Predictable uncertainty: The relation between unrecognized tax benefits and future income tax cash outflows

Transcription

1 Predictable uncertainty: The relation between unrecognized tax benefits and future income tax cash outflows Will Ciconte University of Florida Michael Donohoe University of Illinois at Urbana-Champaign Petro Lisowsky University of Illinois at Urbana-Champaign Michael Mayberry University of Florida July 2013 Abstract: This study examines competing arguments about whether Financial Interpretation No. 48 (FIN 48, now ASC ) provides information to financial statements users regarding the realizability of future income tax cash outflows related to reserves for unrecognized tax benefits (UTBs). Critics believe FIN 48 provides substantial discretion in accruing UTBs, while proponents argue the Interpretation improves the reliability and comparability of UTBs. Our results show that, on average, UTBs are predictive of income tax cash outflows up to three years in the future. This link is economically significant as UTBs explain 8.2 percent as much of the variation in future income tax cash outflows as do contemporaneous income tax cash outflows. Using data provided by the IRS, these results hold in validation tests linking UTBs to future IRS audit settlements. In cross-sectional analyses, we find that UTBs are more informative for future income tax cash outflows in firms that (1) purchase tax services from their auditor; (2) engage in relatively less tax avoidance; and (3) are subject to greater IRS audit scrutiny. Our results should interest financial statement users, standard setters, and tax authorities as these parties estimate the future economic consequences of uncertain tax positions. Keywords: unrecognized tax benefit; tax reserve; tax avoidance; auditor-provided tax services; FIN 48; ASC 740 JEL Classification: M41; M48; H26 We obtain tax audit settlement data from the Internal Revenue Service s (IRS) Large Business & International Division (LB&I). As IRS data are not publicly available and are protected by non-disclosure agreements under the Internal Revenue Code, the statistics are presented in aggregate. Any opinions are those of the authors and do not necessarily reflect the views of the IRS. Corresponding author: 1206 S. Sixth Street, MC-706, Champaign, IL We appreciate the helpful comments of Tom Omer, Eric Rapley, Leslie Robinson, and participants of the 2013 American Taxation Association Mid-Year Meeting.

2 Predictable uncertainty: The relation between unrecognized tax benefits and future income tax cash outflows 1. Introduction With the enactment of Financial Interpretation No. 48 (FIN 48) in 2006, the Financial Accounting Standards Board (FASB) sought to provide more information to financial statement users about the realizability of future tax benefits in an effort to enhance relevance and comparability in the financial reporting of income taxes (FASB 2006; Tax Executives Institute [TEI] 2011). Specifically, FIN 48 mandates the measurement and disclosure of tax-related contingent liabilities as unrecognized tax benefits (UTBs) in financial statements. However, similar to controversies regarding the usefulness of deferred tax information (Lasman and Weil 1978; Cheung et al. 1997; Beechy 2007; Chludek 2011), some critics claim that UTB recognition does not help investors forecast future income tax cash outflows (FASB 2006). Other critics object to the more-likely-than-not threshold for determining the amount of tax benefits recognized in earnings, as well as the subjectivity required to apply FIN 48 (TEI 2011). Our study informs this ongoing debate by investigating if UTBs reported under FIN 48 do, in fact, provide information to financial statement users about future income tax cash outflows. Understanding the predictive ability of UTBs for income tax cash flows is important for three reasons. First, because income taxes account for a material portion of firms earnings (Dyreng et al. 2008), improved forecasts of these cash outlays can aid investors and analysts in valuation decisions. Second, understanding the relation between UTBs and future income tax cash payments can improve firms assessment of future commitments for internal funds. Third, standard setters and regulators, such as the FASB and the Securities and Exchange Commission (SEC), are concerned about the representation, nature, timing, and magnitude of firms net cash flows, a stated purpose of financial reporting (ASC 100, General Principles). 1

3 There are competing arguments as to whether UTBs reported under FIN 48 are predictive of future income tax cash flows. On the one hand, FIN 48 defines UTBs as a contingent liability that should reflect anticipated future disallowed tax benefits, implying that UTBs should explain future income tax cash outflows. That is, current period UTBs are likely informative to tax authorities, who routinely challenge firms uncertain tax positions in order to collect additional tax payments. Further, managers and investors tend to view UTBs as indicative of higher future tax burdens (Blouin and Tuna 2007; Frischmann et al. 2008; Blouin et al. 2010), and other evidence suggests that some elements of deferred taxes map into future income tax cash outflows (Laux 2013). 1 On the other hand, there are several reasons why UTBs may not be informative about future income tax cash outflows. First, the complexity, subjectivity, and discretion inherent in the process of recognizing, measuring, and derecognizing UTBs can result in opportunistic or divergent financial reporting (Gupta et al. 2011; De Simone et al. 2013). Second, in determining the sustainability of tax positions upon audit, FIN 48 requires a 100 percent audit probability assumption (i.e., firms cannot consider detection risk). Third, recent evidence that investors favorably price UTBs suggests investors may not believe that UTBs result in future income tax cash outflows (Koester 2011). We investigate these competing arguments by examining whether, and under what circumstances, UTBs explain future income tax cash outflows. Our study contributes to the financial accounting literature that evaluates the mapping of accruals into cash flows (e.g., Sloan 1996; Dechow and Dichev 2002; Richardson et al. 2005) by examining the focused setting of FIN 48. In particular, we examine whether and to what extent the UTB accrual maps into future income tax cash flows. Although prior research has examined 1 Although UTBs are not technically deferred tax liabilities, they do contain timing and realization issues similar to deferred taxes in that they may or may not be informative about future income tax cash outflows in general. 2

4 the effect of FIN 48 on earnings management (Gupta, et al. 2011) and the responses of managers and investors (Frischmann et al. 2008; Blouin et al. 2010; Koester 2011), our study directly links managers ex ante assessment and financial reporting of tax uncertainty to ex post economic outcomes. In addition, we also contribute to a growing literature on accounting for income taxes (Graham et al. 2012). Theory and empirical evidence suggest that particular elements of deferred taxes reported under ASC 740, Income Taxes, can predict future income tax cash outflows (Cheung et al. 1997; Guenther and Sansing 2000, 2004; Amir et al. 2001; Laux 2013). We complement this research by considering whether UTBs reported pursuant to FIN 48 provide financial statement users with useful information about future income tax cash outflows. To examine whether UTBs are predictive of future income tax cash outflows, we regress the sum of one-, two-, and three-year ahead income tax cash outflows on UTB ending balances over the period during which FIN 48 has been effective and data are available ( ). Following Lisowsky et al. (2013), we rely on a maximum forecasting horizon of three years to coincide with the standard three-year statute of limitations for corporate tax returns. We find a positive relation between UTBs and future income tax cash outflows over this horizon, consistent with firms taking uncertain tax positions that later result in cash payments to tax authorities. This link is economically significant as UTBs explain 8.2 percent as much of the variation in future income tax cash outflows as do contemporaneous income tax cash outflows. 2 Further, we find that UTBs are predictive for future income tax cash outflows while deferred tax accruals are not. We then replicate these findings using proprietary IRS audit settlement data to validate that publicly available UTB balances are indeed informative of uncertain tax position resolution with tax authorities. Our analyses reveal a positive and significant relation between future IRS audit 2 We gauge economic significance by comparing standardized coefficients for contemporaneous income tax cash outflows to those for UTBs across the forecasting horizon of three years. See Section 4.1 for details. 3

5 settlements and UTB balances, suggesting that UTBs indeed capture tax uncertainty that eventually unwinds as income tax cash outflows to tax authorities. Taken together, these findings appear to support the arguments raised by FIN 48 proponents that UTBs are informative of the future realizability of income tax cash outflows. However, we also identify settings that support arguments made by both proponents and critics of FIN 48. In cross-sectional tests, we examine three circumstances in which UTBs are likely to be more or less informative about future income tax cash outflows. First, we examine whether the provision of auditor-provided tax services improves the informativeness of UTBs about future income tax cash outflows. Prior research finds that, before FIN 48, firms purchasing tax services from their auditor accrue tax reserves that are more closely associated with actual IRS settlements than firms that do not (Gleason and Mills 2011). To the extent that knowledge spillovers from the provision of tax services apply to the post-fin 48 period, UTBs are likely more informative when firms purchase tax services from their auditor. Consistent with this notion, we find that the provision of auditor-provided tax services enhances the informativeness of UTBs for future income tax cash outflows. Second, we consider whether firms engaged in significant tax avoidance hinder the informativeness of their UTBs relative to firms engaged in less tax avoidance. We examine tax avoidance characteristics because critics of FIN 48 claim that reporting UTBs in the financial statements could provide tax authorities with a roadmap of information necessary to identify firms most controversial positions (Frischmann et al. 2008, Mills et al. 2010). Similarly, recent anecdotes and empirical evidence suggest that firms engaging in more tax avoidance tend to obfuscate FIN 48 disclosures to minimize scrutiny from tax authorities (TEI 2011; Gross 2011; Robinson and Schmidt 2013; Financial Accounting Foundation [FAF] 2012). Using low long-run 4

6 cash effective tax rates (Dyreng et al. 2008) and high discretionary permanent book-tax differences (Frank et al. 2009) to proxy for high levels of tax avoidance, we find that UTBs for high tax avoiding firms are not informative about future income tax cash outflows. Consistent with the concerns of the FAF (2012), this finding suggests firms with more sensitive tax information distort the informativeness of UTBs to avoid scrutiny from tax authorities. It also raises concerns about whether FIN 48 is achieving it stated goal of increasing relevance (i.e., predictive ability), especially among firms who should arguably be most affected by its mandatory disclosure regime. Finally, we examine whether the informativeness of UTBs for future income tax cash outflows varies with the probability of IRS audit. Because greater IRS enforcement likely increases firms income tax payments (Hoopes et al. 2012), the mapping of UTBs into income tax cash flows should be stronger when the probability of IRS audit is higher. Using data from the Transaction Records Access Clearinghouse (TRAC) to proxy for IRS enforcement probability (also see Guedhami and Pittman 2008, and Hoopes et al. 2012), we find that UTBs are more informative about future income tax cash outflows as the probability of IRS audit increases. This finding suggests that managers assessments of tax uncertainties when IRS audit probability is high translates into financial reporting of UTBs that provides more relevant information to financial statement users than when firms are under a low threat of IRS audit, and thus likely have lower realizations of UTBs as future income tax cash outflows. Overall, our study demonstrates that, on average, the UTB accrual is informative for future income tax cash outflows. However, we also identify settings in which UTBs are more or less helpful to financial statement users. As a result, our empirical evidence informs the debate on the usefulness of FIN 48 information about future cash tax realization. 5

7 Our paper proceeds as follows. Section 2 develops our hypothesis. Our research design and main results are described in Sections 3 and 4, respectively. Section 5 discusses crosssectional tests and Section 6 reports supplemental tests. Section 7 concludes. 2. Background and hypothesis development 2.1 Accounting for unrecognized tax benefits Despite the breadth and volume of rules in the Internal Revenue Code (IRC), ambiguity in tax reporting is common as firms routinely enter into transactions where the appropriate tax treatment is subject to numerous interpretations (Beck and Jung 1989a, 1989b, Mills et al. 2010, Beck and Lisowsky 2013). 3 As a result, many firms take positions on their income tax returns that might not fully be sustained under future audit by tax authorities. In such cases, financial reporting rules require the recognition of a contingent liability to account for the uncertainty of claimed tax benefits. Specifically, ASC , or FIN 48, Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FASB 2006), currently provides guidance on recognizing and measuring uncertain tax benefits in financial statements. For reporting periods after December 15, 2006, firms with uncertain tax positions are required to apply FIN 48 s two-step process to recognize and measure tax reserves in financial statements (FASB 2006). In concept, the tax reserve liability arises from tax benefits (e.g., deductions or credits) claimed on the tax return, but due to their uncertain nature they are not immediately recognized in the financial statements as a reduction to tax expense. Operationally, the first step in FIN 48 is to apply the more-likely-than-not recognition test to each tax position based on its technical merits. If the position meets the recognition threshold, then in the second step the firm measures the tax benefit as the largest benefit that has a greater-than-50 percent 3 For example, tax professionals perceive transactions involving mergers and acquisitions, foreign operations, and financial derivatives as some of the most difficult tax issues to navigate (Burton and Karlinsky 2011). 6

8 likelihood of being realized upon settlement. 4 Thus, FIN 48 splits the total tax benefit into two parts: the recognized tax benefit, which immediately reduces current period income tax expense, and the UTB, which is held in reserve to account for tax uncertainty surrounding the likelihood of tax payments pursuant to a future tax audit (also see Blouin and Tuna 2007; Blouin et al. 2010; and Lisowsky et al. 2013). 5 The Financial Accounting Foundation (FAF), which oversees the FASB, recently conducted a post-implementation review to evaluate whether the informational benefits of FIN 48 to financial statement users outweigh its associated reporting costs. The review concludes that FIN 48 increases the relevance and comparability of information reported about income tax uncertainties, but acknowledges as an open question that UTBs may not be relevant to investors and others using such information to estimate income tax cash flows (FAF 2012, 13). Similarly, in their review of the academic literature pertaining to FIN 48, Blouin and Robinson (2012) call for more research investigating the potential costs of FIN 48 and whether it provides decisionuseful information to investors. Although prior research examines the investor response to the promulgation of FIN 48 and its disclosures (Frischmann et al. 2008), it is still an open question as to whether or how strongly UTBs in fact map into cash payments made to tax authorities. We fill this void in the literature. 2.2 Hypothesis development UTBs are contingent liabilities that reflect the dollar amount of tax benefits likely to be disallowed by tax authorities in the future. Therefore, it might seem like a foregone conclusion 4 Historically, uncertain tax benefits were recorded using an expected value approach under the contingent loss rules of ASC 450, Contingencies, or FAS 5. Although the standard covers many types of potential losses, it provides little guidance regarding income tax uncertainty. Consequently, the FASB implemented FIN 48 to reduce the significant diversity in practice associated with the recognition and measurement of uncertain tax benefits. 5 Lisowsky et al. (2013) note that even if tax positions are supported by legal opinions, the recognition threshold for financial reporting purposes may not be met because (1) the financial auditor may disagree with legal counsel; (2) the strength of a tax position can change over time as similar cases are litigated or new guidance is issued; and (3) legal counsel may have based their opinions on unreasonable factual assumptions or representations by the client. 7

9 that UTBs should have a positive association with future cash payments made to tax authorities. However, prior research provides, at best, indirect evidence as to whether or under what circumstances UTBs are likely predictive of future income tax cash outflows. Some evidence surprisingly suggests that UTBs might reflect net long-run cash tax savings as indicated by their association with higher equity values. Specifically, there are three areas of research that suggest UTBs have a positive association with future cash tax payments. First, some research finds that investors view UTBs as a signal of future tax payments, especially when the probability of tax enforcement is high. For instance, Frischmann et al. (2008) document a negative market reaction to news of a U.S. Senate inquiry into companies with large UTBs. Also, Abernathy et al. (2013) find a comparable response to the promulgation of Schedule UTP, the tax return analog of FIN 48 in which firms disclose to the IRS a ranking of material tax uncertainties claimed on the U.S. federal tax return. 6 Second, other research suggests that managers view the disclosure of UTBs as a signal of future tax liabilities and/or other unfavorable outcomes. In particular, Blouin et al. (2010) find evidence consistent with managers taking real actions prior to the adoption of FIN 48 by settling open positions with tax authorities to avoid disclosing UTB information in financial statements. Third, Laux (2013) finds a positive relation between deferred taxes (in general) and future income tax cash outflows. To the extent his finding generalizes to UTBs, a positive relation between UTBs and future income tax cash outflows is expected. However, there are (at least) three reasons why UTBs may not be informative about future income tax cash outflows. First, critics of FIN 48 contend that the complexity, subjectivity, and discretion inherent in the process of recognizing, measuring, and derecognizing 6 These findings are consistent with other research documenting a negative market reaction to long-term and complex contingent liabilities, including environmental clean-up costs (Barth and McNichols 1994) and product warranties (Cohen et al. 2011). 8

10 UTBs hinder their ability to be informative about future tax cash flows. Consistent with this view, De Simone et al. (2013) find divergent applications of FIN 48 UTB recognition among firms engaged in the same transaction. Similarly, the subjectivity and discretion in applying FIN 48 can create information asymmetry between managers, shareholders, and auditors, a necessary condition for earnings management (Schipper 1989). In fact, some firms use the tax accounts, including tax reserves, to manage earnings (Dhaliwal et al. 2004; Gupta et al. 2011). Yet, Robinson and Schmidt (2013) find that investors react favorably to firms with low UTB disclosure quality, consistent with low quality disclosures preventing tax authorities from discerning a clear roadmap to firms uncertain tax savings (i.e., savings that can benefit shareholders as residual claimants). For these reasons, FAF (2012) states that UTBs may not be relevant to investors in estimating income tax cash flows. Second, in determining whether a tax position will be sustained on its technical merits under the more-likely-than-not recognition or measurement steps, FIN 48 does not allow consideration of detection risk. In particular, firms must assume that tax authorities possess all the available information in determining the sustainability of the firm s tax position, even if the tax authority does not obtain such information. Also, firms must assume the particular tax position will be examined under tax audit, even if the firm does not expect to be (or has not been) audited at all. 7 The omission of detection risk can create a mismatch between the amount of UTBs recorded in firms financial reports and the amount of cash taxes ultimately paid to tax authorities, thus reducing the ability of UTBs to predict future income tax cash outflows. Finally, Koester (2011) provides surprising, but robust, evidence that greater UTBs translate into higher equity valuations for firms, which is inconsistent with the prima facie 7 A separate issue is that firms are not allowed to offset unfavorable positions with favorable positions (within or across jurisdictions) to communicate a potentially more accurate depiction of the total net tax exposure arising from the firm s uncertain tax positions. 9

11 definition of a liability. Specifically, if the UTB represents future cash tax payments from the firm to the government, residual claimants (i.e., shareholders) should view UTBs negatively, not positively. Thus, the evidence in Koester (2011) that the economic consequences of UTBs reflect value creation as opposed to value reduction makes it an open empirical question as to whether, at a more fundamental level, UTBs translate into future income tax cash outflows. Notwithstanding the subjectivity inherent in applying FIN 48 and its omission of factors relating to audit probabilities and negotiations, UTBs in theory aim to reflect the dollar amount of tax benefits that fail to meet the more-likely-than-not recognition threshold. Therefore, on balance, we expect that UTBs have a positive association with future cash payments made to tax authorities. Accordingly, we formalize our hypothesis as follows (in alternative form): H1: UTBs have a positive association with future income tax cash outflows. 3. Research design 3.1 Empirical model To examine the association between UTBs and future income tax cash outflows (H1), we include our measure of UTBs (UBEND) to the following OLS regression model based on Laux (2013) (see the Appendix for all variable definitions): 8 TXPD i,t+k = α 0 + β 1 TXPD i,t + β 2 DEFTAX i,t + β 3 NOL i,t + β 4 UBEND i,t + β j YEAR FIXED EFFECTS i + ε. (1) The dependent variable, TXPD i,t+k, is the sum of future income tax cash outflows for year t+k, where k varies from one to three, scaled by lagged total assets. 9 Consistent with Lisowsky et al. 8 Consistent with Petersen (2009), we employ Huber-White robust standard errors to adjust for potential serial correlation among multiple observations per firm, with year indicators controlling for cross-sectional correlation. All continuous variables are winsorized at the 1 st and 99 th percent levels to mitigate the effect of outliers. 9 Following prior literature on predicting future cash flows (Lev et al. 2010), we use the sum of future income tax cash flows over our horizons rather than a single, isolated future year. Although we cannot observe the exact year of a tax settlement, summing across years increases the likelihood of identifying the time period in which a future settlement occurs because audits by tax authorities typically have a lag of more than one year. Moreover, summing across three years is consistent with the statute of limitations for U.S. corporate income tax returns. 10

12 (2013), we choose a maximum forecasting horizon of three years to coincide with the standard statute of limitations for corporate taxpayers. Our variable of interest, UBEND, is the year-end unrecognized tax benefit reported in Compustat, scaled by lagged total assets, and should reflect all open uncertain tax positions within the three-year statute of limitations window. Consistent with H1, we expect a positive coefficient for UBEND. We control for several factors at time t that Laux (2013) suggests are associated with future income tax cash outflows. First, we include cash taxes paid in the current year (TXPD) because many tax attributes are serially correlated over time (e.g., research and development activities or foreign operations). Consistent with Laux (2013), we expect a positive coefficient for TXPD. Second, DEFTAX reflects year-end net deferred taxes adjusted for UTBs that relate to temporary book-tax differences. As noted by Laux (2013), only deferred tax assets and liabilities that are included in book income prior to taxable income are likely to provide information about future income tax cash outflows. However, because it is difficult to separate deferred taxes with available data, a positive or negative coefficient for DEFTAX is possible. Third, we control for net operating loss carryforwards (NOL) because corporate taxpayers can offset future taxable income with current and prior period taxable losses. Thus, we expect a negative coefficient for NOL. Finally, we include year fixed-effects to control for cross-sectional variation in cash tax payments across years. 10 All variables are scaled by lagged total assets. 3.2 Sample selection and descriptive statistics Our sample consists of firms in Compustat during fiscal years 2007 to We begin with 2007 as this is the first full financial reporting year in which FIN 48 is effective, and end with 2010 as we require a minimum of one future year to calculate our dependent variable, 10 Consist with prior literature on the mapping of accruals into cash flows, we do not control for industry fixedeffects (Dechow and Dichev 2002; Hribar and Collins 2002; Choudhary et al. 2013). However, for completeness, we estimate all models including Fama-French 48 industry fixed effects. Untabulated results are inferentially similar. 11

13 TXPD t+k. We exclude utilities (SIC 49), financial services (SIC 60), and real estate investment trusts (SIC 6798) because these firms operate in fundamentally different statutory and regulatory environments. We then drop observations lacking the data necessary to calculate variables in Equation (1). These data requirements result in a base sample of 6,091 firm-year observations. 11 <INSERT TABLE 1 ABOUT HERE> We report univariate statistics in Table 1. Income tax cash outflows (TXPD) account for 2.2 percent of assets, such that the sum of these payments over the three-year horizon (TXPD t+3 ) equates to 7.2 percent of assets. Similarly, deferred taxes (DEFTAX) and ending UTB balances (UBEND) account for 2.3 and 1.3 percent of assets, respectively. Descriptive statistics for all other variables, including those used in later tests (see Section 5), are similar to prior studies. Untabulated correlations are generally significant and less than Variance Inflation Factors do not indicate any problems arising from multicollinearity. 4. Main results 4.1 UTBs and future income tax cash outflows We report the results of estimating Equation (1) in Table 2. The dependent variable is the sum of future income tax cash outflows in years t+1, t+2, and t+3 (TXPD t+1, TXPD t+2, and TXPD t+3 ) in columns (1), (2), and (3), respectively. Although we include year fixed-effects, we omit these coefficients for brevity. Consistent with H1, we find a positive and significant coefficient on UBEND in all three columns (p<0.05). These results indicate that UTBs are positively related with cash tax payments for up to three years into the future and suggest that shareholders can utilize UTB disclosures to estimate future income tax cash outflows. 11 Our base sample using TXPD t+1 as the dependent variable contains 6,091 firm-year observations, while samples using TXPD t+2 (TXPD t+3 ) as the dependent variable contain 4,015 (2,297) observations. Naturally, the sample size decreases as the dependent variable includes additional years of income tax cash outflows. 12

14 The coefficients for control variables are consistent with prior research. Specifically, current period cash taxes paid (TXPD) are positively related with future period cash taxes paid (p<0.01), suggesting that current year cash tax payments have non-transitory predictive power. 12 In addition, coefficients for NOL are also negative and significant in columns (1) and (2), which is consistent with net operating loss carryforwards offsetting taxable income in future periods. Finally, consistent with only some tax deferrals predicting future income tax cash outflows (Laux 2013), coefficients for DEFTAX are insignificant. <INSERT TABLE 2 ABOUT HERE> To gauge economic significance, we re-estimate Equation (1) with standardized coefficients and report the results in Panel B of Table 2. Coefficients for UBEND relative to the coefficients for contemporaneous income tax cash outflows (TXPD t ), our primary control variable, suggest the UTB is 2.7 (0.020/0.738), 4.3 (0.031/0.721), and 8.2 (0.056/0.681) percent as powerful as TXPD t in explaining future income tax cash outflows in years t+1, t+2, and t+3, respectively. In fact, as the summation periods increase, the standardized coefficients on UBEND (numerators) monotonically increase while the standardized coefficients on contemporaneous income tax cash outflows (denominators) monotonically decrease. This result suggests that the information contained in the UTB becomes increasingly economically significant in predicting future income tax cash outflows as the forecasting horizon increases. Thus, by year t+3, the UTB has an explanatory power of 8.2 percent of that of TXPD t, or about triple its initial predictive ability (at 2.7 percent). Note that the above economic interpretation compares the ability of contemporaneous tax accruals (UBEND), relative to cash flows (TXPD t ), to explain future income tax cash outflows. 12 Relatedly, the significant results on UBEND also suggest that UBEND successfully detects deviations from the time-series trend in income tax cash payments that is informative of future income tax cash payments. 13

15 However, for a more direct comparison, we compare the relative ability of only the contemporaneous tax accruals of UBEND to deferred taxes (DEFTAX) to explain future income tax cash outflows. We first note that the standardized coefficients on DEFTAX are miniscule, as expected, because they are insignificant in the main model. Nevertheless, using DEFTAX as the benchmark (i.e., the absolute value of coefficients), we find that UBEND is 3.3 times more informative than DEFTAX in explaining future income tax cash outflows in year t+1 (0.020/0.006), 31 times as informative in year t+2 (0.031/0.001), and 19 times as informative in year t+3 (0.056/0.003). 13 Overall, as contemporaneous tax accruals go, the UTB is more informative than deferred taxes when predicting future income tax cash outflows. We also estimate a dollar-quantified value of the relation between UTBs and future income tax cash outflows. Specifically, we estimate Equation (1) using unscaled values for all variables (i.e., not scaled by lagged assets) and including the natural log of total assets to control for size effects, consistent with Lisowsky (2009). We find, on average, one dollar of UTBs is associated with 0.17 dollars in year t+1, dollars by year t+2, and by year t+3 (p<0.05). These findings are consistent with a delay between a tax position and ultimate settlement with a tax authority as the 0.17 coefficient in year t+1 is significantly less than one dollar (p<0.01), while the coefficients for years t+2 (0.905 dollars) and t+3 (1.442 dollars) are not significantly different from one dollar (p=0.79 and 0.58, respectively). 4.2 Validation tests using IRS settlement data To ensure that our results on the positive link between UTBs and future income tax cash outflows are indeed (in some significant part) due to income tax cash outflows related to tax uncertainty, we use actual federal tax audit settlement data provided by the IRS to validate our 13 We caveat this analysis recognizing that DEFTAX is insignificant in our model. Thus, our estimates of economic significance here are likely an upper bound and must be interpreted with caution. 14

16 inferences. In particular, we replicate Equation (1) above, but with two alterations. First, we successively replace the dependent variables related to the sum of future income tax cash outflows (TXPD t+1, TXPD t+2, and TXPD t+3 ) with future period IRS audit settlements aggregated over the same time periods (i.e., IRS_SETTLE t+1, IRS_SETTLE t+2, and IRS_SETTLE t+3 ). We retain all of our independent variables. 14 Second, since IRS settlements are themselves rather rare (see below) and to increase the power of our tests, we estimate our modified Equation (1) on only a sub-sample of firms for whom we can confirm settled uncertain positions with the IRS. 15 Note that we cannot rely on the FIN 48 UTB disclosure of settlements for this validation test because FIN 48-related settlements rely on firms establishing the appropriate UTB reserve in the first place. Importantly, our IRS settlement data are not dependent on whether the UTB is initially (or under- or over-) reserved. Therefore, to the extent the UTB is reserved in error relative to future cash flow realizations, there would be no discernible link between UTBs and IRS settlements. Also, an empirical model that regresses future UTB settlements on the UTB balance might erroneously induce a positive statistical relation since FIN 48 information would appear on both sides of the equation. Again, a firm cannot report a reduction in its UTB from settlement activity if the UTB is not established in the first place. Thus, narrowing our sample to firms with only federal IRS settlements decreases the chance of erroneously concluding that there is no link between UTBs and future income tax cash outflows (in the form of settlements), when in fact there is. However, we also caveat that this relation may still be weak to the extent 14 Note that we keep TXPD t as an independent variable rather than replace it with IRS_SETTLE t. In taking an investor perspective, our modified Equation (1) seeks to explain private information (i.e., future tax cash outflows in the form of IRS settlements) by using publicly available information. Such a research design that uses public data to explain actual IRS tax data reflects the spirit of Lisowsky (2009), Lisowsky (2010), and Lisowsky et al. (2013). 15 In effect, this approach attempts to strip out the effects of foreign and state tax reserves by focusing on IRS (i.e., federal) tax settlements and their link to UBEND. 15

17 that non-federal tax uncertainties are accrued in UBEND as current FIN 48 disclosure rules do not require the disaggregation of the UTB by jurisdiction. In Table 3 Panel A, we describe the prevalence and amount of IRS settlements in the IRS settlement sub-sample. Reflecting corporate IRS audit rates more generally, about 5 percent of our sample settles its positions with the IRS at some point over the following three years. For example, 280 firms agree to IRS settlements one year into the future (IRS_SETTLE t+1 ) relative to the 6,091 observations that were used in the original TXPD t+1 tests. In raw terms, the summed mean (median) IRS audit settlement is $3.5 ($0.52) million in year t+1, and rises to $4.7 ($0.58) million after including year t+2, and $7.5 ($0.65) million after including year t+3. This increase is similar when IRS settlements are scaled by lagged total assets, which we use in our modified Equation (1). <INSERT TABLE 3 ABOUT HERE> Panel B reports the main validation test in which we regress the sum of future IRS settlements at time t+1, t+2, and t+3, on the FIN 48 UTB ending balance. Our results show that the UTB is not informative of one-year-ahead IRS settlements (p=0.166), but it is positively associated with IRS settlements two (p=0.086) and three years (p=0.097) into the future. 16 In Panel C, we also split this small sample on domestic versus non-domestic tax exposure. To do so, we classify firms as domestic if their current foreign tax expense (txfo in Compustat) is less than 20 percent of the firm s total current tax expense (txt txdi), and non-domestic otherwise. We find that the coefficient on UBEND is significantly positive for the IRS_SETTLE models at time t+1 (p=0.033) and t+2 (p=0.078), and marginally insignificant at time t+3 (p=0.113). In all, 16 Due to small sample sizes and the established positive association between UBEND and future measures of TXPD in our main results, we use one-tailed tests to make these inferences. Our results strengthen in significance to twotailed levels if we omit TXPD t and year fixed-effects in successive estimations of our modified Equation (1), while the one-year-ahead IRS settlement results remain insignificant (untabulated). 16

18 despite small samples focusing only on federal (IRS) settlements, we find evidence largely consistent with H1 and certainly no evidence to the contrary that FIN 48 UTBs map into future income tax cash outflows, on average. Based on the validation of our main results using IRS data, we proceed in the next section to further test the mapping of UTBs to future income tax cash outflows using our large-sample public data. Specifically, to evaluate settings in which proponents and critics of FIN 48 may be more or less correct about their assertions of this Interpretation, we explore how the relationship between UTBs and future income tax cash outflows is affected by characteristics such as auditorprovided tax services, corporate tax avoidance, and the probability of IRS audit. 5. Cross-Sectional Analyses 5.1 Auditor-provided tax services We first consider whether the provision of auditor-provided tax services improves or weakens the informativeness of UTBs about future income tax cash outflows. A large literature investigates whether nonaudit services influence both audit and financial reporting quality. An ongoing debate within this literature focuses on competing predictions and evidence supporting whether these services yield costs (e.g., lower audit quality as a result of auditor independence impairment) or benefits (e.g., knowledge spillovers that improve audit quality and/or efficiency) (see Simunic 1984; Palmrose 1986; O Keefe et al. 1994; Whisenant et al. 2003). On balance, research focusing directly on the provision of tax services generally finds evidence of a net benefit (e.g., Omer et al. 2006; Seetharaman et al. 2011; Donohoe and Knechel 2013). More specifically, Gleason and Mills (2011) find that firms purchasing auditor-provided tax services accrue tax reserves that are more closely associated with actual IRS settlements, consistent with knowledge spillovers. Although their evidence is from the pre-fin 48 reporting environment, it 17

19 might also apply post-fin 48 in that UTBs are likely more informative about future income tax cash outflows when firms purchase tax services from their auditor than when they do not. To examine the effects of auditor-provided tax services, we estimate Equation (1) across sub-samples of firms purchasing these services. We obtain data regarding auditor-provided tax services from Audit Analytics, which we merge with data from Compustat. This merge yields a base sample of 4,882 firm-year observations for our TXPD t+1 analysis. Table 4 presents the results. In Panel A, we partition the sample by firms that purchase any amount of tax services (i.e., tax fees are greater than zero) (APT1). Because more tax services may result in greater knowledge spillover, Panels B and C partition the sample based on the size of purchased tax services. Specifically, Panel B (Panel C) partitions the sample by APT2 (APT3), equal to one for the top four industry-year quintiles of the ratio of tax fees to total fees (log of tax fees). Within all three panels, the first three columns report results for firms that purchase auditor-provided tax services (APT=1), and the remaining three columns report results for firms that do not (APT=0). Panel D reports results of Seemingly Unrelated Regressions across models (described below). <INSERT TABLE 4 ABOUT HERE> Across the three auditor-provided tax services partitions in Panels A through C, we find a consistent pattern. Coefficients for UBEND are positive and significant (p<0.05) among firms purchasing tax services from their auditor (columns (1) through (3)), and insignificant among firms that do not (columns (4) through (6)). These findings suggest auditor-provided tax services are associated with knowledge spillovers that enhance the informativeness of UTBs for future income tax cash outflows. That is, when auditors are more familiar with firms tax positions, they are more accurate at assessing the tax accounts and thus, future cash tax outcomes. 18

20 Because the results in Panels A through C of Table 4 are estimated on different subsamples, comparing coefficients and p-values across each sub-sample could result in misleading inferences. As a result, we test the significance of coefficients for UBEND across subsamples using Seemingly Unrelated Regressions, which control for potential correlation across error terms. Panel D reports insignificant differences across all three auditor-provided tax services partitions when the dependent variable is TXPD t+1, but significant differences when the dependent variable is TXPD t+2 and TXPD t+3. Overall, our findings suggest that auditor-provided tax services improve the ability of UTBs to predict future income tax cash outflows. 5.2 Corporate tax avoidance Next, we consider whether corporate tax avoidance hinders the informativeness of UTBs about future income tax cash outflows. Critics of FIN 48 claim that reporting UTBs in financial statements could provide tax authorities with information necessary to identify firms most controversial tax positions (Frischmann et al. 2008). Similarly, Mills et al. (2010) analytically demonstrate that the effects of mandatory UTB disclosure on claiming uncertain tax positions depend on firms unique facts and circumstances. In particular, their model suggests that taxpayers with relatively weak facts to support uncertain tax positions are potentially worse off as the mandatory FIN 48 disclosure regime may deter firms from claiming weak positions in the first place. Consistent with these arguments, recent anecdotes and empirical evidence suggest that firms with weakly supported tax positions tend to obfuscate FIN 48 disclosures to minimize scrutiny from tax authorities. For example, the Tax Executives Institute (TEI) asserted in its comments regarding the adoption of FIN 48 that firms with higher costs of disclosure will be less likely to follow the Interpretation. FAF (2012) echoes these concerns in its discussion of how some firms withhold sensitive tax information when that information is likely detrimental to 19

21 tax settlements. Consistent with these conjectures, Gross (2011) and Robinson and Schmidt (2013) find evidence of lower quality FIN 48 disclosures among firms engaging in more tax avoidance. This evidence suggests that an increased obfuscation of UTBs by firms with a high level of tax avoidance should result in a UTB balance that is less informative for future income tax cash outflows than for firms not engaging in as high level of tax avoidance. To examine whether UTBs are less informative for predicting future income tax cash outflows when firms engage in high levels of tax avoidance, we estimate Equation (1) across subsamples of high tax avoidance firms. We use two common proxies for high levels of tax avoidance. First, following Ayers et al. (2009), we consider firms in the bottom quintile of fiveyear cash ETRs by year to be engaging in a high level of tax avoidance (TA $ ). 17 The cash ETR reflects a firm s ability to pay a low amount of cash taxes per dollar of pretax income over a specific period, which we define as five years (t to t 4) consistent with Dyreng et al. (2008). Second, we consider firms in the top quintile of positive discretionary book-tax differences each year, or DTAX, as also engaging in a high level of tax avoidance (TA DT ). 18 Consistent with tax avoidance hindering the informativeness of UTBs for predicting future income tax cash outflows, we expect UBEND to be predictive of future income tax cash outflows only for firms that do not engage in high levels of tax avoidance. <INSERT TABLE 5 ABOUT HERE> Panels A and B of Table 5 partition the sample by firms in the smallest quintile of fiveyear cash ETRs (TA $ ) and highest quintile of discretionary book-tax differences (TA DT ), 17 Ayers et al. (2009) also measure high levels of tax avoidance using current ETRs. We exclude this measure from our analysis because current tax expense is mechanically related to UTBs (e.g., Graham et al. 2012). 18 As developed by Frank et al. (2009), DTAX captures non-timing book-tax differences that are likely related to tax avoidance. To calculate DTAX, permanent book-tax differences are regressed on nondiscretionary items (e.g., intangible assets, minority interests) and other statutory adjustments (e.g., states taxes) known to cause permanent book-tax differences, but likely unrelated to tax avoidance. The residuals from this regression model serve as a proxy for discretionary permanent book-tax differences, or DTAX. 20

22 respectively. 19 Within each panel, the first three columns report results for firms that engage in high levels of tax avoidance (TA=1), and the remaining three columns report results for firms that do not (TA=0). The dependent variable in each of three columns for each partition reflects the aggregate sum of cash taxes paid, namely TXPD t+1, TXPD t+2, and TXPD t+3. In Panels A and B, coefficients for UBEND are insignificant for firms engaging in high levels of tax avoidance (TA=1) across the three-year forecasting horizon (columns (1) through (3)). However, for firms not engaging in high levels of tax avoidance (TA=0), coefficients for UBEND are positive and highly significant (columns (4) through (6)), suggesting that UTBs for these firms are positively related to future income tax cash flows. Panel C reports p-values from testing the significance of UBEND coefficients across each partition using Seemingly Unrelated Regressions. These tests indicate that coefficients for UBEND are statistically different across the subsamples in four of our six specifications. Taken together, the results in Table 5 are consistent with UTBs being uninformative about future income tax cash outflows for firms with high levels of tax avoidance. This evidence supports recent research (e.g., Robinson and Schmidt 2013) suggesting that firms with more sensitive tax information exploit the discretion and judgment inherent within FIN 48 to recognize less informative UTBs. 5.3 Tax audit intensity As mentioned above, it is possible that the effects of FIN 48 on future income tax cash outflows are influenced by how tax authorities use the disclosed FIN 48 information in terms of inferring corporate tax avoidance. Thus, we next examine whether UTBs are positively related to future income tax cash outflows when the probability of tax enforcement is higher. In short, if tax enforcement is higher and, as a result, the probability of paying additional taxes to the government increases, then the mapping from the UTB to future income tax cash outflows 19 Due to data requirements, the inclusion of TA $ reduces the number of observations. 21

23 should be stronger than when tax enforcement is more lax. 20 To proxy for tax enforcement probability, we use the probabilities of corporate IRS audit (AUD) from the Transaction Records Access Clearinghouse (TRAC) database maintained by Syracuse University. These probabilities represent the number of corporate tax returns audited by the IRS compared to all corporate tax returns filed for a given size-year cohort. 21 <INSERT TABLE 6 ABOUT HERE> Table 6 reports the results of estimating Equation (1) after including AUD and its interaction with UTBs (UBEND). Because AUD and UBEND are both continuous, we center these variables at the mean to ease interaction interpretations (Cronbach 1987; Jaccard et al. 1990). The coefficients for UBEND and UBEND AUD are positive and significant in all three columns (all p<0.10), suggesting the information contained within UTBs with respect to future income tax cash outflows is strong on average, and strengthens further as the likelihood of scrutiny by tax authorities increases. 6. Supplemental tests 6.1 Tobit regressions Approximately ten percent of our sample receives net tax refunds (TXPD t+1 < 0) in year t We include these observations in our primary tests because settlements would simply decrease the net refund and not necessarily overturn a positive relation. A refund in one jurisdiction would not preclude a settlement based on a UTB in another. However, for 20 In addition, the more-likely-than-not standard for recognition under FIN 48 ignores detection risk by tax authorities. Thus, for low-detection risk taxpayers, UTBs will likely result in fewer future cash tax payments (because they will not be audited) compared to high-detection taxpayers (who will be audited), even if both firms identically implement FIN 48 and exhibit no financial reporting discretion. 21 We acknowledge that the IRS is not the only tax authority interested in UTB disclosures (e.g., state and foreign governments). We also note that TRAC measures closed audit cases, although prior research uses the data to capture managers ex ante expectations of IRS audit (Hoopes et al. 2012). See Guedhami and Pittman (2008) and Hanlon et al. (2013) for other uses of TRAC data. 22 The percentage of firms with negative tax payments decreases as we aggregate across year t+2 and t+3, with approximately 8 percent and 5 percent of observations having negative dependent variables, respectively. 22