The persistence and pricing of earnings, accruals and cash flows when firms have large book-tax differences

I investigate the role of book-tax differences in indicating the persistence of earnings, accruals and cash flows for one-period-ahead earnings. I also examine whether the level of book-tax differences influences investors, assessments of future earnings persistence. I find that firm-years with large book-tax differences have earnings which are less persistent than firm-years with small book-tax differences. Further, the evidence is consistent with investors interpreting large positive book-tax differences (book income greater than taxable income) as a “red flag” and reducing their expectation of future earnings persistence for these firm-years. However, for firm-years with large negative book-tax differences (book income less than taxable income), investors overestimate the persistence of the accrual component of earnings, consistent with prior research (e.g., Sloan 1996). Finally, analyst forecast data provide evidence consistent with analysts utilizing the information in the book-tax differences in a manner similar to investors: forecast errors for firm-years that have large positive book-tax differences are less optimistic.