An Unintended Consequence of Book-Tax Conformity: A Loss of Earnings Informativeness

by Michelle Hanlon, Edward L. Maydew, and Terry Shevlin

1. Background Information
Some studies have found that conformity between accounting and tax reporting can
improve the informativeness of the earnings by limiting earnings management. However, other
studies found that earnings informativeness are decreased due to the book-tax conformity. This
means that there are mixed results regarding this topic
Therefore, by using a real event of tax law changes that require firms to conform their
book-tax report in 1986, this research wants to find out what is the effect of the increase in
conformity on the earnings informativeness of the financial report.

2. Research Objective
The objective of this research is to find out how tax law changes, specifically on the
conformity of book-tax reporting, can affect the informativeness of accounting earnings.

3. Research Gap
The research gaps are as follow:
a) No prior research regarding the effect of tax law changes on accounting earnings
informativeness.

4. Research Contribution
The research contributions are as follow:
a) This is the first research that gives evidence that tax law changes affect the
informativeness of accounting earnings.
b) Complementing the prior research of Guenther et al. (1997) by providing a more
complete data.

5. Prior Research
The prior research regarding this topic is as follow:
 a) Guenther et al. (1997) find that after increasing their book-tax reporting conformity,
firms deferred more income for financial reporting purposes because of the increased
trade-off between financial accounting and tax.
b) Desai (2005) suggests that increasing book-tax reporting conformity can improve the
informativeness of financial accounting earnings by constraining earnings management.

6. Hypotheses
The hypotheses for this research are as follow:
a) H1: The informativeness of earnings decreases as firms are forced to increase their
book-tax conformity.
b) H2: Prior to the required increase in book-tax conformity, earnings of converting
firms (those with low conformity) are more informative than are earnings of high-
conformity firms.

7. Research Design
a. The sample used are taken from firms identified in earlier research by Guenther et al.
(199&) and complemented by the available data. The total of the sample is 3576 firm-
years data consisting of 450 converting firm-years and 3126 accrual basis firm-years.
b. The data is for the year 1988-1992.
c. The converting firms are the treatment group (experienced a required increase book-tax
conformity) and the accrual basis firms are the control group (experienced no change in
the required level of book-tax conformity).
d. To calculate earnings informativeness, the researcher uses earnings response
coefficients as the variable.

8. Research Result
The result of the research is as follow:
a) Increased conformity of book-tax report reduces the informativeness of earnings
information.
b) Firms that increase their level of book-tax conformity experience a decline in long-
window earnings response coefficients following the tax reform act of 1986.
9. Research Limitations
The researcher mentioned that the limitation of this research is the small number of sample
size that may cause the result to not be generalisable throughout the whole population of US firms.

10. Critical Analysis

a) Abstract
The abstract explains well the summary of the research which contains a slight
introduction, results, research design, and main contribution of this paper.
b) Introduction
The researcher did well in giving the background of this research, some prior studies,
and giving a short summary of the paper. However, the researcher only gave a little
explanation of the motivation on why they made this research.
c) Supporting Theory
The researcher did not mention explicitly the exact theory of this research. However,
the researcher built up his argument regarding the topic well by using prior research and
sound logic. The researcher also further explained the current debate regarding this
issue.
d) Hypotheses
The researcher mentioned explicitly what is the hypotheses of this research.
e) Methodology
The researcher explains the sample, variables and its calculations, and the method of
this research.
f) Internal Validity
Good. In calculating the variables, the researcher uses a proven method and explains it
well. Furthermore, the researcher also conducts further testing to give a more accurate
result of the research.
g) External Validity
Limited. The researcher mentioned that the data is limited and may not even be
generalisable in the US.
h) Result
 The researcher presented the research result in a way (through tables) that makes the
reader can easily understand the results.
i) Conclusion
In this part, the researcher has done well on concluding the research by pointing out the
findings, contributions, and the implication of this research. However, the researcher
did not mention any potential further studies of this research.