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Accounting Research Center, Booth School of Business, University of Chicago

The 1993 Tax Rate Increase and Deferred Tax Adjustments: A Test of Functional Fixation Author(s): Kevin C. W. Chen and Michael P. Schoderbek Reviewed work(s): Source: Journal of Accounting Research, Vol. 38, No. 1 (Spring, 2000), pp. 23-44 Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University of Chicago Stable URL: http://www.jstor.org/stable/2672921 . Accessed: 04/01/2013 05:12
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Journal of Accounting Research Vol. 38 No. 1 Spring 2000


Printed in US.A.

The 1993 Tax Rate Increase and Deferred Tax Adjustments: A Test of Functional Fixation
KEVIN C. W. CHEN" AND MICHAEL P. SCHODERBEKt

1. Introduction
This paper uses a sample of 158 deferred tax adjustments resulting from the Omnibus Budget Reconciliation Act of 1993 (OBRA) to explore the magnitude and nature of analysts' and investors' functional fixation on reported accounting numbers. The 1993 OBRA,passed on August 10 of 1993, included a provision that raised the corporate tax rate from 34% to 35%. GAAPrequires companies to adjust their deferred tax assets and liabilities to recognize the income effects of tax changes in the period of the tax change (SFASNo. 109 [1992]). In this case, the effects of the tax rate increase on deferred taxes would be included in the income tax expense component of 1993 third-quarter earnings.1
*Hong Kong University of Science and Technology; tRutgers University. The authors Inc. for providing earnings forecast data and the School of Business of acknowledge IIBIEIS Rutgers University for providing funding on this study. For their helpful comments and suggestions we thank Rashad Abdel-khalik, Gary Biddle, Carla Hayn, John Hand, YawMensah, Dave Mest, Eric Noreen, and the workshop participants at Georgetown University, Hong Kong University of Science and Technology, National Cheng-Chi University, National Taiwan University, Rutgers University, Temple University, and the University of Maryland. We also thank Brian Yokley of the FASB, Jack Ciesielski of R.G. Associates, Inc., and Pat McConnell and Janet Pegg of Bear, Stearns & Co. for their technical insights and assistance. A previous version of this paper was presented at the Seventh Annual Conference on Financial Economics and Accounting held at Rutgers University. l The new tax rate was applicable to taxable income in excess of $10,000,000, retroactive to the beginning of the year for corporations with taxable years beginning on or after January 1, 1993. 23
Copyright ?, Institute of Professional Accounting, 2000

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JOURNAL

OF ACCOUNTING

RESEARCH,

SPRING

2000

Because this one-period adjustment could have been estimated using deferred tax information in the notes to financial statements, fully rational investors would be able to react to it as a transitory earnings component. In contrast, functionally fixated investors would not distinguish between the various components of reported earnings. Our analysis attempts to test these two competing descriptions of investor behavior. We also explore how financial analysts handled the adjustment in their forecasts of third-quarter earnings per share (EPS). We find that analysts generally did not include these adjustments in their earnings forecasts. This finding is not sensitive to the size or sign (income increasing or decreasing) of the adjustment or proxies for analysts' sophistication. We also find that when 1993 third-quarter earnings were announced, the deferred tax adjustment was mapped into security prices at the same rate as unexpected earnings excluding the tax adjustment, and that this mispricing was more severe for firms with income-increasing tax adjustments. This result may stem from the asymmetric reporting requirements for deferred tax assets and deferred tax liabilities under the accounting standards superseded by SFASNo. 109. The results also suggest that mispricing of the tax adjustment was more likely for firms that did not disclose the adjustments in their third-quarter earnings releases, perhaps because investors would have had to estimate the adjustment for these firms (recall that tests on analysts forecast errors indicated that analysts did not make these estimates). Section 2 discusses the relation of this study to the literature on market efficiency and functional fixation. Section 3 explains the sample selection procedures, provides summary statistics of the deferred tax adjustments, and compares the actual adjustments to available estimates. Section 4 includes the main results. Section 5 explores cross-sectional differences in functional fixation of analysts and investors. A concluding section follows.

2. Deferred Tax Adjustments and the Functional Fixation Hypothesis


In an efficient market, stock prices reflect all publicly available information. Alternatively, investors might interpret accounting information without regard to the rules used to produce it. This "functional fixation hypothesis" (FFH) predicts that the stock prices will be mechanically related to reported earnings numbers. Some research has concluded that investors can "see through" the effects of different accounting methods (e.g., Beaver and Dukes [1973]). More recently, this conclusion has been challenged. As summarized by Bernard [1993], evidence inconsistent with market efficiency suggests either an incomplete initial response to earnings announcements (Ber-

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TAX RATE INCREASE

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nard and Thomas [1989]) or an overreaction (Ou and Penman [1989]) or functional fixation. For example, Dietrich [1984] and Hand [1990] find anomalous positive reactions to accounting gains from debt-for-debt and debt-for-equity swaps, respectively. Both results contradict market efficiency, because the gains from the debt swaps either had been previously announced or could be calculated from public information prior to the earnings release. Hand attributes his findings to unsophisticated investors' fixation on reported accounting numbers. Ball and Kothari [1991], however, note that Hand's proxy for "investor sophistication," the percentage of noninstitutional ownership, is correlated with firm size and suggest that Hand's result is indistinguishable from the other firm size earnings/return anomalies previously documented. Hand [1991] refutes this claim by providing additional analyses showing that his data do not exhibit a reliable firm-size effect. Our study follows the same general approach as that used in Dietrich [1984] and Hand [1990]. However, because the swap gains they examined are reported as extraordinary items, they generally are not included in analysts' forecasts (Philbrick and Ricks [1991]). The deferred tax adjustment, on the other hand, is part of income tax expense, so it is included in income from continuing operations. Thus, our setting permits a more powerful examination of analysts' sophistication in analyzing earnings components. In addition, the swap gains analyzed by Dietrich and Hand were the result of a voluntary financial transaction that was publicly announced before the release of quarterly earnings containing the swap gains. In contrast, the deferred tax adjustments we study were imposed exogenously by SFASNo. 109 and the tax rate change. Thus, we believe the analysis of tax adjustments required considerable expertise. In fact, SFAS No. 109was issued just one year prior to 1993, and for many companies, OBRAwas the first opportunity to apply the provisions regarding tax rate changes. Stories in the financial press (Ciesielski [1993] and Berton [1993]) proposed that investors and analysts might be unaware of the effects of this new rule on 1993 third-quarter earnings.2 Finally, in contrast to swap gains, the deferred tax adjustments could be either income increasing or income decreasing, depending on the prior deferred tax balance. This, along with the fact that some firms did not separately disclose the tax adjustment while most did, allows us to test for cross-sectional differences in functional fixation.
[1993] and Berton [1993] were published about two weeks prior to the end of the third quarter of 1993 (September 15 and 17, respectively). Only negative effects on earnings were mentioned in the Berton article, even though the effects could be positive if a company had a net deferred tax asset balance. Based on the article, it is reasonable to suggest that the investing public was generally not knowledgeable about the intricate accounting rules on deferred taxes.
2 Ciesielski

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3. The Income Effects of the 1993 Deferred Tax Adjustment


3.1
SELECTION OF FIRMS WITH

1993

DEFERRED

TAX ADJUSTMENTS

Our sample consists of firms with deferred tax adjustments in the note disclosures to the annual 1993 financial statements and third-quarter 10-Qs. We assume that ex post selection bias from using 10-K and 10-Q reports is eliminated by paragraph 45 of SFASNo. 109, which requires firms to report all significant tax adjustments, positive or negative.3 Firms with tax adjustments were identified through a keyword search
of the "financial footnotes" fields of Compact Disclosure, NAARS, and Com-

pustat Text.4Sample firms also had to have earnings forecasts available on the IIBIEISmonthly forecast summaries, returns data available on CRSP,and disclosures of the tax adjustments in their 1993 third-quarter 10-Qs. This search yielded 200 sample firms. Eliminating deferred tax adjustments less than 0.1% of market value as of September 1993 reduced the sample to 160 firms.5 Finally, 2 firms were deleted because they were subsidiaries of other sample firms, resulting in a final sample of 158 firms.6 These sample selection procedures are summarized in panel A of table 1. Panel A also shows that 43 firms had positive (income-increasing) deferred tax adjustments and 115 had negative (income-decreasing) tax adjustments. The former are associated with net deferred tax asset positions and the latter with net deferred tax liabilities. The 158 sample firms represent a cross-section of 39 two-digit SIC industries. The largest concentrations are 17 firms in industry 63 (Insurance Carriers) and 14 firms in industry 26 (Paper and Allied Products). Industry 67 (Holding and Other Investment Offices) has 12 firms and industry 13 (Oil and Gas Extraction) has 10. No other industry has more than 8 firms.7
to identify firms 3We considered other sampling approaches, including using Compustat combines dewith large deferred tax balances prior to the tax change. However, Compustat ferred tax assets with "other assets" (data 69), and its balance in deferred tax liabilities includes deferred taxes from foreign, state, and local taxes as well as federal taxes. The 1993 deferred tax adjustment relates to the federal portion only. 4A variety of keyword combinations relating to deferred taxes were used in the search, including "tax rate," "deferred tax," "increase," "34%,"and "35%,"etc. For CompactDiscloText, sure and NAARS,the search was conducted on firms' 1993 10-K reports. For Complustat the search was on firms' 10-Q reports. 5Three firms with deferred tax adjustments less than 0.1% of market value were retained in the sample because estimates of their tax adjustments were provided in Berton [1993]. 6One hundred thirty-one of the sample firms were listed on the NYSE or AMEX in 1993, and the other 27 were on NASDAQThe number of NASDAQfirms is limited because and many of the databases used in the study, including NAARS, CompustatText, JIBIEIS, firms. DowJones News Retrieval,cover only a subset of NASDAQ 7To investigate whether there is event date and industry clustering in our sample, we examined announcement dates by industry. There were five return days in which more

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1 TABLE Sample Selection and the Deferred Tax Adjustment Compared with Earnings and Market Value Panel A: Sample Selection Procedures Number of Firms Firms with Deferred Tax Adjustments Identified in the Financial Field of Compact Disclosure, NAARS, or Compustat Text a Deferred Subsidiary Tax Adjustment Less Than 0.1 % of Market Valueb of Other Sample Firms Tax Adjustments Tax Adjustments Footnotes 200 ( 40 ) ( 2 ) 158 Deferred Deferred 43 115 158 Tax Adjustment Compared 10th Absolute Value of Deferred Tax Adjustment (MM$)C Absolute Adjustment as a Percentage of Absolute Value of 1993 Third-Quarter Earningsd Absolute Adjustment as a Percentage of Market Value Market Value (MM$)e 0.80 to Earnings and Market Value Percentile 25th 1.70 50th 4.00 75th 15.10 90th 36.00

Final Sample Firms with Income-Increasing Firms with Income-Decreasing Total Sample Panel B: The Deferred

7.82 0.13 283

11.46 0.19 584

22.47 0.29 1,444

51.95 0.54 4,599

148.40 0.91 8,442

aFirms were identified in these databases using a variety of keywords such as "tax rate increase," "deferred tax," "34,"and "35,"etc. The sample was limited to firms that (1) were covered by IIBIEIS,(2) had return data available on CRSP,and (3) disclosed the deferred tax adjustments in their 1993 thirdquarter 10-Qs. bMarket Value is measured as firms' common stock price at the end of September 1993 times number of common shares outstanding. Three firms with deferred tax adjustments less than 0.1 % of market value were retained in the sample because estimates of their tax adjustments were provided in Berton [1993]. cDeferred tax adjustments are obtained from 10-Q reports. dEarnings are defined as income from continuing operations. eMarket Value is computed as firms' common stock price two days prior to the announcement of 1993 third-quarter earnings times number of common shares outstanding.

3.2

INCOME

EFFECTS

OF THE

1993

DEFERRED

TAX ADJUSTMENT

Given the August 1993 corporate tax rate increase from 34% to 35%, GAAPrequired firms to remeasure their deferred tax assets and liabiliNo. 109 (para. 27) ties and determine a net deferred tax adjustment. SFAS provides that the net adjustment should be included in income from continuing operations during the quarter of the tax rate change. SFASNo. 109 was passed in February 1992, with adoption required as of the beginning of 1993; however, 90 of our 158 sample firms adopted

than these firms to be

their third-quarter earnings. However, on only one of ten sample firms announced and on only two days did three days did five firms in the same industry announce, does not appear dependence in the same industry announce. Thus, cross-sectional a threat to the inferences we draw.

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TABLE Panel A: Deferred Tax Assets (43 Firms) Most Important Component of Deferred Tax a Loss Reserves (Excluding Loan Losses) Postretirement Benefits Employee Benefits Loan Loss Reserves Claim Reserves
Othersb

Components of Deferred Tax Balances

Number of Firms 15 11 5 3 3
2

Components Not Disclosedc Total Panel B: Deferred Tax Liabilities (115 Firms) Most Important Component of Deferred Tax Depreciation Base of Property, Plant & Equipment Acquisition Costs of Assets or Policies Oil and Gas Exploration Deferred Costs Leases Long-Term Contracts Others Components Not Disclosed Total

4 43 Number of Firms 52 22 17 3 2 2 2 5 10 115

aThe component of deferred tax cited in the firm's 1992 10-Ks (or 1993 first-quarter 10-Qs) as comprising the largest dollar amount of its total deferred tax balance. b"Others"indicates that the component was specified but was not cited by any other sample firms as the most important component. c"Component Not Disclosed" indicates that the income tax footnotes did not disaggregate deferred taxes.

during 1992. The deferred tax balances of the sample firms were all measured using current rates prior to the August 1993 tax rate change. The magnitude of the tax adjustments for the 158 sample firms are summarized in panel B of table 1. The median, absolute adjustment is $4 million, about 22.5% of EPS. As a percentage of market value, the median absolute adjustment is 0.29%. Thus, although the tax adjustments are an important part of quarterly earnings, in general they are a very small percentage of equity value. Finally, the last row of panel B provides the distribution of the sample firms' market values. The median market capitalization is $1,444 million, while the 10th (90th) percentile capitalization is $283 ($8,442) million.8 Table 2 summarizes the components of firms' deferred tax balances. These components provide qualitative evidence on the cash flow implications of the deferred tax adjustment. We collected information on the largest dollar component of deferred taxes from disclosures in 1992
8The difference between means of the absolute values of tax adjustments (as a percentage of market value) of the income-increasing and income-decreasing groups is not significantly different from zero (t = -0.33).

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TABLE

3
a

Comparison of Actual and Estimated Deferred Tax Adjustments for 158 Firms

Panel A: Difference between Estimated and Actual Deferred Tax Adjustments

Distribution of the Absolute Value of the Difference between the Estimated and Actual Tax Adjustment Divided by Actual Tax Adjustment Less Than 10% Between 10% and 20% Between 20% and 30% Between 30% and 50% Greater Than 50% Frequency 48 35 20 28 27 Percentage 30.4 22.2 12.7 17.7 17.1 Cumulative Percentage 30.4 52.5 65.2 82.9 100.0

Panel B: Correlation between Estimated and Actual Deferred Tax Adjustments Spearman Rank Basis Pearson Correlation Correlation Adjustment Per Share 0.97 0.97 0.97 Adjustment Divided by Market Value 0.94
aActual deferred tax adjustment = reported amount in the 1993 third-quarter 10-Q. Estimated deferred tax adjustments = beginning net balance of deferred tax assets (liabilities) x 1/34 (- 1/34).

10-K reports and 1993 first-quarter 10-Qs, for 1993 adopters of SFAS No. 109. For the 43 firms with net deferred tax assets, the most important components of deferred tax assets are loss reserves (15 firms, excluding loan loss reserves) and postretirement benefits (11 firms). For the 115 firms with net deferred tax liabilities, 52 cited depreciation methods and 22 cited the depreciation base of plant assets as the largest component. Some components of deferred taxes reported in table 2, such as postretirement benefits, should reverse over fairly long periods. Others, such as those related to depreciation, may never reverse if capital expenditures increase and there is no change in depreciation methods. Thus, the cash flow implications from the 1993 deferred tax adjustment are generally distant. This, together with the small average percentage of deferred tax adjustment relative to equity value reported earlier, indicates that the tax adjustments should have a negligible effect on firm value. 3.3
ESTIMATION OF THE DEFERRED TAX ADJUSTMENT

We estimate the tax adjustment by multiplying the beginning balance of deferred tax assets (liabilities) by 1/34 (-1/34). Deferred tax balances are collected from tax disclosures in 1992 financial statements (or from 1993 first-quarter 10-Qs for 1993 adopters of SFASNo. 109). All our estimates had the same sign (i.e., positive or negative) as the actual tax adjustments. We calculated absolute "estimate errors" of the deferred tax adjustment by taking the absolute difference between the estimated and actual deferred tax adjustments and then dividing by the absolute value of the actual tax adjustment. As indicated in panel A of table 3, the difference between the estimated adjustment and the actual adjustment

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is less than 10% for 48 (30.4%) of the 158 sample firms. For approximately two-thirds (65.2%) of the sample, the scaled estimate errors are less than 30%; for only 27 firms did the estimate errors exceed 50%. The sign of the estimate errors (obtained by subtracting the actual tax adjustment from the estimate) is positive for 84 (53.2%) of the sample firms. The mean of the signed estimate error as a percentage of the absolute value of the tax adjustment is 9.16%. This mean is significantly different from zero (t = 2.00, p < 0.05). Measurement error in the estimates is unavoidable, since tax disclosures generally do not disaggregate deferred tax balances by foreign, state, local, and federal taxes. The result is a positive bias in the estimates. Correlation coefficients between the estimates and the actual deferred tax adjustments are presented in panel B. The Pearson and Spearman Rank correlations between the estimated adjustments per share and actual tax adjustments are both 0.97. When both are deflated by market value, the correlations are 0.97 and 0.94, respectively. Thus, we believe that analysts and investors could have formed estimates of the deferred tax adjustments using public information available prior to the thirdquarter earnings announcement. 3.4
DISCLOSURE OF THE

1993

DEFERRED

TAX ADJUSTMENTS

The separate disclosure of deferred tax adjustments at the time 1993 third-quarter earnings were announced will affect our measures of earnings components for the capital market tests in sections 4.2 and 5.2. In an efficient market, an information item that is public (or estimable) will be impounded in prices. If the tax adjustment is not disclosed along with the earnings adjustment, rational investors will base their estimate on public information,9 and these investors will also separate the tax adjustment from recurring earnings. We argue that this separation requires a rigorous understanding of accounting (relative to that required to understand a separately disclosed adjustment). To the extent investors cannot or do not make this separation, the probability of functional fixation is higher when the tax adjustment is not separately disclosed. Thus, we partition our sample based on public disclosure of the tax adjustment to test for cross-sectional differences in the market reaction to earnings announcements. We also control for the disclosure of other unusual or nonrecurring items that are included in 1993 third-quarter earnings in our empirical tests. Panel A of table 4 shows that the deferred tax adjustment was disclosed separately on DowJones News Retrieval (DJNR, including the Broad Tapeand PressReleaseFile) for 124 of the 158 sample firms, while 54 firms

9Under the assumption that investors do not observe company disclosures of the tax adjustments in press releases, tests in section 4.2 replace actual tax adjustments with estimates in regressions of cumulative abnormal returns on earnings components.

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4 TABLE Disclosure of the Deferred Tax Adjustment and Unusual Items (UI) on Dow Jones Nezvs Retrieval

Panel A: Number of Firms Disclosing DTADJ and UI on DowJones News Retrieval Deferred Tax Unusual Items Adjustment 54 124 Number of Firmsa 158 158 Total Sample Firms Panel B: Disclosure of Positive and Negative DTADJson DowJones News Retrievalb Total No Disclosure Disclosure 43 19 24 Positive DTADJ 115 15 100 Negative DTADJ 158 34 124 Total
-2 =

17.97 (p < .001)

aNumber of firms with deferred tax adjustments/unusual items reported separately from 1993 third-quarter earnings on DowJones News Retrieval (including the Broad Tapeand the Press ReleaseFile). bPositive deferred tax adjustments are income increasing and result from net deferred tax asset positions. Negative deferred tax adjustments are income decreasing and result from net deferred tax liability positions.

reported unusual items.10 Thus, the actual amount of the tax adjustment was available to the public at the time of the earnings announcement for all but 34 of the firms. Investors, even if unaware of the deferred tax adjustments prior to the earnings announcement, would have the opportunity to separate them out from other earnings components when they reacted to the announcement. For the 34 firms without disclosure of tax adjustments, estimates of the tax adjustments are used instead of actual adjustments in regressions of abnormal returns on earnings components (sections 4.2 and 5.2). Panel B of table 4 shows a 2 x 2 contingency table of positive and negative deferred tax adjustments disclosed in press releases. Nineteen of the 34 firms that did not disclose the adjustment had positive adjustments, even though positive adjustments comprise just 27% of the total sample. A chi-square test indicates that managers of firms with positive tax adjustments were less likely to include the adjustment in their press releases than were firms with negative adjustments (X2 = 17.97, p < 0.001). Conversely, managers of firms with negative adjustments might have found it useful to point out that earnings were decreased by the deferred tax adjustment. The reporting bias discussed here applies only to press releases and related news stories. All the sample firms disclosed the deferred tax adjustments in their quarterly 10-Q reports; SFASNo. 109 requires disclosure for any material adjustment.
10 The Broad Tape on DJNR is option 13 and Press Releases are option 15 in the Dow Jones Text Library. To be defined as a valid disclosure, both the item and the dollar amount had
to be disclosed.

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4. Empirical Results
This section presents our main tests of functional fixation on the part of analysts (section 4.1) and investors (section 4.2). Section 4.1 examines the relation between analysts' forecast errors and deferred tax adjustments; section 4.2 regresses security price changes surrounding thirdquarter earnings announcements on earnings components, including the tax adjustment. 4.1
ANALYSTS' FORECAST ERRORS, UNUSUAL ITEMS, AND THE DEFERRED TAX ADJUSTMENT

To provide evidence on whether analysts rationally impounded estimates of the deferred tax adjustment (DTADJ) in their forecasts, while controlling for unusual items (UI), we provide two versions of our first regression in expressions (1A) and (1B):
FEi = ao + a1DTADJi + a2UIi = ei, (1A)

and: FEi = al + a"PE(DTADJi)+ a"PE(UHi)+ ei, (1B)

where FEi is the forecast error (actual third-quarter EPS from continuthirding operations announced on DJNRminus the most recent IIBIEIS quarter EPS forecast) and PE(.) is our proxy for analysts' expectations of DTADJiand UHi, respectively. In (1A), DTADJiis the actual tax adjustment reported in firms' 10-Qs and UHi is the unusual items reported on DJNRat the time of the earnings announcement. In (1B), PE(DTADJi)is our estimate of the tax adjustment, computed by multiplying the beginning balance of deferred tax assets (liabilities) by 1/34 (-1/34) (from section 3.3). PE(HUi) was derived from a search on DJNR for separate disclosures of UImade prior to the earnings announcement. Of the 54 firms that included unusual items at the time earnings were announced, only 10 provided the information beforehand on DJNR Thus, in regression (1B), the variable PE(UHi)takes on nonzero values for only 10 firms. For those without predisclosure of UI, we assume analysts' expectation to be zero. In estimating (1A) and (1B), all the variables are converted to a per share basis and deflated by the price per share of common stock two days prior to the earnings announcement. We assume that analysts attempt to include transitory items in their forecasts so their earnings predictions are as close as possible to reported income from continuing operations. Under this assumption, in (1A) and (1B), the null hypothesis is that analysts incorporated rational expectations of the tax adjustment and unusual items in their earnings forecasts. In (1A), since rational expectations imply that actual values of DTADJand UI are equal on average to forecasts, the forecast errors should not be correlated with the realized values of DTADJand UI, i.e., a, = a2 = 0. In (1B), we assume that analysts rely on simple estimating rules and public

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1993 TAX RATE INCREASE AND DEFERRED TAX ADJUSTMENTS


TABLE Eq. (1A): 5 + eb

33

and Unusual Items (UI)a Errors(FE) on theDeferredTaxAdjustment(DTADJ) Regressionof Forecast


FEi = a0 + aiDTADJi + a2Ui

Eq. (1 B): Equation (1A)


aO (%) (t-Statistic)

FEi = a" + a" PE(DTADJi) + a' PE(Uhi) + ei


a1

a2

(t-Statistic) 0.90 (7.47) ** 0.43 (2.77)**

(t-Statistic) 0.92 (21.93)* 0.80 (11.47)**

Adjusted R2 (% 75.8

0.03 (0.44) -0.12 (-1.23)

(1B)

45.9

aThe total number of firms included in each regression is 158. The definitions of variables are: FEi: forecast error in earnings (= actual earnings - forecasted earnings for the third quarter of 1993). DTADJi: deferred tax adjustment reported in 1993 third-quarter 10-Qs. UIi: unusual items reported on Dow Jones News Retrieval at the time of the earnings announcement. PE(.) refers to the proxy of the market expectations for UI and DTADJ,respectively. PE(UI) is derived from firms' disclosures of UI made on DJNR prior to the earnings announcement (number of observations = 10 firms), and PE(DTADJ) is the deferred tax adjustment estimated by multiplying the beginning net balance of deferred tax assets (liabilities) by 1/34 (- 1/34). bAll variables are converted to per share basis and deflated by the price per share of common stock two days prior to the announcement of 1993 third-quarter earnings. *"Significant at a level of 0.01 (one-tailed test).

information to form their expectations of DTADJ and UI. Under this assumption, a' = a' = 0. Row 1 of table 5 shows that both a, and a2 are significantly different from zero (p < 0.01). The adjusted R2 of the regression is 75.8%, of which 26% is contributed by DTADJ (measured by the partial correlation). In addition, the coefficient on DTADJh (0.90) is not significantly different from one (F = 0.737, p < 0.39), suggesting that few analysts included the rational expectations of DTADJin their forecasts. Row 2 of table 5 reports the results of estimating (1B). The adjusted R2 of the model is 45.9%, and a' and a' are 0.43 and 0.80, respectively. Since both coefficients are significantly different from zero (p < 0.01), it appears that analysts did not include estimated DTADJ and preannounced UI in their forecasts of 1993 third-quarter earnings either. The 0.43 coefficient on PE(DTADJi) in equation (1B) is less than the 0.90 coefficient on DTADJi in (1A). There are two reasons for this difference. First, the results of (1B) are highly affected by the zero observations of UI (those not preannounced on DJNR). In an additional regression of FEi on PE(DTADJi) and actual UHi(not reported in table 5), the coefficient on the estimated tax adjustment is 0.74, and the model adjusted R2 is 74.7%. Thus, PE( Uhi) is a poor proxy for actual Uhi. Second, the estimates of the tax adjustment have an upward bias (see section 3.3). The bias occurs because the tax adjustments were estimated using the total balance of deferred taxes, while the 1993 OBRA relates to the federal portion only. Since the estimated tax adjustments are biased upward, the coefficient is biased downward.

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Taken together, the results in this section suggest that analysts generally did not include the estimates of the deferred tax adjustment in their forecasts of 1993 third-quarter earnings. 4.2
SECURITY RETURNS SURROUNDING EARNINGS ANNOUNCEMENTS

Analysts' apparent failure to include the deferred tax adjustment in their earnings forecasts will not affect share values if investors made this adjustment, perhaps using the detailed press releases which reported the tax adjustment for 124 of our sample firms. (Recall that analysts did not have access to this information when making EPS forecasts.) To test whether investors have the same functional fixation as analysts, we examine security price responses to announcements of 1993 third-quarter earnings. The security price reaction is defined as the riskadjusted two-day cumulative abnormal return (CAR) on days (0, +1), where (0) is the day of the Broad Tapeearnings announcement. If the announcement came after 4:00 P.M., then day 0 is the following day. Market model parameters to compute CARi are estimated over the 200 days beginning on day (-206) and ending on day (-7) prior to the thirdquarter earnings announcement. Daily stock returns and value-weighted market returns were collected from the CRSPfiles. We partition the forecast error metric, FEi (reported EPS - forecasted EPS), into three components: Ui, DTADJi,and an adjusted forecast error
that excludes Ui and DTADJi (denoted as BTFEi). We expect that BTFEi

consists mostly of recurring earnings components. We test for functional fixation around earnings announcements using regression (2A):
CAR= bo + b1DTADJi + b2Uh + b3BTFEi + ei,

(2A)

where DTADJiand UHiare the deferred tax adjustments and unusual items respectively reported on DJNR at the time of the earnings announcement. If DTADJiwas not reported separately on DJNR (see section 3.3), we used the estimate. All three independent variables are converted to a per share basis and deflated by price per share two days prior to the earnings announcement. Similar to (1A), (2A) is based on predictions of rational expectations that investors' expected value of DTADJequals its realized amount. If investors impounded DTADJinto their expectations of 1993 third-quarter earnings, b1 = 0. In addition, rational investors should discount DTADJi and BTFEi into security prices at different rates (i.e., b1 < b3), while functionally fixated investors will not distinguish between these two earnings components (i.e., b1 = b3). Alternatively, we can assume that (parallel to (1B)) investors used simple rules and public information to form their expectations of UI and DTADJ Under this assumption, an alternative specification of (2A)

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TABLE

SummaryStatisticsfor VariablesUsedin Regressionof CumulativeAbnormal Returns (CAR) on Earnings Componentsa (SampleSize: 158 Firms, All ValuesAre in Percentages)
Variableb Mean Std. Dev. Median N> OC )

CARi PE(DTADJi) PE(Uli) DTADJi Uhi BTFEi

0.01 -0.22 -0.11 -0.21 -0.16 0.07

4.20 0.57 1.27 0.54 1.43 0.77

-0.20 -0.24 0.00 -0.24 0.00 0.04

74 43 1 44 21 90

(46.8%) (27.2%) (0.6%) (27.8%) (13.3%) (60.0%)

aDefinition of variables: CARi: the two-day abnormal return on days (0, +1), where (0) is the day earnings were announced on DowJones News Retrieval. DTADJi: the deferred tax adjustment reported on Dow Jones News Retrieval at the time of the earnings announcement (estimated adjustment is used if actual DTADJnot disclosed). UIi: unusual items reported on DowJones News Retrievalat the time of the earnings announcement. BTFEi: unexpected earnings excluding UIi and DTADJi(= FEi - UIi - DTADJi) PE(.) refers to the proxy of the market expectations for UI and DTADJ,respectively. PE(UI) is derived from firms' disclosures of UI made on DJNR prior to the earnings announcement (number of observations = 10 firms), and PE(DTADJ) is the deferred tax adjustment estimated by multiplying the beginning net balance of deferred tax assets (liabilities) by 1/34 (- 1/34). bAll variables are converted to per share basis and then deflated by price per share of common stock two days prior to the earnings announcement. cN> 0 indicates the number of positive observations for each variable, with percentages in parentheses (out of 158 total sample firms).

that uses proxies for the market's expectations estimated:

of DTADJ and UI can be

CARi = b + bjPE(DTADJ1) + b PE(UhI) + b3BTFEi + ei,

(2B)

and UhT, where PE(.) is the proxy for investor's expectations of DTADJM respectively (proxies defined in section 4.1). In equation (2B), BTFEi is computed as FEi - PE(DTADJi) - PE( UhT).If investors incorporated the ex ante estimate of DTADJh(PE(DTADJh)) in their earnings expectations, bi should be zero. Descriptive statistics, including means, standard deviations, and medians of each variable used in equations (2A) and (2B), are reported in table 6 (all values stated in percentages).11 The pair-wise Pearson correlations of independent variables included in either (2A) or (2B), not reported, are generally small (none is larger than 0.20 in absolute value).

1 The 44 firms with positive tax adjustments reported in row 4 of table 6 are one greater than the number reported in tables 1-5. This is because we collected tax adjustments in tables 1 to 5 from 10-Qs, and those in tables 6 to 8 from press releases. One firm, E. W. Scripps, reported a positive tax adjustment in its press release, but according to its 10-Q, the positive adjustment related to other changes in tax laws. The actual tax adjustment due to tax rate increase was negative.

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TABLE 7

Regressionof CumulativeAbnormalReturns (CAR) Surroundingthe Announcementof 1993 Earningsa Earnings on DifferentDecompositionof Unexpected Third-Quarter (SampleSize: 158 firms) + b2Uli + b3BTFEi+ ei Eq. (2A): CARi = bo + b1DTADJi
Eq. (2B): CARi = b6+ biPE(DTADJi) + b'PE(Uhi) + b BTFEi+ ei

Coefficient on
Equationb

(2A) (2B)

Intercept (%) (t-Statistic) 0.30 (0.86) 0.35 (0.99)

DTADJi (t-Statistic) 1.68 (2.70)** 1.57 (2.62) **

U1i (t-Statistic) 0.25 (1.09) 0.20 (0.75)

BTFEi (t-Statistic) 1.41 (3.32)** 0.86 (2.90) **

Adjusted R2 (%) 7.7 5.4

aDefinition of variables: CAR1: the two-day abnormal return on days (0, +1), where (0) is the day earnings were announced on DowJones News Retrieval. DTADJi: the deferred tax adjustment reported on Dow Jones News Retrieval at the time of the earnings announcement (estimated adjustment is used if actual DTADJnot disclosed). UIi: unusual items reported on DowJones Retrievalat the time of the earnings announcement. PE(.) refers to the proxy of the market expectations for UI and DTADJ,respectively. PE(UJ) is derived from firms' disclosures of UI made on DJNR prior to the earnings announcement (number of observations = 10 firms), and PE(DTADJ)is the deferred tax adjustment estimated by multiplying the beginning net balance of deferred tax assets (liabilities) by 1/34 (-1/34). BFTEi: unexpected earnings excluding UIi and DTADJi(= FEi - UIi - DTADJiin equation (2A); = FEi - PE(Ui) - PE(DTADJi) in equation (2B)). bAll variables are converted to per share basis and then deflated by the price per share of common stock two days prior to the earnings announcement. n*Significantat a level of 0.01 (one-tailed test).

The results of estimating equation (2A) are in row 1 of table 7. Two of the three slope coefficients are significant. Specifically, b3 (the coefficient on BTFEi, the recurring part of earnings) is 1.41 (t = 3.32, p < is 1.68 (t = 2.70, p < 0.01). The 0.01), and b, (the coefficient on DTADJM) did not impound the rational expeclatter result indicates that investors tation of DTADJin forming their earnings expectation. In addition, the F-statistic comparing b, and b3 is 0.14 (p < 0.71), indicating no significant difference between these two coefficients. Thus, investors disinto security prices at the same rates, even counted BTFEi and DTADJh though one is a recurring component of earnings and the other is transitory with distant or uncertain cash flow ramifications. In comparison, the insignificant coefficient on UI (coefficient = 0.25, t= 1.09) suggests that investors were able to separate unusual items from recurring earnings at the time of earnings announcement. While inconsistent with functional fixation hypothesis, this result is similar to the findings in prior research (e.g., Hoskin, Hughes, and Ricks [1986] and Givoly and Hayn [1992]). The reason could be that unusual items are routinely disclosed and more familiar to investors. The results of regression (2B) are reported in row 2 of table 7. The coefficient on PE(DTADJi),bi, is 1.57, with a t-statistic of 2.62 (p < 0.01).

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This suggests that investors, like most analysts, did not incorporate the simple estimate of DTADJin their expectation of earnings.'2 In summary, the tests in this section provide support for the hypothesis that investors were functionally fixated with respect to the deferred tax adjustment as an income component.

5. Cross-Sectional Variation in Analysts' and Investors' Sophistication


The next question is whether functional fixation varies across investors and analysts. This section explores these issues by positing factors that determine the sophistication of analysts (section 5.1) and investors (section 5.2).
5.1 EARNINGS FORECAST ERRORS AND CROSS-SECTIONAL DIFFERENCES SOPHISTICATION

IN ANALYSTS'

We use the following regression to examine three factors posited to affect analysts' sophistication or otherwise explain cross-sectional differences in whether analysts included the tax adjustment in their forecasts: FEi = co + clDV] x DTADJi+ c2DV2x DTADJi+ c3Uhi+ ei. (3) Equation (3) expands equation (1A) to include dichotomous variables (DV1 and DV2) that allow for different slope coefficients for subsets of the 158 sample firms. Three versions of (3) are specified. The first factor predicted to affect the slope coefficient on DTADJis Hand's [1990] measure of "investor sophistication," calculated as the percentage of firms' stock owned by institutions (from Standard & Poor's Stock Guide). In the first specification, DV1 equals one if firms' institutional ownership is lower than the median of 54% (else DV1 = 0), and DV2 equals one if institutional ownership is higher than the median (else DV2 = 0). All other variables are as defined in section 4.1. in anaThe second factor predicted to affect the inclusion of DTADJi lysts' forecasts is the size of the estimated tax adjustment relative to the analyst's EPS forecast, under the assumption that larger tax adjustments are more likely to be incorporated into forecasts. Alternatively, the benefit of becoming proficient in SFASNo. 109 increases if the tax adjustment is large. Therefore, in our second specification of (3), DV1 equals one if the estimated tax adjustment is smaller than the sample median of 22.5% of forecasted EPS (else DV1 = 0), and DV2 equals one if DTADJi is larger than the median (else DV2= 0).13
'2The adjusted R2 (5.4%) of (2B) is lower than the R2 of (2A) (7.7%). This is to be expected, because as noted in section 4.1, PE(UIi) is a poor proxy for UI. based on relative size, both the numerator 13In ranking the deferred tax adjustments (i.e., the forecast of EPS) are taken at their (i.e., the tax adjustment) and the denominator absolute value.

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Finally, it is possible that the sign of the income effect of the tax adjustment would affect the analyst forecasts. The financial press discussed only the income-decreasing effects of the tax change and considered the tax adjustment a "penalty" (see Berton [1993]). This view may stem from the previous accounting standards on deferred taxes, APB No. 11 (AICPA[1967]) and SFASNo. 96 (FASB[1987]). Because these standards resulted in the recognition of no or very few net deferred tax assets, it is possible that analysts were more familiar with deferred tax liabilities and more likely to adjust for income-decreasing effects of the tax rate increase. In our third specification of (3), DV1 equals one if the tax adjustment is income increasing (43 firms) (otherwise DV] = 0), and DV2 equals one if the tax adjustment is income decreasing (115 firms) (otherwise DV2 = 0). The results of these regressions are reported in panel A of table 8. Two general patterns emerge from observing the three specifications of (3) reported in panel A. First, in each specification, all slope coefficients are significant at 0.05 or better. Second, the t-statistics on cl - c2 for the three regressions (the last column) range from -0.65 to -1.29. None is significant at conventional levels. Thus, the probability of analysts including the tax adjustment in their earnings forecasts does not vary due to the level of institutional holding or the magnitude or sign of the deferred tax adjustment.'4 These findings are to be expected since table 5 shows that most analysts did not incorporate the tax adjustments in their forecasts. As a result, there is little variation in analyst sophistication to explain and the tests presented here probably have low power.
5.2 SECURITY RETURNS AND CROSS-SECTIONAL DIFFERENCES IN INVESTORS SOPHISTICATION

To test if there are cross-sectional differences in functional fixation by investors at the time of the earnings announcement, we estimate the following expanded version of equation (2A) for four specifications of DV1
and DV2: CARi = lo + d1DV1 x DTADJi + d2DV2 x DTADJi + d3UIi + d4BTFEi + ei. (4)

In the first specification, DV1 and DV2 are defined based on the percentage of institutional ownership, as in section 5.1. Based on results in Hand [1990], functional fixation concentrated among unsophisticated investors implies d, > d2.

14Two additional measures were used in equation (3) to proxy for analysts' sophistication: (1) number of analysts following the firm (median = 8), and (2) firm's market value of common stock two days prior to the announcement of 1993 third-quarter results (median = $1.444 billion). The t-statistics for c1 - c2 = 0 are -0.03 and 0.09 for these two levels. specifications, respectively. Both are not significant at conventional

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The second specification sets DV1 equal to one if the absolute value of tax adjustment relative to market value is smaller than the sample median of 0.33% (else DV] = 0) and DV2 equal to one if the size of the tax adjustment is larger than the median (else DV2 = 0). This specification is intended to capture the benefits of processing the tax adjustment information. The third specification investigates whether the sign of thle tax adjustment affected investors' ability to interpret this transitory item. The coding of this variable is the same as in section 5.1, except that 44 firms have positive tax adjustments (see n. 11). The fourth specification is based on the disclosure of the tax adjustment at the time of the earnings announcement. Not being able to observe the tax adjustment at the time of the announcement would increase investors' difficulty in distinguishing it from permanent earnings. We set DV1 equal to one if the tax adjustment was not disclosed as a separate component of earnings (else DV1 = 0) and DV2 equal to one if the tax adjustment was separately disclosed (else DV2 = 0). The results of these four specifications are reported in panel B of table 8. In each of the first two specifications, d1 > d2. However, based on the t-statistics for d1 - d2 (reported in the last column) of 0.72 (p < 0.47) for the first specification and 1.45 (p < 0.15) for the second specification, this difference is not significant. So overall, institutional ownership and the size of DTADJdid not affect functional fixation in our setting.'5 In the third specification (row three), the coefficient on DTADJi is not significant for firms with negative tax adjustments (t = -0.68 and p < 0.50). But for firms with positive tax adjustments, this slope coefficient is significant at the 0.01 level (t = 3.97). In addition, d1 exceeds d2 (t= 3.01, p < 0.01), and the adjusted R2 from this regression (12.2%) exceeds the R2 from equation (2A) (7.7%). Thus, investors evidently understood the implications of tax adjustments related to deferred tax liabilities but not deferred tax assets. In the fourth specification of (4) (last row of panel B), the coefficient on DTADJi is significant (t = 3.46, p < 0.01) for the 34 firms that did not disclose the tax adjustment in their press releases but is not significant
for disclosing firms (t = 0.94, p < 0.35). The t-statistic for d1 - d2, 2.37, is

also significant at 0.01. Thus, investors evidently were able to adjust for the tax adjustment if they saw it in press releases. However, they were not able to separate an undisclosed tax adjustment, even though it could have been estimated.

15 As an additional test, we replaced the institutional ownership variable with a size variable (defining firms as large or small based on the median market capitalization of $1.444 billion) in equation (4). The t-statistic on d1 - d2 in this regression is 0.45, insignificant at conventional levels.

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KEVIN

C. W. CHEN

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P. SCHODERBEK

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KEVIN C. W. CHEN

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MICHAEL

P. SCHODERBEK

Table 4's results indicated that firms with positive tax adjustments were also less likely to disclose them. To separate the effects of disclosure from the effects of the sign of the adjustment, we estimate equation (5):
+ g2DV2 x DTADJZ + g3DV3 CARi = go + g1DV1 x DTADJZ X DTADJZ+ g4DV4 x DTADJZ + g5UIz + g6BTFE + ei. (5)

We use indicator variables to capture the relation between the sign of the tax adjustment and its disclosure. DVI equals one if the tax adjustment is income increasing and was not disclosed separately (else DV1 = 0), DV2 equals one if the tax adjustment is income increasing and was disclosed separately (else DV2 = 0), DV3 equals one if the tax adjustment is income decreasing and was not disclosed separately (else DV3= 0), and DV4 equals one if the tax adjustment is income decreasing and was disclosed separately (else DV4 = 0). The estimated coefficients from this regression are shown below (t-statistics are in parentheses):
CARi = -0.82% + 6.19 DV] x DTADJi + 3.24 DV2 x DTADJi + 0.78 DV3

(-1.58)

(4.04)**

(1.81)*

(0.41)

x DTADJi- 0.80 DV4 x DTADJi+ 0.42 UIi + 1.91 BTFEi. (-0.78) (1.82)* (4.19)** The adjusted R2 of equation (5) is 12.5%. Coefficients g1 and g2 are significant at the 0.05 level (or better) and are not reliably different from each other (t= 1.34). On the other hand, coefficients g3 and g4 are not different from zero. Since DV1 and DV2 capture positive tax adjustments, and DV3 and DV4 capture negative tax adjustments, the results suggest that the effects from the sign of the tax adjustment on functional fixation dominate the disclosure effects. These results, however, must be interpreted with caution. The dichotomous variable DV1 (+ DTADJand no DJNR) takes on the value one for only 19 firms (from panel B of table 4), and DV2 (+ DTADJand on DJNR) equals one for only 24 firms. Thus, the number of firms with nonzero values used to estimate these coefficients is small.16

6. Summary and Conclusions


We examine how analysts and investors assessed the income effects of the deferred tax adjustment caused by the August 10, 1993 increase in the corporate income tax rate. SFASNo. 109 required firms to remeasure their deferred tax assets and liabilities and include the net adjustment in their 1993 third-quarter earnings. Although it was possible to estimate
16Equation (5) was also estimated after deleting "outliers" detected through Belsley, Kuh, and Welsch's [1980] DFFITSstatistic. Results were qualitatively the same as those reported. The same checks were performed for the results reported in tables 5, 7, and 8 with no effects on inferences.

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the deferred tax adjustment using public information, our results suggest that analysts generally did not incorporate the tax adjustment in their 1993 third-quarter earnings forecasts. This finding was not influenced by the relative size of the tax adjustment, the sign of the adjustment (i.e., income increasing or income decreasing), or firms' institutional ownership, mostly because there was little variation in analysts' sophistication to explain. We also found that investors impounded the tax adjustment into security prices at the same rate as recurring earnings, despite their different implications for future cash flows. This result is consistent with the functional fixation hypothesis. However, inconsistent with the functional fixation hypothesis, investors appear to have separated unusual items from recurring earnings and not discounted them into security prices. This could be due to the fact that unusual items are routinely disclosed and better known to investors than the tax adjustment. Cross-sectional tests revealed that investor fixation was more pronounced for firms with income-increasing tax adjustments than for firms with income-decreasing adjustments, perhaps because SFASNo. 109 was a relatively new standard and the predecessor standards (APB No. 11 and SFAS No. 96) rarely permitted recognition of net deferred tax assets. On the other hand, deferred tax liabilities, like unusual items, are better known to investors. Results also suggest that fixation was more likely for firms that did not disclose the tax adjustments at the time of earnings announcement; however, this finding could be due to the fact that most nondisclosed tax adjustments are income increasing. Moreover, inconsistent with Hand [1990], we did not find the fixation to be affected by the level of investor sophistication. Overall, this study suggests a degree of functional fixation on the part of analysts and investors with respect to the 1993 deferred tax adjustments. As Lev and Ohlson [1982] observed, many studies in the 1970s generally pointed to investors' ability to adjust for differences in "a few well-known and clearly disclosed accounting techniques," such as depreciation and inventory methods. Our findings suggest that investors might not be able to adjust for accounting numbers that result from more complex rules. One caveat to our results is the possibility that investors may rationally decide not to become informed of specific accounting rules. Although the dollar amounts of the tax adjustments in our sample are generally significant in terms of quarterly earnings, they are rather small (less than 1%) relative to market value.'7 Investors might have been aware of the deferred tax adjustment but considered the estimation of the tax adjustment not cost-beneficial. In addition, over time individuals need not be proficient in specific accounting procedures because they can learn
17 In Hand's [1990] sample, the swap gains are generally less than 1% of market value (see Hand [1990, table 2, p. 750]).

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by observing the behavior of stock prices. Thus, when similar tax rate changes require deferred tax adjustments in the future, the functional fixation behavior documented in this study might be corrected with learning. Finally, our conclusions about analysts' sophistication are conditional on the assumption that analysts attempt to forecast reported income from continuing operations. If analysts deliberately exclude nonrecurring items such as the deferred tax adjustment, further study will be necessary to understand the degree of their sophistication.
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