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 William A. Ciconte III University of Florida Michael P. Donohoe University of Illinois at Urbana-Champaign Petro Lisowsky University of Illinois at Urbana-Champaign and Norwegian Center for Taxation Michael A. Mayberry University of Florida March 20, 2015 Abstract This study estimates the extent to which the reserve for unrecognized tax benefits (UTBs) accrued under Financial Interpretation No. 48 (FIN 48) provides information about the realizability of future income tax cash outflows. Proponents argue that FIN 48 facilitates the ability of UTBs to predict future income tax cash outflows, while critics believe FIN 48 allows for too much discretion in accruing UTBs. We find that UTBs are predictive of future income tax cash outflows and that this empirical relation converges to one over a five-year horizon after considering other tax information. Therefore, we do not find support for systematic over- or under-reserving of the UTB, on average. However, supporting arguments made by FIN 48 critics, we find that this relation is stronger in firms that (1) purchase tax services from their auditor; (2) engage in less tax avoidance; and (3) are subject to greater IRS scrutiny. We also find no increase in informativeness under FIN 48 compared to prior guidance under Statement on Financial Accounting Standards No. 5, suggesting the new recognition and measurement process under FIN 48 did not result in consistent overstatement of UTBs, on average. Keywords: unrecognized tax benefit; tax avoidance; auditor-provided tax services; FIN 48; ASC 740 JEL Classification: M41; M48; H26 Tax audit settlement data are made available to one of the authors by the Internal Revenue Service s (IRS) Large Business & International Division (LB&I). Because IRS data are not publicly available and are protected by non-disclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate. Any opinions are those of the authors and do not necessarily reflect the views of the IRS. All other publicly available data sources are identified in this manuscript. Corresponding author: 1206 S. Sixth Street, MC-706, Champaign, IL The authors appreciate helpful comments from participants at the 2013 American Taxation Association Mid-Year Meeting, the 2013 American Accounting Association Annual Meeting, workshop participants at KU Leuven, the University of Iowa Tax Readings Group, the Arizona State University Tax Readings Group, Paul Demeré, Shane Heitzman, Gary McGill, Tom Omer, Eric Rapley, Leslie Robinson, Terry Shevlin, and Theo Sougiannis. We also thank Hye Sun Chang for excellent research assistance. Michael Donohoe and Petro Lisowsky gratefully acknowledge support from the PricewaterhouseCoopers Faculty Fellowship at the University of Illinois at Urbana-Champaign.

2 Predictable Uncertainty: The Relation between Unrecognized Tax Benefits and Future Income Tax Cash Outflows 1. Introduction Financial Interpretation No. 48 (FIN 48) governs the measurement and disclosure of tax reserves, or unrecognized tax benefits (UTBs), in firms financial statements. FIN 48 was enacted by the Financial Accounting Standards Board (FASB) in 2006 to enhance relevance and comparability in the financial reporting of income taxes, and to provide finer information to financial statement users about the realizability of future tax benefits (FASB 2006; Tax Executives Institute (TEI) 2011). However, similar to disputes about the usefulness of deferred tax information (Lasman and Weil 1978; Cheung et al. 1997; Beechy 2007; Chludek 2011), some critics claim that UTBs do not help financial statement users predict the realizability of future income tax cash outflows (FASB 2006, 20-23). Others object to the more-likely-thannot threshold for recognizing tax benefits in earnings and the subjectivity required to apply FIN 48 (TEI 2011). Our study informs this ongoing debate by (1) estimating the extent to which UTBs reported under FIN 48 provide predictive information about future income tax cash outflows, and (2) identifying settings in which such informativeness varies. Understanding the predictive ability of UTBs for income tax cash outflows is important for three reasons. First, standard setters and regulators, such as the FASB and U.S. Securities and Exchange Commission (SEC), are generally concerned about the nature, timing, representation, and magnitude of firms net cash flows (ASC 100, General Principles). Specific to FIN 48, there has been no stronger interest from stakeholders on tax reporting since Statement on Financial Accounting Standards No. 109 (SFAS 109) formalized financial reporting for income taxes in In fact, the FASB received 255 comment letters on the proposed version of FIN 48 in 2005, which is nearly half of the 586 letters the FASB received on SFAS 109 that now governs 1

3 all financial reporting for taxes (Lisowsky et al. 2013). More recently, the Financial Accounting Foundation s (FAF) post-implementation review (PIR) of FIN 48 notes that UTBs may not be relevant to investors and others using such information to estimate income tax cash flows (FAF 2012, 13). It also suggests that UTBs may not have a direct relation to tax settlements. As a result, Blouin and Robinson (2014) call for more research about whether and to what extent FIN 48 provides decision-useful information; our study answers their call. Second, because income taxes are a material expense for most firms (Dyreng et al. 2008), information about tax outlays can aid financial statement users in forecasting firms cash flows and assessing future internal cash commitments. As a reserve, UTBs should signal the magnitude of uncertainty a firm faces with respect to its tax positions. Prior studies examine the importance of non-tax reserves in financial statements, such as warranties (Heck 1963; Cohen et al. 2011) and environmental costs (Barth and McNichols 1994; Li et al. 1997). Similar to these reserves, estimating UTBs requires substantial managerial judgment. However, warranty or environmental reserves are not relevant to many firms, while income tax matters affect all firms. Third, insofar as tax authorities infer tax compliance by using financial statement information, including FIN 48 UTBs, identifying predictable patterns in UTBs can aid them in developing their audit strategies (Mills and Sansing 2000; Towery 2013; Bozanic et al. 2014). We expect that, on average, UTBs reported under FIN 48 are predictive of future income tax cash outflows. Although it has limitations, FIN 48 intends for UTBs to reflect managers expectations of future disallowed tax benefits, implying that UTBs should explain future income tax cash outflows. That is, UTBs are designed to be informative to financial statement users, who develop expectations about firms future cash outflows, and tax authorities, who challenge firms tax positions to collect additional payments. Along these lines, managers and financial statement 2

4 users view UTBs as indicative of higher future tax burdens (Blouin and Tuna 2007; Blouin et al. 2010). Moreover, some elements of deferred taxes map into future income tax cash outflows (Laux 2013). 1 Yet, if a positive relation between UTBs and future income tax cash outflows indeed exists, the extent to which UTBs can be used to infer future cash tax outflows remains an important question (Blouin and Robinson 2014), especially given critics claims that UTBs are subject to considerable discretion (e.g., De Simone et al. 2014). To estimate the extent to which UTBs are predictive of future income tax cash outflows, we regress the sum of future income tax cash outflows across five horizons (ranging from years t+1 to t+5) on UTB ending balances since FIN 48 has been effective and data are available ( ). While some prior research focuses on the three-year statute of limitations for tax matters (Lisowsky et al. 2013), we consider a maximum forecasting horizon of five years due to concerns that UTBs could require more time to be resolved. 2 We find a significantly positive relation between UTBs and future income tax cash outflows over each horizon, consistent with firms taking uncertain tax positions that later result in cash tax payments. In terms of economic magnitude, the empirical relation between UTBs and future income tax cash outflows should be one-to-one over the period during which the tax positions remain unresolved if UTBs, on average, correctly anticipate the uncertain portion of future income tax cash outflows, after controlling for other available tax information. Consistent with this expectation, our tests reveal that UTBs are resolved within five years. That is, we find a one-to- 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 The IRS can request that the taxpayer extend the statute of limitations beyond three years. This agreement, called a consent, takes two forms: fixed-date and open-ended. The fixed-date consent specifies an expiration date for the extension of the statute, while the open-ended consent extends the statute for an indefinite length of time. The type of consent depends on the time necessary to prepare for, litigate, and/or settle a tax audit (see IRS Publication 1035). Unfortunately, data on the type of consent is not available to us. However, Gleason and Mills (2011) report that the average time from filing a tax return in 1994 to completing a tax audit is 4.6 years, with a range of one to nine years. We limit our analysis to five years due to data availability constraints related to the recency of FIN 48. 3

5 one relation between UTBs and the sum of future income tax cash outflows over the subsequent five years, after controlling for other determinants of cash tax outflows. This result runs counter to claims of systematic under- or over-reserving for uncertain tax positions (TEI 2011), which would yield a relation other than one-to-one. This link is economically significant, with UTBs explaining up to 8.9 percent as much of the variation in future income tax cash outflows as do contemporaneous income tax cash outflows. 3 In additional tests, we use proprietary IRS audit settlement data to validate that publicly available UTB balances are indeed informative of uncertain tax position resolution with tax authorities. We find a significantly positive relation between future IRS audit settlements and UTB balances, suggesting that UTBs reflect tax uncertainty, at least at the U.S. federal level, that eventually unwinds as income tax cash outflows to tax authorities. Second, we use an out-ofsample estimation methodology to confirm that the UTB significantly improves the forecasting of future income tax cash flows over other tax information. In sum, our findings support the arguments raised by FIN 48 proponents: UTBs are, on average, informative about the future realizability of income tax cash outflows. However, in addition to estimating the extent to which UTBs have predictive ability, we identify three settings in which the link between UTBs and future income tax cash outflows might vary in the cross-section. We choose these settings as they help inform arguments made by critics of FIN 48 that UTBs are subject to substantial discretion and noise. First, we find that UTBs have predictive ability among firms that retain their auditor for a material amount of tax services, consistent with knowledge spillover and the reputation concerns of auditors facilitating more accurate measurement of tax uncertainty (e.g., Gleason and Mills 2011). That is, we find 3 We gauge economic significance by comparing standardized coefficients for contemporaneous income tax cash outflows to those for UTBs across the forecasting horizon of five years. See Section 4.2 for details. 4

6 that $1 of UTB maps into $1 of income tax cash outflows over the subsequent five years. Meanwhile, firms that do not purchase a material amount of tax services do not have informative UTBs that relate to future income tax cash outflows. Second, we consider if the predictive ability of UTBs varies with tax avoidance. We consider tax avoidance because critics of FIN 48 claim that public disclosures of UTBs could provide tax authorities with a roadmap that reveals the firm s most controversial tax positions (Frischmann et al. 2008; Mills et al. 2010). Similarly, 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; FAF 2012; Robinson and Schmidt 2013). Using low long-run cash and GAAP effective tax rates (Dyreng et al. 2008) as proxies for high tax avoidance, we find that UTBs for high tax avoiding firms are not systematically predictive of future income tax cash outflows. This finding is consistent with the concerns of the FAF (2012) about whether FIN 48 is achieving its goal of providing information to predict future income tax cash outflows, especially among firms that should be most affected by its mandatory disclosures. In contrast, we find that UTBs are predictive of future income tax cash outflows among firms that are not engaging in high levels of tax avoidance, with $1 of UTB mapping into $1 of income tax cash outflows over the next five years. Third, we examine whether the link between UTBs and future income tax cash outflows varies with IRS audit probability. The mapping of UTBs to income tax cash outflows should be stronger when IRS audit probability is higher because greater tax enforcement increases firms income tax payments (Hoopes et al. 2012). Using Transaction Records Access Clearinghouse (TRAC) data to proxy for IRS audit probability (Guedhami and Pittman 2008; Hoopes et al. 2012), we find that UTBs are more predictive of future income tax cash outflows when the 5

7 probability of IRS audit increases. Specifically, a one percent increase in IRS audit probability increases the mapping of $1 of UTB to future income tax cash payments by approximately 8.1 cents. This finding suggests that firms assessments of tax uncertainties translate into more informative financial reporting of UTBs when audit probability is high, and thus have higher realizations of UTBs as future income tax cash outflows. In all, our cross-sectional tests highlight important nuances as to when UTBs are more or less informative of future tax payments. In our final set of tests, we examine the inter-temporal informativeness of tax reserves on future income tax cash outflows. Specifically, we test whether the tax reserve s informativeness increased under FIN 48 (which requires a more-likely-than-not approach) relative to previous guidance on accruing contingencies under Statement on Financial Accounting Standards No. 5 (SFAS 5; FASB 1975) (which requires an expected value approach). Using estimates of tax reserves pre-fin 48 (i.e., the tax cushion ), as well as data on the FIN 48 cumulative equity adjustment, which signals the degree to which a firm s accounting for tax uncertainty differed pre- versus post-fin 48, we find that informativeness did not change after FIN 48. This result suggests that FIN 48 did not result in systematically greater over- or under-reserving compared to the reserves accrued under SFAS 5. In light of our main results of a one-to-one relation between UTBs and future tax cash outflows, managers appear to provide similarly useful estimates that help predict future income tax cash outflows. Our study contributes to the financial accounting literature on the mapping of accruals into cash flows (e.g., Sloan 1996; Dechow and Dichev 2002; Richardson et al. 2005; Choudhary et al. 2014; Barth et al. 2015) and the accounting for income taxes (Graham et al. 2012). We use the setting of FIN 48 to estimate the extent to which the income tax reserve maps into future income tax cash outflows related to tax uncertainty. Prior research examines the effects of FIN 48 6

8 on earnings management (Gupta et al. 2015), and the responses of managers (Blouin et al. 2010) and investors (Frischmann et al. 2008; Koester 2011) to FIN 48 disclosures. In addition, theory and empirical evidence suggest that elements of deferred taxes reported under SFAS 109 (now 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 extend this literature by directly linking and quantifying the extent to which managers ex ante assessment of tax uncertainty in the financial statements maps into ex post economic outcomes. As such, we do not aim to test the information content of UTBs for valuation (instead, see Frischmann et al and Koester 2011). 4 Rather, we study the fundamental accounting questions of whether and to what extent UTB liabilities in particular map into future income tax cash outflows. We proceed as follows. Section 2 provides a background on FIN 48 and the related literature. We discuss our research design, main findings, cross-sectional tests, and intertemporal tests in Sections 3, 4, 5, and 6, respectively. Section 7 concludes. 2. Background 2.1 Accounting for Unrecognized Tax Benefits Ambiguity in tax reporting is common because firms routinely enter into transactions where the appropriate tax treatment is subject to numerous legal interpretations (Beck and Jung 1989a, 1989b; Mills et al. 2010, Beck and Lisowsky 2014). As a result, 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 have historically required the recognition of a contingent tax liability to account for the uncertainty of claimed tax benefits (SFAS 5). More recently, ASC 4 In addition, our focus on future income tax payments rather than equity valuation allows us to separate numerator (cash flow) from denominator (discount rate) issues. Recent evidence suggests that UTBs are related to the cost of equity capital (Hutchens and Rego 2013; Drake and Koester 2013). Therefore, focusing on equity pricing instead of future tax payments provides, at best, indirect evidence of future cash flow effects. 7

9 , or FIN 48, Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FASB 2006), has provided guidance on recognizing and measuring uncertain tax benefits. As described in Beck and Lisowsky (2014), firms with uncertain tax positions are required to apply FIN 48 s two-step process to recognize and measure tax reserves in financial statements for reporting periods after December 15, 2006 (FASB 2006). Conceptually, the tax reserve liability arises from tax benefits (e.g., deductions or credits) claimed on the tax return, but due to their uncertain nature, the benefits are not immediately recognized in the financial statements as a reduction to tax expense. Instead, those benefits are held in reserve awaiting future resolution, either through a tax audit, new guidance, or a lapse in the statute of limitations. 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 likelihood of being realized upon settlement, according to a cumulative probability table developed by managers. 5 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 future tax payments (see Blouin et al and Lisowsky et al for further details). Although FIN 48 aims to improve the accounting for income tax uncertainty, it can lead to errors in accruing the tax reserve. In particular, differences in the expected probability of tax outcomes relative to the accrued UTB can create an overstatement or understatement of the reserve. To illustrate, assume that a firm claims a $1,000 tax benefit on its tax return that has 5 Historically, uncertain tax benefits were recorded using an expected value approach under the contingent loss rules of ASC 450, Contingencies, or SFAS 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. 8

10 three potential outcomes in the event of a tax audit: (1) retain the $1,000 tax benefit; (2) retain only $690 of the tax benefit; or (3) retain none of the tax benefit. Because tax benefit retention is determined by the legal strength of facts underlying the tax position (Mills et al. 2010), further assume the $1,000 tax benefit is based on either strong, weak, or moderate underlying facts. As shown in Appendix A, the firm records no UTB when the underlying facts of the tax position are strong (Scenario 1), and a $1,000 UTB when the facts are weak (Scenario 2). However, the magnitude of potential UTB over- or under-statement varies based on the expected probability of possible tax audit outcomes. This difference arises because FIN 48 requires a more-likely-than-not threshold for recognition (i.e., a median approach), which may or may not mirror the expected probability of future tax payments (i.e., a mean approach). The probabilities for recognition of tax benefits under FIN 48 are estimated by managers using a cumulative probability table, which introduces considerable discretion into the calculation of UTBs. As shown in Scenario 1, when managers assert that they have strong facts to support the tax benefit, yet expect a non-zero future tax liability related to the benefit, the UTB is understated by $ Conversely, when the facts are weak (Scenario 2) and the mean expected tax liability is less than the tax benefit, the UTB is overstated by $338. In cases of moderate-strength facts, an understated ($152), overstated ($90), and perfectly accurate UTB are all possible (Scenarios 3-5, respectively). In all, managerial discretion and/or measurement error can lead to accurate or over- or under-stated UTBs. However, the extent to which UTBs are over- or under-stated is an open empirical question, which we examine. 2.2 Related Literature UTBs are liabilities that reflect the dollar amount of estimated tax benefits that managers anticipate will be disallowed by tax authorities in the future. Thus, on average, UTBs should be 6 Of course, if managers expect a zero tax liability, a UTB of zero perfectly reflects future additional tax payments. 9

11 positively associated with future income tax cash outflows related to tax uncertainty. Specifically, if UTBs are measured without error, the relation between UTBs and subsequent cash tax payments should be one-to-one over the period during which the positions remain unresolved. However, as noted above, FIN 48 permits considerable managerial discretion in accruing the tax reserve. If such discretion results in an understatement of UTBs, the empirical relation between the UTB at time t and final cash tax settlement will be greater than one. Not only will the entire amount of accrued UTB be paid to the tax authorities, but additional cash tax payments will be required to cover the portion of the settlement for which there was no reserve. Alternatively, an overstatement creates an empirical relation between zero and one. In an extreme case, if the entire UTB were an overstatement (i.e., there is no future cash tax payment on the reserved position), the relation would equal zero. Three areas of research suggest UTBs should generally have a positive association with future cash tax payments. First, Laux (2013) finds a positive link between some deferred taxes (i.e., those that are recognized in book income prior to taxable income) and future income tax cash outflows. To the extent this finding generalizes to UTBs, we expect a positive relation between UTBs and future income tax cash outflows. Moreover, the FAF (2012), which oversees the FASB, conducted a post-implementation review to evaluate whether the informational benefits of FIN 48 to financial statement users outweigh the reporting costs. It concluded that FIN 48 increases the relevance and comparability of information about income tax uncertainties. Second, other research suggests that managers are concerned that disclosure of UTBs will result in future tax liabilities and/or other unfavorable outcomes. Blouin et al. (2010) conclude that managers settled open positions with tax authorities prior to FIN 48 to avoid disclosing UTBs in financial reports. Thus, the act of disclosure itself may alter the information it is 10

12 intended to convey. Finally, some research finds indirect evidence that UTBs are negatively related to investors future expectations of firm value, especially when the probability of tax enforcement is high. For example, Frischmann et al. (2008) document a negative market reaction to news of a U.S. Senate inquiry into firms with large UTBs. Also, Abernathy et al. (2013) find a negative 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 income tax return. These findings are consistent with negative market reactions to longterm and complex non-tax contingent liabilities, similar to studies on environmental clean-up costs (Barth and McNichols 1994) and product warranties (Cohen et al. 2011). However, in some cases, UTBs could be less informative about future income tax cash outflows. For instance, critics of FIN 48 argue that the complexity, subjectivity, and discretion inherent in recognizing, measuring, and derecognizing UTBs hinder their informativeness about future income tax cash outflows (FASB 2006, 20-23). Consistent with this view, De Simone et al. (2014) find divergent applications of FIN 48 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). Indeed, research finds that some firms use the tax accounts, including tax reserves, to manage earnings (Dhaliwal et al. 2004; Gupta et al. 2015). Also, Robinson and Schmidt (2013) find that investors react favorably to firms with low UTB disclosure quality, consistent with low quality disclosures inhibiting tax authorities from discerning a clear roadmap to firms uncertain tax savings (i.e., savings that can benefit shareholders as residual claimants). Aside from managerial discretion, the FIN 48 rules themselves could facilitate a systematic lack of, or reduction in, the informativeness of UTBs for future cash tax outflows. To 11

13 evaluate if a tax position will be sustained under the more-likely-than-not recognition or measurement steps, FIN 48 does not allow managers to consider detection risk. Instead, managers must assume that tax authorities possess all available information, even if tax authorities do not obtain or use that information. Managers must also assume that tax positions will be examined under tax audit, even if the firm does not expect to be (or has not been) audited. 7 The omission of detection risk can create a mismatch between UTBs and cash tax settlements, potentially reducing the ability of UTBs to predict future income tax cash outflows. Such mismatch will result in biased estimates, even in firms that faithfully follow FIN 48 and exhibit no managerial discretion. Therefore, on balance, the extent to which UTBs map into future cash tax payments is an open empirical question. In concurrent work, Robinson et al. (2014) examine the link between cash taxes paid and tax expense (not the UTB) to evaluate whether FIN 48 improves the relevance of income tax reporting compared to SFAS 5. The authors find no such improvement as a result of the implementation of FIN 48. In contrast, our study directly tests the ability of FIN 48 UTBs (rather than total tax expense) to predict income tax cash outflows up to five years (instead of one year) in the future. In addition, our methodology allows us to quantify the magnitude of this economic relation. Finally, we investigate whether the predictive ability of UTBs varies in the cross-section with several contextually important firm attributes. 3. Research Design 3.1 Empirical Model To examine the relation between UTBs and future income tax cash outflows, we specify 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 expected total net tax exposure. 12

14 the following OLS model for firm i at time t (see Appendix B for variable definitions): 8 TTTTTTTT ii,tt+kk = αα 0 + ββ 1 UUUUUUUUUU ii,tt + ββ 2 TTTTTTTT ii,tt + ββ 3 ΔΔTTTTTTTT ii,tt + ββ 4 ΔΔPPPP ii,tt + ββ 5 DDDDDDDDDDDD ii,tt +ββ 6 NNNNNN ii,tt + ββ jj YYYYYYYY ii + εε. (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 five, scaled by lagged total assets. 9 We are careful to use cash tax payments rather than total tax expense as our dependent variable because (a) the UTB is mechanically related to total tax expense; (b) tax expense does not necessarily capture cash tax outflows (Hanlon 2003; Dyreng et al. 2008; Lisowsky 2009; Laux 2013); and (c) our goal is to evaluate how a specific tax accrual, the UTB, maps into future income tax cash outflows, rather than how one tax accrual (UTB) maps into another tax accrual (tax expense). In our main tests, we use the sum of future income tax cash outflows over the five horizons rather than a single future year, consistent with the literature on cash flow prediction (Lev et al. 2010). Furthermore, because tax audits often have a lag of one year or more and are not uniformly distributed over time, summing across years increases the likelihood of identifying the period in which a future settlement occurs. As a specification check, we also define TXPD over single future years (Laux 2013). Our variable of interest, UBEND, is the year-end unrecognized tax benefit (scaled by lagged total assets) reported in Compustat and reflects the firm s unresolved, uncertain tax positions. If the UTB is predictive of future income tax cash outflows, then β 1 >0. To identify control variables at time t, we primarily use the Laux (2013) model explaining future income tax cash outflows. This model examines whether UTBs provide incremental 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 Because 9.6 percent of our sample receives net tax refunds (TXPD t+3 < 0) in year t+3 (and 11.6 percent through year t+4 and 12.5 percent through year t+5), we also estimate Eq. (1) using Tobit regression, censoring the data for firms receiving refunds in future years. All results are qualitatively similar to our OLS results. 13

15 information over other available tax information in predicting the uncertain portion of future income tax cash payments. First, we include cash taxes paid in the current year (TXPD) as many tax attributes are serially correlated over time (e.g., research and development or foreign operations). Consistent with Laux (2013), we expect a positive coefficient for TXPD. Second, to ensure that the UTB is not simply capturing changes in tax payments unrelated to TXPD, we include the change in cash taxes paid ( TXPD). This approach mirrors the financial reporting literature that estimates future earnings by including the current period earnings and its change (Dechow and Dichev 2002; Soliman 2008; Dickinson 2011). However, to the extent that changes in taxes paid are mean-reverting or do not capture changes in underlying profitability, we also include the change in pre-tax profitability ( PI), which would increase future taxes. Thus, we anticipate a negative (positive) coefficient on TXPD ( PI). Third, 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 provide information about future income tax cash outflows. However, because it is difficult to separate deferred taxes along these lines with available data, we do not predict a sign for DEFTAX. 10 Fourth, we control for net operating loss carryforwards (NOL) because corporations can offset future taxable income with current and prior-period tax losses. Thus, we expect a negative coefficient for NOL. The advantage of including both DEFTAX and NOL is that they allow us to control for other available tax accruals at time t that are associated with future tax outcomes. All variables are scaled by lagged total assets. Finally, we include year fixed-effects to control for cross-sectional variation 10 Indicative of the obstacles to collecting detailed deferred tax data in a large sample, Laux (2013) uses a random sample of 200 non-utility, non-financial firms from the S&P 500 during Due to the recency of FIN 48, we aim to retain as many observations as possible, precluding us from hand-collecting deferred tax data. 14

16 in cash tax payments across years. 11 The parsimony of the Laux (2013) model is an appealing feature for both specifying our empirical model and identifying its control variables. In particular, the typical control variables one might use to explain future tax payments, such as R&D, stock option compensation, mergers and acquisitions, foreign operations, and even industry, are already summarized at the firm-level using current TXPD, and thus they need not be included. In fact, as we report later (consistent with Laux 2013), current TXPD is by far the strongest indicator of future TXPD. This modeling approach is also consistent with empirical specifications in Sloan (1996), Dechow and Dichev (2002), and Hanlon (2005), who similarly study the mapping of current-period accounts to their respective future-period accounts. We also note that our goal is not to extend the Laux (2013) model per se our different sample constructions and periods make such a comparison tenuous (see footnote 10). Rather, we use the model to identify adequate controls when investigating our key research question of the extent to which UTBs predict future income tax cash outflows. 3.2 Sample Selection and Descriptive Statistics Our sample consists of firms in Compustat during fiscal years We begin with 2007 as it is the first full financial reporting year in which FIN 48 is effective, and end with 2011 as we require a minimum of one future year (up to 2012) to calculate our dependent variable, TXPD t+k. We exclude utilities (SIC 49) and financials (SIC 6) because these firms operate in fundamentally different statutory, regulatory, and tax environments. We drop observations lacking data necessary to calculate variables in Eq. (1). We require a balanced sample over the 11 In a departure from prior literature, we take a conservative approach and control for year fixed-effects to account for the potential impact of tax legislation during this period that would affect cash tax payments (e.g., American Recovery and Reinvestment Act of 2009). The (untabulated) estimations of all models without year fixed-effects are consistently more statistically and economically significant than those reported. However, consistent with prior literature on the mapping of accruals into cash flows, we do not control for industry or firm fixed-effects (Dechow and Dichev 2002; Hribar and Collins 2002; Choudhary et al. 2014). Nevertheless, (untabulated) estimations of all models using Fama-French 48 industry fixed-effects or firm fixed-effects yield qualitatively similar results. 15

17 forecasting horizons of three, four, and five years, respectively. That is, we require that for each year, data are available to calculate the sum of future cash tax payments over three, four, and five years. 12 We use a balanced sample to remove the possibility that changes in sample composition affect our results and that UTB data in Compustat are incorrect/missing in some years (as reported in Lisowsky et al. 2013, Appendix B). Thus, our balanced sample using TXPD t+1 to 3 as the dependent variable contains 5,469 firm-year observations, while the samples using TXPD t+1 to 4 ( TXPD t+1 to 5 ) contain 3,611 (2,060) firm-year observations, respectively. Naturally, the sample sizes decrease as the dependent variable requires additional years of future tax payments. <INSERT TABLE 1 ABOUT HERE> We report univariate statistics in Table 1. The UTB balance (UBEND) accounts for 1.3% of assets. Income tax cash outflows (TXPD t+1 ) account for 2.4% of lagged total assets while the sum of these payments over the five-year horizon ( TXPD t+1 to 5 ) equates to 13.9% of lagged assets. The change in taxes paid ( TXPD) and change in profitability ( PI) represent 0.03% and 1.5%, respectively, of lagged assets. Descriptive statistics for all other variables 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 Eq. (1) in Table 2. We begin with a three-year forecasting horizon in Panel A, consistent with Lisowsky et al. (2013) who note that the threeyear federal statute of limitations is a reasonable horizon for examining UTBs. However, to acknowledge that UTB resolution may require a longer horizon (Gleason and Mills 2011), we 12 All firms in the t+n horizon must have an observation for each year up to and including year t+n. For example, for an observation to be used for the t+3 horizon, it must have information for each of the years t+1, t+2, and t+3. In untabulated tests, we relax this constraint by not requiring data for all n years in the series and obtain similar results. 16

18 also estimate Eq. (1) using four- and five-year horizons in Panels B and C, respectively. Although we include year fixed-effects in our models, we omit these coefficients for brevity. The dependent variable in Panel A is the sum of future income tax cash outflows in years t+1, t+2, and t+3 (TXPD t+1, TXPD t+1 to 2, and TXPD t+1 to 3 ) in columns (1), (2), and (3), respectively. We find a positive and significant coefficient on UBEND in all three columns (p<0.05). In particular, we find that UTBs are positively related to cash tax payments for up to three years into the future and that the UTB provides significant incremental information over the other taxrelated disclosures of current-period cash taxes paid, change in cash taxes paid, change in profitability, deferred tax balances, and net operating losses. We also find evidence that UTBs take longer than the three-year statute of limitations to resolve as the coefficient for UBEND is positive and significant in periods t+4 and t+5 in Panels B and C, respectively (p<0.05). These findings mirror those of Gleason and Mills (2011), who report the average time from filing the tax return to audit completion at 4.6 years. 13 Another way of gauging when the UTB is effectively settled is to use F-tests of whether the coefficients for UBEND, β 1, in Panels A, B, and C are equal to the theoretically expected value of one. For the forecast horizon of three years in Panel A and four years in Panel B, we find no evidence that β 1 is equal to one. When we restrict the sample to firms with sufficient data to estimate Eq. (1) five years into the future (Panel C), we find that β 1 is indistinguishable from one in year t+5 (F=1.56; p=0.21). These results are consistent with UTBs being fully resolved, on average, over the subsequent five years in the future, which is inconsistent with critics claims that UTBs are systematically over- or understated. 13 We recognize that the UTB can contain positions older than one year, so our results suggest that some positions may take even longer than five years to resolve (e.g., if the UTB ending balance already contains five-year-old positions and they take additional time to resolve). This result is consistent with Gleason and Mills (2011), who report a range of one to nine years from filing the tax return to audit completion. 17

19 The coefficients for control variables across all three panels are generally consistent with Laux (2013). For instance, current period cash taxes paid (TXPD) are positively related with future period cash taxes paid (all p<0.01), suggesting that current year cash tax payments have significant and non-transitory predictive power. In addition, coefficients for TXPD are negative (all p<0.05), suggesting mean-reversion in cash taxes paid. The coefficient for PI is positive (all p<0.01), which is consistent with greater changes in profitability leading to greater income tax payments. The coefficients for NOL are negative and generally significant in Panels A and B, which is consistent with net operating loss carryforwards offsetting taxable income and reducing cash tax payments in future periods, although NOL is insignificant in Panel C. Finally, consistent with Laux (2013) that some tax deferrals, but not others, predict future income tax cash outflows, the coefficients for DEFTAX are insignificant. <INSERT TABLE 2 ABOUT HERE> Next, we re-estimate Eq. (1) after modifying the dependent variable to be a single future year of income tax cash outflows, rather than the sum. The results are reported in Table 3, where Panel A (Panels B and C) estimates future income tax cash outflows over a three-year horizon (four- and five-year horizons, respectively). In all tests, we continue to find a positive and significant coefficient for UBEND (p<0.05). We also add individual coefficients for UBEND in each single year of future payments and find that, over the five-year horizon, the sum of the coefficients for UBEND are statistically indistinguishable from one (F = 1.50) (see Panel C). The sum of the coefficients are significantly less than one for the three- and four-year horizons (see Panels A and B, respectively). These results are consistent with our main findings using the sum of the future income cash tax outflows: UBEND converges to one over a five-year horizon. In all remaining tests, we use only the sum of future cash taxes paid as the results are 18

20 equivalent when using the single-year measure of the dependent variable. It is also conceptually appealing to use a sum to examine how a current period balance sheet account maps into total future cash outflows over a particular horizon period, especially given the potential unevenness of settlements over time. <INSERT TABLE 3 ABOUT HERE> 4.2 Economic Significance To gauge the economic significance of the results, we re-estimate Eq. (1) with standardized coefficients that allow for a direct relative comparison between our tax measures (because σ=1 for each variable). By doing so, we mitigate concerns that differences in the underlying distributions of the independent variables affect our inferences. We compare the coefficients on UBEND to two tax-related benchmark variables in our model (TXPD and DEFTAX) that, in expectation, should also directly predict future income tax payments. We report the results in Table 4 for the three-, four-, and five-year balanced samples. The coefficients for UBEND relative to those for contemporaneous income tax cash outflows (TXPD t ) reported in Panel A suggest the UTB is 2.89 (0.023/0.795), 3.34 (0.027/0.798), and 3.82 (0.030/0.785) percent as powerful as TXPD t in explaining future income tax cash outflows in years t+1, t+2, and t+3, respectively. Similarly, Panel B indicates the UTB is 3.64, 3.75, 4.05, and 4.99 percent as powerful as TXPD t in explaining future tax cash outflows in years t+1, t+2, t+3, and t+4, respectively. In Panel C, the UTB is 7.54, 8.05, 7.16, 7.58, and 8.88 percent as powerful as TXPD t in explaining future income tax cash outflows in years t+1, t+2, t+3, t+4 and t+5, respectively. As the summation periods increase, the coefficients for UBEND (numerators) generally increase while those for TXPD t (denominators) generally decrease. This finding suggests the UTB (current taxes paid) is increasingly (decreasingly) economically 19

21 significant in predicting future income tax cash outflows as the forecasting horizon increases. Note that the above economic interpretation compares the ability of a contemporaneous tax accrual (UBEND), relative to current tax cash payments (TXPD t ), to explain future tax cash payments. For a more direct comparison across tax accruals only, we next compare the ability of UBEND relative 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 this variable is insignificant in the main model. Nevertheless, using DEFTAX (as reported in Panel C) as the benchmark (i.e., absolute value of coefficients), we find that UBEND is 3.44, 6.67, 53, 14, and times more informative than DEFTAX in explaining future income tax cash outflows in year t+1 through t+5, respectively. Overall, as contemporaneous tax accruals go, the UTB is clearly more informative than total deferred taxes when predicting future income tax payments. <INSERT TABLE 4 ABOUT HERE> Collectively, the results in Tables 2, 3, and 4 underscore the long-run nature of the resolution of UTBs. The predictive power of UTBs increases relative to other items of tax information as the forecast horizon is extended. The evidence is also consistent with the resolution of these uncertain tax positions within a horizon of about five years, slightly longer than suggested by Lisowsky et al. (2013), but consistent with Gleason and Mills (2011). 4.3 Validation Tests IRS Audit Settlement Data To validate 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 federal tax audit settlement data provided by the IRS. We replicate Eq. (1), but with three modifications. First, because 2012 settlement data are not available as of the 20

22 writing of this manuscript and the time series is brief, we can only estimate our tests from 2007 to 2011 using a three-year window. Second, we successively replace the dependent variables related to the sum of future income tax cash outflows (TXPD t+1, TXPD t+1 to 2, and TXPD t+1 to 3) with future IRS audit cash settlements aggregated over the same periods (i.e., IRS_SETTLE t+1, IRS_SETTLE t+1 to 2, and IRS_SETTLE t+1 to 3 ). Third, because IRS settlements are rather rare (see below) and to increase the power of our tests, we estimate our modified Eq. (1) using only a sub-sample of firms for which we can confirm they actually settled with the IRS. 14 Other than these three adjustments, we follow our prior analysis. 15 Note that one cannot necessarily rely on FIN 48 disclosures of settlements for this validation test because FIN 48-related settlements can include settlement amounts for subsequent increases or decreases for UTBs related to positions taken in prior periods. Such information would not have been available at time t, thus it could not be incorporated in a prediction model. In our tests, IRS settlements are independent of whether the UTB is initially (or under- or over-) reserved. Thus, 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-related settlements on the UTB balance might erroneously induce statistical significance because FIN 48 information would appear on both sides of the equation. 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 might be. However, we also caveat that the 14 This approach attempts to strip out the effects of foreign and state-related UTBs by focusing on federal (i.e., IRS) tax settlements and their link to UBEND. For example, if the UTB is related to future foreign settlements, UBEND would be erroneously insignificant in our validation test because future IRS settlements are zero, i.e., the dependent variable does not capture the correct jurisdiction s tax uncertainty. 15 Note that we retain TXPD t as an independent variable rather than replace it with IRS_SETTLE t. In taking a financial statement user perspective, this model seeks to explain private information (i.e., future tax cash outflows as IRS settlements, IRS_SETTLE t+1 ) by using public information. Such a research design that infers confidential IRS tax data from public data reflects the approach in Lisowsky (2009), Lisowsky (2010), and Lisowsky et al. (2013). 21