Book‐tax differences and earnings quality for the banking industry: evidence from Taiwan

Purpose - The purpose of this paper is to investigate the relationship between book‐tax differences and earnings quality for commercial banks in Taiwan. The paper focuses on the banking industry because industry‐specific accrual models of accounting discretion in the loan loss provisions are available to develop powerful tests of earnings management related to book‐tax differences. In addition, the paper replicates the analysis of book‐tax differences that previous studies conducted on a heterogeneous sample of nonfinancial firms, to ascertain whether prior inferences also hold in the study's sample of banks in an emerging economy. Design/methodology/approach - This paper estimates the magnitude of discretionary loan loss provisions as a proxy for earnings quality (positively correlated with earnings management; therefore, inversely correlated with earnings quality). Then, the study partitions the sample into three subsamples (large positive book‐tax differences, large negative book‐tax differences, and small book‐tax differences) to set the regression models. Findings - This paper finds that bank‐years with large positive or negative temporary book‐tax differences have discretionary loan loss provisions that are greater than bank‐years with small temporary book‐tax differences. The paper also finds that bank‐years with large temporary book‐tax differences have one‐year‐ahead persistence of current earnings and accruals that are less than those with small temporary book‐tax differences. Additionally, the study does not find a significant relation between permanent book‐tax differences and earnings quality. Overall, the evidence is consistent with the supposition that large temporary book‐tax differences are associated with lower earnings quality. Research limitations/implications - The study contributes to the literature on book‐tax differences and earnings quality in two ways. First, the paper provides evidence to ascertain prior inferences that the association between book‐tax differences and earnings quality also hold in the banking industry, it may generalize to the banking sector in other emerging countries. Second, the study utilizes a banking‐specific accrual model to construct more powerful tests of information in book‐tax differences for earnings quality. The study has an inherent limitation arising from small sample size of the banking industry in an emerging economy. Future tax accounting researchers should develop appropriate country‐specific measures of book‐tax differences. Originality/value - The study focuses on the banking industry because industry‐specific accrual models of accounting discretion in the loan loss provisions are available to develop powerful tests of earnings management related to book‐tax differences. In addition, the study replicates the analysis of book‐tax differences that previous studies conducted on a heterogeneous sample of nonfinancial firms, to ascertain whether prior inferences also hold in the sample of banks in an emerging economy.