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The Interplay Between Taxes and Financial Accounting Research

The Interplay Between Taxes and Financial Accounting Research

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The Interplay Between Taxes and Financial Accounting Research

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  1. The Interplay Between Taxes and Financial Accounting Research Sydney G. Winter Lecture in Accounting October 2006 Terry Shevlin

  2. Outline of talk • Academic accounting research in taxation – what does this mean? • Empirical tax research in accounting – the Shackelford/Shevlin review piece (with some updating) • Taxes and asset (stock) prices - dividend tax capitalization, still an important area • Book-tax differences and recent research • My objective: what can financial accounting empiricists learn from some (recent) tax research.

  3. Academic accounting research in taxation – what does this mean? • All methodologies can be found in tax research • Archival (empirical) • Behavioral or JDM • Analytical • Experimental markets • Legal

  4. General overview of accounting tax research • Most tax research can be classified either as • Tax planning • Tax policy • Tax Compliance (but not mutually exclusive)

  5. Tax planning vs tax policy research • Tax planning vs tax policy : Descriptive vs prescriptive • Tax planning – how do firms react to tax law changes – or what effect do taxes have on economic entities – is descriptive. • Why of interest – how will economic agents react to proposed tax law/policy changes? • Notice the similarity to much financial accounting research – is descriptive or positive research so as to provide relevant data to policy makers so that they (FASB, SEC, Treasury) can (hopefully) make more informed choices

  6. Tax compliance research • Mainly JDM, but some analytical and some empirical • What role tax preparers in the tax return area as tax planners, as educators of taxpayers • What incentives do tax preparers face and what effect does this have on compliance (aggressive positions?) • What role IRS audits on compliance? • What role penalties vs increased education on compliance? • Hypotheses generated from equity theory, prospect theory, and more generally from psychology field

  7. General overview - summary • Note that tax policy research is often going to be more technically tax oriented so less likely to be published in the broad-based accounting journals (TAR, JAR, JAE, CAR) and more likely in JATA, NTJ, etc. • Tax policy research – focus of economists so beware competing with economists

  8. Archival empirical tax research in accounting- Introductory Comments • Micro framework used in empirical tax research (Scholes and Wolfson 1992, updated in SWEMS 2004) • Do taxes matter? • Myers (1984), Ball and Brown (1968) • If not, why not? • If so, how much?

  9. Scholes and Wolfson (1992), SWEMS (2005) - Framework 3 central themes • All parties • e.g., compensation • Matsunaga, Shevlin and Shores 1992 • raising capital • Miller 1977, • Collins and Shackelford 1992 • M&A Erickson 1998 • All taxes - explicit and implicit • Do asset prices reflect tax treatment? An area of focus over last 5-8 years in the literature • All costs • Financial reporting, agency costs, transaction costs

  10. Overview - Scholes and Wolfson (1992), SWEMS (2005) • Not a new theory • Is positive rather than normative • No paper really challenges the framework • Maintained assumption and used to structure tests • Relatively young field – although entering early maturity • Thus documentation • Not integrated empirical development • Changes in tax laws and data availability stimulate research questions • Some depth in specific areas which Shackelford and Shevlin review

  11. SWEMS framework - Tax and Nontax Tradeoffs • Taxes cannot be minimized without affecting other organizational goals • Taxes are not a cost that taxpayers inevitably avoid (the financial reporting cost trade-off) • Effects of financial reporting costs well studied • Quantification of nontax costs has progressed slowly

  12. Tax and Nontax Tradeoffs • Taxes andFinancial reporting trade-off • Inventory - LIFO adoption, LIFO liquidation and inventory management, and LIFO abandonment e.g. Hunt, Moyer and Shevlin JAE 1996 Examined LIFO firms inventory purchases, current and noncurrent accruals as ways to manage both reported earnings and taxable income. Features of the design • Simultaneous equations (to allow for jointness) • Lagged dependent variables (to allow for reversals) • Current and next period earnings and tax objectives (to allow for multiperiod targets).

  13. Tax and Nontax Tradeoffs Compensation • stock options Matsunaga, Shevlin and Shores JAR 1992 Examined why more firms did not undertake disqualifiying dispositions of ISOs to garner the tax savings – because would have lowered reported earnings! • pensions • $1 million limit • Intertemporal income shifting (especially around TRA 86) • Divestitures and asset sales • Tax shelters - oil and gas, R&D • Regulated industries

  14. Tax and Nontax Tradeoffs • Financial reporting tradeoffs • Illustrate by ‘banking’ studies - why? • Scholes, Wilson and Wolfson RFS 1990 • Various tests but examined banks realized security gains • RSG = a + b PC + c LLP + d Tax + …

  15. Tax and Nontax Tradeoffs • Subsequent studies • Beatty, Chamberlain and Magliolo JAR 1995 • Multiple dials available to achieve multiple targets • Simultaneous equations • Shackelford, Collins and Wahlen JAR 1995 • Multiple dials • Time series regression for each bank

  16. Taxes and Asset Prices • Implicit taxes versus tax capitalization? • Muni bond example – classic and simple When two assets give rise to identical pretax cash flows, but the cash flows to one asset are taxed more favorably than those to the other asset, taxpayers will bid for the right to hold the tax-favored asset. Thus the price is bid up and the before-tax r/r on the tax-favored asset will decrease relative to the before-tax r/r on the tax-disfavored asset – the difference in pretax r/r is the implicit tax.

  17. Taxes and Asset Prices Accounting literature examples • ESOPs - Shackelford (1991) • R&D tax credit - Berger (1993) • T-Bills - Guenther (1994) • Dividends Received Deduction tax rule changes • - Erickson and Maydew (1998) M&A literature - complex code! Act as barriers to entry • Stock market reaction (Hayn 1989) • Acquisition premiums • Erickson (1998) • Ayers, Lefanowicz and Robinson (2000) • goodwill amortization

  18. Shackelford 1991 ESOPS • Qualified lenders to ESOPS can exclude 50% of the interest they receive on ESOP loan. • ESOP loan agreements contain 2 interest rates • r/i if the interest exclusion is permitted • r/i if the exclusion is not permitted • Key: The 2 ESOP r/i are for the same loan from the same lender to the same borrower over the same time period. The only difference is the tax treatment.

  19. Shackelford 1991 ESOPS • He examines the discount ratio • (Rb – RELA)/(Rb – REL) • Rb = the fully taxable rate • RELA = the actual ESOP loan rate • REL = the ESOP loan rate if all benefits passed to borrower REL(1-.5tc) = Rb(1-tc) • Results • The lender retains about 21 – 33% of the tax benefit of the tax deduction • Also lenders are high-tax banks – a clientele effect.

  20. Erickson and Maydew TAR 1998 • Capital market event study – effect of an unexpected proposed tax rule change • Reduction of the corporate DRD from 70% to 50%. • Firm’s security as own control – so no need to control for risk differences • Narrow event window • No confounding events

  21. Erickson and Maydew TAR 1998 • If corporations are the marginal investors in preferred stock, in equilbrium • Rp[(1-tc(1-DRD)] = Rb(1-tc) • And define ti = (Rft-Rtf)/Rft • Given tc=35% and DRD = 70%, max implicit tax rate = 27.4% • If individuals are the marginal investor, no implicit tax

  22. Erickson and Maydew TAR 1998 • Assume • Pt = [Divs(1-tc(1-DRD))]/r Price = PV of after-tax div in perpetuity • And Rt = (Pt – Pt-1)/Pt-1 = [tc(DRDt – DRDt-1)]/(1-tc(1-DRDt-1) With tc = 35%, DRDt-1 = 70%, and DRDt= 50%, implies a price decrease of 7.82% = implicit tax borne by the stock

  23. Erickson and Maydew TAR 1998 • Results • EM preferred stock price decreased 1 to 1.5% • Why less than 7.8% • Possible capital market participants might have assessed a low probability of the proposed DRD reduction being implemented • Information leakage – before event window • No price effect for common stocks

  24. Berger, JAR 1993 • Interesting and somewhat overlooked paper. • 1981 R&D tax credit • Did it lead to increased R&D spending? • Did the increased R&D spending increase input factor prices – implicit taxes • Which firms benefited • Which firms suffered (because of increased factor prices)

  25. Berger, JAR 1993 • R&D became tax-favored for some firms – did they bid up the prices (and if want to examine quantity change in R&D spending need to purge price increases) • Event study around enactment – to isolate price effects – firms that do not benefit from R&D tax credit suffered stock price declines – because market expected them to face higher R&D factor input prices

  26. Berger, JAR 1993 • Results • Firms that could use the R&D credit, increased R&D spending by 2.9% on average (or$1.74 for each $1 of credit). • Estimates the ratio of implicit taxes to explicit taxes was between 33 to 76%. (A ratio of 100% indicates pay $1 implicit tax for each $1 of explicit tax subsidy).

  27. Taxes and Stock Prices • ‘Old’ issue in finance - Do stock returns reflect tax treatment (an after-tax CAPM)? • Are dividend taxes capitalized in common stock prices/returns? • Are capital gains taxes capitalized? • Multi-party - do stocks and bonds reflect taxes levied on the holders - capital structure • Current hot topic for some tax researchers

  28. Taxes and Asset Prices • Based on the Brennan (1970) tax-adjusted CAPM which predicts a positive association between stock returns and dividend yields because of the higher taxes on dividends relative to capital gains. • Empirical studies include Litzenberger and Ramaswamy (1979), Black and Scholes (1974), Gordon and Bradford (1980), Blume (1980), Miller and Scholes (1982), Chen, Grundy and Stambaugh (1990), Fama and French (1993), and Naranjo, Nimalendran and Ryngaert (1998). • However, as noted by Fama and French (1998, 836) “no consensus emerges, which suggests that any tax effects are weak.” • Also ex div day studies

  29. Taxes and Asset Prices • Recent accounting research utilizing Residual Income Based Valuation model. • Harris and Kemsley JAR 1999, Collins and Kemsley TAR 2000 and Harris, Hubbard and Kemsley JPE 2000 Argue for full dividend tax capitalization

  30. Taxes and Asset Prices Basic Research Question: Are dividend taxes capitalized into share prices? What is tax capitalization: effect on prices of explicit taxes. The higher the explicit taxes for a given pretax income stream, the lower the price investors willing to pay (and lower the price, the higher the expected pretax return). Why of interest (or what’s the fuss)? If fully capitalized (at top individual tax rate) then 1. Corporate form severely tax disadvantaged (SW: Rc(1-tc)(1-td) = Rp(1-td) implying corporate form has to earn pretax: Rc = Rp/(1-tc) (This is a cost of capital argument)

  31. Taxes and Asset Prices 2. Debt is heavily tax-favored (when consider all parties) 3. Is dividend policy then irrelevant? 4. Are dividend tax clienteles then meaningless?

  32. Taxes and Asset Prices Implausibility of full dividend tax capitalization results ·Alternative methods to distribute value to shareholders Share repurchases Certain M&A ·Liquidations are not taxed as dividends (IRC 331) ·Evidence of tax clienteles – inframarginal investors ·Arbitrage opportunities for tax exempt or institutional investors ·Benefits of deferral of taxes ·Mixed and inconclusive and weak prior evidence (ex div day and return studies)

  33. Taxes and Asset Prices Harris and Kemsley Model: Based on Ohlson, and the additional assumption that all RE will be paid out as taxable dividends whereas returns of CC are tax-free P = BVE + PV of AE = CC + RE + PV(NI – r(CC+RE) = CC + (1-td)RE + PV{NI(1-td) – r[CC + (1-td)RE]} Testable implications (from HK) 1.dividend taxes reduce the value of RE 2.required R/R on RE is lower than that on CC 3.dividend taxes reduce the value of future earnings so firm value decreases as the tax rate increases. How to test? P = b + b1 BV + b2 BV*(RE/BV) + b3 NI + b4 NI*(RE/BV) + e

  34. HK results

  35. Taxes and Stock Prices Hanlon, Myers and Shevlin JAE 2003 Critique HK model and results • Rearrange theoretical model to show little net effect of div taxes on RE and thus on prices (PV effect at most). • REBV interaction significant – why? Not because of dividend/shareholder-level taxes. (Via a series of analyses of Ohlson’s model and the information dynamics) • Correlated omitted variables – is REBV proxying for persistence, growth, other P = b + b1 BV + b2 BV*(RE/BV) + b3 NI + b4 NI*(RE/BV) + e • See also Dhaliwal, Erickson, Myers, Banyi, same issue of JAE

  36. Taxes and Stock Prices • Recent studies: • Invert residual income model to estimate equity cost of capital • Is the resulting estimate related to • Dividend yields - positively • % ownership by institutional investors • See Dhaliwal, Krull, Li and Moser JAR 2005

  37. Other stuff in SS • SS also has discussion of some methodological issues facing tax researchers • Estimating marginal tax rates • Self-selection bias • Specifying trade-off regression model • Incremental decisions • - new debt versus debt levels • Avoids endogeneity of mtr with decision • Tax burdens and implicit taxes • Use of confidential data

  38. Updating SS: Interplay Between Taxes and Financial Accounting Research Other questions and research that has emerged in last few years since SS 2001 • Can we use book-tax differences to detect earnings management? • Can we use large book-tax differences to help interpret persistence of earnings? • Will firms pay taxes to boost reported earnings? • Calls for conforming book and taxable income? • Can we partition book-tax differences into “earnings management” vs “tax aggressiveness” • Do firms manage earnings (book-ax conformity) depending on whether managing earnings up/down? • What can we learn from GAAP tax footnote disclosures about tax planning, about tax shelters?

  39. Some background • Recent corporate financial reporting scandals have given some credence to these RQ • Firms reporting large book profits and low taxable income • Concern with abusive corporate tax shelters • Growing gap between book profits and taxable income

  40. Book-tax divergence (Treasury Report 1999)

  41. Background – Book Tax Differences • Well known that the purpose of GAAP and Tax Rules differ • Gives rise to differing rules of calculation of income • Temporary differences – can create deferred tax assets or deferred tax liabilities • And Permanent differences

  42. RQ 1: Using taxes to detect EM • Phillips, Pincus and Rego TAR 2003 • Using the deferred tax expense account to detect EM. • Assumptions: • Assumes greater discretion under GAAP than IRS • Assumes managers exploit to increase book earnings BUT NOT taxable income • Assumes such EM will generate book-tax differences that increase deferred tax expense • That is, the EM is via discretionary accruals that give rise to temporary differences. • (Note: if 2 violated, if 3 violated)

  43. Detecting EM • All else equal, firms report higher pretax BI than TI when they have increases in their net deferred tax liabilities • = change in DTL – change in DTA > 0, BI > TI • = increase in DTE • Easiest to see with depreciation. Tax depn > book depn gives rise to DTL. • Doubtful accounts, warranty expense. Expense before deduct gives rise to DTA. If reduce doubtful accounts or warranty expense, then DTA decreases.

  44. Detecting EM • Analyze 3 settings • EM to avoid an earnings decline • EM to avoid a loss • EM to avoid failure to meet or beat analysts forecasts • These 3 settings are popular today in light of Hayn 1995 and Burgstahler and Dichev 1997 • Compare DTE with total accruals and modified Jones model discretionary accruals model ability to detect EM.

  45. Detecting EM – Results 1994-2000 data (FAS 109) • EM = α + 1 DTE + 2 AC + 3 Change CFO + 4 Ind Dummies • EM to avoid an earnings decline • Increases in DTE increase the probability of EM to avoid reporting an earnings decline. • Total accruals and forward-looking Jones model also have incremental explanatory power. • EM to avoid an earnings loss • Increases in DTE increase the probability of EM to avoid reporting an earnings loss. And is more accurate in classifying firm-years as having successfully avoiding a loss. • EM to avoid failure to meet or beat analysts forecasts • Only total accruals seem to have any explanatory power.

  46. DTE and EM: Earnings declines

  47. DTE and EM: Earnings loss

  48. DTE and EM: Analyst forecast errors

  49. RQ 2: Using BTD to assess earnings persistence • Hanlon TAR 2005 (her thesis at UW) • Financial accounting texts claim large book-tax differences can inform us about the persistence of current earnings • Assumptions • GAAP rules contain more discretion • Managers use this discretion to manage earnings • Most of the action is in temporary differences • Positive book-tax differences imply BI > TI • Negative book-tax differences imply BI < TI.

  50. Earnings persistence • If large BTD are evidence of EM, then accrual accounting implies reversals in future periods – current earnings will be less persistent. • But BTD arise not just because of EM but because of differences in the rules arising from the different purposes of each set of rules. • And BTD may be generated by tax planning rather than EM. (And some evidence consistent with this – Mills 1998 – firms more likely subject to IRS audit if have large BTD!) • So an empirical question.