Effective Tax Changes, Earnings Persistence, and Value Relevance
Asian Tax Journal Vol. 8 No. 2 (2007), pp. 113-142
Abstract
This paper examines whether effective tax changes, defined as the change in effective tax rates between current and last periods, multiplied by current period's pre-tax earnings, affect earnings persistence and firm value. Under current GAAP, income tax expenses are the sum of income tax payable and deferred tax liabilities or the difference between income tax payable and deferred tax assets. Given that effective tax changes are determined by income tax payable and deferred tax assets/liabilities, they could provide a chance to identify managerial discretion in earnings management and tax management. These indicate that effective tax changes could reflect managers' opportunism. We hypothesize that (1) the larger effective tax changes are, the lower earnings quality and (2) the larger effective tax changes are, the less pricing multiple of earnings. We measure earnings persistence as the first autocorrelation of abnormal earnings over two consecutive periods, as in Ohlson (1995). Empirical analyses are performed for the sample of 779 non-banking firms listed on Korean Stock Exchange over the period of 2000-2002. The empirical results are summarized as follows. First, earnings quality deteriorates as effective tax changes are larger and this is prominent for firms that are more likely to manage earnings. Second, effective tax changes evaluated revenue/gain(not expense/loss) in korean stock market. But pricing multiple of earnings become less effective tax changes are larger and prevalent for firms that are more subject to earnings management. These results imply that effective tax changes have the economic means in valuating accounting income and firm value. Thus, financial statement users could rely on such information to evaluate quality of earnings and make their investment decision, and analysts should pay more attention to the fact that earnings quality deteriorates as effective tax changes are larger. Also the results in this study suggest that value relevance researcher should consider effective tax changes in addition to firm characteristic factors.
Keywords
- earnings persistence
- effective tax changes
- earnings quality
- firm value
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