Book-Tax Differences, Uncertainty about Fundamentals and Information Quality, and Cost of Capital

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