Book-Tax Conformity and the Informativeness of Earnings

Abstract: We examine whether the informativeness of earnings is inversely related to the degree of conformity between financial accounting income and taxable income. Our inquiry exploits a natural experiment first examined by Guenther et al. (1997) in which a set of U.S. firms faced increased book-tax conformity as a result of a change in the tax law. We measure the informativeness of earnings as the long-window earnings response coefficient (ERC) from a regression of returns on earnings. The data are consistent with this long-window ERC decreasing for the set of firms in Guenther et al. (1997) after the tax law required greater book-tax conformity. This result is consistent with the increase in book-tax conformity reducing the usefulness of financial accounting earnings as a measure of firms ’ economic performance. We find that the decline is significantly larger than the changes in the same measure for an industry-matched sample of firms not facing an increase in conformity. These results add to the academic literature on the interaction of taxes and financial reporting as well as to the policy debate about whether the U.S. should conform the tax law to GAAP, a debate that has recently intensified