Do Firms Pay for Earnings Classification? Effects of Financial Reporting on the Market for Housing Tax Credits

Do Firms Pay for Earnings Classification? Effects of Financial Reporting on the Market for Housing Tax Credits Public Deposited

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The purpose of this study is to examine the relative importance to managers of pre-tax and after-tax earnings. I exploit features of investments in housing tax credits and GAAP accounting for those investments. When managers purchase tax credits, accounting rules reduce book earnings for the cost of the tax credits through either i) a pre-tax loss, or ii) a tax expense. Identically priced tax credit investments result in the same net increase to after-tax earnings regardless of the accounting method used. By analyzing the market price of tax credits using a confidential database, I find a premium on tax credits that reduce book earnings through tax expense, thereby avoiding a reduction to pre-tax earnings. This result suggests that managers are willing to sacrifice after-tax earnings, by paying a higher tax credit price, to avoid reductions to pre-tax earnings. On average, I estimate that managers reduce after-tax earnings by $1 to avoid a reduction to pre-tax earnings of $13. This is the first study to my knowledge to suggest that some firm managers place more importance on pre-tax earnings than after-tax earnings.

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