The Role of Revenue-Expense Mismatching in Explaining the Tax Fundamental’s Ability to Predict Earnings Growth

• In Event: Determinants of Future Earnings Performance

Abstract

This paper empirically tests Lev and Nissim’s (2004) conjecture that the deteriorating quality of book income is responsible for the temporal increase in the tax fundamental’s ability to predict earnings growth. Lev and Nissim use the term “tax fundamental” to refer the ratio of estimated taxable income to book income. We find that greater firm-specific revenue-expense mismatching, a comprehensive proxy for low-quality book income, enhances the taxable income to book income ratio’s ability to predict future earnings growth in both cross-sectional and time-series analyses. This finding highlights the substitutive role of taxable income in predicting future earnings growth when book income is of lower quality. Additional analysis reveals that both economic events and accounting standards/practices drive mismatching’s impact on the tax-to-book ratio’s ability to predict future earnings growth.

Authors

• Sangwan Kim, University of Massachusetts Boston

• Allison Koester, Georgetown University

• Steve C Lim, Texas Christian University