings as made explicit in the Ohlson (1995) valuation
model (Barthand Hutton2004). Thus, becausepersistenceis a value-relevantcharacteristic
of earnings,any informationprovidedin the level of book-tax differencesabout the per-
sistence of earningsmay assist investorsin assessing firm value.
Argumentscan be madeboth for and againstbook-taxdifferencesreflectinginformation
about the persistenceof currentearnings.First, many textbooks claim that management's
income-increasingaccrual choices are evidenced by large differencesbetween book and
taxable incomes. For example, Revsine et al. (1999, 633) state that increases in deferred
tax liability balances (which reflect book income in excess of taxable income) "might be
an indicationof deterioratingearningsquality."Revsine et al. (1999, 634) also suggest that
shrinkagein deferredtax asset balances should be investigatedbecause the changes in the
related balance sheet accounts may be used as "a way to artificiallyincrease earnings."
Because the sum of a firm's income over all years must equal the sum of its cash flows,
managersmust eventuallyreverse any "excessive" earnings-increasing(or decreasing)ac-
crualsmade in the past (Jones 1991). As a result,if largebook-taxdifferencesare evidence
of income-increasingaccrual choices, the accruals for these firms should exhibit greater
futurereversals,on average,and thus a lower persistencein accrualsand earnings.
However, book-tax differencesdo not simply reflect discretionin financialreporting.
Financialaccountingaccrualsare intendedto overcome measurementproblemsover finite
intervals and provide a signal of managers'private informationabout firm performance
(Dechow 1994). In contrast, the objectives of the IRC are to provide a frameworkfor
efficient and equitable determinationof tax liabilities and the subsequentcollection of
revenue, and to provide incentives for firms to engage in particularactivities (Scholes et
al. 2002; Manzon and Plesko 2002). Thus, differencesbetween book and taxable incomes
may not be informativeaboutearningsmanagementor cross-sectionalvariationin earnings
persistence.
In addition,book-tax differencescan be generatedby tax-planningstrategies.An im-
plicit assumptionwhen using book-tax differencesto infer earningsquality is that there is
cross-sectionalvariationin the ability of firm managersto manipulatefinancialreporting
income, but that there is not cross-sectionalvariationin managers'ability to manipulate
taxable income. The recent debate surroundingcorporatetax shelterssuggests otherwise.13
12 Schipperand Vincent(2002, 2) state "Althoughthe phrase 'earningsquality'is widely used in the financial
press, in analystreports,in documentsissued by regulators,and in accountingresearch,there is neitheran
agreed-uponmeaningassignedto the phrasenor a generallyacceptedapproachto measuringearningsquality."
13 Corporatetax sheltersof the 1990s were very aggressivestrategiesthatconformedto the letterof the tax law
but not the intent.Some of the sheltershavebeen overturnedin the courtsandbroadlegislationhas beenenacted
in orderto eliminatetheiruse. For moreinformationon tax shelterssee Novackand Saunders(1998) andU.S.
Treasury(1999). However,not all firms engaged in these aggressivetransactions,indicatingcross-sectional
variationin tax aggressiveness.

Consistent with book-tax differences representingaggressive tax reporting,Mills (1998)

reportsthat the largerthe book-taxdifferencesthe greaterthe likelihood of IRS audit and
adjustment.Aggressivetax reportingdecreasestaxableincome relativeto financialreporting
income (assuming firms do not conform financialreportingto tax reporting)and, unless
done using strategiesthat createpermanentdifferences,is reflectedin a largerdeferredtax
expense, all else constant.14
Therefore,because thereare a varietyof sourcesof book-taxdifferences,whetherlarge
book-tax differencesare indicativeof lower persistencein (pre-tax)earningsis not clear.
In the accountingtexts the primaryfocus is on book-taxdifferenceswhere book income is
greaterthan taxableincome. However,recent studies (e.g., Joos et al. 2000) conjecturethat
firm-yearswith largebook-taxdifferencesin eitherdirectionare suspectedof havinglower-
qualityearnings.To allow for differencesacrosspositive and negativebook-taxdifferences,
I investigatethe implicationsof large book-tax differenceson the persistenceof earnings
by partitioningmy sample into three subsamples.The first is comprisedof firm-yearsin
the highest quintile of all firms, each year rankedby temporarybook-tax differences(the
calculationof which is describedbelow) scaled by averagetotal assets. I label this group
LPBTD (large positive book-tax differences-book income in excess of taxable income).
The second groupconsists of firm-yearsin the lowest quintileof all firms,each year ranked
by scaled temporarybook-taxdifferences.I label this groupLNBTD (large negativebook-
tax differences-book income less than taxable income). The final group consists of the
remaining firm-years-those with relatively small scaled book-tax differences-which I
label SmallBTD.Using three subsamplesallows tests of: (1) whetherboth large book-tax
difference groups have lower earningspersistencerelative to firm-yearswith small book-
tax differences,and (2) whetherthe persistenceof earningsis the same between the two
groups with large book-tax differences.My first hypothesisin the alternativeform is:
HI: Pre-tax earnings persistence for firm-yearswith large negative or large positive
book-tax differencesis lower than pre-taxearningspersistencefor firm-yearswith
small book-taxdifferences.
As discussed above, the initial maintainedhypothesis in accountingtexts and recent

researchassumes large book-taxdifferencesindicatelow-earningsqualitybecause of more
subjectivityin the accruals process for financial reportingpurposes as comparedto tax
reportingpurposes. If book-tax differences are indicative of subjectivityin the financial
reportingaccrualsprocess, firm-yearswith large book-taxdifferenceswill have an accruals
componentof earningsthat is less persistentthan firm-yearswith relativelysmall book-tax
differences.This leads to my second hypothesis,statedin alternativeform:
H2: The persistenceof the accrualscomponentof earningsfor futureearningsis lower

for firm-yearswith large negativeor large positive book-taxdifferencesrelativeto
firm-yearswith small book-taxdifferences.
My final hypothesis investigates whether stock prices reflect different investor expec-
tations about future earnings based on the level of book-tax differences. Sloan (1996)
14 In general,these differencescreatedby aggressivetax planningshouldnot be associatedwith lowerpersistence

in financial accruals
reporting theaccrualfortaxis notthesameas theaccrualforbook
because,by definition,
when a book-taxdifferenceis created.I note thoughthatthis cannotbe specificallytestedbecauseone cannot
separatethe differences caused by aggressive tax planning from those motivatedby aggressive earnings
recognition.

144 Hanlon
reportsevidence consistent with investors not incorporatingaccuratelythe persistenceof

accrualsinto their expectationsof earnings.Joos et al. (2000, 21) reportlower-earnings-
responsecoefficientsfor firm-yearswith largebook-taxdifferencesandconcludethat "large
differences between book and tax earnings suggest that managementhas used different
accruals to account for the same underlyingtransactions,introducingthe possibility that
management'sreportingdiscretionis being used opportunistically." The authorsinterpret
the lower earnings-returnrelationas evidence that investorsrecognize this possibility and
attach a lower weight to earnings. Because of these two findings, I investigate investor
expectationsof the persistence of the accrual and cash flow componentsof earnings as
reflectedin shareprices for firm-yearswith largebook-taxdifferencesto determinewhether
the informationin book-tax differencesaffects investors'assessmentsof accrualand cash
flow persistence. Though Sloan (1996) provides evidence consistent with investors not
correctlyunderstandingthe persistencein accrualsand cash flows, if investorsuse the level
of book-taxdifferencesas informationabout the persistenceof accrualsthen they may not
misprice accruals in firm-yearswith large book-tax differences. This leads to my third
hypothesis:
H3: The expectationof pre-tax earnings persistencereflected in stock prices for the
accrualcomponentof pre-taxearningsis consistentwith the observedpersistence
of accrualsfor firm-yearswith relativelylarge book-tax differences.
IV. SAMPLE SELECTION

I begin with a sample of firm-yearsfrom 1994-2000 in the intersectionof CRSP and
Compustatdatabases,thatare incorporatedin the U.S., are in industriesotherthanfinancial
services and utilities, and have nonmissingasset data (47,507 observations).'5I use 1994
as a startingpoint because the accountingfor income taxes changed significantlywith the
implementationof SFAS No. 109 effective in 1993, and thus using firm-yearsafter the
accountingchange provides consistent accountingover the sample period. To be included
in the final sample,the observationmust not have missing variablesused in the regressions
(22,242 observationsexcluded), a reportedpre-taxfinancialreportingloss (6,447 observa-
tions excluded), a negative currenttax expense (1,518 observationsexcluded), or a net
operatingloss identifiedon Compustat(3,194 observationsexcluded).The reasonfor these
screens is that tax losses can be carried forward and thus become deferred tax assets,
changes in which can obscurethe effects of "true"book-taxdifferencesin the deferredtax
expense account.16 My final sample consists of 14,106 firm-years(4,048 firms).I partition
this sample as describedabove into three subsamples:LPBTD (2,823 firm-yearsconsisting
15 I exclude observations with a foreign incorporation code because of different tax reporting in foreign countries.
I exclude financial services and utility industry firm-years because of different reporting requirements (tax and
book) and the lack of Compustat disclosure of the deferred tax accounts for financial institutions.
16
Assuming no deferred tax asset valuation allowance is placed on the net operating loss (NOL), the creation of
an NOL will reduce deferred tax expense. For example, suppose a firm generates an NOL with a temporary
difference, say depreciation. The tax effects of the depreciation book-tax difference will be a debit to the deferred
tax expense (credit to deferred tax liability) and the NOL will be recorded as a credit to the deferred tax expense
(debit to deferred tax asset), thus reflecting a lower (or possibly zero) deferred tax expense when there is a true
book-tax difference for depreciation. Though I cannot eliminate firms that have a valuation allowance established
against deferred tax assets, a change in which may also obscure the information in the deferred tax expense
account, eliminating firms with NOLs should mitigate the effect of the valuation allowance because the NOL
is a common deferred tax asset to which the valuation allowance is applied. I also eliminate firms with a negative
current tax expense as an additional screen to help mitigate the coding errors (Mills et al. 2003).

of 1,663 firms), LNBTD (2,823 firm-yearsconsisting of 1,751 firms), and small book-tax
differences(8,460 firm-yearsconsisting of 3,236 firms)."
V. RESEARCH DESIGN
Hypotheses 1 and 2: Earnings Persistence
I estimatethe persistenceof pre-taxearningsusing the following equation:
PTBI,+1 = y + y~PTBI, + v,+1 (1)
where PTBI is pre-taxbook income (Compustatdata item #170).18 As in Sloan (1996), I

scale all variablesby averagetotal assets to allow for cross-sectionalcomparability.To test
whetherfirm-yearswith large negative (positive) book-taxdifferenceshave lower earnings
persistence, I estimate Equation (2), which permits the coefficient on earnings to vary
dependingon the level of the book-taxdifferencesby introducingan indicatorvariablefor
each of the large book-taxdifferencesubsamples.
PTBIt+ = yo + y^LNBTDt + y2LPBTDt + y3PTBI, + Y4PTBI, * LNBTDt

+ ~yPTBI, * LPBTD, + (2)
e,+1
In Equation (2), LNBTD is an indicator variable equal to 1 for firm-yearswith scaled
temporarybook-taxdifferencesin the lowest quintileof firms in each year (large negative
book-taxdifferences),and 0 otherwise;LPBTDis an indicatorvariableequal to 1 for firm-
years with scaled temporarybook-tax differencesin the highest quintile each year (large
positive book-tax differences),and 0 otherwise.19All other variablesare as definedprevi-
ously. If firm-yearshaving large negative (positive) book-tax differenceshave lower earn-
ings persistencethan firm-yearswith small book-tax differences, then Y4 < 0 (y~ < 0),
consistentwith H1.
In orderto more directlytest the claims that book-taxdifferencesindicatelower earn-
ings persistencebecause of discretionin accruals,I partitionearningsinto pre-taxaccruals
and pre-taxcash flows and estimatethe following equationswhich are analogousto Equa-
tions (1) and (2):
17 Note the total numberof firmsin the subsamplesexceeds the numberof firmsin the total samplebecausefirms
move from being in one subsampleto anothersubsamplefrom year to year. For example,approximately76
percentof the firmsin the SmallBTDgroupare in eitheror both the LPBTD and LNBTD groupsin at least
one yearof the sampleperiod.Thus,the same firmsare not includedin the same subsamplein each yearwhich
controlsfor any time-seriesstationarycorrelatedomittedvariables.
18 I use pre-taxbook income because it is the differencebetweenpre-taxbook income and taxableincome that
constitutesbook-taxdifferences.In contrast,Sloan (1996) uses operatingincome afterdepreciation(item#178)
and Xie (2001) uses income before extraordinary items (item #18). For firm-yearswith a minorityinterest,I
calculatepre-taxbook income as data item #170 less minorityinterest(item #49) to obtainthe pre-taxbook
income on which the tax provisionis calculated.
19 To calculatethe deferredtax expense (benefit)I use the sum of federaland foreigndeferredtax expense (item
#269 and item #270, respectively)and wheremissing I use total deferredtaxes (item #50). I includeforeignas
well as U.S. deferredtaxes because pre-tax financialreportingincome includes income of foreign entities.
However,I exclude state-deferredtaxes since these are taxes on the same income as federaldeferredtaxes. I
grossup the deferred
tax expenseby the statutorytaxrateduringthe sampleperiod(35 percent)in orderto
convertthe numberintoan estimateof the firm'stemporary ratherthanthetaxeffectof
book-taxdifferences
thedifferences.

146 Hanlon
+ + + ,t+,
PTBI,h+ = y0 y1PTCF, y2PTACC, (3)
+ + *
PTBIt+i = _o + yILNBTDt y2LPBTDt + y3PTCF, 1y4PTCFt LNBTDt
+ * + y6PTACC, + *
y•PTCFt LPBTDt y7PTACCt LNBTDt
*
+ y8PTACCt LPBTD, + (4)
et+l
where PTACC,is pre-taxaccruals,PTCF, representspre-taxcash flows, and all other var-
iables are as defined above. I calculate the earningscomponentamountsas pre-taxto be
consistent with the dependent variable measure. I calculate pre-tax cash flows as total
operatingcash flow (item #308) less cash flow due to extraordinaryitems (item #124) plus
taxes paid in cash (item #317).20 I calculate pre-tax accrualsas pre-taxbook income less
pre-taxcash flows.21
In Equation(4), y6 reflects the persistenceof accrualsfor firm-yearswith small book-
tax differencesand ,7 (Y8) reflects the difference,if any, in the persistenceof accrualsfor
firm-yearswith large negative (positive) book-taxdifferences.If the large book-taxdiffer-
ences are associatedwith less persistentaccruals,then y7 < 0 and < 0, consistentwith
H2. The coefficient y3 reflects the persistence of cash flows. Based •8
on prior research I
expect ,6 Y3 (Sloan 1996).
< The coefficient y4 (Y5) reflects the difference,if any, in the
persistence of cash flows for firm-yearswith large negative(positive)book-taxdifferences.
While I have no predictionfor y4 or y5, these coefficientsmay be significantif firm-years
with large book-taxdifferenceshave more (or less) transitorycash flow components.
Hypothesis 3: Tests of Market Pricing

To address H3, I investigate the expectationsof future earnings embedded in stock
prices using the Mishkin(1983) methodologyemployedby Sloan (1996), Barthand Hutton
(2004), Bradshawet al. (2001), Xie (2001), Burgstahleret al. (2002), and others. Specifi-
cally, I jointly estimatethe following systems of equations,for each subsample.
Marketrationalitywith respect to total earnings:
PTBIt+1 = o + yPTBI, + v,,, (1)
+ - - +
SAR,, = P31(PTBIt+, yo y•PTBI) Et+,- (5)
Marketrationalitywith respectto earningscomponents(H3):
PTBI+,1 = To + YIPTCF, + + ,+, (3)

zY2PTACCt
= o + - - - 2y*PTACC,) + (6)
SAR,, 3,(PTBI,+, yo y*PTCF, E,•+
20
I adjustthe cash flow numberby the taxes paid in cash ratherthan the currenttax expense on the income
statementdue to the accountingfor the tax benefitof stock options.Althoughthe optionexpense/deductionis
recordeddifferentlyfor book and tax purposes,it is not reflectedas a book-taxdifferencein calculatingthe
income tax expense for financialreporting.If I use the currenttax expense from the income statementrather
than the taxes paid in cash, cash flow would be overstated(becausethe tax benefitsof the options would be
addedbackto cash flow twice) andthe accrualscomponentunderstatedby this amount.See HanlonandShevlin
(2002) for additionaldetails regardingthe accountingfor tax benefitsof stock options. In addition,because
duringmy sampleperiodalmost all firmselected the intrinsicvalue methodof valuingstock options,thereis
no expensefor financialaccountingpurposesand thus thereare no accrualsrelatedto stock optionexpensing.
21 This methodologyis consistentwith the suggestionsin Collins and Hribar(2002) to use the statementof cash
flow datawherepossibleratherthanbalancesheet datadue to measurementerrorin the balancesheetdatafrom
mergerand acquisitionactivity.Also, because I utilize pre-taxmeasuresin my tests, the tax benefitsof stock
options,if any,will not causemeasurementerrorin the accrualscomponentof earningswhenusing this method.

whereSAR,+1is the annualsize-adjustedabnormalreturn,inclusive of dividends,calculated

as the raw buy-and-holdreturnfor the securityminus the buy-and-holdreturnfor the same
size decile portfolioof firms.The returnaccumulationperiodbegins four monthsafterthe
end of the fiscal year to allow financial statementinformationto be disseminated.If a
securitydelists duringa particularyear, I includethe CRSP delistingreturnin the buy-and-
hold annualreturn,and the proceeds are reinvestedin the CRSP size-matcheddecile for
the remainderof the year.22All other variablesare as definedabove.
I estimatethe system separatelyfor each subsampleto controlfor variationacross the
subsamplesin the persistenceof the accrualsand cash flows. If sharepricescorrectlyreflect
the persistenceof earnings and the cash flow and accrualscomponents,then y* = yi in
Equations (1) and (5), and y* = y, and y* = y2 in Equations (3) and (6). I use a likelihood
ratio statisticto test the restrictionsthaty* = Y, and y* = 1983). The statistic
•2 (Mishkin
is distributedas a X2(q) where q is the numberof restrictions tested. If large book-tax
differences facilitate the accuratepricing of accruals then y* will be closer to y2 in the
system of Equations(3) and (6) for firm-yearswith large book-tax differences.
Return Regression Tests

I supplementthe Mishkin (1983) tests by estimating hedge portfolio returnsusing
annualreturnregressions(Fama and MacBeth 1973).23 The use of the returnregressions
(i.e., examiningreturnsto tradingstrategies)allows an assessmentof the economic signif-
icance of any deviations from marketefficiency implied by the Mishkin (1983) analysis.
Estimatingthe regression annually mitigates any potential foresight bias in the Mishkin
(1983) analysis from pooling observationsover years (Wahlen2002), althoughthe seven-
year sample limits the power of this test. I estimatethe relationbetween futurereturnsand
the portfoliorankof accrualsand other controlfactorsover the entire sample and over the
subsamplesof firms using the following equation.
SAR,+1 = Po + MVEec + 1331nBMdec + 34Betadec

+ 1321n
P•PTACCdec
+ P5EPfec + + ,t+1 (7)
36SARec
PTACCrepresentspre-tax accruals,InMVEis the naturallogarithm of market value of

equity,InBMis the naturallogarithmof the book-to-marketratio,Beta is the commonstock
beta (calculatedas the systematicrisk estimatedfrom a regressionof monthlyraw returns
on the value-weightedportfolioreturnover a 60-monthperiodpriorto the abnormalreturn
accumulationperiod) (Fama and French 1992), EP is the earnings-to-priceratio (Basu
1977), SARis the size-adjustedsecurityreturnsfor the precedingyear to controlfor short-
runreturntrends(JegadeeshandTitman1993). Each variableis convertedto a rankvariable
scaled to range from 0 to 1. This scaling permits the interpretationof the variables're-
spective coefficients as the returnto a zero investmentportfolio with a long position in
22
Firmsthat were delisteddue to poor performance(delistingcodes 500 and 520-584) frequentlyhave missing
delistingreturns.I correctfor this, as recommendedin Shumway(1997) and ShumwayandWalther(1999), by
using delistingreturnsof -35 percentfor NYSE/AMEX firmsand -55 percentfor NASDAQfirmsfor these
delistingcodes.
23
I note thatwhile the Mishkin(1983) test of marketrationalityhas been used extensivelyin accountingresearch,
the Mishkinframeworkas employedin the accountingliteraturehas recentlycome underscrutiny.Forexample,
Kraftet al. (2001) examinethe use of the Mishkin(1983) frameworkand find evidenceconsistentwith speci-
ficationproblemswhen applyingthe Mishkin(1983) frameworkto data similarto that in accountingstudies.
However,they statethey view theirresultsas preliminary.

148 Hanlon
stocks of the firm-yearswith positive weights and a shortposition in the stocks of the firm-
years with negativeweights (Bernardand Thomas 1990; Dechow and Sloan 1997; Frankel
and Lee 1998). To enable interpretationof the coefficients as zero investmentportfolio
returns,the returnsused in the regressionsmust all be for the same time period and the
accountinginformationused as independentvariablesmust be availableto the marketat
the time the returnaccumulationperiod begins. To addressthis issue, I estimate the re-
gressionsusing only the Decemberyear-endfirm-yearsfrom my sample(n = 7,497). Thus,
I estimateEquation(7) annuallyfor Decemberyear-endfirm-yearsand reportthe average
coefficient over the years. I test significance by calculating the standarderror from the
distributionof annualcoefficients (n = 7). If investorsoverweightthe accrualcomponent
of earningsin each subsampleof firm-years,then P, < 0. If book-taxdifferencesfacilitate
the assessment of the persistenceof accruals,then p, should not be significantfor firm-
years with large book-taxdifferences,consistentwith H3.
VI. RESULTS
Descriptive Statistics
Table 1 presents descriptivestatistics and variablecorrelationsfor the entire sample.
All financialstatementvariablesare winsorized(reset) at the 1st and 99th percentiles.The
mean and median accruals are negative, consistent with prior research (Dechow 1994),
primarilyreflectingthe depreciationaccrual.
Panel B presents univariatecorrelations.Scaled pre-tax accruals and scaled deferred
tax expense are correlatedat only -0.008 (p = 0.3227), suggestingthatthe two measures
are not merely substitutesfor each other. Cash flows and accrualsare significantlynega-
tively correlatedconsistentwith prior studies (Dechow 1994).
Table2 providesdescriptivestatisticsfor the three subsamplesof firm-years.The table
reveals several characteristicsof the subsamples.For example, firm-yearswith large neg-
ative book-taxdifferencesare smallerin termsof total assets, but not significantlydifferent
in terms of marketvalue of equity than the other two subsamples.In addition,these firm-
years appearto be higher growthfirms as sales growthand net operatingasset growthare
larger for this set of firm-yearsrelative to the other two groups. The LPBTD subsample
appearsto obtain at least part of the high book-tax differences throughtax planning as
evidenced by the lower currenteffective tax rate (currenttax expense divided by pre-tax
income).
In untabulateddata, I find no industryclusteringwithin the groups. Industrycompo-
sition is similar across the subsamples with no one industry comprising more than 17
percentof any subsampleand industriesthat are more highly representedin one subsample
are also more highly representedin the others. As a result, industrycontrols are not used
in the following tests.
Tests of Hypotheses 1 and 2: Earnings Persistence
Panels A and B of Table 3 presentthe results from estimatingEquations(1) and (2).
Panel A indicates that firm-years in my sample have mean reverting earnings performance
consistent with previous findings in Sloan (1996) and Xie (2001).
Panel B reveals that firm-years with large book-tax differences have lower persistence
in pre-tax earnings than firm-years with small book-tax differences. Firm-years with large
negative and large positive book-tax differences have significantly less persistent earnings
than firm-years with small book-tax differences (y4 = -0.100 and y, = -0.212, two-tailed
p-value of 0.0001), consistent with the alternative hypothesis stated in H1.

The Persistence and Pricing of Earnings, Accruals, and Cash Flows 149
TABLE 1
Descriptive Statistics and Correlations among Selected Variables
(14,106 firm-years, 1994-2000)
Panel A: Descriptive Statistics
Standard
Variable Mean Deviation 25% Median 75%
PTBIt+ 0.093 0.121 0.0368 0.093 0.157
PTBI, 0.132 0.092 0.066 0.113 0.176
PTCF, 0.143 0.114 0.073 0.136 0.207
-0.010 0.094 -0.065 -0.023 0.030
PTACCt
DTE, 0.001 0.037 -0.014 0.001 0.018
AVETA, 1,726 10,938 55.250 168.590 617.890
SARt+ 1 -0.026 0.343 0.000 0.000 0.000
Panel B: ContemporaneousPearson (Spearman) Correlations on the Lower (Upper) Diagonal

PTBIt+ PTBI, PTCF, PTACC, DTE,
PTBI,t1 0.5942 0.5011 -0.0376 -0.0884
(0.0001) (0.0001) (0.0001) (0.0001)
PTBI, 0.5164 0.5846 0.1967 -0.0255
(0.0001) (0.0001) (0.0001) (0.0001)
PTCF, 0.4747 0.5880 -0.6009 -0.0311
(0.0001) (0.0001) (0.0001) (0.0000)
PTACC, -0.0681 0.2441 -0.6285 -0.0074
(0.0001) (0.0001) (0.0001) (0.3809)
DTE, -0.0609 -0.0286 -0.0357 -0.0083
(0.0001) (0.0001) (0.0001) (0.3227)
VariableDefinitions(Compustatdataitem or methodof calculationin parenthesis):

PTBI,,, = pre-taxbook income one-year-ahead(item #170);
PTBI,= pre-taxbook income in the currentyear (item #170);
PTCF, = pre-taxcash flow for the currentyear (item #308 + item #317 - item #124);
PTACC,= pre-taxaccrualsfor the currentyear (PTBI- PTCF);
DTE,= deferredtax expense in the currentyear grossedup by statutorytax rate [(sumof items #269 and
#270 and wheremissing item #50) dividedby 35 percent];
AVETA,= averagetotal assets for the firm(item #6); and
= size-adjustedreturncalculatedas the buy-and-holdreturnof the securitystartingin the fourthmonth
SARt+ afterthe fiscal year-endof the currentyear less the buy-and-holdreturnof a size-matchedportfolio.
All variablesexceptAVETAand SARare scaledby averagetotal assets.
I next decompose earningsinto cash flow and accrualsto test H2. Panels A and B of
Table4 presentthe resultsof estimatingEquations(3) and (4), respectively.Consistentwith
priorresearch,I find that the accrualscomponentof earningsis significantlyless persistent
than the cash flow componentwith coefficientweightingsof 0.49 and 0.75, respectively.24
The results in Panel B are consistent with the accrualscomponentof earningsbeing sig-
nificantlyless persistentfor both the LNBTD and LPBTD subsamplesas comparedto firm-
years with small book-tax differences (y7 = -0.115 and yN = -0.187). In addition,the
24
An F-testrevealsthatthese coefficientsare significantlydifferentat the 0.0001 level.
The Accounting Review, January 2005

;s"
ch
c,
O TABLE 2
X
;s
F~
Descriptive Statistics for Subsamples of Firm-Years Partitioned Based on Level of Tempora
;s
Crq
3CI
LNBTD SmallBTD
n = 2,823a n = 8,460a
Variable Mean St. Dev. 25% Median 75% Mean St. Dev. 25% Median 75% Me
C
0.112 0.140 0.041 0.114 0.195 0.088 0.115 0.036 0.089 0.150 0.0
X
a
PTBI,+,
PTBI, 0.153 0.110 0.069 0.131 0.210 0.123 0.086 0.059 0.106 0.167 0.1
R) PTCF, 0.165 0.130 0.085 0.156 0.243 0.132 0.109 0.067 0.128 0.194 0.1
O
O PTACC, -0.011 0.110 -0.081 -0.026 0.046 -0.009 0.088 -0.060 -0.022 0.027 -0.01
DTE, -0.050 0.033 -0.061 -0.037 -0.026 0.002 0.011 -0.007 0.000 0.010 0.0
AVETA, 1,069 6,233 42.18 114.56 383.29 1.891 12,905 57.65 176.07 642.02 1,8
ROE, 0.179 0.136 0.086 0.158 0.239 0.150 0.108 0.081 0.135 0.195 0.1
MVE, 3,051 20,759 64.84 215.13 855.34 2.535 15,023 59.93 198.35 793.20 2.3
BM, 0.470 0.486 0.209 0.362 0.605 0.608 0.557 0.301 0.492 0.778 0.5
SAR, 0.046 0.485 0.000 0.000 0.000 0.000 0.335 0.000 0.000 0.000 -0.00
SAR,,+ -0.018 0.435 0.000 0.000 0.000 -0.029 0.317 0.000 0.000 0.000 -0.02
Beta, 1.150 0.796 0.709 1.000 1.536 0.956 0.696 0.559 0.942 1.268 0.9
ETR, 0.403 7.241 0.285 0.365 0.400 0.432 2.059 0.339 0.377 0.400 0.3
CETR, 0.802 0.790 0.350 0.400 0.510 0.399 2.318 0.269 0.316 0.354 0.1
TaxPaid, 0.053 0.047 0.019 0.042 0.074 0.040 0.034 0.015 0.032 0.060 0.0
Sales, 1,246 6,497 58.56 162.82 557.97 1,883 8,669 78.99 242.44 856.98 1,9
SalesGrow, 0.365 0.779 0.074 0.210 0.438 0.298 1.981 0.046 0.137 0.285 0.2
NOAGrow, 1.465 0.879 1.019 1.209 1.606 1.349 0.755 1.019 1.142 1.389 1.3
Leverage, 0.046 15.289 0.001 0.108 0.490 0.634 2.334 0.042 0.338 0.810 0.5
Specialltems,-0.013 0.044 0.000 0.000 0.000 -0.001 0.039 0.000 0.000 0.000 0.0
TI, 0.169 0.112 0.085 0.151 0.233 0.108 0.082 0.047 0.092 0.151 0.0
BTD-total, -0.016 0.052 -0.041 0.030 0.002 0.014 0.030 -0.001 0.011 0.023 0.0

TABLE 2 (continued)
a
Samplesize variesbecause some datanecessaryto computethe variablesthat are not includedin the regressionsare not a
Bold font indicatesthatthe amountis significantlydifferentfrom the amountfor the SmallBTDgroup.Italic font indicates
betweenthe LPBTDgroupand the LNBTDgroup.All significancelevels are at p = 0.05 or smaller.
PTBI,+I = pre-taxbook income one-year-ahead (item #170);
PTBI,= pre-taxbook income in the currentyear (item #170);
PTCF, = pre-taxcash flow for the currentyear (item #308 + item #317 - item #124);
PTACC, = pre-tax accruals for the current year (PTBI - PTCF);
DTE, = deferredtax expensein the currentyear grossedup by statutorytax rate ((sum of items #269 and #270 an
(each of the above are shown scaledby averagetotal assets and winsorized(reset) at the 1 percentand 99
AVETAt= averagetotal assets for the firm (item #6) (in millions);
ROE,= earnings(item #18)/average shareholders'equity (item #216);
MVE,= marketvalue of equityat fiscal-yearend of year t (item #199 * item #25) (in millions);
BM, = ratioof the firm'sbook value of equity to its marketvalue of equity at time t (item #60/MVE);
SAR,= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a s
returnaccumulationbegins in the fourthmonthof fiscal year-endt to allow the disseminationof financialr
= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a s
SARt+1 return accumulationbegins in the fourthmonthafterthe fiscal year-endof t to allow the disseminationof f
Beta, = systematicrisk estimatedfrom regressionof monthlyraw returnson the returnto a value-weightedmarket
priorto the abnormalreturnaccumulationperiod.Fifteenmonthsof returndata are requiredto calculatebe
"3
~sl ETR,= effective tax ratein year t (totaltax/pre-taxbook income (item #16/item #170);
CETR,= currenteffectivetax rate (currenttax expense/pre-taxbook income ((item #16 - item #50)/item #170);
Sales, = sales in year t (item #12) (scaledby averagetotal assets);
= in sales from year t-1 to t ((item #12 in year t - item #12 in year t-1)/(item #12 in year t-l1));
O SalesGrowt growth
X NOAGrow, = net operating assets in year t/net operating assets in year t-1 (item #2 + item #3 + item #68 + item #8 +
~Zc. #72 - item #75);
;s
Crq Leverage,= debt-to-equityratio (item #34 + item #9/item #216);
3t~ = special items scaledby averagetotal assets (item #17/average total assets);
SpecItemst = estimate of taxableincome calculatedas currenttax expensegrossedup by statutorytax rate;and
TI,
BTD - total, = estimateof total differencebetweenbook and taxableincomes (PTBI-TI),scaled by averagetotal assets.
LPBTD(LNBTD)representsthe groupof firm-yearswith a deferredtax expense,positivebook-taxdifferences,(deferredta
C the top (bottom)quintileof firm-yearsin the sample.SmallBTDrepresentsthe groupof firm-yearsnot includedin the grou
with relativelysmall book-taxdifferences).
a
R)
O
O

152 Hanlon
TABLE 3
Regression Results: OLS Regressions of Future Pre-Tax Earnings Performance on Current
Pre-Tax Earnings Performance
(n = 14,106)
Panel A: Earnings Forecasting Equation
PTBI,,, = Yo0+ y-1PTBI,+ v,+, (1)
Variables '1o Y1 Adj. R2
Estimate 0.003 0.678 0.267
t-stat 2.120** 71.620*
Panel B: Earnings Forecasting Equation with CoefficientsAllowed to Vary for Firm-Yearswith
Large Book-Tax Differences
PTBIh+= Yo+ + y2LPBTD,+ y3PTBI,
y•aLNBTD,
+ y4PTBI, * LNBTD,+ y5PTBI,* LPBTD,+ (2)
F,+1
Variables To 71 7Y2 ^3 74 T_5 Adj. R2
Estimate -0.003 0.017 0.017 0.742 -0.100 -0.212 0.272

t-stat -1.620 4.430* 4.000* 57.350* -4.560* -7.990*
F-test of y4
-=
Y5:15.01 (p = 0.0001)
*** Denotes
*, significance at the .01, .05 and .10 levels, respectively, using a two-tailed test.
All**,
variables are defined as in Table 2.
coefficients representingthe differencein the persistenceof cash flows for both the large
book-taxdifferencegroupsare significantlydifferentfrom zero (y4 < 0 and y, < 0). Thus,
althoughI had no predictionfor the cash flow interactionterms, it appearsthe firm-years
with large book-taxdifferenceshave less persistentcash flows.25
Figure 1 shows the pre-tax earnings and accruals patternsfor the sample firm-years
with data availablefor the two years prior to the currentyear (where currentyear is the
year used to rank the firm-yearsand place them into subsamples)and two years afterthe
currentyear. Figure 1, Panel A shows that the LPBTD group has a larger increase and
subsequentdecreasein mean-scaledpre-taxearningsthan do the othertwo groupsof firm-
years. Figure 1, Panel B provides even more striking results for pre-tax accruals. The
subsamplewith large positive book-taxdifferenceshas a sharpincreasein pre-taxaccruals
in the currentyear and a sharpdecreasein pre-taxaccrualsin the following year.
In sum, the results for the Hi and H2 tests indicate that firm-yearswith large book-
tax differenceshave lower earningsand accrualpersistenceconsistentwith these firm-years
having a higher level of discretionaryaccrualsthat subsequentlyreverse. In supplemental
tests describedbelow, I investigatepotentialsources of this lower persistence.
The lower persistencein the cash flow componentof earningsfor the firm-yearswith
largebook-taxdifferenceswarrantsfurtherdiscussion.Althoughthe informationaboutearn-
ings quality in temporarybook-taxdifferences,if any, is not generallythoughtto be about
the quality or persistenceof cash flows, there are potential explanationsex post of why
book-tax differencesand the persistenceof cash flows are associated.For example, firms
likely manageearningsby managingcash flows in additionto managingaccruals.Managing
25
I discuss this finding more fully below.

TABLE 4
Regression Results: OLS Regressions of Future Pre-Tax Earnings Performance o
and Cash Flow Components of Current Pre-Tax Earnings Performan
(n = 14,106)
Panel A: Earnings Forecasting Equation with Accrual and Cash Flow Components as Independent Var
= + y1PTCF, + y2PTACC, +
PTBI,+1 Y7 5,t+
Variables '1
To02
Estimate -0.010 0.752 0.490
t-stat -6.280* 79.550* 42.400*
F-test of y, = Y2: 799.69 (p = 0.0001)
Panel B: Earnings Forecasting Equation with the Coefficients on the Accrual and Cash Flow Componen
Allowed to Vary for Firm-Years with Large Book-Tax Differences
= + + + * + *
PTBI,+1 Y7 y1LNBTD, y2LPBTD, + y3PTCF, y4PTCF, LNBTD, y5PTCF, LPBTD,
+ y6PTACC, + y7PTACC, * LNBTD, + * + t+,,
?5 y8PTACC, LPBTD,
Variables To 7 12 73 Y4 75 76
•,•?
Estimate -0.014 0.011 0.009 0.806 -0.083 -0.167 0.557
t-stat -6.990* 2.880* 2.120** 62.510* -3.790* -6.200* 34.720*
(h F-test of y4 = y5: 8.11 (p = 0.0044) F-test of y7 = 4.25 (p
y•:
S****** Denotes significanceat the .01, .05 and .10 levels, respectively.
All variablesare as definedin Table2.

154 Hanlon
FIGURE 1
Graph of Pre-Tax Earnings Performance and Pre-Tax Accrual Performance
for Each Subsample Based on the Level of Temporary Book-Tax Differences
Panel A
0.1600
m 0.1400
"E 0.1200
S M
- - LNBTD
C
L 0.060000
20.0400SmaBTD
0.0200
0.0000
-2 -1 0 1 2
Event Year
Panel B
C
0.0000
E
.
-0.0100
-0.0200
t -0.0300 -.- LNBTD
x -0.0400SmaBTD
-i-- LPBTD
S-0.0500
S-0.0600
-2 -1 0 1 2
Event Year
Sample includedin the figureare firm-yearsin the sample for the regressionsthat have nonmissing
data for two years priorto the currentyear and two years afterthe currentyear (9,560 firm-year
observations).
Pre-taxearningsis pre-taxbook income (item #170) scaled by averagetotal assets (item #6).
Pre-taxaccrualsis measuredas pre-taxbook income less pre-taxcash flow (item #108 - item #124
+ item #317). LPBTD is the subsampleof firm-yearswith large positive book-taxdifferences,
LNBTD is the subsampleof firm-yearswith large negativebook-taxdifferences,and SmallBTDis
the subsampleof firm-yearswith relativelysmall book-taxdifferences.
cash flows would avoid the scrutiny of auditors and regulators more than accrual manage-
ment. Burgstahler and Dichev (1997) present evidence on how firms accomplish earnings
management around the 0 earnings level. They plot the 25th, 50th, and 75th percentiles of
cash flows from operations (CFO) for each earnings interval and find that the distribution
of CFO shifts upward in the first interval to the right of 0. They argue that this is evidence

that firms manage the cash flow component of earnings upward to report small profits
instead of losses. They also find similar evidence with accruals.Thus, there is evidence
that firms manage both cash flows and the accrualscomponentsmaking both potentially
less persistentwhen book-tax differencesare large.26
Further,Grahamet al. (2004) using survey responses from 401 financial executives
provide evidence consistent with executives claiming that earnings are often managed
throughcash flows. For example, they find that 80 percent of survey participantsreport
that they would decreasediscretionaryspendingon researchand development,advertising,
and maintenanceand more than half say they would delay startinga new projectto meet
earningstargetseven if such a delay entails a small sacrificein value. Thus, their findings
provide furtherevidence that cash flows are also managedto achieve earningsgoals.
Thus, while book-tax differences reflect discrepanciesin the calculation of accruals
betweenbook and tax methods,high levels of book-taxdifferenceswill likely be associated
with the persistenceof cash flows as well becausefirmsmanagingearningsthroughaccruals
are likely also managingcash flows. However,because the link between book-tax differ-
ences and accrualsis more directand because the claims in financialaccountingtextbooks,
recent academic literature,and the press focus on the persistence (quality) of accruals,I
base my ex ante predictionsand tests on accrualsratherthan cash flows.
Tests of Hypotheses 3: Market Pricing When Book-Tax Differences Are Large

Table 5 presentsthe results of testing H3. I first presentresults of tests of the pricing
of total pre-taxbook income. The tests are performedusing the Mishkin (1983) method-
ology. Panel A shows that investorsappearto reduce their expectationof earningspersist-
ence for firm-yearsin the LPBTD group. In fact, for this subsample,investors have an
expectationof earningspersistencelower than the actual persistenceof earnings((y/*y1)
<1). Thus, when thereare largepositive book-taxdifferences,investorsappearto recognize
that these firm-yearswill not have persistentearningsand lower their expectationof earn-
ings persistence.For the LNBTD group, investorshave an expectationof the persistence
of total pre-tax earningsthat is consistent with the actual persistence.For the SmallBTD
group, I find that total earningspersistenceis underestimated.
Next I estimate the system of Equations(3) and (6) to allow the coefficients on the
accrualsand cash flow componentsto vary. The equationsare again estimatedusing the
nonlineargeneralizedleast squares approach.Table 5, Panel B presents the results. The
evidence is consistentwith priorresearch(e.g., Sloan 1996; Xie 2001) for the full sample
and for firm-yearswith small book-tax differences;investors appearto overestimatethe
persistenceof the accrualcomponentof earnings(-y2> 72) andunderestimatethe cash flow
componentof earnings(y" < Y1). For firm-yearswith large positive book-tax differences
(book income in excess of taxable income), however, I find evidence consistent with the
accrual componentof earningsbeing priced rationally(X2 = 0.00, p = 1.00), consistent
with H3, and the persistenceof the cash flow componentof earningsbeing underestimated
(x2 statistic of 8.69, significantat p = 0.0032). For the sample of firm-yearswith large
negative book-tax differences, investors overestimate the persistence of accruals, consistent
26 Roychowdhury(2003) investigateshow firmsaccomplishthe cash flow managementwhenreportingsmallannual

profits.He findsevidenceconsistentwith firmsavoidinglosses by offeringpricediscountsto temporarilyincrease
to reducereportedcost of goods sold, andby reducingdiscretionaryexpensesto report
sales, by overproduction
highermargins.

Oro
TABLE 5
Regression Results: Nonlinear Generalized Least Squares Estimation (The Mishkin Test)
of Pre-Tax Earnings with Respect to Its Implications for One-Year-AheadPre-T
8 Panel A: Market Pricing of Pre-Tax Earnings with Respect to Its Implications for One-Year-AheadPre-
PTBI,+, = 7yo+ yPTBI, + v,+,
= o + - yo - y*PTBI) + e,,
SARt+1 P3I(PTBIt+,
LNBTD
(book income<tax income) SmallBTD
Asymptotic Asymptotic
Standard Standard
Parameter Estimate Error Estimate Error
P, 0.581 0.067 0.681 0.035
y* (PTBI) 0.699 0.127 0.533 0.058
y1 (PTBI) 0.642 0.021 0.742 0.012
Ratio 1.088 0.718
(y*/-y1)
Tests of RationalPricingof Pre-TaxEarnings
Likelihood Marginal Likelihood Marginal

Null Ratio Significance Ratio Significance
Hypothesis Statistic Level Statistic Level
y = 'Y 0.542 0.4617 13.558 0.0002

TABLE 5 (continued)
Panel B: Market Pricing of Earnings Components with Respect to Their Implications for One-Year-Ah
+ +
PTBI,t+ = Yo y1PTCFt + y2PTACCt ,t+1
O + p,(PTBI,+ - Yo - y*PTCF, - y*PTACC,) +

SARt+ = ,t+
Full Sample LNBTD SmallBTD
Asymptotic Asymptotic Asympto
Parameter Estimate Stand. Error Estimate Stand. Error Estimate Stand. Er
[1 0.606 0.282 0.545 0.069 0.669 0.036
y* (PTCF) 0.482 0.054 0.589 0.141 0.521 0.062
Yl (PTCF) 0.752 0.009 0.723 0.021 0.806 0.012
Ratio (y*/ly) 0.641 0.815 0.646
Y2* (PTACC) 0.700 0.065 0.831 0.173 0.726 0.075
Y2(PTACC) 0.490 0.012 0.442 0.025 0.557 0.015
Ratio (y*/ly2) 1.429 1.880 1.303
Tests of Rational Pricing of Earnings Components
ch
c, Likelihood Marginal Likelihood Marginal Likelihood Mar
c,
o Ratio Significance Ratio Significance Ratio Signif
Null Hypothesis Statistic Level Statistic Level Statistic Le
;s
o~cr PTCF: y* = y, 25.84 0.0001 1.073 0.3003 22.099 0.00
PTACC: y* = ,2 10.69 0.0011 5.450 0.0196 5.260 0.02
rh All y* = y 93.43 0.0001 13.620 0.0011 68.308 0.00
ac;s Equations(1) and (5) and (3) and (6) are estimatedusing iterativegeneralizednonlinearleast squaresestimationprocedureb
2000.
All variablesare definedas in Table2.
oo
~I

158 Hanlon
with Sloan (1996) but inconsistentwith H3, and appearto price cash flows rationally(Ty
1
= y0).27
Overall,the results suggest that for firm-yearswith large positive book-taxdifferences
either investorsuse the book-tax differencesto infer lower persistencein accrualsor the
type of accrualsthat the book-tax differencesare associatedwith are easily identifiedand
pricedby the market.However,the evidence also indicatesthatinvestorsunderestimatethe
persistenceof the cash flow componentfor these firm-yearssuggestingthatinvestorsover-
weight the informationin the book-tax differences.Conversely,for firm-yearswith large
negativebook-taxdifferences,the resultsindicatethatinvestorsoverestimatethe persistence
of the accrualcomponentof earnings,consistentwith priorresearchexaminingbroadcross-
sections of firm-years(e.g., Sloan 1996).
Abnormal Returns Regressions
Table6 presentsthe resultsof the annualreturnregressiontests intendedto complement
the Mishkin (1983) tests of marketrationality.As noted previously,I use only December
year-endfirms and estimatethe regressionsannuallyin orderto estimatethe returnsto an
implementablehedge portfoliostrategy.I find thatfor the entiresamplethe abnormalreturn
to an accrual-basedstrategyis 4 percent (p = 0.046). For firm-yearswith large negative
book-tax differences,the returnto an accrualinvestmentstrategyis marginallysignificant
at the 0.10 level. Consistentwith my Mishkintests, I find thatfor firm-yearswith relatively
large positive book-taxdifferences,an investmentstrategybased on the accrualcomponent
of earningsdoes not earn a significantreturn(p = 0.16). Thus, overall the regressiontests
supportthe resultsfrom the Mishkin(1983) test: in firm-yearswith large positive book-tax
differences investors appearto price accrualsrationally.This evidence is consistent with
the large positive book-taxdifferencesprovidingadditionalinformationto investorsabout
the persistenceof accruals.
Additional Analysis
An Investigationof the Specific Sources of Lower Persistence
The effect of special items. I examine the effect of special items on my results to
determineif the persistencedifferencesI find reflect aggressivereportingin currentoper-
ating accrualsor if the persistencedifferencesare largely drivenby transitoryitems below
operatingincome (i.e., special items). Specifically,I performthe persistencetests in Equa-
tion (4) using the definitionsof earnings,accruals,and cash flows as in Sloan (1996). Sloan
(1996) defines earnings as operatingearnings after depreciation(data item #178), which
excludes the effects of special items. In my originaltests I use total pre-taxearnings,which
includes the effects of special items because the deferredtax expense numberis relatedto
the total pre-taxearningsnumber.
There is no way to separatethe book-tax differencesrelatedto special items.28As a
result, I assume that all special items create a book-taxdifferenceand subtractthe amount
of special items for each observationfrom the amountof book-tax differences.I then use
this adjusted measure of book-tax differences to partition the firm-years into subsamples
27 I have no explanationfor why cash flows are pricedcorrectlyfor this groupof firms.However,the resultsare
similarto those in recentstudies.Forexample,in Bradshawet al. (2001) the ratioof investorimpliedto observed
persistencein cash flows is 0.97 (significancenot reported)and Barthand Hutton(2004) reporta ratioof 0.95
(p = 0.362) for one subsampleof firms (those with consistentaccrualand forecastrevision signals) in their
study.
28 Handcollectionwouldnot reliablyaccomplishthis taskeitheras only materialdeferredtax assets andliabilities
are requiredto be reportedand changesin these are often affectedby mergersand acquisitionsand the taxes
relatedto extraordinary items.

TABLE 6
Summary Regression Statistics of the Relation between Abnormal Stock Ret
Scaled Deciles of Accruals, Cash Flows, and Control Factors
December Year-End Firm-Years Only
(n = 7,497)
SAR, =, + + P2 In MVEec + In BMfec +4Betadec

+ + + +
-PTACC" 3P3 ,5EPdte P6SARtec Et+
Full Sample LNBTD Small BTD
n 7,497 1,401 4,432
Mean over Number Mean over Number Mean over Nu
Pred. the Years of the Years of the Years
Parameter Sign (n = 7) Years +/- (n = 7) Years +/- (n = 7) Year
Intercept ? -0.071 -0.663 -0.475
t-stat -1.410 3/4 -1.182 2/5 -0.957 3
p-val (0.207) (0.282) (0.378)
PTACCdec - -0.038 -0.035 -0.038
t-stat -2.496 2/5 -1.927 2/5 -2.182 2
p-val (0.046) (0.102) (0.072)
- 0.039 0.020 0.026
lnMVEtdec t-stat 1.023 4/3 0.394 5/2 0.741 5
p-val (0.346) (0.707) (0.487)
lnBMtdec + -0.015 -0.001 -0.046
t-stat -1.210 3/4 -0.019 4/3 -2.713 2
p-val (0.272) (0.986) (0.035)
Betadec + -0.004 0.005 -0.015
0C t-stat -0.288 2/5 0.131 3/4 -1.100 3
0h
=Ct•
0h p-val (0.783) (0.901) (0.313)
0 + 0.416 0.050 0.039
EPtdec
t-stat 4.159 7/0 1.832 5/2 1.751 5
tro p-val (0.006) (0.116) (0.131)
0
0s
0 SAR,dec + 0.064 0.033 0.074
t-stat 1.158 6/1 0.626 5/2 1.247 5
0 p-val (0.291) (0.554) (0.259)

t%
0
;S
t0
0P•
0,
t• TABLE 6 (continued)
t-statistic(secondnumber)is computedas the ratio of the mean of the annualcoefficientsto the standarderrorcalculatedfr
p-valuesare in parentheses.
VariableDefinitions:
= size-adjustedreturncalculatedas the buy-and-holdreturnof the securityless the buy-and-holdreturnof a size
SARt+,
begins in the fourthmonthafterthe fiscal year-endof t to allow the disseminationof financialreports;
= accrualsdividedby averagetotal assets, transformedto a scaled-decilevariablewith values rangingfro
PTACCtd'e pre-tax
= the naturallogarithmof the marketvalue of commonequity,transformedto a scaled-decilevariablewith valu
InMVEtdec the natural
lnBMdec = logarithmof the book to marketratio,transformedto a scaled-decilevariablewith values rangingf
Beta"dec = systematicrisk estimatedfrom regressionof monthlyraw returnson the returnto a value-weightedmarketpor
to the abnormalreturnaccumulationperiod,transformedto a scaled-decilevariablewith values rangingfrom 0
requiredto calculatebeta;
EPdec = earnings-to-price ratio,transformedto a scaled-decilevariablewith values rangingfrom 0 to 1; and
= annualbuy-and-holdraw returnfor the securityless the buy-and-holdreturnto a size-matchedportfolioof fir
SARtdec
accumulationperiodtransformedto a scaled-decilevariablewith values rangingfrom 0 to 1.

and performtests similar to those above. Although some of the results are weakenedby
excluding the effects of special items, I continueto find results consistentwith firm-years
with large book-tax differences having lower persistence in earnings, accruals, and cash
flows. More specifically,I find in a regression analogous to Equation(4), but excluding
special items from the variablecomputations,that firm-yearswith both large negative and
large positive book-tax differences have a lower persistencein accrualsrelative to firm-
years with small book-tax differences (y, = -0.096 and y8 = -0.075). Both groups of
large book-taxdifferencefirm-yearsalso have significantlylower persistencein cash flows
as well (y4 = -0.068 and = -0.100). Thus, while the results of this test appearto be
y5
somewhatweaker(i.e., the coefficientsare smaller)indicatingthatthe special items do have
an effect, overall they are robustto the adjustmentfor special items.29
Examination of the disclosure of changes in deferred tax assets and liabilities. I
hand-collectthe changesin deferredtax assets and liabilitiesfor a small subsampleof firm-
years in both the large book-tax differences groups to examine what types of book-tax
differencesare generatingthe deferredtax expense for these groups of firms. However,I
providea caveatto the examinationof these data.One reasonI use the deferredtax expense
(income statement)numberratherthan the change in the deferredtax assets and liabilities
in the formal tests above is that the change in the deferredtax assets and liabilities listed
in the tax footnote does not always tie out to the deferredtax expense as one might expect.
The changes in the deferredtax asset and liabilities in the notes to the financialstatements
can include changes resultingfrom mergerand acquisitionactivity and changes relatedto
deferredtaxes attributedto income or losses from discontinuedoperationsor extraordinary
items. Thus, it is very difficult to identify the actual "components"of the deferredtax
expense (income statementnumber)even when hand-collectingthe data.30In the sample I
have hand-collected,I find that in only 27 out of the 60 firm-yearscollected does the
deferredtax expense tie out exactly to the change in the deferredtax assets and liabilities.
This caveat notwithstanding,I find that most of the change in the deferredtax assets
andliabilitiesfor firm-yearswith largepositivebook-taxdifferencesis fromthe depreciation
book-tax difference (or other differencesthat affect property,plant, and equipment)with
the next largestcategoriesincludingbad debt reserve,pensions and postretirementbenefits,
the category labeled "other,"and investments in affiliates, partnerships,and unrealized
securitygains.
For firm-yearswith large negativebook-taxdifferencesthe largestcategoriesof change
are reserves and accruals(both individuallylabeled and those called "miscellaneous"ac-
cruals), the line item labeled "other,"and depreciationdifferences.The largest category,
reserves and accruals,includes the accountsthat are generallysuspectedof earningsman-
agement in the texts (warrantyexpense, miscellaneous reserves, etc.). This is consistent
29 I also performanotheranalysisto examinethe effects of special items. I use the same definitionsof earnings,
accruals,and cash flows as in the originaltests, but I use a samplethat excludes all firm-yearswith material
special items (definedas those firm-yearswith special items that are largerin absolutevalue than one percent
of averagetotal assets). I find that all the results are qualitativelysimilarto those found in the originaltests
with the exceptionof firm-yearswith largepositivebook-taxdifferencesnot havinglowerpersistencein accruals
relativeto firm-yearswith small book-taxdifferences.Specifically,when I estimateEquation(4) over the sub-
sampleof firm-yearswithoutmaterialspecialitems, I findthatthe coefficienton the interactionof accrualsand
the indicatorvariableLPBTDis -0.040 (p = 0.274). Thus,this test would indicatea strongereffect of special
items on the results.However,a caveatto this test is that it excludes approximately2,900 observationsand it
may be the case thatthese observationswith largespecialitems arefirmsthatmanageearningsin otheraccounts
as well.
30 For furtherexplanationsee Revsineet al. (1999) and Hanlon(2003).

162 Hanlon
with this subsample'saccrualshaving a lower persistencefor futureearningsas compared

to the accrualsfor firm-yearswith small book-taxdifferences.31
Scaler
My two researchquestionsare (1) whetherfirm-yearswith largerbook-taxdifferences
have less persistentearnings and (2) whetherthe large book-tax differencesinfluence in-
vestors' assessmentsof persistence.In looking at the first question,I follow priorresearch
in using earningsperformance(returnon assets). However,recent researchby Fairfieldet
al. (2003) arguesthat the persistenceeffect documentedby Sloan (1996) is partiallyattrib-
utable to growth in operatingassets (i.e., growth in the denominatorratherthan reversals
in the numeratorgenerate the results in the forecasting regressions). As a result, I re-
estimatethe above forecastingEquation(4) using total assets in year t- 1 as the common
scale for all variablesin the regression.I find that the coefficienton the accrualinteraction
term for the LPBTD group continuesto be negative and significantbut that the coefficient
on the accrualinteractiontermfor the LNBTD groupis not statisticallysignificant.In order
to furtherinvestigatethis issue, I re-estimatethe tests thatuse lagged assets as the common
scaler in ranks and find that firm-yearswith both large positive and large negative book-
tax differences have lower persistence in earnings and accruals as found in the original
tests. Thus, these rankresults suggest that the lagged asset deflatoris a noisier measureof
scale than averagetotal assets and that the inferencesof the originaltests above are robust
to the alternativescaler measure.32
Return on Equity as a CorrelatedOmittedVariable

I also investigatereturnon equity (ROE)as an omittedcorrelatedvariablein the earn-
ings forecastingequationbecause firms with relatively high and low levels of returnon
equity are known to have less persistent earnings (Freemanet al. 1982). I include an
interactionterm of ROE times the scaled earningsvariablein Equation(2). The coefficient
for this interactiontermis significantlynegative(-0.428) consistentwith higherROEfirms
having more mean revertingincome. However, the inferences with regard to the other
variablesare qualitativelysimilar suggesting the results are not caused by differentlevels
of ROE.33
Book-TaxDifferences as a Proxyfor DiscretionaryAccruals

To furtherinvestigatethe informationin book-tax differencesabout futureearnings,I
separatemy accrualsmeasureinto two variables-financial accountingaccrualsexcluding
book-tax differences and the temporarybook-tax differences-and include both as inde-
pendent variablesin a regressionof one-year-aheadearningson accrualsand cash flows.
This regressionuses book-taxdifferencesas a proxy for discretionaryaccruals,in the spirit
of Phillips et al. (2003), and then conducts a test similar to Xie (2001) of the relative
persistenceof nondiscretionaryaccrualsas comparedto discretionaryaccruals.
31 See Phillipset al. (2004) for furthertests of hand-collectedcomponentsof the temporarybook-taxdifferences

as they relateto earningsmanagement,proxiedin theirtests by firmsthatjust avoid an earningsdecline.
32 I thankMaureenMcNicholsfor suggestingthe rankregressiontests in this case.
33 I also conducta sensitivitytest includingloss firms (i.e., both book and tax loss firms)and using an estimate
of total book-tax differences(althoughthis estimate is likely subject to much more measurementerroras
discussedpreviouslyin the manuscript).I estimatetotal book-taxdifferencesby grossing up the currenttax
expense by the statutorytax rate (35 percent).The sample with availabledata consists of 29,101 firm-years.
When annualreturnregressionsare estimatedthere is not a significantassociationbetweenabnormalreturns
and the book-taxdifferencesconsistentwith investorsrealizingthatincome thatis differentbetweenbook and
tax is less persistent.

In untabulatedresults I find that the coefficienton cash flows is 0.747, the coefficient
on accruals excluding the book-tax differences is 0.481 (significantlydifferent from the
coefficient on cash flows, p-value on an F-test of 0.0001), and the coefficient on the
book-tax differences is 0.402 (significantlydifferentthan the coefficient on accruals ex-
cluding book-tax differences,p-value of an F-test of 0.0005). Thus, these results are con-
sistentwith book-taxdifferenceshaving lower persistencefor one-year-aheadearningsthan
accrualsexcludingthe book-taxdifferences,consistentwith the book-taxdifferencesprox-
ying for discretion.
VII. CONCLUSIONS AND LIMITATIONS

The objective of my study is to investigatethe role of temporarybook-taxdifferences
in: (1) indicatingthe persistenceof earnings,accruals,and cash flows, and (2) influencing
investors'assessmentsof the persistenceof earningsand earningscomponents.
My results indicatethat firm-yearswith large positive book-tax differenceshave lower
earningspersistencethan firm-yearswith small book-taxdifferences.This result is consis-
tent with the commonconjecturethatwhen book income is far in excess of taxableincome,
earningsare of lower quality,if one accepts the definitionof quality as persistence.Addi-
tional analysis suggests the results are robustto controllingfor the effects of special (tran-
sitory) items.
My results also indicate that firm-yearswith large negative book-tax differenceshave
significantlyless persistentearnings,accruals,and cash flows. This lower earningspersist-
ence is also robustto the adjustmentfor special items and, from the results of additional
analyses, appearsto be due to these firms having accrualsof the type that are easily man-
aged (e.g., warrantyexpense, miscellaneous reserves, etc.). Thus, even though negative
book-tax differences are not the focus of textbook claims about using tax disclosures to
assess earningsquality,largenegativebook-taxdifferencesare associatedwith accrualsthat
have lower persistencefor futureearnings.
Finally, I investigatethe markets'use of book-tax differencesin assessing the persist-
ence of earnings.Althoughthe evidence is somewhatmixed, I find results consistentwith
the marketassessing a lower expectationof earningspersistencefor firm-yearsthat have
large positive book-taxdifferences,suggestingthat investorsinterpretthis informationas a
"red flag" about currentearnings quality or can more easily price the type of accruals
common to these firm-years.Investors appearto correctly assess the persistence of the
accrualscomponentof earningsfor these firm-years,but underestimatethe persistenceof
cash flows. For firm-yearswith small book-tax differences and large negative book-tax
differences,investorsappearto overestimatethe persistencein the accrualscomponentof
earnings,consistentwith priorresearch.Overall,it appearsthat book-taxdifferencesinflu-
ence investors'perceptionsof earningspersistence,but large book-tax differencesdo not
fully aid investors in their assessment of the persistence of earnings or its components
because for each group of firm-years(i.e., firm-yearswith large positive book-tax differ-
ences, firm-yearswith large negativebook-taxdifferences,and firm-yearswith small book-
tax differences) return inefficiencies remain.
There are several limitations and caveats to this study. First, the limited sample size
and time period inhibits generalizing the results to other samples and time periods. However,
the limitation in time is necessary so that the accounting for income taxes is consistent
over the sample period. The limitation on sample size (omission of loss firms) is necessary
as well in order to obtain a deferred tax number that can be interpreted as representing true
book-tax differences. The results of the market rationality tests should be considered in
light of my sample selection process.

164 Hanlon
Second, for the main tests, I partition the sample based on the level of temporary book-
tax differences and investigate the relative earnings persistence between groups. To the
extent there are omitted correlated variables that cause the firm-years to be partitioned
similarly, these other factors could be contributing to my results. However, tests of industry,
scale (growth), and return on equity indicate that the results are robust to these controls.
My findings lend support to the case being made by some in Congress for requiring
additional tax disclosure by firms. Large book-tax differences as disclosed in the financial
statements appear to provide information about the persistence of current earnings perform-
ance and have predictive power for future earnings. In addition, it appears that investors
assess different persistence expectations for firm-years with large book-tax differences.
More complete disclosure of the book-tax differences (such as more detailed disclosure of
the components of the change in deferred tax assets and liabilities and a reconciliation of
the total change to the deferred tax expense) would likely provide additional information
that would help investors assess the information in book-tax differences.
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The Persistence and Pricing of Earnings, Accruals, and Cash Flows When Firms Have Large

This content downloaded from 188.72.96.149 on Tue, 10 Jun 2014 16:01:38 PM

The Persistence and Pricing of Earnings,

I appreciatethe helpfulcommentsandsuggestionsfrommy dissertationcommittee-Bob Bowen,DaveBurgstahler,

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about managementdiscretionin the accrualsprocess. For example, Revsine et al. (1999,

1 These statementsdo not imply that taxableincome is

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earnings managementincentives and lower earnings response coefficients are associated

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II. BOOK-TAX DIFFERENCES

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8 See Hanlon(2003) for a moredetaileddiscussionof problemsusing the ratereconciliationor effectivetax rate

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III. HYPOTHESIS DEVELOPMENT

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Consistent with book-tax differences representingaggressive tax reporting,Mills (1998)

As discussed above, the initial maintainedhypothesis in accountingtexts and recent

H2: The persistenceof the accrualscomponentof earningsfor futureearningsis lower

14 In general,these differencescreatedby aggressivetax planningshouldnot be associatedwith lowerpersistence

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reportsevidence consistent with investors not incorporatingaccuratelythe persistenceof

IV. SAMPLE SELECTION

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PTBI,+1 = y + y~PTBI, + v,+1 (1)

where PTBI is pre-taxbook income (Compustatdata item #170).18 As in Sloan (1996), I

PTBIt+ = yo + y^LNBTDt + y2LPBTDt + y3PTBI, + Y4PTBI, * LNBTDt

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Hypothesis 3: Tests of Market Pricing

PTBIt+1 = o + yPTBI, + v,,, (1)

PTBI+,1 = To + YIPTCF, + + ,+, (3)

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whereSAR,+1is the annualsize-adjustedabnormalreturn,inclusive of dividends,calculated

Return Regression Tests

SAR,+1 = Po + MVEec + 1331nBMdec + 34Betadec

PTACCrepresentspre-tax accruals,InMVEis the naturallogarithm of market value of

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Panel B: ContemporaneousPearson (Spearman) Correlations on the Lower (Upper) Diagonal

VariableDefinitions(Compustatdataitem or methodof calculationin parenthesis):

The Accounting Review, January 2005

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Estimate -0.003 0.017 0.017 0.742 -0.100 -0.212 0.272

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Tests of Hypotheses 3: Market Pricing When Book-Tax Differences Are Large

26 Roychowdhury(2003) investigateshow firmsaccomplishthe cash flow managementwhenreportingsmallannual

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PTBI,+, = 7yo+ yPTBI, + v,+,

Likelihood Marginal Likelihood Marginal

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O + p,(PTBI,+ - Yo - y*PTCF, - y*PTACC,) +

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SAR, =, + + P2 In MVEec + In BMfec +4Betadec

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with this subsample'saccrualshaving a lower persistencefor futureearningsas compared

Return on Equity as a CorrelatedOmittedVariable

Book-TaxDifferences as a Proxyfor DiscretionaryAccruals

O + p,(PTBI,+ - Yo - yPTCF, - yPTACC,) +