Evidence of differing market responses to beating analysts’ targets through tax expense decreases

Abstract

Returns are positive when firms meet or beat analysts' consensus forecasts, but negative when firms miss. Prior research finds little substantial discount for managing earnings to beat the forecasts via accruals generally. We consider whether the market reward for beating the forecast is smaller when firms use tax expense decreases, which are visible and transparent at the earnings announcement date, unlike accruals. When firms beat analysts' forecasts by decreasing their tax expense relative to the third-quarter rate, the market discounts the reward by an economically significant amount: approximately 86%. We document lower persistence of current-year tax changes for those firms that decrease tax expense to beat the target. The observed discount for beating the forecast only because of a third to fourth quarter tax decrease may reflect market perceptions of the lack of persistence of the decrease.

A review of tax research

“…19 An interesting follow-up study by Gleason and Mills (2008) provides evidence consistent with the market understanding and discounting the reward to firms for meeting a target through managed tax expense; however, note that the company is still rewarded more than having missed the target so managing the expense is not useless even though the market discounts the reward. 20 This idea of actual tax planning as opposed to accrual management being used to manage the tax expense is similar in spirit to Roychowdhury's (2006) examination of real transactions for earnings management more generally.…”

“…Miller and Skinner (1998) find no evidence of earnings management in this account, while Bauman et al (2001) find limited evidence and conclude that earnings management in the account is not 18 The accounting for the effective tax rate falls under APB 28 Interim Financial Reporting, which requires firms to adjust the GAAP ETR each quarter to the estimated annual GAAP ETR. 19 An interesting follow-up study by Gleason and Mills (2008) provides evidence consistent with the market understanding and discounting the reward to firms for meeting a target through managed tax expense; however, note that the company is still rewarded more than having missed the target so managing the expense is not useless even though the market discounts the reward. 20 This idea of actual tax planning as opposed to accrual management being used to manage the tax expense is similar in spirit to Roychowdhury's (2006) examination of real transactions for earnings management more generally.…”

The Role of Additional Non-EPS Forecasts: Evidence Using Pre-Tax Forecasts

“…To test my third hypothesis, I extend the findings of Gleason and Mills (2008) SA_CAR i,t = β 0 + β 1 * Beat w/ tax i,t + β 2 * AFE i,t + (Equation 3a) β 3 * Persistence i,t + β 4 * Beat w/ Tax * Persistence i,t + β 5 *BM i,t + β 6 * Size i,t + β 7 * Momentum i,t + ε i,t I then expand the initial model to examine whether the market discounts managed earnings more or less when pre-tax coverage exists on the entire sample (Equation 2b). SA_CAR i,t = β 0 + β 1 * Pre i,t + β 2 * Beat w/ tax i,t + (Equation 3b) β 3 * Beat w/ tax * Pre i,t + β 4 * AFE i,t + β 5 * Persistence i,t + β 6 * Beat w/ Tax * Persistence i,t + β 7 *BM i,t + β 8 * Size i,t + β 9 * Momentum i,t + ε i,t…”

“…Gleason and Mills (2008) examine whether investors discount earnings which result specifically from the management of the tax expense. By examining market reactions to earnings surprises, they provide evidence that investors significantly discount earnings which have been managed through decreasing the effective tax rate from the third to fourth quarter.…”

“…Dhaliwal et al (2004) and Cook et al (2008) find that firms manage the tax expense account to meet analysts' after-tax earnings forecasts. Gleason and Mills (2008) examine the market reaction to this form of earnings management and find investors significantly discount the reward for beating analysts' forecasts through the manipulation of the tax expense account. I examine whether investors' reaction to the management of earnings through the tax expense account is impacted by the availability of analysts' tax-related forecasts.…”