The Persistence and Pricing of Earnings, Accruals, and Cash Flows When Firms Have Large Book-Tax Differences

TLDR

The study investigates how book‑tax differences affect the persistence of earnings, accruals, and cash flows and whether their magnitude influences investors’ expectations of future earnings persistence, also exploring sources of lower persistence in high‑difference firm‑years. The authors examine potential sources of lower earnings persistence in firm‑years with large book‑tax differences. Large book‑tax differences are associated with lower earnings persistence, and investors view them as a red flag that reduces expectations of future earnings persistence, even after accounting for special items.

Abstract

I investigate the role of book-tax differences in indicating the 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-years with large book-tax differences have earnings that are less persistent than firm-years with small book-tax differences. Further, the evidence is consistent with investors interpreting large positive book-tax differences (book income greater than taxable income) as a “red flag” and reducing their expectation of future earnings persistence for these firm-years. I then investigate potential sources of the lower persistence for firm-years with large book-tax differences. I find that special items contribute in part to the results but that firm-years with large booktax differences continue to have lower persistence in earnings after controlling for the effect of the special items.