Analyst Forecasts and the Permanence of the Tax Change Component of Earnings

• In Event: Ongoing Research Session II

Abstract

Despite the central importance of equity analysts as information intermediaries in capital markets, prior studies provide only limited evidence on how analysts use tax information reported in financial statements. To seek a deeper understanding of the mechanisms that underlie analysts’ use of tax information in GAAP financial statements, we investigate the association between sell-side equity analysts’ forecasts and the change in earnings attributable to a change in ETRs (i.e., the tax change component of earnings). We provide evidence that the persistence of the tax change component of earnings embedded in analysts’ forecasts is systematically lower than that implied by our model’s time-series properties. Recent research shows that the persistence of the tax change component of earnings is a complex combination of both the persistence of pretax earnings and the persistence of the ETR. We provide evidence that the analysts’ underestimation of the tax change component of earnings is primarily attributable to analysts’ failure to impound the full implications of the difference between permanent and transitory ETR changes. The results also provide strong evidence that analysts’ underreaction to the tax change component of earnings is significantly attenuated when managers voluntarily provide earnings forecasts. Further, analysts’ incorporation of tax information into earnings forecasts becomes less biased after Regulation FD.

Authors

• Sangwan Kim, University of Massachusetts - Boston

• Andrew P Schmidt, North Carolina State University