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By Liz Warren-Pederson

The difference between the income a firm reports to investors and the income it reports to the Internal Revenue Service can shed light on how useful the former actually is, according to a new paper co-authored by professors Dan Dhaliwal and Mark Trombley of the Eller College and Linda Chen (Eller Accounting Ph.D. ‘09) of the University of Massachusetts Boston.

Frances McClelland Endowed Chair and Professor of Accounting Dan Dhaliwal.

Frances McClelland Endowed Chair and Professor of Accounting Dan Dhaliwal.

A firm may manage these measures — book income and tax income — to appear more profitable to investors and less profitable to the government. In contrast to prior studies, this is the first to focus on the consistency of tax aggressiveness and earnings quality over time.

“We find that the difference between book income and tax income is a really good combined measure of a firm’s tax aggressiveness and the extent to which it is managing its earnings,” said Trombley, Beach Fleischman Professor of Accounting.

A consistent or stable measure of book-tax difference indicates that a firm is not engaging in aggressive earnings management and tax planning. “The less earnings management and the less tax aggressive a firm is, the more useful the book income data is going to be to investors,” Trombley explained.

Beach Fleischman Professor of Accounting Mark Trombley.

Beach Fleischman Professor of Accounting Mark Trombley.

Firms that do not engage in earnings management are likely to have greater earnings persistence, and firms that avoid aggressive tax positions are likely to have more persistent tax benefits from their tax planning activities. “Since this increase in persistence in turn leads to higher earnings quality, we predict that consistent book-tax differences are associated with more informative book income and taxable income,” Trombley said.

He emphasized that the paper is not prescriptive for investors. “But if you see a lot of variance between the book income and the tax income year after year, it’s a good bet that the firm is in there messing around with earnings and tax planning, and that their income is going to be less predictable over time.”

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