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ARTICLE IN PRESS

Journal of Accounting and Economics 50 (2010) 111125

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Journal of Accounting and Economics


journal homepage: www.elsevier.com/locate/jae

Book-tax conformity, earnings persistence and the association


between earnings and future cash ows$
T.J. Atwood a, Michael S. Drake b, Linda A. Myers c,
a
Florida State University, USA
b
The Ohio State University, USA
c
University of Arkansas, Business Building 401, 1 University of Arkansas, Fayetteville, AR 72703, USA

a r t i c l e in fo abstract

Article history: Calls for eliminating differences between accounting earnings and taxable income in the
Received 1 November 2007 US have been debated extensively. Proponents of increased book-tax conformity argue
Received in revised form that tax compliance will increase and earnings quality will improve. Opponents argue
22 September 2009
that earnings quality will decline. We examine whether the level of required book-tax
Accepted 5 November 2009
Available online 12 November 2009
conformity affects earnings persistence and the association between earnings and
future cash ows. We develop a comprehensive book-tax conformity measure and nd
JEL classication: that earnings have lower persistence and a lower association with future cash ows
H2 when conformity is higher. Our evidence suggests that increased book-tax conformity
M4
may reduce earnings quality.
M40
Published by Elsevier B.V.
M41
M44

Keywords:
Book-tax conformity
Book-tax differences
Usefulness of earnings
Earnings persistence
Future cash ows

1. Introduction

Potential benets and costs from increasing the required conformity between reported earnings and taxable income
have been debated in the United States (US) for more than half a decade. Proponents suggest that increased book-tax
conformity will simultaneously reduce aggressive nancial reporting and abusive corporate tax sheltering, thereby
improving earnings quality and increasing tax compliance (Desai, 2005; Whitaker, 2006; Joint Committee on Taxation,
2006). Opponents argue that the information required by nancial statement users is substantially different from that
required by taxing authorities, and because Congress (rather than an independent body like the Financial Accounting

$
We especially thank S.P. Kothari (the editor), and Ed Maydew for helpful comments and suggestions. We also thank Michelle Hanlon, James Myers,
Tom Omer, Terry Shevlin, and workshop participants at Florida State University, Texas A&M University, and the University of North Texas. Linda Myers
gratefully acknowledges nancial support from the PricewaterhouseCoopers Faculty Fellowship while at Texas A&M University. Michael Drake gratefully
acknowledges nancial support from the Deloitte & Touche Foundation.
 Corresponding author. Tel.: + 1 479 575 5227.
E-mail address: lmyers@walton.uark.edu (L.A. Myers).

0165-4101/$ - see front matter Published by Elsevier B.V.


doi:10.1016/j.jacceco.2009.11.001
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112 T.J. Atwood et al. / Journal of Accounting and Economics 50 (2010) 111125

Standards Board) is likely to control rule-making, increased book-tax conformity will lower earnings quality (Hanlon et al.,
2005; Hanlon et al., 2008).
We contribute to this debate by examining whether the degree of required book-tax conformity across countries affects
earnings persistence and the association between earnings and future cash ows. According to proponents, increasing
required book-tax conformity in the US will limit opportunistic management behavior, allow taxing authorities to act as
additional monitors of reported prots, and allow shareholders to observe taxes paid, making the overall economic
performance of rms more transparent (Desai, 2005). These arguments suggest that current earnings will be less (more)
persistent and less (more) closely associated with future cash ows in countries with lower (higher) book-tax conformity.
Opponents argue that, if required book-tax conformity is increased, tax policymakers will interfere in the standard-setting
process, eroding the quality of earnings reported to investors (Shackelford, 2006). This argument suggests that current
earnings will be more (less) persistent and more (less) closely associated with cash ows in countries with lower (higher)
book-tax conformity.
We suggest that rms operating in countries with lower required book-tax conformity will report greater book-tax
differences, resulting in more unexplained cross-sectional variation in current tax expense. Thus, we infer the degree of
required book-tax conformity in a country from the amount of observed variation in current tax expense that cannot be
explained by the variation in pre-tax earnings, income from foreign operations, and dividends. This approach allows us to
estimate the degree of required book-tax conformity on a country-by-country basis.1 This approach also allows for
continuous differences in the degree of book-tax conformity and for changes in the degree of book-tax conformity over
time.2
We nd that the one-year-ahead persistence of current earnings decreases as book-tax conformity increases.
Furthermore, the association between current earnings and one-year-ahead future cash ows decreases as book-tax
conformity increases. These ndings are robust to the inclusion of a control variable for cross-country variations in
institutional and accounting structures (developed from a factor analysis using country-specic legal tradition, investor
rights, and ownership concentration as components), as well as controls for characteristics of the rms economic
environment (i.e., product type, barriers-to-entry, and capital intensity) which are associated with industry membership,
for variability in pre-tax earnings, for statutory tax rates, and for xed differences in earnings persistence across countries.
Thus, we conclude that higher book-tax conformity is associated with lower earnings persistence and a lower association
between current earnings and future cash ows.
Our study supports the position of those opposing increases in the required level of conformity between earnings and
taxable income in the US (i.e., Hanlon et al., 2005, 2008; Shackelford, 2006). The primary benet of lower book-tax
conformity is that it provides managers with the exibility to convey information about rm performance without
incurring tax penalties. The primary costs are the additional compliance burden3 and the potential for manager
opportunism. Our results suggest that earnings quality (dened as earnings persistence and the association between
current period earnings and future cash ows) is lower when book-tax conformity is higher, even though conformity may
restrain managers from using their discretion to report earnings opportunistically. We interpret this result as an indication
that the benets derived from allowing all managers the exibility to convey their private information may outweigh the
potential costs incurred if some managers choose to use their discretion to report opportunistically.
Our study also contributes to the literature on international differences in the properties of accounting earnings. Ali and
Hwang (2000) provide evidence that earnings are less value relevant when book-tax conformity is high, and Lang et al.
(2009) suggest that managers smooth earnings less when the link between nancial and tax income is weaker. Other
studies nd no effect of book-tax conformity on differences in the properties of earnings across countries (Hung, 2001;
Leuz et al., 2003) or do not specically test for effects of book-tax conformity (Ball et al., 2000; DeFond et al., 2007). Our
results suggest that book-tax conformity is an important determinant of the properties of accounting earnings, and that
book-tax conformity should be considered in the design of cross-country studies.
Finally, we contribute a new, comprehensive book-tax conformity measure to the literature. Our book-tax conformity
measure includes more countries, can be easily calculated from publicly available data, allows for a continuum of book-tax
conformity levels, and allows for changes in the level of book-tax conformity over time. Moreover, this measure is more
powerful than those used in prior studies.4
The remainder of this paper is organized as follows. Section 2 discusses prior literature and develops our hypotheses.
Section 3 describes our research design. Section 4 discusses sample selection, descriptive statistics, and test results.

1
Prior studies use an indicator variable based on subjective judgments made from information contained in summaries of international tax policies
for high versus low book-tax conformity (see, for example, Ali and Hwang, 2000; Hung, 2001; Leuz et al., 2003; Lang et al., 2009).
2
Testimony before the US Senate Committee on Homeland Security and Governmental Affairs suggests that the degree of book-tax conformity in
other countries has changed over time (Desai, 2007).
3
Hanlon and Shevlin (2005) nd that revenues of the Big Four accounting rms were approximately 3% of earnings reported by all Standard & Poors
(S&P) 500 rms in 2003. This excludes the cost of in-house tax departments and information systems used to track potential tax accounting effects.
Proponents argue that these costs will decrease substantially if rms report essentially the same numbers for tax and nancial reporting purposes.
4
Specically, our book-tax conformity measure subsumes the explanatory power of the traditional indicator variable measure in explaining earnings
persistence and the association between earnings and future cash ows.
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Section 5 considers the effects of differences in institutional and accounting structures across countries, and Section 6
presents results of additional analyses. Section 7 concludes.

2. Prior literature and development of hypotheses

Discussions about the potential benets and costs of required book-tax conformity often address whether the degree of
book-tax conformity affects the quality of accounting earnings and/or the amount of information conveyed by accounting
earnings. Proponents of conformity argue that the quality (or informativeness) of accounting earnings will improve if
book-tax conformity increases, while opponents argue that the quality (or informativeness) of accounting earnings will
deteriorate with increased conformity.

2.1. Alleged effects of book-tax conformity

Among the proponents, Desai (2005) argues that low book-tax conformity has contributed to the degradation of
reported prots because managers engage in transactions that are designed to exploit book-tax differences for the dual
purposes of manipulating reported prots and avoiding tax payments. This degradation of reported prots is purported to
be evidenced by the growing gap between accounting earnings and taxable income, by increases in revisions to estimated
prots recorded in the National Income and Product Accounts generated by the Bureau of Economic Analysis, and by the
declining value-relevance of earnings. Proponents generally assert that increasing book-tax conformity simultaneously
provides incentives for managers to reduce tax avoidance and to report accounting earnings less aggressively, which will
result in improved earnings quality (Yin, 2001; Desai, 2005; Joint Committee on Taxation, 2006; Whitaker, 2006).
Opponents of increased book-tax conformity argue that high book-tax conformity will result in lower quality (or less
informative) accounting earnings (Hanlon and Shevlin, 2005; Hanlon et al., 2005, 2008; Plesko, 2006; Shackelford, 2006).
They argue that the information required by taxing authorities differs from that required by other stakeholders.
Specically, the tax system is designed to meet the governments goals of raising revenue, providing economic incentives
or disincentives for taxpayers to engage in particular activities, and rewarding particular constituencies. In contrast,
accounting earnings provides information about rm performance and is intended to reduce information asymmetries
between management and outside stakeholders. Thus, the accounting system is designed to allow managers exibility in
conveying information to the market (Hanlon et al., 2005; Shackelford, 2006). As a result of these different goals,
opponents argue that increasing book-tax conformity will reduce the quality of information available to investors and
other nancial statement users because it may lead Congress to interfere in the standard-setting process.

2.1.1. Earnings quality: US evidence


Prior research addressing the relation between book-tax conformity and earnings informativeness in the US includes
Guenther et al. (1997) and Hanlon et al. (2008). These studies examine a small sample of rms that were required, under
the Tax Reform Act of 1986, to change from the cash method to the accrual method for tax purposes. These two studies
provide evidence that the required change caused these rms to defer income for nancial reporting purposes and resulted
in accounting earnings that were less informative as measured by long-window earnings response coefcients. The authors
attribute this result to the change from the cash method to the accrual method, which substantially increased book-tax
conformity. However, the differences reported in these studies may represent temporary reductions in accruals, intended
to partially offset the cumulative adjustments taken into taxable income in those years, rather than permanent changes in
the quality of accounting earnings.5 Furthermore, the samples in these studies are small, consisting of an unusual set of
rms that issued accrual method nancial statements but used the cash method for tax purposes. Thus, the result that
increased book-tax conformity reduces earnings informativeness may not generalize to a broader set of rms.
In another study addressing the relation between book-tax conformity and earnings informativeness, Hanlon et al.
(2005) examine the information content of reported accounting earnings and taxable income (estimated from the current
tax expense adjusted for net operating loss carryforwards). They nd that signicantly more of the variation in long-
window returns is explained by accounting earnings than by estimated taxable income, but both income measures exhibit
signicant incremental explanatory power. They suggest that if accounting earnings were conformed to taxable income,
the explanatory power of earnings would be reduced by approximately 50%.6

2.1.2. Earnings quality: international evidence


Studies examining the value-relevance of accounting earnings across countries provide mixed evidence on the effects of
book-tax conformity. Ali and Hwang (2000) provide evidence that accounting earnings are less value relevant in countries

5
Guenther et al. (1997) and Hanlon et al. (2008) compare mean nancial ratios and long-window earnings response coefcients, respectively, pre-
versus post-change. However, the cumulative difference between the methods was generally taken into taxable income over 36 years (Rev. Proc. 8537,
1985-2 C.B. 438). Thus, the income deferral and loss of informativeness in the post-change period may result from management efforts to partially offset
the taxable portion of the cumulative adjustment in those years.
6
Our conclusions are consistent with Hanlon et al. (2005) but they examine earnings incremental explanatory power for returns and their sample
consists of exclusively of US companies, so the level of required book-tax conformity is consistent for all rms in their sample.
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with high book-tax conformity than in countries with low book-tax conformity. In contrast, Hung (2001) nds no
signicant difference in the value-relevance of accounting earnings and book values of equity in countries with high
book-tax conformity versus countries with low book-tax conformity.
Similarly, studies examining earnings management across countries provide mixed evidence regarding the impact of
book-tax conformity. Lang et al. (2009) suggest that rms in countries with lower book-tax conformity engage in less
income smoothing, while Leuz et al. (2003) nd no signicant relation between book-tax conformity and earnings
management.

2.2. Our contribution

We contribute to the literature on the effects of book-tax conformity by introducing a new measure of book-tax
conformity and by examining whether book-tax conformity is associated with cross-country differences in earnings
persistence and with the association between earnings and future cash ows. The Financial Accounting Standards Boards
conceptual framework suggests that the primary focus of nancial reporting is on information about an enterprises
performance as provided by earnings measures, because earnings measures are generally better indicators of rm
performance than is information about current cash receipts and payments (Statement of Financial Accounting Concepts No.
1, (FASB,1978, Con 1) paragraphs 43 and 44).7 Moreover, information about earnings should be helpful to users in assessing
the amounts, timing, and uncertainty of future cash ows (Statement of Financial Accounting Concepts No. 1, paragraph 43).
Thus, an important property of accounting earnings is its usefulness for predicting future earnings and future cash ows.
We focus on cross-country differences in book-tax conformity because we are interested in the effects of required book-
tax conformity (i.e., the extent to which managers are allowed to report accounting earnings that differ from taxable
income). Studies that focus on book-tax differences within the US (e.g., Hanlon et al., 2005; Chen et al., 2007; Ayers et al.,
2009) examine cross-sectional differences in managers choices within a country where large differences between
accounting earnings and taxable income are allowed. We are concerned with the effects of the amount of discretion that
managers are allowed, rather than with the extent to which they use that discretion.

2.3. Hypotheses

We suggest an increase in required book-tax conformity may potentially improve or reduce earnings quality. First,
an increase in required book-tax conformity may result in changes to nancial accounting rules so that these rules more
closely reect legislators tax policy goals. Financial accounting rules are generally based on the conservatism and
matching principles whereas tax accounting rules are based on the ability-to-pay principle, with incentives for taxpayers
to engage in specic economic activities. Financial accounting requires forward-looking estimates of potential losses and
recognizes reserves for bad debts, warranties, self-insurance, asset write-downs, and contingent liabilities to match
expenses with revenues and to reect rm performance conservatively. Tax accounting does not allow for these
deductions until economic performance occurs (when services or property are provided) or losses are realized. In addition,
Congress frequently makes changes to the tax laws. If increased book-tax conformity results in changes to nancial
accounting rules to reect Congressional tax policies, the resulting earnings are likely to be less conservative and less
consistent over time.
Second, an increase in required book-tax conformity may result in a shift in the way in which managers use their
discretion in applying the accounting rules, from conveying information about rm performance to minimizing taxes paid.
This shift may occur even if tax rules are changed to conform to nancial accounting rules. Because of the incentive to
reduce taxes, managers may estimate and record possible future losses more aggressively, potentially resulting in lower
earnings quality.
Third, managers may engage in fewer costly transactions that produce little or no economic benets to the rm other
than exploiting differences between book and tax rules. For example, consider the case of synthetic leases. These are
nancial products designed to meet the denition of an operating lease under US Generally Accepted Accounting Principles
(GAAP) but they are treated as capital leases for federal income tax purposes. These nancial arrangements distort the
companys earnings and balance sheets and are more costly than traditional nancing arrangements (Weidner, 2000;
Bergsman, 2002; Kaikati, 2004). If the leasing and consolidation rules were the same for book and tax purposes, these and
other similar types of arrangements would not exist, and nancial statements would be more comparable across rms.
This would be true whether the nancial rules were conformed to the tax rules or vice versa.
Finally, an increase in required book-tax conformity may result in improved earnings quality due to additional
monitoring of aggressive nancial reporting by government tax auditors or because managers are unwilling to pay the tax
costs of aggressive nancial reporting (Desai, 2007).
The overall relation between earnings quality and the degree of book-tax conformity is an empirical question. We
address this question by examining earnings persistence and the association between current earnings and future cash
ows. We examine earnings persistence because it is often considered to be an indicator of earnings quality or to relate to

7
Consistent with this, Dechow (1994) nds that earnings better predict stock returns than do cash ows.
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the usefulness of earnings (Schipper and Vincent, 2003). Our focus on the association between current earnings and future
cash ows is motivated by the FASBs conceptual framework, which suggests that nancial reporting should provide
information helpful to users in assessing future cash ows (FASB, 1978, Con 1). Thus, all else equal, higher quality earnings
numbers should be more highly associated with future cash ows. We predict that earnings persistence and the
association between current earnings and future cash ows will increase with the level of required book-tax conformity if
benets from reduced manager opportunism exceed the costs of reduced reporting exibility, as proponents argue.
Alternatively, if the costs of restricting managers ability to communicate relevant information exceed the benets from
reduced manager opportunism, as opponents argue, earnings persistence and the association between current earnings
and future cash ows will decrease with the level of required book-tax conformity.

3. Research design

Prior studies examining cross-country differences in the properties of accounting earnings generally do not control for
the effects of book-tax conformity or follow an indicator variable approach, where the indicator variable is based on
subjective assessments of each countrys book-tax conformity level (e.g., Hung, 2001; Leuz et al., 2003; Lang et al., 2009).8
We rst develop a comprehensive book-tax conformity measure that can vary across countries and within a country over
time. We then examine whether a countrys current book-tax conformity level, as derived from this model, is associated
with earnings persistence and with the extent to which current earnings are associated with future cash ows. We describe
the book-tax conformity measure and the prediction tests below.

3.1. The book-tax conformity measure

Our paper focuses on differences in required book-tax conformity (or allowed book-tax nonconformity) across
countries. We dene book-tax conformity as the exibility that a rm has to report taxable income (TI) that is different
from pre-tax book income (PTBI). Assume that a rm domiciled in Country A with PTBI of $100 has the exibility to report
TI anywhere in the range ($90110). Now assume that the same rm if domiciled in Country B would have only the
exibility to report TI in the range ($95105). The mean of the range of TIs which the rm could report for the given level of
PTBI, E(TI9PTBI), is $100 in both countries. However, the allowed variation in TI for the given level of PTBI, VAR(TI9PTBI),
is higher in Country A than in Country B. In other words, for a given level of PTBI, rms in Country B have less exibility to
report TI that is farther away from PTBI than do rms in Country A.
Assuming that rm managers have incentives to report higher earnings to investors while minimizing taxes paid
(which is a basic premise maintained by proponents of increased book-tax conformity in the US), then the variation in
reported TI will reect the degree of allowed variation in TI, and thus will reect the amount of required book-tax
conformity. Reported TI is generally not publicly available information; however, current tax expense (CTE) in the nancial
statements provides an estimate of income taxes currently payable based on expected taxable income. Thus, the allowed
variation in TI for a given level of PTBI, VAR(TI9PTBI), can be estimated using the variation in reported CTE for a given level
of PTBI, VAR(CTE9PTBI).
Similarly, the expected level of TI for a given level of PTBI, E(TI9PTBI), can be estimated using the expected level of CTE
for a given level of PTBI, E(CTE9PTBI).
Our goal is to develop a measure that reects the level of required book-tax conformity in each country and a measure
that is allowed to vary over time (i.e., the measure should reect the extent to which managers must report the same
amounts for accounting earnings and taxable income).
In a regression of CTE on PTBI, the expected level of CTE for a given level of PTBI is
ECTE9PTBI y0 y1 PTBI 1
The coefcient y1 reects the average level of CTE per unit of PTBI. When required book-tax conformity is low, managers
may use their discretion to report earnings in book income earlier or later than in taxable income, and the direction of
these book-tax differences will vary by rm. For example, one rm may aggressively report higher book accruals to
increase earnings to meet earnings expectations, while another rm may conservatively report book accruals to avoid
exceeding earnings expectations (thus, banking earnings for future years). These timing differences will reverse at some
point in the future. Because of the initiation and reversal of timing differences, rms will report more negative book-tax
differences in some years and more positive book-tax differences in other years. In a cross-sectional regression for a given
year, the y1 coefcient provides an average of the tax effects of these timing differences (i.e., it is the mean tax effect of the
positives and negatives). However, the y1 coefcient does not reect the range of TIs that the rm can report (i.e., the
extent to which the rm can report TI that is farther away from PTBI). Instead, the conditional variance of CTE,
VAR(CTE9PTBI), provides a measure of the range of CTEs that a rm can report for a given level of PTBI.

8
Hung (2001) constructs the book-tax conformity variable using ve factors derived from international tax and accounting summaries: the existence
of deferred taxes; whether additional accelerated depreciation is allowed; whether amortization periods depend on tax laws; whether lease
capitalization depends on tax laws; and a subjective determination of the relation between book and tax income. These factors may be suggestive, but
many other factors result in differences between accounting earnings and taxable income in countries with low required book-tax conformity.
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In a regression of CTE on PTBI, the conditional variance of CTE is calculated from the residuals as follows:

Vare ECTE  y0  y1 PTBI2 

VARCTE9PTBI 2

The conditional variance of CTE, VAR(CTE9PTBI), is the expected variation in CTE for a given level of PTBI. The root mean-
squared error, RMSE, from a regression of CTE on PTBI provides an unbiased estimate of the standard error of the
regression, SE(CTE9PTBI), which is the square-root of VAR(CTE9PTBI) (Weisberg, 1985, pp. 1213). For this reason, we base
our book-tax conformity measure on the RMSE from the following model, estimated by country-year (country and rm
subscripts are suppressed, and item numbers refer to the Compustat Global Industrial/Commercial database):

CTEt y0 y1 PTBIt y2 ForPTBIt y3 DIVt et 3

where CTE is the current tax expense (Items #2325)9; t the year indicator; PTBI the pre-tax book income (Item #21);
ForPTBI the estimated foreign pre-tax book income (foreign tax expense (Item #51)/total tax expense (Item #23)  PTBI)10;
DIV the total dividends (Item #34)11; and e the error term.12
We divide CTE, ForPTBI, and DIV by average total assets (Item #89) to control for cross-sectional scale differences.
We include an estimate of foreign pre-tax book income because foreign earnings of multinationals may be taxed at rates
that differ from the domestic statutory rate. We include dividends in the model to control for potential cross-sectional
differences in current tax expense that are related to dividend distributions, such as those arising in countries with
imputation tax systems and/or dividend surtaxes. For countries with fewer than 8 observations with nonzero values for
DIV or ForPTBI in a particular year, we winsorize the nonzero values to zero for that year.
The standard error of CTE for a given level of PTBI not explained by the model, SE(CTE9PTBI), provides an indication of
the overall amount of discretion that managers have to report earnings that differ from taxable income (either higher or
lower). We estimate Model (3) by country-year to allow for changes in tax rates and book-tax conformity across countries
and within a country, over time. A higher (lower) RMSE indicates lower (higher) book-tax conformity.13 For our regression
analyses, we rank countries each year, based on the Model (3) RMSEs, so that countries with higher rankings in a given year
have higher book-tax conformity (i.e., we use descending ranks so that the highest RMSE in the year is ranked 0 and the
lowest RMSE in the year is ranked n  1, where n is the number of included countries in that year). We then divide by n 1
to scale these rankings to range between zero and one.14 The resulting scaled rankings are labeled BTaxC.

3.2. Tests for earnings persistence and the association between earnings and future cash ows

We test for differences in earnings persistence and the association between earnings and future cash ows across book-
tax conformity levels using the cross-section of rm-year observations. Specically, we estimate the following models
(country and rm subscripts are suppressed):
EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt  BTaxCt a4 LOSSt
a5 EARNt  LOSSt a6 EVARt a7 EARNt  EVARt a8 SRATEt a9 EARNt  SRATEt et 4

CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt  BTaxCt b4 LOSSt


b5 EARNt  LOSSt b6 EVARt b7 EARNt  EVARt b8 SRATEt b9 EARNt  SRATEt ut 5
where EARN is the net income before extraordinary items (Item #32); t the year indicator; ayear the year xed effects in the
future earnings model; BTaxC the scaled descending rank of the RMSE from Model (3); LOSS 1 if pre-tax book income is
negative in year t, 0 otherwise; EVAR the scaled descending rank of the standard deviation of PTBI; SRATE the statutory tax

9
More observations in the Compustat Global Industrial/Commercial database have total tax expense (Item #23) and deferred tax expense (Item #25)
than current tax expense (Item #24). When total tax expense or deferred tax expense are missing, we use current tax expense, if available.
10
The Compustat Global Industrial/Commercial database does not break pre-tax book income into its domestic and foreign components, nor does it
break foreign tax expense into its current and deferred components. Thus, we estimate the foreign percentage of pre-tax book income as foreign tax
expense/total tax expense. A limitation of our model is that this ratio over- (under-) estimates the percentage of foreign earnings if the foreign tax rate is
higher (lower) than the domestic tax rate. However, we estimated Model (3) without ForPTBI for rms without foreign tax expense and the results are
qualitatively similar.
11
For observations with missing values for total dividends (Item #34), we set DIV equal to zero.
12
Graduated tax rates and tax credits could also affect the relation between current tax expense and pre-tax book income but most countries do not
have graduated rates or, like the US, the rates are graduated for very small amounts of taxable income. Since we divide CTE by average assets, the impact
of graduated tax rates on the variance of CTE/Assets should be very small and we have no reason to believe that they are systematically related to future
earnings or cash ows.
13
We also performed our main tests using mean absolute residuals and the difference in the mean residuals for the top and bottom quintiles of rms
in each country-year. The results are quantitatively similar.
14
This transformation converts the ranks into percentiles. Because the number of included countries varies by year, this transformation is necessary
to ensure that the book-tax conformity variable is scaled consistently across years.
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rate15; e the error term in the earnings persistence model; CFO the cash ows from operations; byear the year xed effects
in the future cash ows model; and u the error term in the future cash ows model.
We follow Pincus et al. (2007) and calculate CFO as EARN less the change in noncash current assets (Items #60  75)
plus the change in current liabilities (#104) less the change in the current portion of long-term debt (#94) plus
depreciation (Item #11).16 Accruals are calculated as EARN less CFO. We then scale EARN and CFO by average total assets
(Item #89).
Model (4) estimates one-year-ahead earnings persistence. EARN  BTaxC allows earnings persistence to vary across
book-tax conformity levels. A positive (negative) and signicant a3 coefcient suggests that earnings are more (less)
persistent when book-tax conformity is higher. Similarly, Model (5) estimates the extent to which current earnings are
associated with one-year-ahead cash ows. A positive (negative) and signicant b3 coefcient suggests that earnings are
more (less) strongly associated with future cash ows when book-tax conformity is higher.
In Models (4) and (5), we control for negative earnings (LOSS) and allow the coefcient on EARN to vary across positive
and negative earnings. We do this to control for differences in earnings persistence and the association between earnings
and future cash ows across operating gains and losses, which result from the transitory nature of losses (Hayn, 1995; Joos
and Plesko, 2005). We also control for earnings variability (EVAR) and for the statutory tax rate (SRATE) to ensure that our
book-tax conformity measure is not just reecting differences in the variance of PTBI or in statutory tax rates which exist
across countries. To mitigate the inuence of error terms that are correlated across rms and across time, we follow the
recommendation in Petersen (2009) by estimating all regression models using ordinary least squares (OLS), using standard
errors clustered by rm (Rogers, 1993), and including year xed effects.17

4. Sample selection, descriptive statistics and results

4.1. Sample selection

We rst obtain all rm-year observations from 1992 to 2005 with sufcient data available in the Compustat Global
Industrial/Commercial le to compute the variables in Models (3)(5).18 We then delete observations in the top or bottom
one-half percent of the distributions of CTE, PTBI, ForPTBI, DIV, EARN, or CFO in each year to remove potential outliers.19
We also delete all rm-year observations from countries that do not have at least 40 usable rm-year observations,
which is a less stringent data availability criterion than previous research. This sample selection procedure yields 125,859
rm-year observations from 33 countries for our main tests (i.e., Models (4) and (5)).
When computing country-year book-tax conformity levels, we also remove all rm-year observations with negative
pre-tax book income (i.e., PTBIo0) or with negative current tax expense (i.e., CTE o0). In general, the current tax expense
reported in loss years reects the extent to which losses may be carried backward versus forward and the amount of prots
in the carryback years, as well as differences between reported losses and taxable losses for the current year. Thus,
including these observations would add noise to our estimate of the relation between current tax expense (or benet) and
pre-tax book income. After removing all rm-year observations with negative PTBI or negative CTE, the sample consists of
93,893 rm-year observations from 33 countries; we use this sample in Model (3) to estimate our book-tax conformity
measure.20 Finally, to remove the inuence of potential outliers, we removed the top or bottom one-half percent of the
distributions of residuals from Model (3) in each year; the results are robust to relaxing this truncation procedure

4.2. Descriptive statistics

Table 1 lists our sample countries and country-specic averages from the results of estimating Model (3). It also
presents the average RMSE for each country, as well as the number of years, N(years), that each country appears in the
sample. The countries are sorted from low to high average book-tax conformity.
As book-tax conformity increases, we expect y1 to approach the statutory tax rate. In other words, when book-tax
conformity is very high, CTE will approach the statutory rate times PTBI. To test whether y1 approaches the statutory tax

15
We hand-collected these statutory rates from a KPMG LLP online summary, PricewaterhouseCoopers LL online information, and Coopers & Lybrand
LLP s worldwide tax summary guides. We also collected statutory tax rates from the Organisation for Economic Co-operation and Development (OECD)
but the latter reduces our sample to 19 countries. Untabulated analyses using the OECD data yields qualitatively similar results.
16
We also use an alternative specication where we include deferred tax expense or benet in accruals. The results from the models using this
specication (not tabulated) are quantitatively similar to those reported in the paper.
17
Following the recommendation in Petersen (2009), we test for time-series and cross-sectional dependence in the data by estimating Model (4)
without year xed effects and comparing the White corrected standard errors to the standard errors clustered by rm or by year. We nd (untabulated)
that clustered standard errors are larger (with one exception) than the White corrected standard errors. Thus, we control for both types of dependence.
18
Since the dependent variables in Models (4) and (5) are future earnings and future cash ows, respectively, the dependent variables are from 1993
to 2005.
19
In robustness tests, we also omit all observations with absolute studentized residuals greater than three. Again, the results are qualitatively similar.
20
When we include rms with negative pre-tax book income and negative CTE and re-estimate Model (3) with an interaction term between LOSS
and PTBI in untabulated sensitivity analyses, the average adjusted R2 falls for 31 of 33 sample countries, consistent with our conjecture that including
rms with negative pre-tax book income or negative current tax expense adds noise to our book-tax conformity measure.
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Table 1
Book tax conformity measures by country.

Model 3 : CTEt y0 y1 PTBIt y2 ForPTBIt y3 DIVt et

Country N(years) Avg. y0 Avg. y1 Avg. y2 Avg. y3 Avg. RMSE Avg. Adj. R2 Avg. N(rms)

Canada 13 0.000 0.238  0.037 0.109 0.017 0.459 254


South Africa 7 0.003 0.221  0.027 0.112 0.016 0.544 60
Germany 13 0.003 0.342  0.006 0.064 0.016 0.602 273
USA 13  0.001 0.326  0.012 0.005 0.015 0.680 1819
India 12  0.008 0.314 0.000 0.000 0.014 0.708 130
Greece 7 0.001 0.254 0.000 0.146 0.014 0.717 53
Belgium 9 0.002 0.254 0.000 0.078 0.014 0.576 59
Indonesia 8 0.000 0.215 0.000 0.237 0.013 0.673 101
Mexico 6  0.002 0.272 0.000 0.099 0.013 0.642 52
Norway 12  0.002 0.231  0.034 0.123 0.013 0.540 52
New Zealand 5  0.001 0.287 0.000 0.058 0.013 0.769 46
Australia 13 0.000 0.238 0.000 0.140 0.012 0.589 149
Sweden 13 0.000 0.213 0.018 0.068 0.012 0.605 102
Thailand 13  0.001 0.215 0.000 0.062 0.012 0.569 148
Philippines 6 0.002 0.177 0.000 0.095 0.011 0.464 59
Brazil 10 0.001 0.250 0.000  0.023 0.011 0.670 67
Denmark 13 0.000 0.269 0.000  0.020 0.010 0.683 73
UK 13  0.001 0.253 0.032 0.126 0.010 0.734 605
Italy 11 0.003 0.336 0.013 0.096 0.010 0.702 103
Finland 8 0.002 0.244 0.000 0.059 0.010 0.695 70
Malaysia 13 0.002 0.193  0.021 0.050 0.010 0.558 262
Netherlands 13  0.001 0.305  0.026 0.003 0.009 0.746 95
Taiwan 7 0.001 0.122 0.000 0.000 0.009 0.423 132
Austria 7 0.002 0.211  0.006 0.042 0.009 0.544 50
Singapore 13 0.003 0.171 0.022 0.005 0.008 0.537 157
France 13 0.000 0.331  0.017 0.104 0.008 0.805 290
Spain 13  0.002 0.256 0.000 0.108 0.008 0.764 77
Switzerland 13 0.002 0.186  0.001 0.098 0.008 0.612 112
Japan 11 0.001 0.398 0.000 0.404 0.008 0.806 1630
Korea 7 0.002 0.242 0.000 0.066 0.007 0.816 125
China 8 0.000 0.195 0.007  0.008 0.007 0.566 965
Hong Kong 10 0.000 0.121 0.023 0.018 0.007 0.512 64
Chile 7 0.000 0.140 0.000  0.019 0.006 0.619 67

Variable denitions: CTE is current tax expense (Items #2325); PTBI is pre-tax book income (Item #21); ForPTBI is estimated foreign pre-tax book
income, calculated as foreign tax expense (Item #51) divided by total tax expense (Item #23) times PTBI; and DIV is total dividends (Item #34); N(years)
is the number of years that the country appears in our sample; Avg. RMSE is the average root mean-squared error from estimating Model (3) by year for
each country; Avg. Adj R2 is the average explanatory power (Adjusted R2) from the regression; Avg. N(rms) is the average number of rms, per year,
entering the regression.

rate as book-tax conformity increases, we compute the absolute difference between y1 and the statutory rate, and label this
difference DiffRate. We nd that DiffRate is highly correlated with RMSE, our book-tax conformity measure (r = 0.48,
p o0.01). Thus, our book-tax conformity measure increases when y1 is closer to the statutory rate.21
The presence of deferred taxes on the income statement and/or the balance sheet provides another indication of the
extent to which TI can deviate from PTBI. As an additional check on the efcacy of our book-tax conformity measure, we
examine the correlations between RMSE and two measures of deferred taxes. First, we divide the mean absolute deferred
tax expense from the income statement by assets, and label this MabsDTE. Second, we divide the mean deferred tax
liability from the balance sheet by total assets, and label this MDTL. We nd that the RMSE is positively correlated with
both MabsDTE (r =0.5219, po0.0001) and MDTL (r = 0.2065, p o0.0001). Thus, the RMSE increases as rms in the country
report more temporary book-tax differences.22

21
If we scale DiffRate by the statutory rate, the correlation is still positive and signicant (r =0.27, po 0.01).
22
One striking difference between our book-tax conformity measure and prior measures is that Germany has a relatively high RMSE (indicating low
book-tax conformity) while the conventional wisdom is that Germany has high book-tax conformity (Hung, 2001). However, the close tie between tax
and book numbers in Germany applies to the individual accounts (or separate company accounts) used to assess taxes and to limit the dividends that
separate companies can pay. The book-tax conformity requirement does not apply to the group accounts in the consolidated nancial statements,
which may differ signicantly from those in the individual accounts (Leuz and Wustemann, 2004). German RMSEs from Model (3) suggest signicant
differences between taxable income and consolidated nancial statement income. Moreover, German mean absolute deferred tax expense (scaled by
assets) is similar to that of Australia where conventional wisdom suggests low book-tax conformity.
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Table 2
Descriptive statistics and correlations.

Panel A: Descriptive statistics


Variable Mean Std. Dev Quartile 1 Median Quartile 3

EARNt + 1 0.010 0.130 0.001 0.030 0.066


CFOt + 1 0.051 0.142 0.007 0.064 0.120
EARNt 0.012 0.133 0.001 0.030 0.068
LOSSt 0.23 0.42 0 0 0
N 125,859

Panel B: Pearson (below) and Spearman (above) correlations


EARNt + 1 CFOt + 1 EARNt LOSSt

EARNt + 1 0.583 0.691  0.472


o 0.0001 o 0.0001 o 0.0001
CFOt + 1 0.705 0.405  0.291
o0.0001 o 0.0001 o 0.0001
EARNt 0.625 0.478  0.716
o0.0001 o 0.0001 o 0.0001
LOSSt  0.461  0.326  0.638
o0.0001 o 0.0001 o 0.0001

Variable denitions: EARN is net income before extraordinary items (Item #32), deated by average total assets (Item #89); CFO is EARN less the change
in noncash current assets (Items #75  60) plus the change in current liabilities (Item #104) less the change in the current portion of long-term debt (Item
#94) plus depreciation (Item #11), deated by average total assets; and LOSS equals 1 if the rm has negative pre-tax book income for the year,
0 otherwise.

Table 2, Panel A presents descriptive statistics for our sample variables, while Panel B presents the Pearson and
Spearman correlations between sample variables. Correlations between future EARN, future CFO, and current earnings are
all positive (p o0.001). The correlations between the indicator variable, LOSS, and future earnings, future cash ows, and
current earning are all negative (p o0.001). Thus, we include interactions with LOSS in all association tests.

4.3. Results from tests of earnings persistence and the association between earnings and future cash ows

Table 3, Panel A presents the results from Model (4). Since the Model (4) book-tax conformity measure is BTaxC, which is
the scaled, descending rank of the RMSE from Model (3), higher values of BTaxC correspond to higher book-tax conformity.
The overall persistence parameter from the earnings persistence model (a1) is 0.812 (p o0.01). This is similar in
magnitude to the persistence parameters in Sloan (1996). The coefcient on EARN  LOSS (a5) is  0.203 (p o0.01),
conrming that accounting losses are not as persistent as prots (Hayn, 1995; Joos and Plesko, 2005). However, we nd no
evidence that earnings persistence is related to earnings variability or to the statutory rate. Most importantly, the
coefcient on EARN  BTaxC (a3) is 0.191 (po0.01). Thus, earnings are less persistent as book-tax conformity increases.
The magnitude of the coefcients a1 and a3 provide an indication of the economic signicance of the results. The ratio of a3
to a1 is approximately 23.5% (i.e., 0.191/0.812). Thus, all else equal, earnings persistence in countries with the highest
book-tax conformity is almost one-quarter lower than earnings persistence in countries with the lowest book-tax
conformity. Moreover, using US dollars as the currency, on average, 1 dollar of current earnings is associated with
approximately 81 cents of future earnings in countries with the lowest book-tax conformity versus approximately 62 cents
in countries with the highest book-tax conformity.
Table 3, Panel B presents the results from Model (5). As in the earnings persistence model, future cash ows are
positively associated with current earnings (b1 =0.625, p o0.01).23 Furthermore, consistent with Panel A, the coefcient on
EARN  LOSS is negative (b5 = 0.060, p o0.01), indicating that current prots are more informative about one-year-ahead
cash ows than are current losses. Moreover, the coefcient on EARN  EVAR is negative (b7 =  0.086, p o0.01), indicating
that current earnings are less informative about future cash ows when the cross-sectional standard deviation in earnings
is greater. Most importantly, the coefcient on EARN  BTaxC is negative (b3 =  0.201, po0.01), suggesting that current
earnings are more highly associated with future cash ows when book-tax conformity is lower. Here, the ratio of b3b1 is
approximately 32.2% (i.e., 0.201/0.625). Thus, all else equal, the association between current earnings and future cash ows
in countries with the highest book-tax conformity is almost one-third lower than in countries with the lowest book-tax
conformity.

23
The coefcient on current earnings is greater than that reported for US rms in Barth et al. (2001) of 0.42. This difference is likely due to the
interaction of current earnings with the control variables and to differences in time period and sample composition. When we regress future cash ows
on only current earnings, the coefcient for our sample (0.51) is closer to that in Barth et al. (2001).
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Table 3
Tests of earnings persistence and the association between current earnings and future cash ows.

Model 4 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt  BTaxCt a4 LOSSt


a5 EARNt  LOSSt a6 EVARt a7 EARNt  EVARt a8 SRATEt a9 EARNt  SRATEt et
Model 5 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt  BTaxCt b4 LOSSt
b5 EARNt  LOSSt b6 EVARt b7 EARNt  EVARt b8 SRATEt b9 EARNt  SRATEt ut

Variable Panel A: Model (4) Panel B: Model (5)

Mean coeff. t-stat. Mean Coeff. t-stat.

EARNt 0.812 15.37nnn 0.625 11.58nnn


BTaxCt 0.015 7.71nnn  0.001  0.46
EARNt  BTaxCt  0.191  5.27nnn  0.201  5.37nnn
LOSSt  0.031  22.15nnn  0.016  10.57nnn
EARNt  LOSSt  0.203  15.55nnn  0.060  4.05nnn
EVARt  0.003  1.49  0.006  2.57nn
EARNt  EVARt  0.034  1.18  0.086  2.85nnn
SRATEt 0.001 0.26  0.019  2.70nn
EARNt  SRATEt  0.104  0.81  0.018  0.14
Year indicators Yes Yes

Adjusted R2 0.410 0.237


N 125,859 125,859

n, nn, nnn indicate signicant at the p o0.10, 0.05, 0.01 level.


Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before
extraordinary items (Item #32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled
descending rankings of RMSEs from Model (3); CFO is EARN less the change in noncash current assets (Item #60  75) plus the change in current liabilities
(Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets; LOSS
equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pre-tax
book income (Item #21); and SRATE is the statutory rate. Year xed effects are not reported.

Overall, these associations are consistent with claims made by opponents of increased book-tax conformitythat
increased book-tax conformity will lower earnings quality (Shevlin, 2002; Hanlon et al., 2005; Plesko, 2006; Shackelford,
2006; Hanlon et al., 2008).

5. The effects of differences in institutional and accounting structures across countries

5.1. Country-level controls for institutional and accounting structures

In this section, we add controls for country-level variables that may be associated with earnings persistence and with
the association between earnings and future cash ows. First, we control for the countrys legal tradition using a code-
versus common-law indicator variable (CommonLaw) developed by La Porta et al. (1998). Ball et al. (2000) suggest that in
code-law countries, the inuence of politics on accounting is stronger, leading to a stakeholder corporate governance
model. In contrast, in common-law countries, accounting practices are typically determined in the private sector, leading
to a shareholder corporate governance model. Second, we control for cross-country differences in investor rights
(InvRights) using the investor rights proxy developed by La Porta et al. (1998).24 All things equal, stronger investor rights
reduce managements ability to exercise discretion over reported earnings (La Porta et al., 1998; Hung, 2001; Pincus et al.,
2007), which potentially inuences earnings persistence and the association between earnings and future cash ows.
Third, we control for ownership concentration (OwnCon) using the ownership concentration variables developed by La
Porta et al. (1998) because accounting theory suggests that ownership structures affect reported earnings (Watts and
Zimmerman, 1986, 1990).25
Table 4, Panel A presents data on the additional country-level variables, which are available for all sample countries
other than China. The resulting sample consists of 116,902 observations from 32 countries.
Table 4, Panel B reveals a high degree of collinearity among the country-level variables. The Pearson (Spearman)
correlation between CommonLaw and InvRights is 0.679 (0.778) and between InvRights and OwnCon is  0.661 (  0.668).
Factor analysis (untabulated) suggests that these three variables converge to one underlying construct, which explains

24
The InvRights variable is a score ranging from 0 to 5, where a 5 implies greater minority shareholder rights. The score is based on the
Anti-Director Rights index in La Porta et al. (1998).
25
The OwnCon variable is the median percentage of common shares owned by the three largest shareholders in the ten largest privately owned,
nonnancial rms in the country.
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Table 4
Factor analyses with other country-level variables.

Panel A: Other country-level variables


Country CommonLaw InvRights OwnCon

Australia 1 4 0.28
Austria 0 2 0.51
Belgium 0 0 0.62
Brazil 0 3 0.63
Canada 1 5 0.24
Chile 0 5 0.38
China NA NA NA
Denmark 0 2 0.40
Finland 0 3 0.34
France 0 3 0.24
Germany 0 1 0.50
Greece 0 2 0.68
Hong Kong 1 5 0.54
India 1 5 0.43
Indonesia 0 2 0.62
Italy 0 1 0.60
Japan 0 4 0.13
Korea 0 2 0.20
Malaysia 1 4 0.52
Mexico 0 1 0.67
Netherlands 0 2 0.31
New Zealand 1 4 0.51
Norway 0 3 0.34
Philippines 0 3 0.51
Singapore 1 4 0.53
South Africa 1 5 0.52
Spain 0 4 0.50
Sweden 0 3 0.28
Switzerland 0 2 0.48
Taiwan 0 3 0.14
Thailand 1 2 0.48
UK 1 5 0.15
USA 1 5 0.12

Panel B: Pearson (below) and Spearman (above) correlations


BTaxC CommonLaw InvRights OwnCon FACTOR

BTaxC  0.557  0.458 0.324  0.499


o 0.0001 o 0.0001 o 0.0001 o 0.0001
CommonLaw  0.567 0.778  0.322 0.738
o 0.0001 o 0.0001 o 0.0001 o 0.0001
InvRights  0.240 0.679  0.668 0.940
o 0.0001 o 0.0001 o 0.0001 o 0.0001
OwnCon 0.106  0.190  0.661  0.843
o 0.0001 o 0.0001 o 0.0001 o 0.0001
FACTOR  0.360 0.757 0.960  0.743
o 0.0001 o 0.0001 o 0.0001 o 0.0001

Variable denitions: BTaxC is the book-tax conformity variable, computed as the scaled descending rankings of RMSEs derived from Model (3);
CommonLaw equals one if the countrys legal tradition is common-law, zero if code-law; InvRights equals the investors rights score developed by La
Porta et al. (1998); OwnCon is the ownership concentration variable developed by La Porta et al. (1998); and FACTOR is the principal factor score obtained
from a factor analysis with CommonLaw, InvRights, and OwnCon as the component variables.
NA indicates not available.

approximately 68% of the variation in CommonLaw, InvRights, and OwnCon.26 As expected, in Panel B, the principal factor
(FACTOR) is highly correlated with its components; all correlations are greater than 0.73 in absolute magnitude. BTaxC is
also correlated with FACTOR but to a lesser extent, with a Pearson (Spearman) correlation of  0.360 (  0.499). To mitigate
improper inferences (due to multicollinearity) that might result from entering the components into the models, in
subsequent analyses, we include FACTOR rather than the underlying components.27 However, our results are qualitatively
similar if we include the individual components.

26
The Eigenvalue on the principal factor is signicant at 2.05. All others are insignicant (Eigenvalues o1).
27
Jaccard and Turrisi (2003) state that high collinearity between main effect terms and interaction terms is generally not problematic, but high
collinearity between main effect terms can be an issue. We test whether high collinearity is present in our models by estimating main effects models
using OLS and by calculating the variance ination factors (VIFs). When we regress (untabulated) future earnings on current earnings, BTaxC, Loss,
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Table 5
Tests of earnings persistence and the association between current earnings and future cash ows with a factor to control for other country-level variables.

Model 6 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt  BTaxCt a4 LOSSt


a5 EARNt  LOSSt a6 EVARt a7 EARNt  EVARt a8 SRATEt
a9 EARNt  SRATEt a10 FACTOR a11 EARNt  FACTOR et
Model 7 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt  BTaxCt b4 LOSSt
b5 EARNt  LOSSt b6 EVARt b7 EARNt  EVARt b8 SRATEt
b9 EARNt  SRATEt b10 FACTOR b11 EARNt  FACTOR ut

Variable Panel A: Model (6) Panel B: Model (7)

Mean coeff. t-stat. Mean coeff. t-stat.

EARNt 0.828 15.63nnn 0.614 11.51nnn


BTaxCt 0.018 9.14nnn 0.004 1.64
EARNt  BTaxCt  0.215  5.69nnn  0.186  4.86nnn
LOSSt  0.032  22.37nnn  0.017  11.11nnn
EARNt  LOSSt  0.191  14.04nnn  0.073  4.79nnn
EVARt  0.009  4.80nnn  0.020  8.02nnn
EARNt  EVARt 0.033 0.98 0.011 0.32
SRATEt 0.011 1.97  0.003  0.39
EARNt  SRATEt  0.257  2.01nn  0.091  0.71
FACTOR  0.003  6.83nnn  0.009  16.46nnn
EARNt  FACTOR 0.037 4.48nnn 0.039 4.83nnn
Year indicators Yes Yes

Adjusted R2 0.415 0.254


N 116,902 116,902

n, nn, nnn indicates signicant at the p o 0.10, 0.05, 0.01 level.


Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before
extraordinary items (Item #32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled
descending rankings of RMSEs derived from Model (3); CFO is EARN less the change in noncash current assets (Items #60  75) plus the change in current
liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets;
LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pre-
tax book income (Item #21); SRATE is the statutory rate; and FACTOR is the principal factor score obtained from the factor analysis with Common- vs.
Code-Law, investors rights, and ownership concentration as the component variables. Year xed effects are not reported.

5.2. Results from tests of earnings persistence and the association between earnings and future cash ows with a country-level
control for institutional and accounting structures

In this section, we enter FACTOR into Models (4) and (5) and interact it with EARNt to allow for differences in earnings
persistence and in the association between current earnings and future cash ows across levels of FACTOR. We estimate
the following models (country and rm subscripts are suppressed):
EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt
BTaxCt a4 LOSSt a5 EARNt  LOSSt a6 EVARt a7 EARNt
EVARt a8 SRATEt a9 EARNt  SRATEt a10 FACTOR a11 EARNt  FACTOR et 6

CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt  BTaxCt b4 LOSSt


b5 EARNt  LOSSt b6 EVARt b7 EARNt  EVARt b8 SRATEt
b9 EARNt  SRATEt b10 FACTOR b11 EARNt  FACTOR ut 7
where FACTOR is the principal factor score obtained from the factor analysis with CommonLaw, InvRights, and OwnCon
(as described in the previous section) as the component variables; and all other variables are as previously dened.
Table 5, Panel A presents results of the earnings persistence model. EARN  FACTOR is positive (a11 = 0.037, po0.01),
suggesting that earnings are more persistent, on average, in countries with common-law legal traditions, strong investor
rights, and lower ownership concentration. Moreover, the coefcient on EARNt  BTaxCt remains negative (a3 =  0.215,
p o0.01). Similarly, Table 5, Panel B presents results of the future cash ows model. As in the future earnings model,
EARN  FACTOR is positive (b11 = 0.039, p o0.01), suggesting that earnings are more closely associated with future cash
ows, on average, in countries with common-law legal traditions, strong investor rights, and lower ownership
concentration. Moreover, the coefcient on EARNt  BTaxCt remains negative (b3 =  0.186, p o0.01). Thus, our ndings,

(footnote continued)
CommonLaw, InvRights, and OwnCon, the VIFs range from 1.72 to 7.37. In contrast, when we regress (untabulated) future earnings on current earnings,
BTaxC, Loss, and FACTOR, the VIFs range from 1.36 to 1.78.
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that earnings persistence is lower and that current earnings are less highly associated with future cash ows when book-
tax conformity is higher, are robust to a control for country-level differences in legal systems, investor rights, and
ownership concentration.28
Taken together, the results from Models (4) to (7) provide evidence that earnings persistence is higher and current
earnings better predict future cash ows when the required level of book-tax conformity is lower. Our results suggest that,
on average, even though some managers may take advantage of their reporting discretion to report accounting earnings
opportunistically when book-tax-conformity is lower, the benets of allowing managers exibility in reporting accounting
earnings outweigh the costs from manager opportunism (at least with respect to earnings ability to provide information
about future rm performance).

6. Additional analyses

In this section, we present the results of two additional tests. First, we test whether the main results are robust to
controls for differential earnings persistence across industries which results from differences in product type, barriers-to-
entry, and/or capital intensity (Lev 1983). Second, we assess whether our book-tax conformity measure provides
information beyond the traditional book-tax conformity indicator variable.

6.1. Controlling for differential earnings persistence by industry

Lev (1983) nds that characteristics of a rms economic environment (e.g., product type, barriers-to-entry, capital
intensity, and rm size) are associated with earnings persistence. Following Lev (1983), we control for potential differences
in earnings persistence related to economic factors using industry membership by creating industry indicator variables
using the Fama and French (1997) 17-industry classication scheme.29 We enter the industry variables and their
interactions with EARNt into Models (4)(7) to investigate whether our results hold in the presence of industry controls.
The untabulated results are qualitatively similar.

6.2. Assessing the incremental information in BTaxC beyond that in the traditional book-tax conformity indicator variable

Next, we assess the incremental information in our measure, BTaxC, beyond that of the traditional book-tax conformity
indicator variable in Hung (2001). Table 2 of Hung (2001) presents the level of book-tax conformity in 21 countries (where
1 indicates high conformity and 0 indicates low conformity). Countries included in the Hung (2001) sample and their
respective levels of conformity are similar to those in other studies. Thus, in tests that follow, we limit the sample to 20 of
the 21 countries in Hung (2001).30,31
We begin by estimating the Spearman correlation between our book-tax conformity measure, BTaxC, and the
traditional book-tax conformity indicator variable, which we label TradBTC. As reported in Table 6, Panel A, BTaxC and
TradBTC are positively and signicantly correlated but the Spearman correlation is only 0.565, suggesting that a substantial
amount of variation between these two measures exists.32 In Panel A, we nd that relative to BTaxC, TradBTC is more
highly correlated with CommonLaw, InvRights, and FACTOR, and the correlations between BTaxC and OwnCon and
between TradBTC and OwnCon are quite similar in magnitude. The correlation between TradBTC and CommonLaw
(r =  0.927) is particularly striking. In fact, a review of Table 2 in Hung (2001) reveals that TradBTC (labeled Tax-book
conformity index) and CommonLaw (labeled Legal system) have opposite indicator values (i.e., TradBTC=1 when
CommonLaw= 0, and vice versa) in 18 of the 21 countries studied, suggesting that the traditional book-tax indicator
variable is picking up little more than whether the country is in a code-law legal system. The correlation between TradBTC
and InvRights is also very high (r =  0.782), resulting in a high correlation between TradBTC and FACTOR (r =  0.739).
Overall, results suggest that our measure contains information different from that in the traditional book-tax conformity
measure and that the traditional measure is almost exclusively a function of the legal system and the strength of investor
rights.
Next, we enter TradBTC and the interaction of TradBTC and EARNt into Models (4) and (5), and label these Models (8)
and (9), respectively, to investigate whether our book-tax conformity measure is signicant after controlling for the

28
We also remove EVAR, SRATE, FACTOR and the associated interactions from Models (6) and (7) and include country xed effects and interact
country xed effects with current earnings to control for xed differences in earnings persistence across countries. Untabulated results are qualitatively
similar.
29
Lev (1983) forms product type and barriers-to-entry indicator variables using industry membership. Capital intensity also likely varies across
industries. We cannot directly control for rm size because our sample observations do not have a common currency but we scale earnings and cash
ows by average total assets.
30
One country, Ireland, is included in the sample of Hung (2001), but is not in our sample.
31
Using this reduced sample of 20 countries, we recalculate the scaled descending rankings of the RMSEs (BTaxC) from Model (3) and of the standard
deviation of PTBI (EVAR).
32
These correlations differ from those in Table 4, Panel B because they are estimated using only the 20 countries included in both our sample and in
Hung (2001). However, the correlation signs and magnitudes are similar.
ARTICLE IN PRESS
124 T.J. Atwood et al. / Journal of Accounting and Economics 50 (2010) 111125

Table 6
Tests of earnings persistence and the association between current earnings and future cash ows including the traditional book-tax conformity indicator
variable as a control.

Panel A: Spearman correlations between BTaxC, TradBTC, other country-level variables, and FACTOR
TradBTC CommonLaw InvRights OwnCon FACTOR

BTaxC 0.565  0.583  0.504 0.372  0.548


o 0.0001 o 0.0001 o 0.0001 o 0.0001 o0.0001
TradBTC  0.927  0.782 0.357  0.739
o 0.0001 o 0.0001 o 0.0001 o0.0001

Panels B and C: Earnings persistence and the associations between current earnings and future cash ows including the traditional book-tax conformity
indicator variable as a control

Model 8 : EARNt 1 ayear a1 EARNt a2 BTaxCt a3 EARNt  BTaxCt a4 LOSSt


a5 EARNt  LOSSt a6 EVARt a7 EARNt  EVARt a8 SRATEt
a9 EARNt  SRATEt a10 TradBTC a11 EARNt  TradBTC et
Model 9 : CFOt 1 byear b1 EARNt b2 BTaxCt b3 EARNt  BTaxCt b4 LOSSt b5 EARNt  LOSSt
b6 EVARt b7 EARNt  EVARt b8 SRATEt b9 EARNt  SRATEt
b10 TradBTC b11 EARNt  TradBTC ut

Variable Panel B: Model (8) Panel C: Model (9)

Mean coeff. t-stat Mean coef. t-stat

EARNt 0.817 13.10nnn 0.682 10.60nnn


BTaxCt 0.012 5.16nnn  0.017  5.27nnn
EARNt  BTaxCt  0.110  2.27nn  0.148  3.09nnn
LOSSt  0.031  20.37nnn  0.018  10.79nnn
EARNt  LOSSt  0.178  12.17nnn  0.038  2.33nn
EVARt 0.006 2.39nn  0.007  2.09nn
EARNt  EVARt  0.190  3.94nnn  0.158  3.33nnn
SRATEt  0.004  0.63  0.102  11.07nnn
EARNt  SRATEt  0.057  0.40  0.125  0.85
TradBTC 0.000 0.04 0.017 9.04nnn
EARNt  TradBTC 0.018 0.86 0.014 0.62
Year indicators Yes Yes

Adjusted R2 0.422 0.271


N 100,402 100,402

n, nn, nnn indicates signicant at the p o 0.10, 0.05, 0.01 level.


Test statistics are based on Rogers standard errors (Rogers, 1993), allowing the residuals to cluster by rm.Variable denitions: EARN is net income before
extraordinary items (Item # 32), deated by average total assets (Item #89); BTaxC is the book-tax conformity measure, computed as the scaled
descending rankings of RMSEs derived from Model (3); CFO is EARN less the change in noncash current assets (Items #60  75) plus the change in current
liabilities (Item #104) less the change in the current portion of long-term debt (Item #94) plus depreciation (Item #11), deated by average total assets;
LOSS equals 1 if the rm has negative pre-tax book income for the year, 0 otherwise; EVAR is the scaled descending rank of the standard deviation of pre-
tax book income (Item #21); SRATE is the statutory rate; and FACTOR is the principal factor score obtained from the factor analysis with Common- vs.
Code-Law, investors rights, and ownership concentration as the component variables. Year xed effects are not reported.

traditional measure.33 Table 6, Panels B and C present the estimation results for Models (8) and (9), respectively. In Panel B,
EARN  BTaxC remains negative (a3 =  0.110, p o0.05) but EARN  TradBTC is not different from zero. Similarly, in Panel C,
EARN  BTaxC remains negative (b3 = 0.148, p o0.01), and EARN  TradBTC is not different from zero. Thus, our book-tax
conformity measure subsumes the explanatory power of the traditional measure in explaining earnings persistence and
associations between current earnings and future cash ows.

7. Conclusions

We examine whether the required level of book-tax conformity in a country affects one-year-ahead earnings
persistence and the association between current earnings and one-year-ahead cash ows. We nd that earnings
persistence and the association between current earnings and future cash ows are lower when the level of required
book-tax conformity is higher. Our results are robust to the inclusion of the traditional indicator variable for book-tax
conformity used in prior studies, the inclusion of a control variable for differences in legal systems, investor rights, and

33
We enter TradBTC into Models (4) and (5), which do not contain FACTOR, due to the high collinearity between the TradBTC and FACTOR. However,
in untabulated analyses, we enter TradBTC into Models (6) and (7), which contain FACTOR. We nd that our main result strengthens. Specically, the
coefcient on EARN  BTaxC is more negative and is more highly signicant in Models (6) and (7) than in Models (4) and (5).
ARTICLE IN PRESS
T.J. Atwood et al. / Journal of Accounting and Economics 50 (2010) 111125 125

ownership concentration, and to controls capturing differences in earnings persistence across countries and industries. Our
results imply that researchers examining cross-country differences in accounting earnings properties should consider
including book-tax conformity in their models.
We introduce a measure of country-wide required book-tax conformity, which can be easily estimated using publicly
available data and which is more comprehensive (in that it includes more countries) and more powerful than the
traditional indicator variable measure used in prior studies. Moreover, this measure allows for a continuum of book-tax
conformity levels and for changes in required book-tax conformity over time.
Opponents of increased book-tax conformity in the US suggest that the information required by investors is very
different from that required by tax authorities, and that increasing book-tax conformity will lower (rather than increase)
earnings quality. Consistent with this view, we nd that increasing the required level of book-tax conformity in the US may
result in reported accounting earnings that are less persistent and less highly associated with future cash ows. Some
proponents of increased book-tax conformity suggest that something less than full conformity should be considered (for
example, taxable income could equal book income less explicitly allowed book-tax differences only). Since our tests are
based on a continuum of book-tax conformity levels, our results suggest that any movement toward book-tax conformity
(even to something less than full book-tax conformity) may result in reported accounting earnings that are less persistent
and less closely associated with future cash ows.

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