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Abstract:
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 the earnings announcement. While 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 the earnings announcement. We hypothesize that changes from 3rd to 4th 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 pretax 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, 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 smaller. 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.

earnings management, tax expense, target earnings

Abstract:
Following the enactment of the Sarbanes Oxley Act 2002, US stock exchanges strongly advocate the presence of financial experts on audit committees. However, the ideal definition of financial expertise proves to be a controversial issue culminating with the stock exchanges adopting a wide scoped definition of financial expertise. Using this definition, prior studies have not provided consistent evidence of financial expertise positively influencing audit committee effectiveness. We investigate the association between three types of audit committee financial expertise (accounting, finance and supervisory expertise) and accruals quality. We find significant positive relation between accounting expertise and accruals quality, which is more pronounced in the presence of strong audit committee governance. The findings indicate that the current definition of financial expertise is too broad and any future refinements must focus on accounting expertise of the audit committee members.

Audit committee, Accounting Expertise, Accruals quality

Abstract:
Lee (1988) finds LIFO firms have higher earnings-price (EP) ratios than non-LIFO firms despite the income-reducing effects of LIFO, a result contrary to economic intuition and which Lee describes as a ?puzzle.? This paper attempts to resolve the puzzle identified by Lee using an approach that involves improved measurement of those variables which theory suggests should determine EP ratios. We examine EP ratios for a sample of firms for the years 1982 through 1993. Although EP ratios are consistently higher for LIFO firms during this period, we find the difference is reduced substantially when firms with losses are excluded. When the regression model used by Lee (1988) is estimated, the coefficient on the LIFO indicator variable is positive for both the full sample of firms and for the subsample with loss firms excluded. A regression model is then estimated which includes improved proxies for risk and expected growth. The improved proxies are analysts' expectations of future growth rather than realized growth, beta computed using a procedure designed to reduce measurement error rather than the usual OLS beta, and leverage as a supplemental risk measure. Further, we control for expected earnings changes, since transitory earnings shocks that are not expected to persist in future earnings can affect EP ratios. Results of this model indicate that EP ratios are positively related to risk and negatively related to expected earnings growth. After controlling for differences in risk, expected earnings growth, and transitory earnings, we find that EP ratios for LIFO firms are actually lower than those of non-LIFO firms, a result consistent with economic intuition and the result expected by Lee (1988).

Abstract:
We estimate firm level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax-penalized portion of dividend yield, which we define as the product of dividend yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax-penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax advantaged investors. The evidence in this study adds to the understanding of the effect of investor-level taxes on equity value.

Abstract:
We estimate firm level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax-penalized portion of dividend yield, which we define as the product of yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax-penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax advantaged investors. We further explore the effect of institutional ownership on the dividend tax premium by partitioning institutional owners into groups of relatively homogeneous investors but fail to find consistent results across different institutions or different measures of cost of equity capital. This part of our analysis is exploratory, but we believe that it provides useful insights for future research that can identify stronger settings within which to examine the effects of investor tax attributes on the dividend tax premium.

dividend tax capitalization, dividend yield, implied cost of capital, institutional ownership

Abstract:
The purpose of this paper is to evaluate the model used by Harris and Kemsley (1999), Harris, Hubbard and Kemsley (2001) and Collins and Kemsley (2000), hereafter CHHK, and to investigate their empirical results. We demonstrate that the model underlying CHHK is flawed, and show that their interpretation of the data is incorrect. Finally, we find that after controlling for market to book ratio, Harris and Kemsley's first main result vanishes. In total, we reject CHHK's conclusions that equity prices are discounted for shareholder dividend taxes on retained earnings.

taxes, dividends, tax capitalization

Abstract:
Recently, several studies have concluded that individual investor level dividend taxes on corporate retained earnings are impounded in common stock prices, independent of the timing of dividend payments. We show that the model underlying these studies is internally inconsistent. We also discuss why the model of dividend tax capitalization described in these recent studies is not likely to be descriptive of the taxation of corporate distributions, and we present several reasons, with corroborating data, to believe that common stock prices are not affected by dividend taxes in the manner articulated in these studies. Our empirical results can be summarized as follows. We replicate some of the basic results of prior dividend capitalization studies. We test for evidence of dividend tax capitalization around tax rate changes resulting from the ERTA81, the TRA86 and the OBRA93. Using the same methodology employed in recent research, the evidence does not support dividend tax capitalization across the three tax regimes. We also perform numerous additional data analyses that in general produce results that do not support the conclusions of recent dividend tax capitalization studies. Finally, we find that after controlling for market to book ratios, the main results in prior studies vanish. Overall, the analyses and evidence in this study indicate that shareholder dividend taxes on corporate retained earnings are not impounded in stock prices.

Taxes, Dividends, Tax capitalization

Abstract:
We demonstrate how the level of institutional ownership as a measure of tax-induced investor heterogeneity impacts the trading volume effect of dividend yield around ex-dividend days. Cross-sectional tests support the tax-motivated trading hypothesis: 1) Ex-day excess trading volume increases in dividend yield and this positive relation is a concave quadratic function of the level of institutional ownership. 2) The volume effect of dividend yield peaks when the level of institutional ownership is at 32.18% - lower than 50%, consistent with the view that institutional investors may be more risk tolerant than individual investors. 3) Across tax regimes, some support is also found for the ex-day tax-motivated trading hypothesis. We contribute to the literature by considering the interaction between payout policy and ownership structure in explaining the variation in ex-day excess trading volume.

ex-dividend, trading volume, institutional ownership

Abstract:
We examine the associations between leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958, 1963], the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. This expression predicts that the cost of equity is increasing in leverage, but that corporate taxes mitigate this leverage related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium associated with leverage is increasing in the personal tax penalty associated with debt.

Capital structure, Cost of capital, Tax

Abstract:
We examine the associations between leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958,1963], the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. This expression predicts that the cost of equity is increasing in leverage, but that corporate taxes mitigate this leverage related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium associated with leverage is increasing in the personal tax penalty associated with debt.

Capital structure, Cost of capital, Tax

Abstract:
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced shareholder level taxes on equity income. If shareholder level taxation is a component of cost of equity capital, then the cost of equity capital should decrease after the Tax Act. We find that the cost of equity capital decreases by 1.02% and that the decline is smaller for firms largely held by institutional investors to whom the tax rate reduction does not apply. These results suggest that the Tax Act lowered the cost of equity capital and add further evidence to the question of whether taxes impact valuation.

Abstract:
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 Tax Act) drastically reduced shareholder level taxes on equity income. If shareholder level taxation is an important component of cost of equity capital, then cost of equity should decrease after the 2003 Tax Act. Using the approach of Dhaliwal, Krull, Li, and Moser (2005) that relies on estimates of implied cost of equity capital, we find that cost of equity decreased by about 1.02% after the 2003 Tax Act. We also show that for firms largely held by institutional investors to whom the tax rate reduction does not apply, the decline in the cost of equity capital is smaller. These results suggest that the 2003 Tax Act may have achieved its intended goal of lowering the cost of equity capital. They also add further evidence to a more fundamental research question, that is, taxes impact valuation.

Implied cost of capital, institutional ownership, dividend taxes, capital gain taxes

Abstract:
This paper examines the effect of tax planning and earnings management on the relative informativeness of book income and taxable income. We conduct two sets of tests documenting (1) the incremental effect of tax planning and earnings management on the relative informativeness of book and taxable income and (2) the relation between voluntary conformity and the relative informativeness of book and taxable income. Based on these two sets of tests, we conclude that tax planning and earnings quality jointly affect the relative informativeness of book and taxable income.

earnings management, taxable income, book income, information content

Abstract:
We investigate the backdating of stock option exercises. Before SOX, we find evidence that some exercises were backdated to days with low stock prices. Consistent with a tax-based incentive, these suspect exercises are more likely when the personal tax savings from backdating are higher. However, suspect CEO exercises generate average (median) estimated tax savings of $96,000 ($7,000). These savings appear modest relative to the costs insiders and firms face. We find that the likelihood of a suspect exercise increases in the likelihood of option grant backdating. This suggests that agency problems associated with backdating permeate option compensation in some firms.

Stock option compensation, Backdating, Taxes, Insider trading, Regulation

Abstract:
We investigate the backdating of stock option exercises. Before SOX, we find evidence that some exercises were backdated to days with low stock prices. Consistent with a tax-based incentive, these suspect exercises are more likely when the personal tax savings from backdating are higher. However, suspect CEO exercises generate average (median) estimated tax savings of $96,000 ($7,000). These savings appear modest relative to the costs insiders and firms face. We find that the likelihood of a suspect exercise increases in the likelihood of option grant backdating. This suggests that agency problems associated with backdating permeate option compensation in some firms.

Stock option compensation, Backdating, Taxes, Insider trading, Regulation

Abstract:
We document that short sellers exploit both post-earnings-announcement drift and the accrual anomaly. In addition, using a unique dataset of shares available for borrowing as of the earnings announcement date, we find that short selling plays an important role in the pricing of accruals: the downside effect of high accruals disappears when at least 6.8% of a firm's shares are available for borrowing by short sellers. Furthermore, we demonstrate that this effect is distinct from that of institutional holdings, which can affect pricing of accruals in ways unrelated to short selling.

Short sales, short interest, market efficiency, post earnings announcment drift, accruals

Abstract:
This paper tests the hypothesis that there is an inverse relation between non-audit services (NAS) provided by a firm auditor and the value relevance of earnings (measured as the earnings response coefficient) and that this relation is weaker for firms with Big 6 auditors. The hypothesis is based on anecdotal evidence and previous research that suggests that the provision of NAS by the external auditor is likely to adversely affect investors' perceptions of the credibility of financial reports, and that Big 6 auditors, because of reputational capital and litigation costs, are likely to mitigate the adverse effects of NAS. Results using 840 firm-year observations of Australian companies document a statistically significant inverse relationship between NAS and the value relevance of earnings, and this inverse relationship is weaker for Big 6 auditors, therefore supporting the hypothesis.

Abstract:
This paper tests the hypothesis that there is an inverse relation between non-audit services (NAS) provided by a firm auditor and the value relevance of earnings (measured as the earnings response coefficient) and that this relation is weaker for firms with Big 6 auditors. The hypothesis is based on anecdotal evidence and prior research which suggest that the provision of NAS by the external auditor is likely to adversely affect investors' perceptions of the credibility of financial reports and that Big 6 auditors due to reputational capital and litigation costs are likely to mitigate the adverse effects of NAS. Results using 840 firm-year observations of Australian companies document a statistically significant inverse relationship between NAS and the value relevance of earnings and that this inverse relationship is weaker for Big 6 auditors, thus supporting the hypothesis.

Auditor Independence, Non-audit Services, Audit Quality, Value Relevance, Earnings

Abstract:
We examine a potential benefit associated with the voluntary reporting of corporate social responsibility performance, a reduction in firms' cost of equity capital. We find that firms with high cost of equity capital tend to release corporate social responsibility reports and that reporting firms with relatively superior social responsibility performance enjoy a reduction in the cost of equity capital. Further, reporting firms with superior social responsibility performance attract dedicated institutional investors and analyst coverage. Superior social responsibility performance also serves to reduce forecast errors and dispersion. Finally, firms appear to exploit the benefit of a reduction in the cost of equity capital associated with social responsibility reporting: Reporting firms are more likely than non-reporting firms to raise equity capital in the two years following the reporting and among firms raising equity capital, reporting firms raise a significantly larger amount than non-reporting firms.

voluntary disclosure, non-financial disclosure, CSR, cost of equity capital

Abstract:
Motivated by the theoretical results of Yee (2006), we extend the empirical analysis of Francis et al. (2005) to test the prediction that the effect of accruals quality on cost of capital increases with fundamental risk. In asset pricing tests, we find that there is essentially no relation between accrual quality and cost of capital as measured by future return realizations for firms with the lowest fundamental risk. In contrast, for firms with the highest fundamental risk, there is a strong relation between accrual quality and future return realizations. Using earnings-price ratios and average implied cost of capital as alternative measures of cost of capital, we find that as fundamental risk increases, accrual quality has an increasing effect on cost of capital, and that the effect of accrual quality on cost of capital is reduced for firms with low fundamental risk. Overall, the results in this paper show that that relation depends critically on the level of fundamental risk, consistent with the model of Yee (2006). The results also serve to qualify the findings of Francis et al (2005), who document a relation between accrual quality and cost of capital.

of capital, accrual quality, earnings quality, fundamental risk

Abstract:
We estimate firms' implied cost of capital and examine the effects of dividend taxes on this ex ante measure. The results support the dividend tax capitalization hypothesis. We find a positive relation between implied cost of equity capital and dividend yield that is decreasing in aggregate institutional ownership. We further explore the effect of institutional ownership on the dividend tax premium by partitioning institutional owners into groups of homogeneous investors. We find evidence that ownership by certain groups of tax-favored institutions, including insurance companies, endowments, and pensions, decreases the dividend tax premium and that ownership by mutual funds, non-tax-favored institutions, does not significantly affect the dividend tax premium. Although banks do not face the dividend tax penalty that individual investors face, we do not find that the dividend tax premium is decreasing in ownership by banks, contrary to our predictions. We believe that this exploration paves the way for future research that can identify stronger settings within which to examine the effects of institutional owners' tax attributes on the dividend tax premium.

Abstract:
We examine the influence of taxes on U.S. corporations' methods of financing taxable stock acquisitions during 1987-1997. Our tests provide the first empirical evidence that acquiring-firms' foreign tax credit positions can significantly reduce their propensity to use debt (versus internal funds) to finance acquisitions. This is true even though the acquirers are high-tax rate firms that would ordinarily have tax incentives to use debt. We also find that acquiring firms are significantly less likely to use debt financing when the target firms they acquire have tax-loss carryovers. These results provide new insights regarding how taxes relate to acquisitions financing.

Financing choice, Corporate acquisitions, Taxes

Abstract:
We investigate the equity valuation effects of the Pension Protection Act of 2006 (hereafter PPA 2006). The PPA 2006 has two main provisions: (1) firms must fully fund their pension plans within seven years (previously allowed 30 years to fund 90 percent of the pension liability), and (2) firms receive a tax deduction for contributions up to 150 percent of the pension liability (previously 100 percent). After controlling for the effects of SFAS 158, growth opportunities, the cost of external funds and other information released during our sample period, we examine pension firms' abnormal returns surrounding key dates in the legislative process leading to the adoption of the PPA 2006. First, we find a mean negative abnormal return of -4.20 percent during the period in which the PPA 2006 was first voted on by Congress. The mean (median) firm in our sample experienced a $310 million ($60 million) decline in market capitalization. Second, we find that the valuation effect was more negative for firms with larger unfunded pension liabilities and larger capital expenditure requirements, while firms with higher marginal tax rates experienced a positive effect. Third, we find no evidence of differential valuation effects for firms in different "at risk" categories as defined by the PPA 2006. Finally, we find a significant number of pension freezes occurred during our sample period. Our results are stronger when excluding these firms from our sample.

Pension liabilities, defined benefit plans, pension accounting, Pension Protection Act of 2006

Abstract:
Prior research suggests that differences between book and taxable incomes reflect firms' underlying economic fundamentals and their earnings management activities. We investigate the extent to which book-tax differences (BTDs) explain differences in cost of equity capital across firms. Our analysis spans the 1982-2006 period. The results indicate that variability in BTDs estimated over five or six years is positively and significantly related to cost of equity capital (estimated in various ways), whereas other BTD variables generally are not. These findings are consistent with variability in BTDs over time capturing information regarding uncertainty about firms' economic fundamentals and uncertainty about the quality of their earnings. If we assume that only a relatively short time-series of data is available, then we find that the absolute value of BTDs is positive and significantly related to cost of capital.

Variability of book-tax differences, innate characteristics, information uncertainty

Abstract:
This paper examines the economic reasons for the observed negative abnormal common stock performance of firms whose reported earnings and stockholders' equity were negatively affected by the proposed elimination of full cost accounting in the oil and gas industry. Four explanations of the market effects of this mandatory accounting change are examined: (1) naive investor theory, (2) modified naive investor theory, (3) contracting cost theory, and (4) estimation risk theory. These hypotheses are developed in detail and used to generate variables for a cross-sectional model which explains observed return behavior. The effect of the accounting change on total stockholders' equity, the existence of financial contracts denominated in terms of accounting numbers and, to a lesser extent, firm size are shown to be important explanatory variables. The importance of these variables is consistent with both the contracting cost and estimation risk theories.

contracting cost, full cost accounting, oil and gas industry, mandatory accounting change

Abstract:
This study examines the relation between product market competition and accounting conservatism. Extant research offers three reasons why intense competition can lead to more timely recognition of economic losses in accounting income. First, intense product market competition improves the flow of firm-specific information and hence limits managers' ability to conceal bad news. Second, product market competition, by increasing liquidation risk, contributes to a firm's demand for accounting conservatism to achieve more efficient contracting. For instance, it allows for better debt contracting and hence enables firms in a competitive setting to obtain funds at a lower cost. Third, intense product market competition induces greater demand for conservatism because sub-optimal managerial decisions contrary to shareholders' interest can quickly lead to costly firm liquidation. Timely loss recognition serves to discourage negative net present value investments and to encourage quicker abandonment of loss-making projects. An alternative prediction is that product market competition reduces the severity of agency conflicts and hence limits the demand for accounting conservatism. We attempt to shed light on the competing views by investigating the association between product market competition and the asymmetric timeliness of economic loss recognition. Using a sample of 99,315 firm-year observations over the period 1964-2006, we find asymmetric timeliness of economic loss recognition to increase with the intensity of product market competition. Moreover, this relation is not qualitatively affected by the inclusion of various controls for the demand for conservatism, in particular, managerial ownership. We also find an inter-temporal increase in asymmetric timely recognition of economic losses following industry deregulation. Overall, our evidence points to a relation between product market competition and properties of accounting numbers.

Abstract:
This paper investigates the relation between institutional ownership, financial health, and the market valuation weights on earnings and book value of equity. We find that firms with high levels of institutional ownership are financially healthier, or less financially distressed, than firms with low levels of institutional ownership. More importantly, we find that the market valuation weight on earnings (book value of equity) increases (decreases) with the level of institutional ownership for profit firms. In contrast, the valuation weight on book value of equity increases with the level of institutional ownership for loss firms. Our findings of the above valuation effect of institutional ownership are consistent with two potential roles of institutions documented in prior literature: (1) institutions merely play a fiduciary role and (2) they play a positive governance role. Additional tests suggest that the level of institutional ownership appears to be an ex ante parsimonious proxy for both current and future financial health and that the valuation effect of institutional ownership cannot be subsumed by incorporating current measures of financial health. Moreover, we show that the valuation effect of institutional ownership is mainly driven by institutions with long investment horizons and monitoring incentives rather than institutions with short investment horizons and little monitoring incentives. We conclude that our findings of the valuation effect of institutional ownership are more consistent with institutions playing a positive governance role than merely playing a fiduciary role.

Institutional ownership, equity valuation, financial health

Abstract:
Regulation Fair Disclosure (Regulation FD hereafter) prohibits selective disclosure of firm specific information and hence is posited to impact firm information environment. However, the evidence to date on the impact of Regulation FD on firm information environment is mixed. We re-examine this issue and differ from prior research in three important ways. First, we relate and examine how Regulation FD impacted managerial financing decisions involving debt and equity. Second, we also relate Regulation FD to firm attributes in the form of proprietary and litigation costs of public disclosure. Third, we also take into consideration the specific safe harbor provisions of Regulation FD which allow for selective disclosure of firm specific information to debt related intermediaries including credit rating agencies. Empirically, we find, on average, a positive association between Regulation FD and the choice of equity financing. However, we find this relation is attenuated and turns negative for firms with especially high public disclosure costs. These results support the contention that Regulation FD has a detrimental information effect for these firms and that they will find it advantageous to raise funds in debt markets where selective disclosure is permitted. Overall, our evidence supports the contention that Regulation FD affected firm’s information environment. However, we provide a more refined picture taking into consideration both firm attributes as well as the specific provisions of Regulation FD.

Regulation FD, capital structure, debt financing, equity financing, disclosure, information environment, proprietary cost

Abstract:
Using a sample of 2,012 new debt issues, we investigate the relation between firms' cost of capital and internal financial resources, using mandatory pension contributions as a proxy for internal financial resources. Rauh (2006) documents a negative association between mandatory pension contributions and capital expenditures. We find that an increase in mandatory pension contributions increases the cost of both debt and equity, but only for firms facing external financing constraints. Our results suggest that firms’ cost of capital is an intervening variable that can explain Rauh’s finding that mandatory pension contributions (i.e. internal financing constraints) result in foregone investment.

Abstract:
We examine the effect of Regulation Fair Disclosure (Reg FD) on the cost of equity capital. We find some evidence that (1) the cost of capital declines in the post-Reg FD period relative to the pre-Reg FD period, on average, for a broad cross-section of U.S. firms, (2) the decrease in the cost of capital post Reg FD is mainly for medium and large firms but is insignificant for small firms, and (3) the decrease in the cost of capital post Reg FD is systematically related to firm characteristics indicative of selective disclosure before Reg FD. In contrast, we find little evidence of a decrease in the cost of capital for American Depositary Receipts and U.S.-listed foreign firms, which are legally exempt from Reg FD. Overall, our findings do not support a conclusion in recent studies that the cost of capital has increased post Reg FD and, if anything, suggest the opposite.

Cost of Capital, Selective Disclosure, Information Asymmetry, Regulation Fair Disclosure

Abstract:
Using a sample of 560 new debt issues, we investigate the relation between audit, nonaudit, and total auditor fees and firms' cost of debt. The Securities and Exchange Commission (SEC) argues that fees from nonaudit services weaken auditor independence, reduce financial statement reliability, and increase firms' cost of capital. To test this assertion, we examine the association between auditor fees and the cost of debt, as well as the effects of auditor fees on the relation between financial statement information and the cost of debt. We find evidence that nonaudit fees are directly related to the cost of debt for investment-grade issuers. Our results are robust to controlling for auditor tenure and firm governance. We also find evidence that the association between earnings and the cost of debt decreases as audit fees increase. We find no evidence that auditor fees directly affect the cost of debt for the non-investment-grade firms, but we do find that the association between earnings and the cost of debt decreases as nonaudit fees increase.

Auditor Independence, Cost of Capital, Bonds

Abstract:
This study investigates whether changes in personal tax rates on dividends and capital gains affect firms' incremental financing decisions. The evidence in this study suggests that following the 1997 and 2003 Tax Acts, which decreased tax rates on equity income, firms are less likely to issue debt relative to equity, consistent with the expectation that decreases in tax rates on equity income decrease the tax benefits of debt. Further, the magnitude of this effect varies predictably with dividend yield, a proxy for the proportion of equity income taxed at capital gain tax rates versus dividend tax rates. The magnitude of this effect is also decreasing in institutional ownership, a proxy for the probability that the marginal investor is tax exempt. This paper contributes to the literature that examines the effect of taxes on corporate financing decisions.

capital structure, dividend taxes, capital gain taxes, corporate taxes

Abstract:
The purpose of this study is to investigate if and how shareholder level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high dividend yield and whose marginal investor is likely to be an individual. For firms with high share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernable effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings-return relation.

Abstract:
We examine the influence of corporate taxes on U.S. firms' financing methods for taxable acquisitions of 100 percent of a target corporation's stock. We conduct tests of acquirer firms' use of debt or internal funds as the funding source for these acquisitions over the period 1987-1997. Our results provide the first empirical evidence that U.S. firms' use of debt to fund acquisitions significantly declines as foreign tax credit limitations reduce the marginal tax benefits they receive from borrowing. This finding is consistent with earlier speculation that U.S. foreign tax credit provisions could materially affect the capital costs of U.S. companies in debt-financed acquisitions. We also find that these firms are generally high-tax rate corporations whose financing choices are not significantly influenced by whether they acquire target-firm tax loss carryovers. Our findings contribute to the accounting literature on the influence of taxes on the structure and financing of corporate acquisitions.

Corporate taxes, foreign tax credit, financing choice, acquisitions

Abstract:
We propose that ex-dividend day excess volume is motivated by tax heterogeneity among investors, and thus is increasing in investor tax heterogeneity. Institutional ownership is our measure of heterogeneity. Since investor heterogeneity is a concave function of institutional ownership, we hypothesize that ex-day volume is a concave function of institutional ownership. Cross-sectional tests support the tax-motivated trading hypothesis. Additional tests, using trade size and pension ownership as proxies for institutional trades, yield similar results. We contribute to the literature by considering the interaction between payout policy and ownership structure in explaining the cross-sectional variation in ex-day volume.

Abstract:
This paper investigates the impact of the seller's tax liability on the price paid in hospital acquisitions. Lock-in theory predicts that for a given asset, asset holders with larger tax liabilities demand a higher price to compensate for income tax liabilities generated on the sale. We apply this theory to a sample of hospital acquisitions by for-profit firms where the primary difference among target hospitals is the seller's tax status - either taxable or tax-exempt. Consistent with the predicted lock-in effect, the evidence indicates that purchase prices are higher when the seller is taxable than when the seller is tax-exempt. Thus, our findings suggest that seller tax liabilities are positively related to purchase prices.

Abstract:
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 the earnings announcement. While 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 the earnings announcement. We hypothesize that changes from 3rd to 4th 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 pretax 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, 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 smaller. 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.

Earnings management, tax expense, target earnings

Abstract:
We find that a firm's dividend yield has a positive impact on its common stock return that is decreasing in the level of institutional and corporate ownership, our indicator of whether the marginal investor in a firm's common stock is more likely to be a low-tax or a high-tax investor. These results suggest that 1) a dividend tax penalty is incorporated into the return on a firm's common stock and 2) both a firm's dividend policy and its ownership structure impact the size of the dividend tax penalty.

taxes, dividend tax capitalization, expected return on common stocks

Abstract:
The theory of tax clienteles for dividend policies predicts that tax-exempt/tax-deferred and corporate investors will increase their ownership of the equity of firms that initiate a cash dividend as these investors purchase shares of stock that are being sold by individual investors for whom dividends are tax-disadvantaged. We analyze the change in stock ownership for a sample of firms that initiate a cash dividend and find evidence that is consistent with this theory. These results offer convincing new evidence that the effects of tax clienteles for dividend policies are strong enough to influence the decisions of investors.

Abstract:
We examine the influence of taxes on where firms source their interest deductions using data on foreign debt offerings by U.S. multinationals during 1987-1997. This unique data not only allows us to identify the location of firms' debt issues, but it allows us to control for non-tax factors related to the decision to issue foreign debt (such as currency hedging). By examining whether U.S. multinationals issue foreign debt through a subsidiary (yielding a deduction against foreign income) or as a direct placement by the U.S. parent (yielding a domestic interest deduction), we are able to construct strong tests of tax incentives to concentrate interest deductions in foreign tax jurisdictions. Our access to data on the location and characteristics of these foreign debt offerings (combined with survey evidence we obtain from U.S. multinationals active in these markets) also allows us to investigate the role of conflicting non-tax incentives to structure these debt offerings as a direct obligation of the U.S. parent.

Our empirical results indicate that taxes have a significant influence on where firms source their interest deductions. Consistent with geographic income-shifting predictions, we find (1) that firms with a domestic tax-loss carryforward are significantly more likely to issue foreign subsidiary debt, and (2) evidence that firms are more likely to issue debt through foreign subsidiaries in 'high' versus 'low' tax rate countries. In terms of the foreign tax credit (FTC) position of firms, we find that U.S. multinationals are significantly more likely to issue debt through a foreign subsidiary if binding FTC limitations adversely affect their ability to use a domestic interest deduction. These tax incentive findings are robust to a variety of sensitivity tests. In addition, our findings suggest that these tax incentives are traded-off against non-tax factors, such as subsidiary firms' higher cost of capital, characteristics of foreign markets that favor direct placements, and internal management control issues.

This study makes several contributions. First, while prior accounting research provides general evidence that U.S. multinationals shift taxable income between geographic locations in response to variations in tax rates, this is the first study to document the use of interest-sourcing decisions as a mechanism to achieve income shifting. Second, this study provides initial evidence on conflicting incentives that moderate the influence of taxes on firms' financing decisions. Third, our finding that taxes influence the way in which U.S. multinationals structure their foreign debt offerings contributes to policy debates regarding tax distortions.

Abstract:
This paper investigates why LIFO firms have higher reported earnings-price (EP) ratios compared with non-LIFO firms, a result reported by Lee (1988). Observed cross-sectional differences in financial statement variables between LIFO and non-LIFO firms identified by prior research do not explain EP ratio differences. We explain the differences in EP ratios by controlling for cross-sectional differences in risk and growth, using analysts' expectations of future growth rather than realized growth. Also, we control for expected earnings changes, to mitigate the effect of transitory earnings components on the measurement of EP ratios. When we combine risk, expected growth, and expected earnings changes in our multivariate tests, the EP ratios of LIFO firms are no longer significantly higher than those of non-LIFO firms. When we allow the coefficient on risk to vary between LIFO and non-LIFO firms, as suggested by Watts and Zimmerman (1986), the EP ratios of the LIFO firms are significantly lower than those of the non-LIFO firms.