We investigate the association between aggressive tax and financial reporting and find a strong, positive relation. Our results suggest that insufficient costs exist to offset financial and tax reporting incentives, such that nonconformity between financial accounting standards and tax law allows firms to manage book income upward and taxable income downward in the same reporting period. To examine the relation between these aggressive reporting behaviors, we develop a measure of tax reporting aggressiveness that statistically detects tax shelter activity at least as well as, and often better than, other measures. In supplemental stock returns analyses, we confirm that the market overprices financial reporting aggressiveness. We also find that the market overprices tax reporting aggressiveness, but only for firms with the most aggressive financial reporting.
This paper investigates whether managers use the deferred tax asset valuation allowance account (VAA) to manage earnings around three earnings targets: positive net income, historical annual earnings, and the mean analyst forecast. While early studies using broad samples find little evidence of earnings management via the VAA, recent studies using narrowly defined samples conclude that certain firms use the VAA to manage earnings around these three earnings targets.The difference in conclusions drawn from prior research creates a gap in the academic literature and raises questions about the usefulness of the current literature to standard setters, who must determine the appropriate amount of discretion for a diverse population of firms. This paper provides broad evidence on the use of accounting discretion by investigating the pervasiveness of earnings management via the VAA for a diverse sample of firms.Using SFAS No. 109 to model the VAA, we estimate expected (i.e., nondiscretionary) and unexpected (i.e., discretionary) changes in the VAA, and use the unexpected change in VAA to compute premanaged earnings. We find substantial evidence that when premanaged earnings are below the mean analyst forecast, managers use the VAA to manage earnings upward, and when premanaged earnings are sufficiently above the mean analyst forecast, managers use the VAA to smooth earnings downward. We find little evidence that firms manage earnings via the VAA around the positive net income and historical earnings targets. This paper provides the most comprehensive evidence to date regarding the extent to which managers take advantage of the discretion allowed by SFAS No. 109 in order to manage earnings.
Mutual funds must disclose their portfolio holdings to investors semiannually. The costs and benefits of such disclosures are a long-standing subject of debate. For actively managed funds, one cost of disclosure is a potential reduction in the private benefits from research on asset values. Disclosure provides public access to information on the assets that the fund manager views as undervalued. This paper tries to quantify this potential cost of disclosure by testing whether "copycat" mutual funds, funds that purchase the same assets as actively-managed funds as soon as those asset holdings are disclosed, can earn returns that are similar to those of the actively-managed funds. Copycat funds do not incur the research expenses associated with the actively-managed funds that they are mimicking, but they miss the opportunity to invest in assets that managers identify as positive return opportunities between disclosure dates. Our results for a limited sample of high expense funds in the 1990s suggest that while returns before expenses are significantly higher for the underlying actively managed funds relative to the copycat funds, after expenses copycat funds earn statistically indistinguishable, and possibly higher, returns than the underlying actively managed funds. These findings contribute to the policy debate on the optimal level and frequency of fund disclosure.
This paper investigates the extent to which taxes affect a corporation’s decision to allocate its defined benefit plan’s assets between equity and bonds. Prior theoretical research shows that if a corporation integrates its financial policy and pension investment policy, differences in tax rates create an arbitrage opportunity. The firm’s tax benefits from the arbitrage should be positively related to the percentage of its pension assets allocated to bonds. Consistent with this prediction, but contrary to prior empirical work, this paper finds firms’ tax benefits are positively and significantly associated with the percentage of their pension assets invested in bonds.
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