The Smoothing and Informativeness of GAAP Effective Tax Rates

Transcription

1 The Smoothing and Informativeness of GAAP Effective Tax Rates Presented by Dr Petro Lisowsky Assistant Professor University of Illinois at Urbana-Champaign #2015/16-17 The views and opinions expressed in this working paper are those of the author(s) and not necessarily those of the School of Accountancy, Singapore Management University.

2 The Smoothing and Informativeness of GAAP Effective Tax Rates Paul Demeré University of Illinois at Urbana-Champaign Laura Yue Li University of Illinois at Urbana-Champaign Petro Lisowsky University of Illinois at Urbana-Champaign Massachusetts Institute of Technology and Norwegian Center for Taxation R. William Snyder University of Illinois at Urbana-Champaign January 2016 Please do not cite or distribute without permission from the authors. Abstract We examine the extent to which the smoothing of GAAP effective tax rates (ETRs) through tax accruals affects the ability of current-period GAAP ETRs to predict future cash ETRs. We develop a measure of GAAP ETR smoothing that isolates smoothing due to tax accruals from the fundamental smoothness of tax rates evident in the volatility of cash ETRs. Our results show that a one standard deviation increase in GAAP ETR smoothing is associated with a 37 percent increase in the ability of current-period GAAP ETRs to predict future cash ETRs. We find that managerial discretion plays an important role in the informativeness of tax accrual smoothing. While smoothing through discretionary tax accruals explains the average informativeness of smoothing, the informativeness decreases significantly in the presence of alternative reporting objectives such as maintaining perfectly smooth ETRs or avoiding audit attention from tax authorities. Our findings add to the tax reporting literature by showing the informational value of ETR smoothing through tax accruals, and the negative impact of alternative reporting objectives on the informativeness of ETR smoothing. We thank Hye-Sun Chang, Katharine Drake, Brian Gale, Jeffrey Gramlich, Theo Sougiannis, James Stekelberg (Discussant), the University of Illinois at Urbana-Champaign Archival Research Seminar, and workshop participants at Fordham University, the University of Illinois at Urbana-Champaign, Penn State University, Washington State University, and the 2015 AAA annual meeting for comments. Paul Demeré and R. William Snyder gratefully acknowledge financial support from the AICPA Accounting Doctoral Scholars Program. Laura Li and Petro Lisowsky gratefully acknowledge financial support from the PricewaterhouseCoopers Faculty Fellowship at the University of Illinois at Urbana-Champaign.

3 I. INTRODUCTION As one of the largest corporate costs, tax expense is a significant determinant of companies profitability. Therefore, whether tax reporting on financial statements is informative about the level and uncertainty of firms future tax payments is an important question to financial statement users. This study examines how the smoothing of GAAP effective tax rates (ETRs) affects the ability of GAAP ETRs to provide useful information about future cash ETRs. 1 We define smoothing as the difference in volatility between GAAP ETRs and cash ETRs, which isolates the smoothing effect of managers estimation of tax accruals from the volatility in firms fundamental tax payouts determined by innate firm performance and tax planning. We examine GAAP ETR smoothing to aid researchers, analysts, investors, and tax authorities to better understand the informational role of tax accruals in developing expectations of future cash tax claims on the firm. This study is motivated in part by the intriguing results in Wagener and Watrin (2012) that a disproportionately large number of firms report a relatively unchanged GAAP ETRs from year to year, yet this discontinuity around a zero-change does not exist for cash ETRs. Their findings suggest that firms report smooth GAAP ETRs, and the smoothness of GAAP ETRs comes from tax accruals instead of the lack of variation in actual underlying cash payouts. However, it remains unclear what information is contained within this difference in ETR variations. In particular, we examine whether the smoothing of GAAP ETRs through tax accruals improves or reduces the ability of GAAP ETRs to infer future cash ETRs. 2 1 GAAP (cash) ETR is calculated as total tax expense (cash taxes paid) scaled by pretax income. 2 We use the term informativeness to refer to the ability of GAAP ETRs to predict future cash ETRs. This definition is consistent with recent literature that examines the mapping of financial accruals to future cash outcomes (e.g., Badertscher et al. 2012). This definition does not consider assumptions about market efficiency or relies on the market s perception of the informativeness of smoothing, which is important as investors may not understand and/or price the information content in smoothing (McInnis 2010) or taxes (Lev and Nissim 2004; Weber 2009). 1

4 While prior research on smoothing has typically focused on earnings (e.g., Tucker and Zarowin 2006; Jayaraman 2008), we focus on the smoothing of GAAP ETRs. We do so because the smoothing of GAAP ETRs through tax accruals is unique compared to earnings smoothing. First, smoothing of GAAP ETRs appears to be more significant and prevalent than smoothing of earnings. As we report later in the paper, changes in GAAP ETRs are prominently clustered around zero while changes in cash ETRs are not, whereas there is little evidence that changes in pretax return on assets (i.e., pretax earnings-to-lagged assets) are clustered more around zero than changes in pretax operating cash flows-to-lagged assets. 3 Second, earnings and total accruals reflect aggregation of all revenue and expenses, and the informativeness of smoothing can be misestimated due to such aggregation. 4 Tax expense and tax accruals, however, reflect only tax outcomes and can be accurately measured using the separately reported tax cash flows, making ETR a powerful setting to study the informational role of smoothing. Finally, the high subjectivity and unique incentives for tax reporting (e.g., ensuring stable non-core expenses and avoiding tax authority scrutiny) may play a part in motivating and achieving the smoothness in ETRs, heightening the uniqueness of the informativeness of ETR smoothing. Smoothing through tax accruals to achieve smoother GAAP ETRs can arise from two sources, GAAP standards and managerial discretion, each of which could lead to more or less informative ETRs. While GAAP standards are intended to make the information in financial reports more informative (FASB 1978), and in general accrual accounting is designed to smooth volatilities in cash outcomes, whether or not standards-induced ETR smoothing is informative 3 Results discussed later documenting minimal earnings smoothing through accruals is consistent with Bushman et al. (2015), who document that the smoothing role of accruals has largely disappeared in recent years. 4 For instance, Bushman et al. (2015) document that in recent years frequent one-time items significantly reduce the smoothing effect of total accruals, and thus the informational value of earnings smoothing may be driven by onetime items. However, there is no sufficient disclosure of cash flows to separately examine the informativeness of smoothing from recurring vs. one-time accruals. 2

5 depends on the underlying nature of a firm s transactions. 5 Moreover, the significant managerial discretion that GAAP allows in the reporting of tax accruals (Choudhary et al. 2015) can play an important role in the informativeness of GAAP ETR smoothing. On one hand, managers can use tax accruals to smooth out temporary shocks to cash tax payouts to communicate their expected long-term tax payout rate. If managers expectations regarding future tax outcomes are accurate on average, we will observe an increase in GAAP ETR informativeness for future cash tax outcomes when GAAP ETR smoothing is greater. On the other hand, tax managers might have incentives to use tax accruals to achieve a smoother pattern of GAAP ETRs without communicating their private information on future tax outcomes. For example, GAAP ETRs are important in calculating compensation to business unit managers (Phillips 2003) and tax directors (Armstrong et al. 2012). To the extent that smoothing can be used to reduce variation in a measure tied to the compensation of risk-averse managers, these managers may have incentives to smooth the GAAP ETR, regardless of underlying tax payments. 6 In addition, investors may perceive smoother GAAP ETRs as lowering uncertainty in firms tax outcomes, or tax authorities may view changes in GAAP ETRs or tax accruals as red flags for tax aggressiveness (Mills et al. 2010; Bozanic et al. 2014). Both incentives could drive managers to keep GAAP ETRs stable. Thus, when managers smooth GAAP ETRs for purposes other than communicating their private information about future cash tax outcomes, smoothing of GAAP ETRs can decrease the informativeness of GAAP ETRs for future cash ETRs. To investigate whether GAAP ETR smoothing conveys useful information to predict future cash ETRs, we first differentiate tax accrual smoothing from smoothness of GAAP ETRs. Smoothness of a firm s GAAP ETR is a function of both the innate smoothness of taxes paid 5 We provide a numerical example of this phenomenon in Appendix A. 6 Armstrong et al. (2012) find that tax director compensation is linked to GAAP ETR, but not cash ETR, which further suggests that information in GAAP ETR may not be informative of future cash ETR. 3

6 (due to the natural variability in the underlying components of taxable income, as well as from tax planning strategies) and the smoothing effect of a firm s reported tax accruals. Conceptually, tax smoothing separates innate tax smoothness from the smoothing effect of tax accruals. Operationally, we develop our measure of GAAP ETR smoothing as the inverse difference between the variance of a firm s GAAP ETR and the variance of cash ETR. 7 To assess whether smoothing of GAAP ETRs through tax accruals increases the informativeness of GAAP ETRs on the level of future cash ETRs, we regress the future level of cash ETR on the interaction of our measure of GAAP ETR smoothing with the level of currentperiod GAAP ETR, controlling for other measures of firm performance. Results in pooled and out-of-sample tests show that GAAP ETR smoothing through tax accruals on average is associated with greater informativeness of GAAP ETRs regarding future levels of cash ETRs. We estimate that a one standard deviation increase in GAAP ETR smoothing increases the predictive ability of GAAP ETRs by an economically significant 37 percent. Next, we study the role of managerial discretion in GAAP ETR smoothing. First, following the definition of discretionary tax accruals in Desai and Dharmapala (2006), we split smoothing into two components: smoothing through non-discretionary tax accruals versus smoothing through discretionary tax accruals. The former reflects smoothing due to underlying fundamentals and direct application of GAAP standards while the latter reflects smoothing due to managerial discretion. We find that our main result is driven by the discretionary component, consistent with managers using their discretion over tax accruals to smooth out GAAP ETRs to convey their firms expected long-term tax payout rates. Second, we study the informativeness of tax accrual smoothing when potential 7 Our GAAP ETR smoothing measure is calculated as -1 (Variance GAAP ETR Variance Cash ETR). We multiply by -1 to facilitate interpretability so that higher levels represent greater GAAP ETR smoothing through tax accruals. In developing our measure, we follow Jayaraman (2008). See Section IV. 4

7 manipulative reporting incentives exist. We first examine how maintaining perfect smoothness of ETRs affects the informativeness of smoothing. Specifically, we compare the informativeness of smoothing of Perfect Smoothers (i.e., firms with an annual GAAP ETR change within one percentage point) to other firms. We argue that although accrual reporting may, on average, smooth out some of the volatility of cash ETRs and lead to smoother GETRs, natural accrual reporting alone is unlikely to produce a disproportionally large number of Perfect Smoothers. Thus, relative to the rest of the sample, Perfect Smoothers are more likely to represent situations where the smoothness of ETRs, rather than communicating information about future cash tax realization, becomes the goal of tax accrual smoothing. We find that smoothing through tax accruals by Perfect Smoothers does not increase GAAP ETR informativeness, while smoothing by other firms does increase GAAP ETR informativeness. This result suggests that although ETR smoothing through accruals on average increases the informativeness of GAAP ETRs, the informational value of ETR smoothing diminishes during firms pursuit for perfect stability in ETR reporting. Third, we study the alternative reporting incentive of avoiding audit scrutiny from tax authorities. We find that ETR smoothing through the tax accrual that most likely receives the most IRS attention the FIN 48 tax reserve (or unrecognized tax benefits, UTB) is significantly less informative compared to ETR smoothing through other, non-utb tax accruals. Coupled with our Perfect Smoother results, this finding suggests that alternative reporting incentives divert managers from using tax accrual smoothing to convey expectations of longterm cash tax payouts, further supporting the significance of managerial discretion in smoothing through tax accruals. In our final set of tests, we examine whether GAAP ETR smoothing provides information about future cash ETR volatility by regressing the variability of future cash ETRs on our 5

8 measure of GAAP ETR smoothing and controls. Results show that greater GAAP ETR smoothing is negatively associated with future cash ETR volatility, consistent with reductions in GAAP ETR volatility being informative about lower future cash ETR volatility. This association is significant, although only when we use ranked variables in our regressions to control for outliers. Overall, we conclude that smoothing GAAP ETRs through tax accruals provides useful information regarding future cash tax outcomes. This study makes several contributions to the accounting literature. First, while the literature exhibits the importance of GAAP ETRs to managers (Phillips 2003; Armstrong et al. 2012; Graham et al. 2014) and provides preliminary evidence of the lack of variation in GAAP ETR changes over time (Wagener and Watrin 2012), the channel and impact of GAAP ETR smoothing remain unexplored. We construct a measure of GAAP ETR smoothing that captures smoothing through the reporting of tax accruals rather than tax avoidance or tax planning (Mayberry et al. 2015). We find that in both pooled and out-of-sample tests, smoothing through tax accruals significantly increases the informativeness of GAAP ETRs for future tax outcomes. Moreover, we find that managerial discretion plays a significant role in the informativeness of ETR smoothing. These findings extend our understanding of GAAP ETR smoothing and establish a useful link between current-period GAAP ETR reporting and future tax outcomes. Second, we add to the literature on the informational role of tax accruals. Although they are complex and subject to managerial discretion, tax accruals have been mostly studied in the context of managing financial earnings, rather than informing outside parties of future tax outcomes. For example, prior literature investigates earnings management via tax accruals generally (Dhaliwal et al. 2004) and individually (e.g. Frank and Rego 2006; Krull 2004; Cazier et al. 2015). Only recently is research examining whether particular tax accruals (e.g., the FIN 48 tax reserve; see Ciconte et al. 2014) provide predictive information on the level of future income 6

9 tax cash flows, but does not examine the role of smoothing through tax accruals. We extend this literature by demonstrating that the variability in GAAP ETRs attributable to total tax accruals helps predict both the level and variability in future tax cash outcomes. This finding is important because it reflects how the pattern of accruals helps investors predict future claims against the firm, which the FASB Conceptual Framework explicitly states as a strategic objective of financial reporting (FASB 2010). 8 Yet, we also find that other reporting concerns, such as maintaining perfectly smooth ETRs or avoiding attention from tax authorities, decrease the usefulness of tax accruals. Finally, our findings add to the general smoothing literature. Although smoothing is a highly favored reporting strategy by managers (Graham et al. 2005), the extent to which smoothing leads to more informative reporting is very much an open question (Dechow et al. 2010, ). In particular, few studies examine the informativeness of smoothing in overall earnings, and those that do find mixed evidence (e.g., Tucker and Zarowin 2006; Jayaraman 2008). In addition, prior literature frequently finds a negative correlation between smoothness and other accrual quality measures, suggesting that smoother accounts may exhibit worse reporting quality (Dechow et al. 2010). We demonstrate with ETR smoothing through tax accruals a clear and powerful setting that ETR smoothing is associated with an increase in reporting informativeness in general, however the pursuit of perfect smoothness reduces the informational value of ETR smoothing. This paper develops as follows. Section II describes the related literature. Section III 8 Objective No. 13 of the Statement of Financial Accounting Concepts No. 8 states, Information about the nature and amounts of a reporting entity s economic resources and claims can help users identify the reporting entity s financial strengths and weaknesses Information about priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among those with a claim against the reporting entity (FASB 2010, 3). In the context of this study, the ability of GAAP ETR smoothing to predict future tax payments highlights the role of tax accruals to communicate managers expected tax claims on firm resources. 7

10 develops our hypotheses and Section IV describes our empirical methodology. We report our results in Section V and conclude in Section VI. Smoothing through Tax Accruals II. BACKGROUND In discussing earnings quality, Dechow et al. (2010, 362) state the following: accounting choice can be motivated either to increase decision usefulness or to distort it. Thus, to understand smoothness as a proxy for earnings quality requires differentiating inherent or fundamental smoothness from smoothness related to accounting choice. In this study where we take a tax perspective within financial reporting, we make such a distinction by examining the difference between the smoothness (volatility) of GAAP ETRs and the smoothness (volatility) of cash ETRs. The smoothness of cash ETRs captures the impact of a firm s fundamental performance and tax planning on the stability of cash tax payouts per unit of income. Thus, the difference between the smoothness of GAAP and cash ETRs isolates the extent to which reporting standards and managers tax accrual estimates smooth out the variance in cash ETRs. We refer to this difference as the smoothing of GAAP ETRs through tax accruals. Recent tax research examines the smoothness of cash taxes paid and its implications for the level of future tax outcomes. These studies use the ratio of the standard deviation of estimated taxable income to the standard deviation of pretax cash flows as the (inverse) measure of smoothness. 9 In particular, Mayberry et al. (2015) find that smoothness in estimated taxable income is associated with lower levels of future cash ETRs, suggesting that better managerial control over the tax function enables greater tax avoidance over future periods. In extending the 9 We stress that this measure of smoothness is of the amount of taxable income as inferred from current tax expense only, not the cash ETR, which also includes the effects of temporary differences. We focus on effective tax rates because Wagener and Watrin (2012) investigate ETR changes as benchmarks, and Graham et al. (2014) find that managers of public firms focus on the reporting of GAAP ETR. Thus, the role of tax accruals should be more salient around ETR values than tax income amounts. 8

11 idea that smoothness indicates better managerial control, McGuire et al. (2013) find that smoother taxable income contains information about the persistence of pre-tax earnings and earnings components, while Neuman et al. (2012) find that higher disclosure transparency is associated with smoother taxable income. The authors note that their measure of smoothness could reflect the volatility of underlying firm performance and/or results from managerial tax planning. In contrast, our design and definition of smoothing as the difference between the volatilities of GAAP and cash ETRs helps identify tax accrual reporting decisions by managers distinct from firm performance or real cash impacts from tax planning. Because GAAP and cash ETRs both use pre-tax income in the denominator, the difference between them is solely derived from their numerators (total tax expense and cash taxes paid, respectively). We refer to this difference between total tax expense and cash taxes paid as tax accruals. Our definition of tax accruals mirrors financial reporting research that defines total accruals as the difference between earnings and cash flows (Dechow 1994; Dechow et al. 1995). In short, tax accruals are a function of financial reporting standards (alone and in comparison to the tax rules), tax managers projections of the future, and managers financial reporting strategies; our definition of tax accruals captures these three items. Specifically, our definition of tax accruals captures tax-related financial reporting adjustments, such as changes in deferred tax asset valuation allowances, tax reserves, and accruals (nonaccruals) of foreign earnings that are (are not) designated as permanently reinvested. Our definition also captures temporary book-tax differences, or changes in deferred tax assets and liabilities. To the extent that a transaction gives rise to a current year tax benefit, but a future tax liability relative to financial reporting (e.g., accelerated depreciation for tax and straight line for GAAP), then total tax expense will be higher than cash taxes paid in the current year, while cash taxes paid will be higher in the following year when the cash outflow occurs and 9

12 the deferred tax liability is reversed. Our definition of tax accruals does not capture permanent book-tax differences, such as income exclusions, tax credits, and foreign tax rate differentials, because they affect tax expense and cash taxes paid equally and are thus netted to zero. Overall, managers can exercise judgment over these categories of tax accruals. They can be subjective and thus can be used either to communicate (Ciconte et al. 2014) or mask future cash outcomes (Schrand and Wong 2003; Krull 2004; Cazier et al. 2015). We use this comprehensive definition of tax accruals to allow our measure of GAAP ETR smoothing to focus on the entire menu of financial reporting strategies, including the possibilities that managers use any or all types of tax accruals to smooth the volatility in cash tax payouts, or managers use one group of accruals to smooth out the volatility in another group of tax accruals. Informativenesss of GAAP ETRs As stated in the FASB Statement of Financial Accounting Concepts No. 1, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows (FASB 1978, p. 5; emphasis added). Thus, the goal of reporting GAAP ETRs should be to help investors and analysts better predict the amounts, timing, and uncertainty of future tax outcomes. We assess the informativeness of GAAP ETRs through its association with both the level and volatility of future cash ETRs, consistent with the FASB s conceptual definition and recent literature that examines informativeness as the ability of financial reporting to predict future cash outcomes (Badertscher et al. 2012; Laux 2013). We do not assess the informativeness of GAAP ETRs using market tests, as such tests make assumptions about market efficiency that may not hold in this setting. In particular, prior evidence suggests that investors and analysts may not understand and price the information content in tax accounts (Lev and Nissim 2004; Weber 2009) and that investors may not reasonably understand and price the informativeness of smoothing (McInnis 2010). 10

13 In general, most of the literature on tax accruals focuses on either examining how they are manipulated to achieve certain earnings targets, or their relation to earnings characteristics (see Graham et al. 2012); there is almost no literature on the informativeness of GAAP ETRs on future tax payouts or their volatility. 10 One recent exception is Laux (2013), which provides evidence on how certain deferred tax assets and liabilities map into future tax payments. 11 He finds that deferred taxes associated with temporary differences that are included in GAAP income prior to (after) taxable income are associated (not associated) with future tax payments. Another exception is Ciconte et al. (2014), which finds that the FIN 48 tax reserve is positively associated with future income tax payments. Both results are consistent with tax accruals containing predictive information about future tax outcomes. Finally, Choudhary et al. (2015) extend the framework of the Dechow and Dichev (2002) accruals quality model to develop a measure for tax accrual quality that estimates the precision of how past, current, and future tax cash flows map into current tax expense. They show that their measure of quality predicts future tax-related restatements and internal control material weaknesses. Our study extends the literature in the following ways: (1) we study the informativeness of total GAAP ETRs (i.e. total tax accruals), rather than specific, isolated tax accruals or current tax accruals; 12 (2) we focus not on the average mapping between current tax accruals and future cash tax payouts (i.e., a main effect), but rather how GAAP ETR smoothing through tax accruals 10 Graham et al. (2012) classify the tax accrual literature generally into three categories: (1) earnings management generally (e.g., Dhaliwal et al. 2004) and through specific tax accruals, such as valuation allowances (e.g., Frank and Rego 2006), permanently-reinvested earnings designations (e.g., Krull 2004), and uncertain tax benefit reserves (e.g., Gupta et al. 2015; Cazier et al. 2015); (2) the relation between tax accruals and earnings characteristics (e.g., Lev and Nissim 2004); and (3) the market pricing of tax accruals (e.g., Frischmann et al. 2008). 11 Laux (2013) focuses on levels of tax payouts and directly extends prior work by Givoly and Hayn (1992), Amir et al. (1997), Sansing (1998), Guenther and Sansing (2000, 2004), and Amir et al. (2001). To our knowledge, no research also examines these links to future levels or volatility of cash effective tax rates. 12 In addition to current tax accruals, which is the focus of Choudhary et al. (2015), we also study total tax accruals. Total tax accruals include long-term temporary book-tax differences, changes in permanently reinvested earnings designations, and the reserve for uncertain tax positions. 11

14 affects the informativeness of GAAP ETRs on future cash ETRs (i.e., an interactive effect); and (3) we assess informativeness for both the level of future cash ETRs and their volatility. Smoothing of GAAP ETRs through Accruals and the Informativeness of GAAP ETRs Prior research examines the impact of earnings smoothing on a firm s information environment, but yields mixed results (Dechow et al. 2010). Tucker and Zarowin (2006) find that smoothing through discretionary accruals leads to higher informativeness of stock prices on future earnings, suggesting that smoothing earnings helps investors better predict future earnings and improves a firm s information environment. Contrary to this view, Jayaraman (2008) shows that bid-ask spreads and the probability of informed trading are higher when earnings volatility differs significantly from cash flow volatility. His results suggest that managers choices over the volatility of reported earnings increases information uncertainty, and thus garbles information. In addition to the mixed evidence, the literature on earnings smoothing may not speak directly to the smoothing of GAAP ETRs through tax accruals because the reporting incentives differ between the two settings. Armstrong et al. (2012) find that the compensation incentives of tax directors but not CEOs, CFOs, or General Counsel explain the variation in GAAP ETRs. This finding suggests that the reporting of earnings, which is the primary focus of the CEO and CFO, may follow a fundamentally different pattern from the reporting of GAAP ETRs, which is the primary focus of tax directors. As we show later, a disproportionally large number of GAAP ETRs experience near zero change year over year, while there is no significant concentration of near zero change ROAs, suggesting there might be a higher emphasis on the smoothness of GAAP ETRs compared with earnings. In addition, even if the tax director would like to report a particular GAAP ETR for compensation reasons, or to communicate private information about expected future tax outcomes, the CEO or CFO may overrule the tax director s discretion in the interest of reporting a particular earnings number. This additional layer of managerial input may 12

15 reduce the ability of GAAP ETRs to predict future cash ETRs. Further, the tax disclosures of firms, including GAAP and cash ETRs, could be used by tax authorities to select firms for audit and identify particular transactions to audit (Graham et al. 2012; Bozanic et al. 2014). Thus, the use of tax information in financial statements by tax authorities and firms related efforts to prevent being selected for audit provide a unique setting in which the findings from the earnings smoothing literature may not directly apply. III. HYPOTHESIS DEVELOPMENT Conceptually, the extent of GAAP ETR smoothing and its impact on the informativeness of GAAP ETRs can be the product of GAAP standards and/or discretionary reporting choices of managers. Smoothing from either of these two sources could lead to more or less informative GAAP ETRs. As noted above, a key objective of GAAP is to make financial information more informative about future cash flows (FASB 1978). Thus, when following GAAP standards also leads to smoother ETRs, smoothing through tax accruals should be associated with GAAP ETRs that are more informative about future cash tax outcomes. However, the opposite is also possible; because the goal of GAAP standards is to make financial information more informative and not necessarily to smooth volatilities in cash flows, GAAP standards that result in less smooth ETRs could also make ETRs more informative. Ultimately, whether GAAP standards result in more or less smooth ETRs depends on the underlying volatility of cash flows relative to the volatility of economic realizations of income. Therefore, whether GAAP standards-induced ETR smoothing increases or decreases the informativeness of GAAP ETRs is an open question; in fact, the answer could vary with standards and the types of underlying transactions. In Appendix A, we use a numerical example on depreciation to illustrate how the simple operation of GAAP standards regarding depreciation can result in (a) differential smoothing and (b) differential 13

16 impacts of smoothing on the informativeness of tax expense for future cash taxes paid, depending on firms future investment activities. In this study, however, we do not explicitly examine the impact of GAAP standards on the informativeness of ETR smoothing since we do not focus on any particular GAAP standard or specific type of transaction. GAAP standards and particularly those regarding tax accrual reporting also grant managers significant discretion over reporting methods and amount estimation (Choudhary et al. 2015). Managers may use their discretion to smooth out shocks to cash tax outcomes to convey a long-term average tax rate. If managers can forecast future tax payout rates, managerial discretion will lead to a positive association between tax accrual smoothing and informative GAAP ETRs. Following the Appendix A example on depreciation, it is reasonable to expect managers to be aware of firms future investment plans and therefore can accurately predict firms future tax payouts. Managers may then, for example, choose an asset life length to achieve a smoother GAAP ETR that is closer to the future average tax cash payout rate. Such managerial discretion can increase the informativeness of GAAP ETRs. However, managers may also smooth GAAP ETRs through tax accruals for reasons other than conveying long-term cash tax payout rates. First, the growing use of financial information by tax authorities gives managers an incentive to garble information about transactions with material tax effects in an attempt to prevent tax audits or assessments. For instance, managers can choose their level of confidence in sustaining a tax position to garble the FIN 48 disclosure so that the tax authorities, who can also observe the tax reserve, are not tipped off by an increase in the reserve (Graham et al. 2012). As such, discretionary smoothing may not make GAAP ETRs more informative about future cash ETRs. Second, because GAAP ETRs are important to manager compensation at the business unit level (Phillips 2003) and to tax directors (Armstrong et al. 2012), GAAP ETR smoothing can be used to reduce variation in a measure tied 14

17 to the compensation of risk-averse managers. Third, investors may perceive firms with volatile GAAP ETRs to have higher tax-related risk. To lower investors risk perception, managers may smooth GAAP ETRs through tax accruals. These three reasons for discretionary smoothing will not be associated with higher informativeness of GAAP ETRs. Given the competing effects of tax accrual smoothing on the informativeness of GAAP ETRs for future cash ETRs, we state our hypothesis in the null form: Hypothesis: GAAP ETR smoothing does not help improve the informativeness of current period GAAP ETRs for future cash ETRs. GAAP ETR Smoothing Measure IV. RESEARCH DESIGN AND SAMPLE SELECTION We develop a measure conceptually similar to Jayaraman (2008) by defining GAAP ETR smoothing (GETR_SMO) as the difference between the variances of a firm s GAAP ETR and cash ETR, multiplied by negative one to facilitate interpretability so that higher levels of GETR_SMO represent smoother GAAP ETRs compared to cash ETRs. GAAP ETR can be deconstructed as follows: Thus, the variance of the GAAP ETR can be expressed as: 2, As shown above, the variance of GAAP ETRs is generated by three sources: the variance of cash ETRs, the variance of the portion of GAAP ETRs that is due to tax accruals, and their 15

18 covariance. To create our ETR smoothing measure, we calculate the variance of the GAAP ETR and the cash ETR over the current year and the prior two years (i.e., over t, t-1, and t-2). We then subtract the variance of the cash ETR from the variance of the GAAP ETR to arrive at our measure of GAAP ETR smoothing (i.e., GETR_SMO) due to tax accrual choices, as follows: GETR_SMO = 1 [Var(GAAP ETRt 2,t 1,t) Var(Cash ETRt 2,t 1,t)] With this formulation, the GAAP ETR could be smoothed either by reducing the variance of tax accruals and/or by changing the extent to which tax accruals covary with cash taxes paid. 13 Regression Model To empirically test whether GAAP ETR smoothing makes current-period GAAP ETRs (GETR) more informative of future cash ETRs (CETR), we estimate the following OLS model (year and time subscripts suppressed): _ (1) _ _ Our dependent variable Future_CETR is the average CETR (FAVG_CETR) calculated over the future 3 years (t+1, t+2, and t+3). We also use the average 3-year future GETR (FAVG_GETR) as an alternative dependent variable. Our primary variable of interest is the interaction between GETR and GETR_SMO. If GAAP ETR smoothing improves (reduces) the informativeness of GAAP ETRs for future levels of cash ETR, we expect 4 >0 ( 4 <0). We expect the levels of both current GAAP ETR and cash 13 Jayaraman (2008) further describes that both the variance of accruals and the extent to which accruals covary with cash flows are needed to measure smoothing. However, given that some prior literature (e.g., Tucker and Zarowin 2006) focuses only on the covariance between accruals and pre-managed earnings in measuring smoothing, in a supplemental test we split our measure into the portion due to (a) the variance of accruals and (b) the covariance of accruals and cash flows and examine the effect of each portion separately on GAAP ETR informativeness. We find that both components are significant. Separately, Jayaraman (2008) explains that using the ratio of earnings volatility to cash flow volatility as a measure of smoothing may lead to problematic inferences, as it incorrectly classifies certain accrual manipulations (e.g., big baths) as smoothing and does not effectively remove cash flow smoothness from the smoothing measure. 16

19 ETR to be positively associated with the level of future cash ETR, or 1 >0 and 2 >0, consistent with Dyreng et al. (2008) and Hoopes et al. (2012). However, we make no prediction about the direct association between GAAP ETR smoothing and future cash ETRs ( 3 ). In interpreting Eq. (1), we do not intend to show a causal effect, but rather to examine the association between GAAP ETR and future levels of cash ETR as GAAP ETR smoothing increases. It is possible that GAAP ETR smoothing could alter how the tax department prepares its tax returns, thus indirectly affecting future cash ETR. However, it is more likely that the estimation of tax accruals has no impact on underlying cash ETRs, but merely provide information about it. As such, a significantly positive (negative) coefficient on the interaction term indicates that smoothed GAAP ETRs are more (less) informative for future cash ETRs, but does not indicate that GAAP ETR smoothing has a causal effect on cash ETRs. We include control variables in Eq. (1) that are theoretically or empirically expected to be correlated with both the levels and volatility of GAAP ETRs and cash ETRs, and/or variables that might be correlated with ETR smoothing. Because we expect the levels and variance of past cash ETRs to be correlated with the levels of future cash ETRs, we include both the level of current cash ETR as well as the variance of cash ETR (VAR_CETR). We also control for the volatility of pretax income, the denominator of our ETR measures (VAR_PTI). We include other concurrent (period t) control variables, including profitability (ROA), size (SIZE), market-tobook ratio (MB), leverage (LEV), research and development expense (R&D), net operating loss carryforwards (NOL), foreign income-producing activity (FOR), intangible assets (INTAN), 17

20 mergers and acquisitions (M&A), capital intensity (PPE), and cash holdings (CASH). 14 All variables are mean-centered and defined in Appendix B. Sample Selection We begin our sample in 1994 to ensure a full year after the implementation of SFAS 109 and end in We exclude from our sample financial and insurance (NAICS 52) and utility firms (NAICS 22), as these firms have different regulatory and tax rules than other firms. We require six years of consecutive data for any observation (i.e., for years t-2, t-1, t, t+1, t+2, and t+3) so that both our smoothing measure and future cash ETRs can be calculated. We also require year t to have all control variables available. 15 Our final sample consists of 44,468 firm year observations obtained from Compustat from 1996 to The number of firms fluctuates between 2,470 and 3,072 (in 1996 and 2002, respectively), with each year representing no more than 6.9% of the total sample. The number of firms each year is consistent with other recent studies (Hoopes et al. 2012; Demeré et al. 2015). V. RESULTS Descriptive Statistics Table 1 reports our descriptive statistics of firm-level characteristics. Both current and future cash ETRs have means of 0.20, which are slightly lower than those found in recent research (e.g., Ciconte et al. 2014; Mayberry et al. 2015); however, this study has seven and two times, respectively, the number of observations of those studies. By utilizing more observations, 14 In untabulated tests, we also include interactions between GETR and each of our control variables to ensure that our interaction of interest (GETR GETR_SMO) is not capturing an interaction between GETR and another variable correlated with GETR_SMO. The significance and sign of our interaction of interest remains unchanged. 15 Studies that examine ETRs (e.g., Dyreng et al. 2008; Demeré et al. 2015) typically omit loss firms, as a negative ETR denominator leads to ETRs that are not meaningful. We retain loss firms in our sample as we are interested in the predictive ability of GAAP ETR smoothing and the smoothing measure (along with ETR variability) is not affected by negative ETR denominators. Nevertheless, in untabulated tests, we find that our results are robust to the exclusion of loss firms, and thus generalize to the sample of firms typically examined in the tax literature. We also find that our results are robust to requiring all observations to have un-winsorized GAAP ETRs between 0 and 1. 18

21 our study likely includes smaller firms, which is evidenced by a slightly lower mean of the natural log of assets of Taken together with a positive correlation between CETR and size, we would expect our CETR mean to be lower than other studies. GETR has a mean of 0.27, which is slightly lower than that of Wagener and Watrin (2012), who use data back to 1968 when U.S. statutory tax rates were higher. Our GAAP ETR smoothing variable (GETR_SMO) has a mean of and a median of This variable is more often positive (61% of observations) than negative or zero (32% and 7% of observations, respectively). 16 Note that positive values indicate smoother GAAP ETRs than cash ETRs. In addition, this distribution provides corroborating evidence to Wagener and Watrin (2012) that, for the most part, GAAP ETRs are smoother than cash ETRs. We investigate the Wagener and Watrin (2012) results further below. Table 2 shows Pearson correlations of key variables used in our regressions. GETR_SMO is significantly and positively correlated with all measures of future level of both cash ETR (FAVG_CETR) and GAAP ETR (FAVG_GETR), as well as our measure of future cash ETR volatility (FVAR_CETR); however, as we are interested in the multivariate interaction between GETR and GETR_SMO, we do not interpret these univariate results. 17 Wagener and Watrin (2012) Replication Recent research by Wagener and Watrin (2012), as reproduced in Figure 1, reveals that a disproportionately large number of firms have a near-zero change in their GAAP ETR from year 16 The 7 percent of observations for which GETR_SMO equals zero are generally those with either negative or extreme positive GAAP tax expense and cash taxes paid over the three-year smoothing window. Because we winsorize all ETRs to lie between 0 and 1 before computing ETR variances, these observations exhibit no variation over time, leading to a GETR_SMO value of zero. 17 The positive correlation between GETR_SMO and FVAR_CETR is opposite of what we find in multivariate analyses. We believe the change in sign is due to a positive correlation between the variation in tax accruals and cash-tax flows across macroeconomic and industry conditions. By controlling for year and industry fixed effects in our multivariate analyses, we remove these large sources of positive correlation. 19

22 to year, yet there is no such discontinuity when examining changes in cash ETR. Given that the results in Wagener and Watrin (2012) motivate our study, we replicate their findings on GAAP and cash ETRs using our sample to ensure that our data also exhibit these patterns. 18 We show in Figure 2 a similar discontinuity around zero GAAP ETR change. 19 We graphically overlay the changes in GAAP ETR with the changes in cash ETR, the latter of which reveals a much smaller discontinuity around zero. 20 Because tax accruals are the only difference between cash ETR and GAAP ETR, these results suggest that tax accruals are used to smooth GAAP ETR. In addition, we recalculate GAAP ETRs by subtracting special items (SPI) from the denominator. We display our results in Figure While ETRs are calculated inclusive of special items in the denominator as this is how they are typically calculated in practice and for compensation purposes (Armstrong et al. 2012), special items are frequently removed from the denominator in the research literature (e.g., Dyreng et al. 2008). If the distribution in Figure 2 around zero change is driven by an attempt to smooth GAAP ETRs around a key ETR benchmark, then we would expect that using a metric different from that used by managers (i.e., changes in GAAP ETR after subtracting SPI in the denominator) will result in a less-pronounced 18 Wagener and Watrin (2012) start with firms from 1968 through 2011 and remove observations that have GAAP ETRs which are not interpretable. Following their methodology, we start with firms in our sample (1994 through 2013) and remove firms with zero or negative pre-tax income and truncate GETR values to the range [0,1]. 19 The discontinuity around zero change in GAAP ETR is significant at the 0.01 level (z-stat 28.69). The test statistic is calculated as, where is the number of observations in the two bins adjacent to zero, and is the number of observations in the bin to the left and right of the center two bins. Similar to Burgstahler and Dichev (1997), we assume the number of observations in each bin is independent of observations in adjacent bins, and as such calculate the variance as 1 1, where is the number of observations in the sample, is the portion of total observations in the two bins centered at zero and is the portion of total observations in the bin adjacent to the left and right of the two bins centered around zero. 20 The discontinuity around zero change in cash ETR is weakly significant at the 0.10 level (z-stat 1.94) and is calculated as described in the previous footnote. Our sample departs slightly from Wagener and Watrin (2012) who do not find significance at the 0.10 level. 21 Special items (SPI) include prior year adjustments, significant nonrecurring items, discontinued operations, flood, fire, and other natural disaster losses, interest on tax settlements, inventory write-downs, repurchase of debentures, relocation expenses, severance pay, special allowances for under construction facilities, transfers from prior year reserves, write-downs of intangibles, etc. Write-downs of goodwill and other assets are GAAP-only items that have no effect on taxes (Dyreng et al. 2008). 20

23 mass centered around zero. Indeed, as seen in Figure 3, we find that there is less mass centered around zero change in ETRs when SPI is removed, giving support to our implication that managers manage GAAP ETRs. To contrast the prominence of ETR smoothing through tax accruals to earnings smoothing through non-tax accruals, in Figure 4 we plot changes in pretax ROA (earnings-tolagged assets) and pretax cash flow ROA. We find a considerably lower percentage of observations clustered around zero in this figure than in Figures 2 and 3. Importantly, changes in pre-tax ROA are only slightly more centered at zero than changes in cash flow ROA. The contrasting figures are consistent with ETRs being subject to greater smoothing than earnings. 22 Multivariate Results Main Results We now investigate whether smoothing through tax accruals is informative of future cash tax outcomes using a multivariate regression framework. Table 3 Panel A reports the results of testing our hypothesis. To provide a baseline analysis, we first examine whether the smoothness of GAAP ETRs (i.e., VAR_GETR) is linked to greater informativeness of current GAAP ETRs for future cash ETRs. Since VAR_GETR is an inverse measure of smoothness, the statistically negative signs on the interaction between GAAP ETR and GAAP ETR smoothness (GETR VAR_GETR) in columns (1) and (2) support that general GAAP ETR smoothness makes GAAP ETRs incrementally informative of future levels of cash ETR. However, we are primarily interested in whether GAAP ETR smoothing makes GAAP ETRs more informative about future cash ETRs. Our first estimation of Eq. (1) includes only GAAP ETR (GETR), cash ETR (CETR), GAAP ETR smoothing (GETR_SMO), and the 22 The discontinuity around zero pre-tax ROA is not significant. In separately plotting changes in after-tax earnings and operating cash flows (both scaled by lagged assets), we find slightly more clustering around zero for the former measure, suggesting that tax accruals seem to facilitate earnings smoothing. 21

24 interaction between GAAP ETR and GAAP ETR smoothing (GETR GETR_SMO), as well as industry and year fixed effects. As shown in column (3), the interaction between GETR and GETR_SMO is significantly positive, indicating that smoothing of tax accruals makes GAAP ETRs incrementally informative of future levels of the average cash ETR for the subsequent three year period. These results are consistent with GAAP ETR smoothing being a significant part of overall GAAP ETR smoothness, and with GAAP ETR smoothing making GAAP ETRs more informative of future cash ETRs. 23 In columns (4) we re-estimate Eq. (1) after adding control variables. We find similar results in both sign and significance for our key independent variables (GETR, CETR, GETR_SMO, and GETR GETR_SMO), indicating that our results are robust to controls used in the extant literature. Overall, we find support that the smoothing of tax accruals makes GAAP ETRs incrementally informative of future cash ETRs. In a related test, we examine whether smoother GAAP ETRs are more informative in predicting future GAAP (rather than cash) ETRs. For each of the three subsequent periods as well as the average over the subsequent three periods, we similarly find that smoother GAAP ETRs are more informative regarding future GAAP ETRs. For brevity, in column (5) we only tabulate the results using future three-year average GAAP ETR as our dependent variable. Results using each individual future year (t+1, t+2, t+3) GAAP ETR are similar. In terms of control variables, we find that the main effects of the variance of cash ETR (VAR_CETR) is positively related to future cash ETR. Combined with the negative sign on GETR_SMO, our results complement Mayberry et al. (2015) in that firms with greater control 23 Note that we also find a significantly negative interaction between GETR and VAR_CETR, which is consistent with fundamental cash tax smoothness making GAAP ETRs more informative of future cash ETRs. However, GETR GETR_SMO remains incrementally significant to the effects of fundamental cash tax smoothness, suggesting that it has a significant role in the informativeness of GAAP ETRs. We do not include VAR_GETR in the specification because by construction GETR_SMO begins with the variance of GAAP ETR. 22

25 over their tax function appear to exhibit greater future tax avoidance. The insignificant sign on the variance of pretax income (VAR_PTI) ensures that our results are not driven by underlying earnings smoothness. The other main effects load in directions consistent with prior research. In Table 3 Panel B, we report the results of specification checks that use ranked variables to rule out the possibility that outliers are driving our results. In column (1), we re-estimate Eq. (1) to aid comparability. In column (2), we rank our dependent and independent variables based on the entire sample and divide by our sample size (44,468) so that our ranked variables vary between 0 and 1. This global ranked estimation model yields similar significant results for the interaction between GETR and GETR_SMO. In column (3), we rank our dependent and independent variables within each year and industry, and divide by the total observations in that year and industry so that our ranked variables are between 0 and 1. Our by-industry, by-year ranked model yields similar results for the interaction between GETR and GETR_SMO. In both ranked analyses, all coefficients generally retain the same sign and significance, except that the signs on the main effects of GETR_SMO and VAR_CETR become negative when ranked variables are used. This result suggests that care should be taken when using these variables in future research as inferences are highly susceptible to outlier observations. In columns (4) and (5), we show that our results are robust to calculating our variance and smoothing measures over five and seven years, respectively, instead of only three. We choose to display our results using three-year variance and smoothing calculations in other tables to maximize our number of observations and demonstrate the importance of even short-term smoothing. However, our results are consistent when using five- and seven-year calculations. In all, we find support that smoothing of tax accruals makes GAAP ETRs incrementally informative of future levels of cash ETRs. 23

26 Out-of-sample Prediction Tests To verify that GAAP ETR smoothing improves the prediction of future cash ETR, we conduct out-of-sample prediction tests as shown in Table 4. Using an approach similar to prior research (e.g., Lev et al. 2010; Ciconte et al. 2014), we estimate industry-specific coefficients for Eq. (1), both with and without GETR_SMO. We develop our estimates using observations during and compute firm-specific unsigned prediction errors _ _ using a hold-out sample of data from For the final step, we test the distribution of the prediction errors across the two models (with and without GETR_SMO). If GETR_SMO improves the predictability of future levels of cash ETR, then we expect significantly smaller absolute prediction errors when the prediction models include GETR_SMO. The mean and median tests indicate that Eq. (1) generates significantly smaller absolute errors when GETR_SMO is included rather than excluded, suggesting that smoothing through tax accruals helps predict future cash ETRs. While these results show that GAAP ETR smoothing makes current GAAP ETRs more informative, they do not give a sense of how much more informative GAAP ETRs are when they have been smoothed. In untabulated results, we standardize all of our variables to enable direct comparisons across coefficients. These results show that a one standard deviation change in smoothing at the mean makes GAAP ETRs 37 percent more informative about future cash ETRs, which is an economically significant increase in predictive power. The Role of Managerial Discretion Having established that GAAP ETR smoothing through tax accruals increases the informativeness of GAAP ETRs for future cash ETRs, next we examine the role of managerial discretion. To examine whether managers discretion in the informativeness of tax accrual smoothing plays a part in our results, we separate tax accruals into those with higher versus 24

27 lower levels of discretion, i.e., discretionary and non-discretionary tax accruals. Discretionary tax accruals are computed as the sum of the residuals and firm fixed effects from a regression of GAAP ETR on pre-tax accruals scaled by lagged total assets (similar to the TS measure of Desai and Dharmapala 2006), with the remaining tax accruals classified as non-discretionary. We use these estimates to decompose our GETR_SMO measure into its discretionary (DA_SMO) and non-discretionary (NDA_SMO) components. 24 We then interact each of these smoothing measures with GETR to examine the degree to which discretionary smoothing (which we attribute to managerial actions) and non-discretionary smoothing (which we attribute to the role of GAAP standards) explain the informativeness of GAAP ETR for future cash ETR. As reported in Table 5, we find that smoothing through discretionary tax accruals makes GAAP ETRs more informative of future cash ETRs. However, we find the opposite relation with non-discretionary tax accruals. Taken together, we infer that our main results are due in large part to the discretionary financial reporting of tax accruals by managers rather than GAAP standards, although we also acknowledge that measurement error in our discretionary tax accruals measure could result in some of the effects of GAAP standards being treated as discretionary. Overall, the results are consistent with managerial discretion improving the informativeness of tax accruals, on average. The Role of Managerial Discretion in the Presence of Alternative Reporting Objectives In this section, we examine reporting considerations that potentially alter the informativeness of GAAP ETR smoothing for future cash ETRs. First, we compare the 24 Specifically, we estimate the following regression:, where TA is total accruals scaled by lagged total assets and is firm fixed effects. Our measure of discretionary accruals is, while non-discretionary accruals are. Therefore, the smoothing of discretionary tax accruals is calculated as -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [NDA scaled by PTI plus Cash Effective Tax Rate (CETR)]}, while the smoothing of non-discretionary tax accruals is calculated as -1 {Variance of GETR Variance of [DA scaled by PTI plus CETR]}. 25

28 informativeness of ETR smoothing for Perfect Smoothers to other firms (non-perfect smoothers). We define Perfect Smoothers as firms with less than a one percentage point change in GAAP ETRs over two consecutive reporting periods. Perfect Smoothers likely signify managers intention to maintain smooth ETRs as a goal, regardless of being informative of future cash ETRs. The desire to maintain perfectly smooth GAAP ETRs is consistent with CEOs minimizing the risk of the tax accounts generating a negative surprise to earnings, and/or riskaverse tax directors minimizing the variation in their compensation (Armstrong et al. 2012). In order to compare Perfect Smoothers to non-perfect Smoothers and rule out that our results might be explained by the fundamental differences between the two groups we create a control sample that is similar to Perfect Smoothers on multiple firm dimensions. In particular, we conduct entropy balancing on GETR_SMO, variance of cash ETR, industry, and year (Hainmueller 2012). 25 We match on GETR_SMO so that our results are not attributable to the amount of GAAP ETR smoothing (i.e., that Perfect Smoothers are not simply firms that smooth more or less than other firms). We also match on the variance of cash ETR to rule out that fundamental tax performance or planning is different between firms (i.e., to ensure that Perfect Smoothers lack of variation in GAAP ETRs does not occur simply because their underlying tax performance has lower variation than other firms). The difference in means of all four entropy balancing covariates between treatment and control samples converge to less than 0.02%. Successful balancing on these variables enables our tests to focus on whether the informativeness of GAAP ETR smoothing is higher or lower for Perfect Smoothers than for other firms. 25 Entropy balancing achieves covariate balance in specifications using a binary outcome (in our case, whether or not a firm is a Perfect Smoother). The advantages over propensity score matching are that entropy balancing (1) can balance covariates not only on the first moment (i.e., means are similar), but also on the second and higher moments (i.e., variances and skewness are similar); (2) eliminates the iterative process needed to check for covariate balancing as required under propensity score matching; and (3) reweights units to achieve balance rather than discards them or forces a match as under nearest neighbor matching. In effect, entropy balancing is a generalization of the propensity score weighting approach. See Hainmueller (2012) for details. 26

29 Results in Table 6 Panel A show that for Perfect Smoothers, smoothing through tax accruals does not increase the informativeness of GAAP ETRs on future cash ETRs (see column (1)). Yet, for non-perfect Smoothers, smoothing does increase the informativeness of GAAP ETRs (see column (2)). 26 We confirm that the difference in effects between the two groups is statistically significant. These results indicate that smoothing through tax accruals loses its informational value when there is a reporting goal of generating perfectly smooth GETRs. In our second set of tests, we examine a setting in which managers may have incentives to smooth the GAAP ETR to avoid tax authority scrutiny. To do so, we examine a tax accrual that is likely of greatest interest to the tax authorities the FIN 48 tax reserve, or UTB (Bozanic et al. 2014). In this context, managers may smooth the GAAP ETR using the UTB accrual to avoid signaling any red flags that would heighten the likelihood the firm will be selected for audit by the tax authorities. If a smoother UTB translates into a smoother GAAP ETR to primarily avoid tax scrutiny, then UTB smoothing will not be informative about future cash tax ETRs. To isolate the UTB and non-utb components of GAAP ETR smoothing, we first split total tax accruals into UTB and non-utb tax accruals, then decompose our GETR_SMO measure to isolate UTB smoothing (UTB_SMO) and non-utb smoothing (NUTB_SMO). 27 We then interact each of these smoothing measures with GETR to examine whether smoothing of UTB and non-utb tax accruals makes GETR more or less informative of future cash ETRs. Results reported in Table 6 Panel B show that the coefficient on the interaction between GETR and UTB_SMO is insignificant, suggesting that smoothing of the UTB component of 26 Note that the size of the coefficients on GETR_SMO and GETR GETR_SMO are larger than in previous tests. This result occurs because the scale of GETR_SMO is much smaller than in our main specifications; recall that the Perfect and non-perfect Smoother sub-samples are entropy balanced on GETR_SMO. 27 We calculate the smoothing of UTB tax accruals (UTB_SMO) as -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [Non-UTB Accruals scaled by PTI plus Cash Effective Tax Rate (CETR)]} and we calculate the smoothing of non-utb tax accruals (NUTB_SMO) as -1 {Variance of GETR Variance of [UTB Accruals scaled by PTI plus CETR]}. 27

30 GAAP ETR is not informative of future cash tax ETRs. Our results also show a significantly positive coefficient on the interaction between GETR and NUTB_SMO, consistent with the smoothing of the non-utb component being informative of future cash ETRs. 28 These results are consistent with firms trading off smoothing to be informative with smoothing to avoid audit scrutiny from tax authorities. In all, we find that GAAP ETR smoothing, on average, can be informative of future cash tax outcomes, and discretionary tax accruals explain the informativeness of ETR smoothing. However, the Perfect Smoother and UTB results in this section demonstrate that alternative reporting objectives can divert managers from using tax accrual smoothing to convey expectations of long-term cash tax payouts. These results further support the pivotal role of managerial discretion in smoothing through tax accruals. Supplemental Analyses To further examine the information in GAAP ETR smoothing, we first decompose GAAP ETR smoothing into its two potential sources of volatility, the variance of (scaled) tax accruals and the covariance between cash ETR and (scaled) tax accruals. 29 In untabulated results, we successively re-estimate Eq. (1) by replacing GETR_SMO with the variance of (scaled) tax accruals and the covariance between cash ETR and (scaled) tax accruals. 30 We find that both sources of smoothing volatility yield significant coefficients on their interaction with GETR, indicating that both the variance and covariance portions of our GAAP ETR smoothing measure 28 Unfortunately the lack of machine-readable data prevents us from directly analyzing other non-utb tax accruals, such as the valuation allowance or permanently reinvested earnings. 29 Recall that we scaled tax accruals by pre-tax income. 30 Covariance of cash ETR and tax accruals is calculated as for periods t-2, t-1, and t. 28

31 help predict future cash ETRs. 31 These results support the argument in Jayaraman (2008) that both elements are necessary to infer smoothing. Second, we decompose GAAP ETR smoothing into its reporting components, or smoothing from current versus deferred GAAP ETR. If only one component of GAAP ETR is significant, then we can gain a better understanding of the specific tax accruals used to informatively smooth GAAP ETRs. In untabulated results, we successively re-estimate Eq. (1) by replacing total GETR_SMO with smoothing in current GAAP ETR and smoothing in deferred GAAP ETR. 32 We find that both smoothing components yield significant coefficients on their interaction with GETR with the same sign and significance level as the original GAAP ETR smoothing measure. This finding is consistent with smoothing in both current and deferred ETRs providing information about future cash tax outcomes. Third, Brown et al. (2015) provide evidence of a shift around the passage of FIN 48 in the way that managers bonuses vary with ETRs. They find that bonuses in the pre-fin 48 period are associated with GAAP ETRs but not cash ETRs, while bonuses in the post-fin 48 period are associated with cash ETRs but not GAAP ETRs. We re-estimate Eq. (1) separately on the pre- and post-fin 48 periods and find results across the periods that are consistent with our main tests. We infer that managers compensation-related motives do not solely drive our results. Finally, we test whether the informativeness of GAAP ETR smoothing varies based on the level of a firm s tax avoidance. In untabulated tests, we re-estimate Eq. (1) separately for firms in the highest, middle, and lowest tercile of cash ETR relative to the firm s industry 31 Both the variance of tax accrual ETRs and the covariance between cash ETRs and tax accrual ETRs have the same sign and significance level as the original GAAP ETR smoothing measure. 32 These measures are constructed similarly to GETR_SMO, namely as the variance of the current (deferred) ETR less the variance of the cash ETR (CETR) for periods t-2, t-1, and t. Here the current (deferred) ETR is constructed as and deferred portions of cash ETR. ( ). However, we caveat this analysis because we cannot identify current 29

32 average cash ETR. 33 We find that the effect of smoothing (i.e., the coefficient on the interaction between GETR_SMO and GETR) is not significantly different across any of the terciles, indicating both that (a) our results are likely not affected by tax planning, as intended by the construction of our smoothing measure, and (b) that GAAP ETR smoothing as a financial reporting strategy appears to be available to firms regardless of their level of cash tax avoidance. Informativeness of Future Variance of Cash ETRs While our results show that, on average, smoothing of tax accruals makes GAAP ETRs more informative about levels of future cash ETRs, it is also possible that smoothing can be used to provide information to market participants about the expected variance in future cash ETRs. To empirically test the relation between GAAP ETR smoothing through tax accruals and the variance of future cash ETRs, we estimate the following OLS model: _ _ _ (2) Our dependent variable, the variance of future cash ETRs (FVAR_CETR), is defined as the variance of future cash ETR for periods t+1, t+2, and t+3. GAAP ETR smoothing through accruals (GETR_SMO) is our main variable of interest. A positive (negative) coefficient on GETR_SMO would indicate that GAAP ETR smoothing is a direct (inverse) predictor of future cash ETR volatility, while an insignificant relation would indicate that GAAP ETR smoothing contains no incremental information about future cash ETR volatility. 34 Table 7 reports our tests on the relation between GAAP ETR smoothing and the future volatility of cash ETRs. In column (1), we report the results of estimating Eq. (2) using only GETR_SMO and the variance of cash ETR (VAR_CETR), as well as industry and year fixed 33 Specifically, terciles are determined based on the firm cash ETR minus its industry average cash ETR. This test is equivalent to interacting all variables by CETR, including GETR*GETR_SMO, in Eq. (1). 34 Again, these results should not be interpreted as identifying a casual relation. Thus, a significant association does not necessarily indicate that GAAP ETR smoothing increases or reduces future cash ETR variance. 30

33 effects. Results show no relation between GETR_SMO and the future volatility of cash ETRs. In column (2), we add additional control variables and the results remain insignificant, consistent with smoothing not providing any information about future cash ETR volatility. In columns (3) and (4), we use ranked variables to rule out the possibility that outliers are affecting our ability to detect a relation between GAAP ETR smoothing and future cash ETR volatility. In column (3), we rank our dependent and independent variables based on the entire sample and divide by 44,468 so that our ranked variables are between 0 and 1. In column (4), we rank our dependent and independent variables within each year and within each industry, and divide by the total observations in that industry and year so that our ranked variables are between 0 and 1. Unlike in columns (1) and (2), both ranked estimation models show a significant negative relation between GAAP ETR smoothing and future cash ETR volatility. These results are suggestive of smoother GAAP ETRs providing information about lower future cash ETR volatility, although the results appear sensitive to outliers. VI. CONCLUSION This study examines whether GAAP ETR smoothing through tax accruals helps predict future cash ETRs. We measure GAAP ETR smoothing as the difference between the variances of GAAP and cash ETR. This measure controls for firm fundamentals and tax planning on the smoothness of GAAP ETR while isolating the impact of tax accruals. In pooled and out-ofsample validation tests, we show that GAAP ETR smoothing through tax accruals enhances the ability of GAAP ETRs to predict future cash ETRs. Importantly, we find that managerial discretion over tax accruals, rather than GAAP standards-based effects, explains our primary results. However, in additional tests we find that alternative reporting objectives, such as maintaining a perfectly smooth GAAP ETR and attempting to avoid audit scrutiny from tax 31

34 authorities, reduces the informativeness of GAAP ETR smoothing for future cash ETRs. Finally, we show that greater GAAP ETR smoothing is associated with lower future tax cash ETR volatility, but only after reducing the influence of outliers using ranked regressions. Our study contributes to the accounting literature on taxes and financial reporting by demonstrating the implications of GAAP ETR smoothing on GAAP ETR informativeness. Our new measure of smoothing allows researchers to focus on managers financial reporting strategies (reflected in tax accruals), rather than fundamental performance or tax savings strategies (reflected in tax cash flows). We show that the variability in GAAP ETR attributable to total tax accruals, but separate from innate firm performance, helps predict both the level and variability in future cash tax outcomes. By examining the channel and impact of GAAP ETR smoothing on future cash tax ETRs, we extend prior research that finds GAAP ETRs are important to managers (Armstrong et al. 2012; Graham et al. 2014) and lack variation over time (Wagener and Watrin 2012). Our research provides new evidence regarding the role of tax accruals in predicting future tax claims against the firm (FASB 2010) and helps researchers to better understand the informational value of smoothing in a unique and powerful setting (Dechow et al. 2010). 32

35 APPENDIX A Illustration of Smoothing and Informativeness: The Case of Depreciation To illustrate how tax information can be smoothed to provide useful information about future cash tax outcomes, we provide a numerical example in Figure A1. 35 Beginning in Panel A, assume a firm on June 30, 2008 decides to purchase a fixed asset that has a five-year life for tax purposes, is eligible for 50 percent bonus tax depreciation, and costs $1,000. Further, the firm is subject to a 20 percent tax rate, and must decide on June 30 of subsequent years whether or not to purchase another identical asset. In scenario one, the firm only purchases the asset in 2008 and not again in future years. Assuming a five-year life for book purposes, then GAAP standard (i.e., straight-line) depreciation will reduce the standard deviation of tax expense from 37.2 to 16.6 relative to cash reporting, thus resulting in a smoothing effect. Because it also reduces the mean square error (MSE) of expense reporting from the long-term future expected cash tax outcome of $0 (i.e., the limit of the cash tax outcome of the firm s investment policy taken as time increases), this is a case where standard-based smoothing results in a more informative ETR. 36 In scenario two, the firm purchases the asset in 2008 and the same asset on June 30 of each subsequent year. Here GAAP standard depreciation increases the standard deviation of tax expense relative to cash reporting, from 27.0 to 65.9, resulting in anti-smoothing. Additionally, the MSE relative to the long-term expected cash tax outcome of -$200 increases, making this a scenario where GAAP standards act to make tax expense less smooth and less informative for future cash tax outcomes. Finally, scenario three shows a setting where the firm purchases the asset in 2008 and 2009, does not purchase the asset in 2010, and follows the same pattern of two years purchasing 35 For brevity, we only report the end impact of asset depreciation on cash taxes paid and tax expense. Full depreciation calculations are available upon request. 36 Because pre-tax income does not change within scenarios, we can apply this tax expense example to ETRs. 33

36 followed by one year not purchasing in subsequent years. GAAP standard depreciation results in smoothing, reducing the standard deviation of tax expense from 44.4 to 41.2 relative to cash taxes. However, this smoothing effect results in a greater MSE relative to the long-term expected cash tax outcome of -$133. Here standard-based smoothing results in less informative tax expense. Across all three scenarios in Panel A, the simple operation of GAAP standards can result in (a) differential smoothing and (b) differential impacts of smoothing on the informativeness of tax expense for future cash taxes paid. Importantly, these very different results come about simply due to the way that the same GAAP reporting standards map to different firm fundamentals. Moving now to Panel B of Figure A1, assume that managers in the same three scenarios have discretion over what life to apply for book income purposes. As such, they all decide to choose a six-year depreciable life rather than a five-year depreciable life. In scenario one, this discretionary change results in smoother tax expense recognition (i.e., lower expense standard deviation) than even the GAAP standards would have created. This change also reduces the MSE of tax expense relative to the pre-manipulation expense, resulting in more informative tax expense recognition. Here discretionary smoothing acts to make GAAP ETRs more informative than even what GAAP standard smoothing alone would. This type of smoothing would be consistent with managers trying to smooth out the earnings shock of a one-time investment to make the GAAP ETR more informative about the average future cash tax consequences of the firm s investment plans. In scenario two, the use of managerial discretion acts to smooth GAAP ETRs from what GAAP standards alone would provide, as evidenced by the decrease in standard deviation. However, the discretionary choice of managers also acts to increase the MSE from GAAP standard expense, thus making tax expense less informative. This scenario shows how 34

37 managerial discretion can be used to smooth GAAP ETRs in such a way that they become less informative for future cash ETRs. This scenario is consistent with either managers smoothing GAAP ETRs to reduce the variation in their compensation metric, to hinder monitoring from tax authorities, to obscure riskiness of tax outcome, or consistent with the loss of informativeness being an unintended consequence of other reporting strategies (e.g. using tax accruals to meet or beat earnings benchmarks). Finally, scenario three illustrates how managerial discretion can result in anti-smoothing relative to GAAP standards alone. The standard deviation increases due to managerial use of discretion from 41.2 to This discretionary choice also increases MSE relative to GAAP standards alone, consistent with a reduction in smoothing that makes GAAP ETRs less informative for future cash ETRs. This final scenario does not fit the managerial incentives previously discussed to smooth GAAP ETRs; however, it would be consistent with managers seeking a particular reporting incentive, such as beating GAAP ETR benchmarks in a period when stock options vest or taking a big tax expense bath to build cookie-jar reserves, that would increase GAAP ETR volatility and make GAAP ETRs less informative as an unintended consequence. Across all three scenarios in Panel B, a small (and likely within GAAP) change made by managers using the discretion afforded them by GAAP can result in differential smoothing and differential impacts of smoothing on the informativeness of tax expense for future cash taxes paid, depending on the underlying firm fundamentals. Across both Panels A and B, it is clear that both GAAP standards and managerial discretion can result in smoothing outcomes that alternately make GAAP ETRs more and less informative, even in a setting as seemingly simple as asset depreciation. 35

38 Figure A1: Smoothing Examples Panel A Scenario One Scenario Two Scenario Three Cash Taxes GAAP Cash Taxes GAAP Cash Taxes GAAP Total Std. Dev > < > 41.2 Long-Run MSE > < < Panel B Scenario One Scenario Two Scenario Three Manager Manager Discretio Manager GAAP Discretion GAAP n GAAP Discretion Total Std. Dev > > < 41.7 Long- Run MSE > < < This Figure illustrates the tax expense implications of depreciating assets, assuming a tax rate for the firm of 20%. The Cash Taxes columns are the implications for tax expense accounted for using the cash method. GAAP columns are the implications for tax expense accounted for under U.S. GAAP. Manager Discretion columns are the implications for tax expense under U.S. GAAP given that managers have made a judgment that the assets have a six-year, rather than a five-year life. In Scenario One, a single asset that is eligible for 50% tax bonus depreciation is purchased for $1,000 on June 30, 2008, and depreciated over a five-year life for both tax and GAAP purposes (sixyear life when managers use discretion). Scenario Two begins like Scenario One, but the firm then purchases an identical asset on June 30 of each subsequent year. Scenario Three shows a setting where the firm purchases the asset from Scenario One in 2008 and 2009, does not purchase the asset in 2010, and follows the same pattern of two years purchasing followed by one year not purchasing in subsequent years. Standard deviations (Std. Dev.) and mean-squared errors (MSE) are calculated over the entire eight-year period shown. MSEs are calculated using the long-run average cash tax implications of the firm s investment strategy (Long-Run) as the target. 36

39 Dependent Variables FAVG_CETR FAVG_GETR FVAR_CETR APPENDIX B Variable Definitions Future 3-Year Average Year Cash Effective Tax Rate, computed as the Sum of {Cash Taxes Paid (TXPD) [Pretax Income (PI)] for periods t+1, t+2, & t+3} 3 Future 3-Year Average Year GAAP Effective Tax Rate, computed as the Sum of {Total Tax Expense (TXP) [Pretax Income (PI)] for periods t+1, t+2, & t+3} 3 Variance of Cash Effective Tax Rate, computed as Variance of {Cash Taxes Paid (TXPD) [Pretax Income (PI)]} for periods t+1,t+2,& t+3. Independent Variables GETR GAAP Effective Tax Rate, computed as Total Tax Expense (TXT) [Pretax Income (PI)] CETR Cash Effective Tax Rate, computed as Cash Taxes Paid (TXPD) [Pretax Income (PI)] GETR_SMO Tax Accrual Smoothing, -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of Cash Effective Tax Rate (CETR)} for periods t-2,t- 1,& t. VAR_CETR VAR_GETR VAR_PTI Variance of Cash Effective Tax Rate, computed as Variance of {Cash Taxes Paid (TXPD) [Pretax Income (PI)]} for periods t-2,t-1,& t. Variance of GAAP Effective Tax Rate, computed as Variance of {Total Taxes Expense (TXT) [Pretax Income (PI)]} for periods t-2,t-1,& t. Variance of Pre-Tax Income, computed as Variance of {Pretax Income (PI)} for periods t-2,t-1,& t. Control Variables ROA Return on Assets, computed as the ratio of Pretax Income (PI) Total Assets (AT). MB Market to Book ratio, computed as the [Common Shares Outstanding (CSHO) * End of Fiscal Year Stock Price (PRCC_F) Common Equity Book Value (CEQ). SIZE LEV R&D NOL NOL_DELTA Firm size, computed as the natural log of Total Assets (AT). Leverage, computed as the ratio of Long-Term Debt (DLTT) Total Assets (AT). Research & Development, computed as the ratio of Research Expense (XRD) prior-period Total Assets (AT). Missing values in Compustat are recoded as $0. Net Operating Loss Carryforward, coded as one if Tax Loss Carryforward (TLCF) is non-zero; zero otherwise. Change in NOL from Previous Period, calculated as Prior Period NOL minus Current Period NOL FOR Foreign activity, computed as the ratio of Foreign Pretax Income (PIFO) prior-period Total Assets (AT). Missing values in Compustat are recoded as $0. INTAN M&A Intangible assets, computed as Intangibles (INTAN) Total Assets (AT). Mergers and Acquisitions, coded as one if M&A (AQC) is missing or not equal to zero; zero otherwise. 37

40 PPE CASH BIG4 Other Variables NDA_SMO DA_SMO NUTB_SMO UTB_SMO Property, Plant, & Equipment, computed as the ratio of Property, Plant & Equipment (PPEGT) divided by Total Assets (AT). Cash holdings, computed as cash and short-term investments (CHE) Total Assets (AT). Big Four Auditor of the financial statements, coded as one if one of the Big Four Auditors audited the financial statements; zero otherwise. Non-Discretionary Tax Accrual Smoothing, -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [Discretionary Accruals scaled by PTI plus Cash Effective Tax Rate (CETR)]} for periods t-2,t-1,& t. Discretionary Tax Accrual Smoothing, -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [Non-Discretionary Accruals scaled by PTI plus Cash Effective Tax Rate (CETR)]} for periods t-2,t-1,& t. Non-UTB Tax Accrual Smoothing, -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [UTB Accruals scaled by PTI plus Cash Effective Tax Rate (CETR)]} for periods t-2,t-1,& t. UTB Tax Accrual Smoothing, -1 {Variance of GAAP Effective Tax Rate (GETR) Variance of [Non-UTB Accruals scaled by PTI plus Cash Effective Tax Rate (CETR)]} for periods t-2,t-1,& t. 38

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44 Figure 1 Reproduction of Wagener and Watrin s (2012) Figure 1 Change in GAAP ETR Wagener and Watrin s (2012) Figure 1 showing change in prior year vs current year GAAP ETR over 1968 through Wagener and Watrin calculate GAAP ETR as total tax expense/pre-tax income (TXT/PI). Observations with zero or negative pre-tax income were excluded and GAAP ETR was truncated to the range [0,1], leaving Wagener and Watrin with n=92,467 observations. 42