The Market Response to Beating After‐tax Earnings Targets Revisited using Analysts’ Pre‐tax Earnings Forecasts and Concurrent Tax Note Disclosures

• DOI: http://doi.org/10.1111/jbfa.12181
• Published date: 01 January 2016
• Date: 01 January 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(1) & (2), 31–65, January/February 2016, 0306-686X

doi: 10.1111/jbfa.12181

The Market Response to Beating After-tax

Earnings Targets Revisited using Analysts’

Pre-tax Earnings Forecasts and

Concurrent Tax Note Disclosures

KATHLEEN HERBOHN,IRENE TUTTICCI AND ZHI TAN∗

Abstract: We investigate whether the premium for achieving after-tax earnings targets is

informed by the availability of pre-tax and after-tax earnings forecasts. We find evidence the

premium is discounted for firms achieving only after-tax earnings forecasts compared with firms

achieving both forecast targets. This is likely due to the uncertainty about future profitability and

earnings quality created by failing to attain pre-tax earnings targets. For firms achieving only

pre-tax earnings forecasts, no premium is documented. Taken together, our results indicate

that while pre-tax earnings forecasts may not move the market, they have an informational

role in providing a context for assessing the achievement of after-tax earnings targets. We also

consider the usefulness of the tax note disclosures of deferred tax assets from carry-forward

losses for assessing the premium for achieving after-tax earnings targets. Reflecting the duality

of this tax deferral, we find evidence that recognition of these tax assets conveys information

about lower earnings quality when recognition is likely to be opportunistic (in the case of firms

achieving only after-tax forecasts), and provides a signal of future profitability (in the case of

firms achieving only pre-tax forecasts).

Keywords: tax notes, carry-forward losses, deferred tax assets, market reaction, earnings quality,

earnings targets, earnings surprise, analysts earnings forecasts, analysts pre-tax earnings forecasts

1. INTRODUCTION

This study re-examines the market response to firms achieving analysts’ forecasts of

after-tax earnings. Prior research has considered whether the market response to

earnings announcements is adjusted to reflect likely earnings management, typically

identified by abnormal accruals, measures of real activities management, expense

∗The authors are from the Business School at the University of Queensland, St. Lucia Queensland,

Australia. The authors gratefully acknowledge the research assistance of Keay Shen and Marcelo Goncalves,

the invaluable programming assistance of Alan McCrystal, and the helpful comments provided by the

anonymous referee, Peter Clarkson, David Emanuel, Gordon Richardson, Grace Hsu, Mark Soliman, Sarah

Zechman, and seminar participants at Auckland University. (Paper received February 2014, revised version

accepted January 2016).

Address for correspondence: Kathleen Herbohn, UQ Business School, The University of Queensland,

St Lucia 4072, Australia.

e-mail: k.herbohn@business.uq.edu.au

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32 HERBOHN, TUTTICCI AND TAN

re-classification or models of predicted quarterly effective tax rate (ETR) changes

(e.g., DeFond and Park, 2001; Bartov et al., 2002; Gleason and Mills, 2008; Bhojraj

et al., 2009; Athanasakou et al., 2011). An interesting question is whether other sources

of information are used by market participants to assess the premium. In this study,

we investigate whether the premium awarded is informed by a firm’s ability to achieve

pre-tax and after-tax earnings forecasts, in conjunction with concurrent tax note

disclosures containing prospective information on profitability and earnings quality.

There is a growing trend whereby analysts provide pre-tax as well as after-tax

earnings forecasts. This begs the question of whether there is incremental information

content from pre-tax and after-tax earnings surprises as measured by the difference

between actual pre-tax and after-tax earnings and analysts’ forecasts of these values.

Pre-tax earnings forecasts provide insights into expectations about the intrinsic

profitability of the firm, an important feature of earnings quality (Dichev et al.,

2016). They also provide a window into tax expense surprise since implied forecasts

of firms’ ETRs can be formed by comparing pre-tax and after-tax earnings forecasts.

The general consensus is that tax expense fills a proxy-for-profitability role since the

current and deferred components of tax expense provide information about longer-

term profitability and current earnings quality that is incremental to after-tax earnings

(Hanlon et al., 2005; Raedy et al., 2011; Thomas and Zhang, 2011, 2014). That is, tax

expense surprise has incremental information content relative to earnings surprise.

We investigate whether the market differentially responds to firms on the basis of pre-

tax and after-tax earnings surprises.

Specifically, we use pre-tax and after-tax earnings forecasts to identify three achiever

groups of firms, so called because they achieve either a pre-tax or after-tax earnings

benchmark: (1) firms achieving both earnings forecasts (‘achieve both’); (2) firms

achieving only after-tax forecasts (i.e., ‘achieve after-tax’); and (3) firms achieving

only pre-tax forecasts (i.e., ‘achieve pre-tax’). We compare the premium for meeting

(or beating) after-tax expectations identified in prior literature between the ‘achieve

after-tax’ firms and ‘achieve both’ firms. A discount for achievers of only after-

tax benchmarks is likely because of the mixed signals conveyed by their earnings

announcements. These firms achieve after-tax expectations providing a positive signal

about future profitability in the medium-term (Bartov et al., 2002; Bhojraj et al., 2009).

However, the failure to achieve pre-tax expectations is a negative signal regarding

profitability of core business activities and earnings quality (Thomas and Zhang, 2011,

2014; Dichev et al., 2016). It also raises a question of whether these firms are possibly

meeting after-tax forecast levels through a reduction in the ETR, which is consistent

with Dhaliwal et al.’s (2004) view of tax expense as a last chance to achieve after-tax

earnings targets.

The tax note is a second source of potential incremental information on future

profitability and earnings quality that may influence the market premium for achieving

after-tax earnings expectations. Over time, there have been various attempts to

understand whether market participants inform their decisions using what has been

described as ‘one of the most detailed, complex and costly [notes] to produce’ (Raedy

et al., 2011, p.1). From this body of literature, there is some evidence that market

participants do not use components of the tax note to inform their decisions because

of its opacity and complexity (e.g., Chen et al., 2003; Plumlee, 2003; Weber, 2009;

Raedy et al., 2011). However, recent evidence suggests that market participants use

deferred tax accruals that are included in GAAP income prior to taxable income to

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THE MARKET RESPONSE TO BEATING AFTER-TAX EARNINGS TARGETS 33

inform their decisions, because these accruals provide forward-looking information

about tax payments and therefore profitability (Laux, 2013).

In this study, we investigate whether the concurrent release of a tax note with

earnings announcements is useful for assessing the quality and informativeness of the

tax accruals. Specifically, we investigate deferred tax assets arising from carry-forward

losses, the recognition of which reduces current tax expense and increases after-tax

earnings. Within an Australian context, managers have significant discretion as to the

timing of recognition and the measurement of deferred tax assets from carry-forward

losses. Thus, recognition of these assets may convey information about the quality of

reported earnings, if such recognition is conducted opportunistically (Herbohn et al.,

2010), or provide a signal of future profitability if such recognition reflects managers’

private information (Amir and Sougiannis, 1999; De Waegenaere et al., 2003; Zeng,

2003; Chang et al., 2009). We examine whether the information content of these tax

note disclosures is contextual, varying with firm performance against pre-tax and after-

tax earnings forecasts.

Our investigation answers a call by Graham et al. (2012) for future research about

the pricing of tax information reported in the financial statements. It is also timely

because, as Raedy et al. (2011) highlight, the information content (or lack thereof) is

a significant issue for regulators such as the International Accounting Standards Board

(IASB) and the Financial Accounting Standards Board (FASB) which are coming

under pressure from constituents to reduce the complexity of tax disclosures (e.g.,

PricewaterhouseCoopers, 2011). Finally, there has been little investigation of the

consequences of providing pre-tax and after-tax earnings forecasts, with researchers

largely focussing on the information content of cash flow and sales forecasts (e.g.,

Givoly et al., 2009; Keung, 2010; Ertimur et al., 2011; McInnis and Collins, 2011; Call

et al., 2013). In this study, we address this shortfall in knowledge.

The Australian institutional setting provides the opportunity for an interesting test

of this issue. Managers of companies listed on the Australian Securities Exchange

(ASX) may elect to either: (1) concurrently disclose earnings with the associated notes

(including tax), or (2) disclose earnings and delay the note disclosure. This allows an

investigation of any differential market reaction between the three achiever groups of

firms disclosing and not disclosing the recognition of deferred tax assets from carry-

forward losses at the earnings announcement date.

Our sample comprises all firms listed on the ASX over the 11-year period from

1998 to 2008 with consensus analyst forecast data available from the Institutional

Brokers Estimate System (IBES), stock prices and index data available from the SIRCA,

and financial accounting data available from the Aspect FinAnalysis databases. A total

of 2,651 firm–year observations were available. In univariate and multivariate tests,

we find a statistically significant discount to the market reward for attaining after-

tax earnings forecasts for the ‘achieve after-tax’ group of firms compared with the

‘achieve both’ group of firms. This result is consistent with the proposition that the

inability of ‘achieve after-tax’ firms to meet (or beat) pre-tax expectations is a negative

signal about future profitability and earnings quality (Dhaliwal et al., 2004; Thomas

and Zhang, 2011, 2014). The discount is also economically significant at an estimated

39% of the premium. It appears that market participants make use of both pre-tax and

after-tax earnings forecasts when assessing a firm’s earnings quality and profitability

prospects. In contrast, we find that there is no significant market reward to ‘achieve

pre-tax’ firms. Thus, there is preliminary evidence that achieving after-tax rather than

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