Understanding the Informativeness of Book-Tax Differences

Abstract: We contribute to the literature attempting to understand the specifics of the information contained in book-tax differences. We begin by illustrating that the relation found in the literature between book-tax differences, earnings growth and persistence stems from uncorrelated measurement error in the accounting systems developed to report income for tax filings and financial statements. Using a series of counterfactual tests and simulation analyses, we show that the information contained in book-tax differences is not necessarily unique. We also develop a theoretical model that incorporates a report of taxable income in the Fischer and Verrecchia (2000) reporting bias framework. The model suggests that large book-tax differences are particularly informative when there is greater noise in the measurement of book and/or taxable income. However, manipulation of earnings by managers reduces the information content of book-tax differences. Ultimately, we find evidence consistent with our theory. Namely, that book-tax differences are informative because they provide information regarding the potential inability of the accounting systems underlying book and taxable incomes to capture economic performance.