Large Book-Tax Differences, Earnings Persistence, and Investment Expenditures

We re-examine the question why large positive and large negative book-tax differences (LPBTDs and LNBTDs) are associated with lower earnings persistence (Hanlon, 2005). Specifically, we investigate whether lower earnings persistence of LPBTD firms and LNBTD firms, relative to firms in the middle BTD quintiles, is due to earnings management or is a consequence of high levels of investment expenditures. First, we show that high CAPX (HiCAPX) firms and high R&D (HiR&D) firms are disproportionately represented in the LPBTD and LNBTD quintiles respectively, whereas high discretionary accrual (HiDA) firms are uniformly distributed across the LPBTD, LNBTD and middle BTD quintiles. Next, we find that HiDA firms are associated with lower earnings persistence in all BTD quintiles, but HiCAPX and HiR&D firms are only associated with lower earnings persistence in the LPBTD and LNBTD quintiles respectively. Extending the Hanlon (2005) model, we demonstrate that the differential earnings persistence associated with LPBTDs and LNBTDs comes from the intersection of HiCAPX and LPBTD firms and the intersection of HiR&D and LNBTD firms respectively. These intersections reflect growth through investment in physical capital and innovation through investment in R&D respectively