Conservatism and book-tax differences

I investigate the relation between conservatism and book-tax differences (BTDs), where "conservatism" refers to conservatism in the financial statement context (as opposed to the taxable income context). Specifically, "conservatism" refers to conditional and unconditional conservatism per Basu [1997]. The objectives of my study are to gain further insights into how BTDs may be interpreted and why they arise. I find that the financial statement conservatism of firm-years with large positive BTDs (book income is greater than taxable income) is similar to that of other sample firm-years, while the conditional and unconditional conservatism in taxable income of firm-years with large positive BTDs is greater than that of other sample firm-years. Thus, contrary to teachings in popular accounting textbooks, large positive BTDs do not reveal information about a firm's relative level of financial statement conservatism; instead, large positive BTDs reveal information about a firm's relative level of conservatism in taxable income. I additionally find that the financial statement conservatism of firm-years with large negative BTDs (taxable income is greater than book income) is greater than that of other sample firm-years, while the conservatism in taxable income of firm-years with large negative BTDs is less than that of other sample firm-years. Thus, large negative BTDs reveal information about a firm's relative level of financial statement conservatism and its relative level of conservatism in taxable income. These combined findings suggest that large positive BTDs are driven by incremental decreases to taxable income, while large negative BTDs are driven by both incremental decreases to book income, and incremental increases to taxable income. The findings contained herein are important to anyone who uses taxable income for valuation purposes, either alone or as a benchmark against book income, academics and regulators interested in causes of BTDs, policy-makers considering increasing disclosure of taxable income or aligning book income with taxable income, and academics who study proposed causes of conservatism.