The Use of Tax Accruals to Fool the Market: The Case of PRE before the Tax Cuts and Jobs Act

Abstract

In this chapter we analyze how the designation of foreign earnings as “permanently reinvested” outside the US (PRE) is related to subsequent firm growth and market returns. Prior research suggests that firms that hold excess cash in foreign markets to avoid the US corporate income tax experience lower growth, since such “trapped” cash is inefficiently invested. However, foreign earnings can be inefficiently invested in forms other than cash. We hypothesize and find that as the ratio of PRE to total assets increases, firms' growth rates decline. Our results suggest that trapped earnings, and not just trapped cash, are associated with lower growth. Because PRE have also been associated with earnings management in the literature, we further analyze the association between the use of PRE to meet or beat earnings targets and subsequent growth, observing a significant and persistent negative association. Finally, we note that the market discount for PRE, and especially for the use of PRE to manage earnings, appears to be relatively small. Our results provide support for FASB's stated plans to increase disclosure requirements surrounding the tax accrual.

Citation

Furner, Z., Morrow, M.L. and Ricketts, R.C. (2020), "The Use of Tax Accruals to Fool the Market: The Case of PRE before the Tax Cuts and Jobs Act", Hasseldine, J. (Ed.) Advances in Taxation (Advances in Taxation, Vol. 28), Emerald Publishing Limited, Leeds, pp. 101-126. https://doi.org/10.1108/S1058-749720200000028004