An International Study of the Relation between Book-Tax Conformity and the Value Relevance of Earnings Components

INTRODUCTION International factors in accounting information are becoming more important due to growth in international capital markets (Meek and Thomas, 2003). As the economies of different countries have become more closely linked, factors that affect a firm's performance in one country may impact the economies of other countries. In today's globalized environment, international accounting research can help us understand how current financial accounting data relate to future performance and overall firm value. Prior research (Alford et al. 1993, Joos and Lang 1994, Guenther and Young 2000, Ali and Hwang 2000, Ball et al. 2000, Herrmann et al. 2000, Hung 2001, Young and Guenther 2003, Ball et al. 2003, Leuz et al. 2003, and Haw et al. 2004) suggests that the value relevance of a country's financial reporting may be affected by various accounting practices and tax rules because each country has different political, social, and economic systems. Since the primary objective of tax rules is not to satisfy the information needs of capital market participants, the value relevance of financial reports in countries with high tax-book conformity may be compromised (Ali and Hwang, 2000). Additionally, because firms have competing incentives between tax planning and financial reporting, accounting information in countries with a strong link between tax and financial accounting may be less value relevant. As Guenther and Young (2000, p. 58) state, "firms have strong incentives to reduce taxes, and if financial and tax accounting must conform, tax considerations may dominate other considerations. Hence, financial accounting information may be less likely to reflect underlying economic events when firms attempt to minimize taxes. " Ali and Hwang (2000, p. 2) argue that, "requiring book-tax conformity provides incentives to reduce taxes by reporting systemically lower profits, thereby undermining the value relevance of financial reporting. " If financial statements are to provide a true and fair view of performance, financial accounting should not be influenced by tax considerations. Hence, if a country's financial accounting principles are strongly aligned with tax rules, its financial accounting information is likely to be less value relevant. Many prior studies (e.g., Alford et al. 1993; Ali and Hwang 2000; Guenther and Young 2000; Young and Guenther 2003) have found that the degree of book-tax conformity is negatively associated with the value relevance of a firm's earnings for financial reporting. However, Hung (2001) does not find evidence to support a relation between book-tax conformity and value relevance of earnings, which is contrary to the findings of Ali and Hwang (2000) and Young and Guenther (2003). Given these contrary findings, the relation between book-tax conformity and the value relevance of earnings remains unresolved. This study adds to existing literature by providing evidence regarding the relation between book-tax conformity and the value relevance of earnings across countries. It is not clear why book-tax conformity is related to value relevance of accounting earnings. The reason may be either that high book-tax conformity causes earnings to be less value relevant or that high book-tax conformity is related to an information and regulation environment that results in limited association between accounting information and stock price. One way to address this issue is to examine the value relevance of earnings components. A Special Report issued by the Financial Accounting Standard Board (FASB) suggests that disaggregating earnings components would be a useful format for reporting income (FASB, 1998, para. 4.4). Prior research (e.g., Lipe 1986; Ohlson and Penman 1992; Lev and Thiagarajan 1993; Abarbanell and Bushee 1997) also indicates that earnings components contain useful information in the U.S. market; however, to-date there has been little to no investigation of the relation between the value relevance of earnings components and country-specific factors. …