Cristi A. Gleason

Last Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts

We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre-tax accruals must be posted in the year-end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third- to fourth-quarter effective tax rates (ETRs) are negatively related to whether and how much a firm’s earnings absent tax expense management miss analysts’ consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre-tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non-tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.

Valuation Model Use and the Price Target Performance of Sell-Side Equity Analysts

This study investigates the influence of inferred valuation model use on the investment performance of sell-side equity analysts’ published price target opinions. There is limited and inconclusive evidence on how analysts’ price targets are determined and on their value for investment decisions. Using a broad sample of 45,693 price targets provided to First Call by sell-side analysts during 1997 through 2003, we first show that price targets have investment value because they predict future stock returns. Next, we develop and implement an innovative large-sample procedure for inferring valuation model use from the observed correlation between analysts’ price targets and two researcher-constructed stock valuation estimates that differ in simplicity and rigor. Reliance on a less rigorous valuation model may diminish the investment advantage associated with an analyst’s more accurate earnings forecasts but it may also mitigate the disadvantage of less accurate forecasts. We test whether the apparent use of a more rigorous valuation technique yields higher quality price targets as measured by realized investment returns over a 12-month horizon, controlling for possible differences in earnings forecast accuracy. The central message from our data is that price targets exhibit superior investment performance when analysts appear to be using a fundamental residual income (RIM) stock valuation technique rather than a simple price-earnings-growth (PEG) valuation heuristic. This investment advantage is reduced when analysts’ earnings forecasts are inaccurate. Our results underscore the importance of valuation model choice to analyst’s stock investment evaluation process.

Forecasting Tax Expense: New Evidence from Analysts

Using recently available pre-tax earnings forecast data from 2003 to 2012, we infer analysts’ income tax expense and effective tax rate (ETR) forecasts and provide the first large-sample evidence on their dispersion and accuracy. Even though managers provide annual ETR estimates each interim quarter, management’s estimates are not equal in information content and analysts do not merely mimic these estimates, consistent with analysts providing incremental information. Analysts’ forecasts are more disperse and less accurate when management’s interim ETR estimate include discrete items, consistent with more uncertainty and greater difficulty in understanding the tax environment when accounting standards require exceptions to the integral method. Taken together, our results suggest management interim ETR estimates are critical to the market’s understanding of tax expense.

Does FIN 48 Improve Firms' Estimates of Tax Reserves?

This paper examines whether the increased accounting guidance and reporting requirements of FIN 48 impact the adequacy and accuracy of tax reserves and the effect of auditor-provided tax services on tax reserves. While we do not find FIN 48 affected the adequacy or accuracy of tax reserves on average, FIN 48 eliminated the differences in the tax reserve adequacy of firms with and without auditor-provided tax services that existed prior to its adoption. We also find evidence of more timely recording and less premature releasing of tax reserves post-FIN 48. Our evidence is consistent with an increase in comparability of reserves for firms that do and do not purchase auditor-provided tax services, consistent with one of the FASB’s objectives for FIN 48.