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

23 statistical relation may still be weak to the extent that non-federal tax uncertainties are accrued in the UTB and that these uncertainties do not appear in future IRS settlements as current FIN 48 rules do not require a disaggregation of the UTB by jurisdiction. 16 In Panel A of Table 5, we describe the prevalence and amount of IRS settlements in the sub-sample. Reflecting corporate IRS audit rates more generally, about 5 percent of our sample settles its positions with the IRS over the following three years. That is, 216 firms settled with the IRS by the third year ( IRS_SETTLE t+1 to 3 ) relative to the observations available through 2011 that are included in the main TXPD t+1 to 3 tests. 17 In raw terms, the summed mean (median) settlement is $4.1 ($0.65) million in year t+1, and rises to $5.7 ($0.77) million after including year t+2, and $8.1 ($0.75) 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 Eq. (1). <INSERT TABLE 5 ABOUT HERE> Panel B reports results from two validation tests in which we regress the sum of future IRS settlements at time t+1, t+2, and t+3 on UTBs for firms with IRS settlements. Our first test shows that, for firms reporting IRS settlements, the UTB is informative of these settlements two and three years into the future, with increasing coefficients as the time horizon increases. In our second test, we split our small sample based on domestic versus non-domestic tax exposure because IRS settlements are domestic by definition. We classify a firm as domestic if its current foreign tax expense (TXFO) is less than 20 percent of its total current tax expense (TXT TXDI), and non-domestic otherwise. Although the sample size is reduced by about one-third from the full IRS sample, the coefficients for UBEND are significantly larger in the domestic-only sub- 16 As a corollary, we cannot conclude with the available data whether the link between UTBs and future IRS settlements suggests that the UTB is over- or under-stated because of the possibility of non-federal positions being accrued in the UTB (Gupta et al. 2013; Robinson et al. 2014). 17 Again, our main sample period is (n=5,469), but IRS settlement data are not available for

24 sample. In all, despite small sample sizes and focusing only on IRS (federal) settlements, we find evidence largely consistent with our main tests and certainly no evidence to the contrary that UTBs map positively into future income tax cash outflows, on average Out-of-Sample Prediction Tests As a second validation, we conduct out-of-sample prediction tests (untabulated) to verify whether the UTB improves the predictability of future income tax cash outflows. Following prior research in forecasting (e.g., Lev et al. 2010), we estimate year-specific parameters for Eq. (1) with and without UBEND. Then, using data from prior periods, we compute firm-specific prediction errors (TTTTTTTT tt+nn TTTTTTTT tt+nn, where TTTTTTTT tt+nn is the sum of each model parameter multiplied by the relevant independent variable). Finally, we compare the absolute value of these prediction errors across the two models (with and without UBEND). 18 If the UTB improves the predictability of future income tax cash outflows, we expect absolute forecast errors to be significantly smaller when the prediction model (Eq. (1)) includes UBEND. The sample size for these tests is smaller than in previous tests. First, following Lev et al. (2010), we truncate observations at the 1 st and 99 th percentiles to mitigate the adverse effects that influential outliers have on predictions (leaving n=8,693). Second, because we require lagged values of UBEND to generate forecasts, our tests begin in 2008 for the t+1 forecasting horizon (leaving n=7,940). Third, consistent with Lev et al. (2010), we truncate the top 1% and 99% of errors to minimize the influence of outliers (leaving n=7,782). Both mean and median tests indicate that Eq. (1) generates significantly smaller absolute errors when UBEND is included for 18 For example, to determine if UBEND in 2009 improves the predictability of TXPD t+1 in 2010, we obtain forecasting parameters by estimating Eq. (1) with data from 2008 (i.e., examine how the independent variables from 2008 map into income tax cash flows in 2009). We then apply these forecasting parameters for 2008 to actual values in 2009 in order to obtain a forecast for TXPD t+1 in The difference between actual and forecasted TXPD t+1 in 2010 is the forecast error. We take the absolute value of the error and compare it across models estimated with and without UBEND. Due to the short time-series, we can only conduct these tests for TXPD t+1 and TXPD t+1 to 2. 23

25 the forecasting horizon t+1 (p<0.05), suggesting the UTB improves the predictability of future income tax cash outflows. However, when performing the same analysis for a t+2 forecasting horizon, we find insignificant differences in the forecast errors (p=0.29), perhaps due in part to a smaller sample size (n=4,637). 5. Cross-Sectional Tests 5.1 Auditor-Provided Tax Services Having established that UTBs unwind fully into future income tax cash outflows over five years, on average, our remaining tests focus on the relative predictive power of UTBs across subsets of firms (i.e., cross-sectional variation) and over time (i.e., inter-temporal variation). Based on the evidence above and for brevity, we only use the TXPD t+1 to 5 sample. We first consider if the purchase of auditor-provided tax services (APTS) improves or weakens the ability of UTBs to predict future income tax cash outflows. A large literature examines whether nonaudit services influence audit and financial reporting quality, typically measured as accruals quality (Ashbaugh et al. 2003; Causholli et al. 2014; Frankel et al. 2002). An ongoing debate focuses on competing predictions and evidence as to whether these services yield net costs (e.g., lower audit quality due to independence impairment) or benefits (e.g., higher audit quality and/or efficiency due to knowledge spillovers and/or reputation concerns) (see Simunic 1984; Palmrose 1986; O Keefe et al. 1994; Whisenant et al. 2003). Recent research on the provision of tax services finds evidence of net benefits (e.g., Omer et al. 2006; Seetharaman et al. 2011; Donohoe and Knechel 2014). When considering tax reserves, the net benefits of APTS could be large as (1) knowledge spillover can improve accrual estimation, and (2) reputation concerns may lead auditors to constrain earnings management. Consistent with these explanations, Gleason and Mills (2011) find firms purchasing APTS accrue tax reserves that are more closely aligned with 24

26 actual IRS tax settlements than those that do not purchase APTS. While their evidence is from the pre-fin 48 period, we test whether their inferences apply to the post-fin 48 period because tax accruals in general are more informative when firms purchase APTS than when they do not. We estimate Eq. (1) across sub-samples of firms purchasing APTS. 19 We obtain audit and tax fee data from Audit Analytics, which we merge with Compustat. This merge yields a sample of 1,889 firm-year observations for our balanced sample using TXPD t+1 to 5. Table 6 reports the results. Panel A partitions the sample based on APTS1, equal to one for the top three annual quartiles of positive tax fees, while Panel B partitions on APTS2, an indicator equaling one for the top three annual quartiles of the ratio of tax fees to total fees paid to the auditor. 20 Within each panel, the first five columns report results for firms that purchase a material amount (APTS1=1) or portion (APTS2=1) of APTS, and the remaining five columns report results for firms that purchase very little or no APTS (APTS1=0, APTS2=0). Panel C reports Chow (1960) tests of UBEND coefficients across models, computed using Seemingly Unrelated Regressions. <INSERT TABLE 6 ABOUT HERE> Across the APTS partitions in Panels A and B, we find a consistent pattern of results. Coefficients for UBEND are positive and significant in all five columns among firms purchasing a material amount or portion of APTS (columns (1) through (5)), and insignificant among firms that do not (columns (6) through (10)). These findings suggest the knowledge spillovers and/or reputational concerns of APTS enhance the ability of UTBs to predict future income tax cash outflows relative to firms that do not purchase tax services from their auditor. That is, when 19 We use a sub-sample analysis rather than an interaction model because of the potentially endogenous nature of selecting the auditor to provide tax services (see Omer et al. 2006; McGuire et al. 2012). 20 We classify firms purchasing an immaterial amount of tax services as not purchasing material APTS. In particular, we split the distribution of positive tax fees along quartiles and select the top three as material. The immaterial observations represent the bottom quartile of positive tax fees and firms with zero tax fees. We use this method because almost 26 percent of our sample reports zero tax fees. 25

27 auditors are more familiar with firms tax positions, the tax accounts more strongly reflect future income tax cash outflows. Among firms that purchase a (relatively) material amount of auditor provided tax services, we find $1 of UTB is associated with 91.4 cents (95.1 cents) of future income tax cash outflows over the subsequent five year horizon, which is statistically indistinguishable from $1 (p<0.84 and p<0.91, respectively). Thus, we find among firms that purchase tax services from their auditors, UTBs are not systematically over- or under-stated. Because the results in Panels A and B use different sub-samples, comparing coefficients and p-values across each partition could result in misleading inferences. As a result, we use the Chow (1960) test, which controls for potential correlation across error terms, to formally examine if the coefficients for UBEND are higher for APTS1=1 (APTS2=1) firms versus APTS1=0 (APTS2=0) firms. Panel C reports significant differences (p-values) across the two APTS partitions for each of the five dependent variables, TXPD t+1 through TXPD t+1 to 5. For both five-year forecasting horizons, we find significant differences across the five years (all p<0.10). 21 Overall, our findings suggest APTS significantly improves the ability of UTBs to predict future income tax cash outflows, and knowledge spillovers create more useful accruals. The latter is consistent with prior research examining the relation between APTS and financial reporting quality (Kinney et al. 2004; Gleason and Mills 2011). 5.2 Corporate Tax Avoidance We next consider if the predictive ability of UTBs for future income tax cash outflows is different for firms engaging in high versus low tax avoidance. Critics of FIN 48 claim that publicly reporting UTBs allows tax authorities to identify a firm s most controversial tax positions (Frischmann et al. 2008). Similarly, Mills et al. (2010) analytically demonstrate that the 21 Because we test a directional prediction as to whether the coefficients on UBEND are higher in APTS=1 firms than APTS=0 firms, we use one-tailed p-values for the Chow (1960) tests. Also see footnote

28 effects of mandatory UTB disclosure on claiming uncertain tax positions depend on firms unique underlying facts. Their model suggests that taxpayers with relatively weak facts are potentially worse off because the mandatory FIN 48 disclosure regime deters 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, TEI (2011) asserts in its comments regarding FASB s PIR of FIN 48 that firms with higher costs of disclosure will be less likely to follow FIN 48. FAF (2012) echoes these concerns in its discussion of how some firms withhold sensitive tax information when it is likely detrimental to tax settlements. Supporting these conjectures, Gross (2011) and Robinson and Schmidt (2013) find evidence of lower quality FIN 48 disclosures among firms engaging in more tax avoidance, which in turn supports the arguments of Desai and Dharmapala (2006), Desai et al. (2007), and Balakrishnan et al. (2012) that tax avoidance is linked to opaque reporting and a less transparent information environment. Therefore, prior research 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 (relative to firms not engaging in as high a level of tax avoidance). To evaluate this argument, we estimate Eq. (1) across subsamples of high tax avoidance using two common proxies. 22 First, we designate firms in the bottom quartile of five-year cash ETRs (by year) as engaging in high tax avoidance (TA_CASH=1). 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 1 to t 5), following Dyreng et al. (2008). Second, we designate 22 As in the auditor-provided tax services tests, we utilize a sub-sample analysis as opposed to an interaction model because of the potentially endogenous nature of firms choice and ability to avoid taxes (see Dyreng et al. 2010). 27

29 firms in the bottom quartile of GAAP effective tax rate (by year), GAAPETR, as also engaging in high tax avoidance (TA_GAAP=1). The intuition behind the split along tax avoidance measures mirrors Beck and Lisowsky (2014), where an increasing UTB is more (less) likely to indicate tax aggressiveness in a sub-sample of high (low) tax avoidance firms. Consistent with greater tax avoidance reducing the ability of UTBs to predict future income tax cash outflows, we expect UBEND to be more predictive of future tax cash outflows for firms that do not engage in high levels of tax avoidance (i.e., TA_CASH=0 and TA_GAAP=0). Data requirements yield a sample of 1,479 firm-year observations for our balanced sample using TXPD t+1 to 5. Panels A and B of Table 7 partition the sample by high (TA=1) and low (TA=0) tax avoidance. Within each panel, the first five columns report results for firms that engage in high levels of tax avoidance, and the remaining five columns report results for firms that do not. The dependent variable in each column for each partition reflects the aggregate sum of cash taxes paid, TXPD t+1 through TXPD t+1 to 5. <INSERT TABLE 7 ABOUT HERE> The coefficients for UBEND are insignificant for firms engaging in high levels of tax avoidance (TA_CASH=1; TA_GAAP=1) in Panel A (B). However, for firms not engaging in high tax avoidance (TA_CASH=0; TA_GAAP=0), the coefficients for UBEND are positive and significant in each period (columns (6) through (10)). Among firms that do not engage in a high level of tax avoidance, we find that $1 of UTB unwinds as (122.3) cents of income tax cash outflow over the subsequent five years (see column (10) in Panels A and B, respectively), which are statistically indistinguishable from $1 (p=0.61 and p=0.55, respectively). These results indicate that UTBs for lower tax avoidance firms are positively related to future income tax cash outflows and do not appear to be systematically over-reserved for these firms. Panel C reports p- 28

30 values from Chow (1960) tests, which confirm that coefficients for UBEND are significantly larger in the low tax avoidance partition than in the high tax avoidance partition in periods t+3 through t+5 (p<0.10). 23 Taken together, the results in Table 7 are consistent with UTBs being uninformative about future income tax cash outflows for firms with high levels of tax avoidance compared to firms that are not classified as high tax avoiders. This evidence supports research suggesting that firms with more sensitive tax information can exploit the discretion inherent within FIN 48 to weaken the relation between disclosures of UTBs and future income tax cash outflows (Robinson and Schmidt 2013). The results also support FIN 48 critics by raising concerns about whether the Interpretation is indeed achieving its stated goal of providing useful information to predict future income tax cash outflows, especially among tax avoiding firms that should arguably be most affected by its mandatory disclosure regime. 5.3 Tax Enforcement Recall that FIN 48 does not permit managers to incorporate detection risk in the estimate of UTBs. Therefore, the predictive ability of UTBs for future income tax cash outflows is likely influenced by whether tax authorities use the disclosed FIN 48 information to infer corporate tax avoidance (Mills et al. 2010). For example, Bozanic et al. (2014) find evidence that IRS attention over tax avoidance transactions has surged due to the increased disclosures required under FIN 48. Thus, we next examine whether UTBs are more positively related to future income tax cash 23 Because we test a directional prediction as to whether the coefficients on UBEND are higher when TA=0 than TA=1, we use one-tailed p-values for the Chow (1960) tests. Nevertheless, it is possible that we find insignificant coefficients on UBEND when TA=1 in Table 7 (or when APTS=0 in Table 6) because our tests do not possess sufficient statistical power to detect an effect in the lowest/highest quartile of observations. To mitigate this possibility, we conduct a post hoc power analysis, which computes achieved statistical power (1 β) as a function of significance level (α), sample size (n), and effect size (Faul et al. 2007). Following Cohen (1988), we define effect size as the incremental adjusted-r 2 that is obtained when UBEND is included in the regression model (relative to a model including only control variables). Using a significance level of 0.10, sample sizes for tests of TXPD t+1 to 5 in Tables 6 and 7, and incremental adjusted-r 2 (untabulated), we find statistical power at conventional levels. Thus, lack of statistical power is not an alternative explanation. 29

31 outflows as the probability of tax enforcement increases (i.e., the assumption of certain detection risk becomes more realistic). 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 should be stronger than when tax enforcement is more lax and the positions underlying the FIN 48 reserve go unchallenged. To proxy for tax enforcement, we use the probability of corporate IRS audits (AUD) from the TRAC database (Hoopes et al. 2012). These probabilities represent the number of corporate tax returns audited by the IRS compared to all corporate tax returns filed for a given size-industry-year cohort. 24 <INSERT TABLE 8 ABOUT HERE> Table 8 reports the results of estimating Eq. (1) after including AUD and its interaction with UBEND in columns (1) through (5). 25 Because AUD and UBEND are continuous measures, we center them at their means to ease interaction interpretations (Cronbach 1987; Jaccard et al. 1990). The coefficients for UBEND and UBEND AUD are positive and significant in all columns (p<0.01), suggesting that the information contained within UTBs with respect to future income tax cash outflows strengthens as the likelihood of scrutiny by a tax authority increases. We estimate that 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 over the subsequent five years. Overall, UTBs are more predictive of future income tax cash outflows as the likelihood of tax enforcement increases. This result provides some support for critics that contend FIN 48 induces measurement error by not allowing managers to consider tax enforcement risk. 6. Inter-temporal Tests 24 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 IRS audit cases, although prior research uses the data to capture managers ex ante expectations of IRS audit (Hoopes et al. 2012) because the enforcement statistics are publicly available. Also see Guedhami and Pittman (2008) and Hanlon et al. (2014), who use TRAC data. 25 We use an interaction model as opposed to a sub-sample split because IRS audit enforcement is likely exogenous. 30

32 In this section, we report two tests that evaluate whether the informativeness of tax reserves for estimating future income tax cash outflows calculated under FIN 48 improves relative to previous guidance on tax contingencies under SFAS 5. First, we estimate the change in tax reserve for the pre-fin 48 period, known as the tax cushion ( CUSH), using the method of Blouin and Tuna (2007) and Gleason and Mills (2011). 26 Note that we are unable to estimate the level of the reserve as proxies only exist for the change in tax reserve. Accordingly, we reestimate Eq. (1) separately after (1) replacing UBEND with CUSH on a sub-sample of firms during 2005 and 2006 (i.e., the last two years pre-fin 48); and (2) replacing UBEND with UBEND for a sub-sample of firms during 2007 and 2008 (i.e., the first two years of FIN 48). For consistency, we include the 594 firms that appear in both the pre- and post-fin 48 subsamples and for which we have balanced panel data on UTBs that were the basis of our main (post-fin 48) tests. However, due to sample attrition caused by limited data required to calculate CUSH (i.e., we can only use firms with Execucomp data), we cannot reliably use more than two years in each of the pre- and post- periods. Table 9 reports our results. We find that both CUSH (Panel A) and UBEND (Panel B) predict future income tax cash outflows, suggesting the tax reserve is informative in both the pre- and post-fin 48 periods. Panel C reports a test of differences in coefficients between CUSH and UBEND for each horizon using a Chow (1960) test. The results show no difference in the informativeness between CUSH and UBEND, suggesting no improvement in informativeness due to FIN 48 compared to previous guidance on tax contingencies under SFAS The change in cushion is calculated as current tax expense (TXC, or TXT TXDI, if missing) less the tax benefit of options (0.35 number of options exercised [OPTEXD] compensatory element of each option) less current taxes paid (TXPD). The compensatory element of each option equals the difference between the average price [(PRCH_F + PRCL_F)/2] and the weighted average price of exercisable options (OPTPRCWA). If the compensatory element is less than zero, we calculate it as the difference between the highest price of the year (PRCF_F) and the weighted average price of exercisable options. If the option tax benefit is negative, we reset to zero. We obtain option data from Execucomp. 31

33 <INSERT TABLE 9 ABOUT HERE> Second, we use firms cumulative equity adjustments (CEA) that were disclosed during the first reporting year of FIN 48 to account for the change in accounting method between FIN 48 and SFAS To the extent informativeness increased post-fin 48, we should find a positive link between CEA and future income tax cash outflows as the information communicated by managers about tax uncertainty becomes more precise. To test for this possibility, we re-estimate Eq. (1) after replacing UBEND with CEA on a sub-sample of firms used in our main tests for 2007, the first year of FIN 48. In Table 10, we find an insignificant coefficient for CEA in all future periods, suggesting the reporting differences between SFAS 5 and FIN 48 do not translate into more accurate information being included in FIN 48 about future income tax cash outflows. This result corroborates our previous test finding no improvement in the informativeness of tax reserves for future tax payments under FIN 48 compared to SFAS 5. <INSERT TABLE 10 ABOUT HERE> Overall, our inter-temporal results corroborate the findings in Robinson et al. (2014), who report no difference in informativeness of total tax expense for future income tax payments after FIN 48. Although our evidence concludes that FIN 48 did not improve the informativeness of the UTB portion of tax expense, our interpretation is that FIN 48 did not lead to systematic under- or over-statement of estimated tax uncertainty. One potential explanation is that managers continue to have reporting discretion under FIN 48 and seemingly use it to continue providing useful estimates, at least on average, as they relate to estimating future income tax cash outflows. 7. Conclusion Beginning in 2007, FIN 48 mandates the disclosure and measurement of tax reserves, or UTBs, in firms financial statements. Proponents of FIN 48 argue it provides financial statement 27 We obtain CEA values from Audit Analytics. We scale CEA by lagged assets (at) from Compustat. 32

34 users with more information about the realizability of future tax benefits as well as enhances relevance and comparability in the financial reporting of income taxes (FASB 2006). Critics, however, contend that UTB recognition does not help financial statement users forecast future income tax cash outflows, and object to both the more-likely-than-not threshold for determining the amount of tax benefits recognized in earnings and subjectivity required to apply FIN 48 (FASB 2006, 20-23; TEI 2011). Our study informs this ongoing debate by investigating the extent to which UTBs reported under FIN 48 do, in fact, provide predictive information to financial statement users about future income tax cash outflows. We find that, on average, UTBs have a dollar-for-dollar relation with the sum of future income tax cash outflows over a five-year horizon. This link is economically significant as UTBs explain 8.9 percent as much of the variation in future income tax cash outflows as do contemporaneous income tax cash outflows. We validate these results using confidential IRS tax audit settlement data and out-of-sample prediction tests. Overall, our findings support arguments raised by FIN 48 proponents that UTBs are informative of the future realizability of income tax cash outflows, at least on average. However, we also identify settings that support critics arguments that FIN 48 introduces significant managerial discretion and noise into the accrual of UTBs. In cross-sectional tests, we find that UTBs are more predictive 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. We also find no evidence of a change in informativeness of tax reserves after FIN 48 compared to previous guidance under SFAS 5. In all, our findings should interest financial statement users, standard setters, and tax authorities as these parties evaluate the financial reporting and economic consequences of uncertain tax positions. 33

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39 APPENDIX A UTB Measurement and Recognition Examples Assume a $1,000 tax benefit is claimed on the current year tax return. The following five scenarios summarize the financial reporting for uncertainty in these tax benefits under the recognition and measurement steps of FIN 48: Scenario 1: UTB Understatement with Strong Facts Possible Tax Benefit Retained Individual Probability Cumulative Probability $1,000 55% 55% % 75% 0 25% 100% FIN 48 tax benefit retained = $1,000 Accrued UTB liability = $1,000 $1,000 = $0 Mean expected tax benefit = ($1, ) + ($ ) + ($0 0.25) = $688 Mean expected tax liability = $1,000 $688 = $312 Overstatement (Understatement) = $0 $312 = ($312) Scenario 2: UTB Overstatement with Weak Facts Possible Tax Benefit Retained Individual Probability Cumulative Probability $1,000 20% 20% % 40% 0 60% 100% FIN 48 tax benefit retained = $0 Accrued UTB liability = $1,000 $0 = $1,000 Mean expected tax benefit = ($1, ) + ($ ) + ($0 0.60) = $338 Mean expected tax liability = $1,000 $338 = $662 Overstatement (Understatement) = $1,000 $662 = $338 Scenario 3: UTB Understatement with Intermediate Facts Possible Tax Benefit Retained Individual Probability Cumulative Probability $1,000 40% 40% % 60% 0 40% 100% FIN 48 tax benefit retained = $690 Accrued UTB liability = $1,000 $690 = $310 Mean expected tax benefit = ($1, ) + ($ ) + ($0 0.40) = $538 Mean expected tax liability = $1,000 $538 = $462 Overstatement (Understatement) = $310 $462 = ($152) 38

40 Scenario 4: UTB Overstatement with Intermediate Facts Possible Tax Benefit Retained Individual Probability Cumulative Probability $1,000 40% 40% % 95% 0 5% 100% FIN 48 tax benefit retained = $690 Accrued UTB liability = $1,000 $690 = $310 Mean expected tax benefit = ($1, ) + ($ ) + ($0 0.05) = $780 Mean expected tax liability = $1,000 $780 = $220 Overstatement (Understatement) = $310 $220 = $90 Scenario 5: UTB Alignment with Intermediate Facts Possible Tax Benefit Retained Individual Probability Cumulative Probability $1,000 40% 40% % 82% 0 18% 100% FIN 48 tax benefit retained = $690 Accrued UTB liability = $1,000 $690 = $310 Mean expected tax benefit = ($1, ) + ($ ) + ($0 0.18) = $690 Mean expected tax liability = $1,000 $690 = $310 Overstatement (Understatement) = $310 $310 = $0 39

41 APPENDIX B Variable Definitions Dependent Variables TXPD t+k Sum of cash taxes paid (txpd) at year t+k, where 1 k 5, scaled by lagged total assets (at). IRS_SETTLE t+k Sum of IRS audit settlements at year t+k, where 1 k 3, scaled by lagged total assets (at). Tax audit settlement data is made available by the IRS. Independent Variables UBEND Ending balance of unrecognized tax benefits (txtubend) at year t, scaled by lagged assets (at). TXPD ΔTXPD ΔPI DEFTAX NOL Cash taxes paid (txpd) in year t, scaled by lagged total assets (at). Change in cash taxes paid (txpd) between year t and t 1, scaled by lagged total assets (at). Change in pre-tax income (pi) between year t and t 1, scaled by lagged total assets (at). Net deferred taxes (txndb) less UTBs related to temporary book-tax differences (txtubend txtubtxtr) at year t, scaled by lagged total assets (at). Tax loss carryforwards (tlcf) at year t, scaled by lagged total assets. Partitioning Variables TAX_FEES Fees paid to the auditor for tax services [tax_fees] (unscaled). APTS1 APTS2 CASHETR TA_CASH GAAP TA_GAAP AUD Other Variables ΔCUSH ΔUBEND Indicator variable equal to 1 if natural logarithm of tax fees [TAX_FEES] is in highest three annual quartiles; 0 otherwise. Indicator variable equal to 1 if the ratio of tax fees [TAX_FEES] to total fees [TOTAL_FEES] is in highest three annual quartiles; 0 otherwise. Five-year cash effective tax rate, computed as the sum of cash taxes paid (txpd) from year t 5 through year t 1 divided by the sum of pre-tax income (pi) less special items (spi) for year t 5 through year t 1. Observations with negative denominators are dropped. ETRs are reset to 1 (0) if greater (less) than 1 (0). Indicator variable equal to 1 if firm in the bottom quartile of five-year cash ETR (CASHETR) (by year); 0 otherwise. Five-year GAAP effective tax rate, computed as the sum of total tax expense (txt) from year t 5 through year t 1 divided by the sum of pre-tax income (pi) less special items (spi) for year t 5 through year t 1. Observations with negative denominators are dropped. ETRs are reset to 1 (0) if greater (less) than 1 (0). Indicator variable equal to 1 if firm in the bottom quartile of five-year GAAP ETR (GAAP) (by year); 0 otherwise. Continuous measure of audit intensity (%) in year t provided by Transaction Records Access Clearinghouse (TRAC) database maintained by Syracuse University. Change in tax cushion (see Gleason and Mills 2011), scaled by lagged total assets (at). Ending balance of unrecognized tax benefits (txtubend) less beginning balance of unrecognized tax benefits (txtubbegin), scaled by lagged total assets (at). CEA Cumulative equity adjustment [cumulative_change_in_stockholder] in millions multiplied by 1, scaled by lagged total assets (at). Note: Compustat (Audit Analytics) data items are indicated in parentheses (brackets). 40

42 TABLE 1 Univariate Statistics Mean Std. Dev. Q1 Median Q3 N Dependent variables TXPD t ,469 TXPD t+1 to ,469 TXPD t+1 to ,469 TXPD t+1 to ,611 TXPD t+1 to ,060 Independent variables UBEND ,469 TXPD ,469 ΔTXPD ,469 ΔPI ,469 DEFTAX ,469 NOL ,469 Partitioning variables TAX_FEES ($) 363, , , ,300 1,889 APTS ,889 APTS ,889 CASHETR ,479 TA_CASH ,479 GAAP ,479 TA_GAAP ,479 AUD ,469 Other variables ΔUBEND ,188 ΔCUSH ,188 CEA Continuous variables are winsorized at the 1 st and 99 th percentiles except for CASHETR, which is winsorized at 0 and 1. Unless otherwise indicated, variables are measured in year t. Variables are defined in Appendix B. 41

43 TABLE 2 Regression of Future Income Tax Cash Outflows on UTBs Panel A: Three-year horizon (1) (2) (3) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β ** 0.098** 0.167** (2.09) (2.23) (2.36) TXPD 0.827*** 1.607*** 2.417*** (46.71) (39.51) (34.98) ΔTXPD 0.156*** 0.364*** 0.603*** ( 6.60) ( 8.16) ( 8.41) ΔPI 0.021*** 0.035*** 0.049*** (6.186) (5.54) (5.51) DEFTAX ( 1.29) ( 0.64) ( 0.03) NOL 0.001*** 0.003*** 0.005*** ( 2.82) ( 3.68) ( 4.33) Constant 0.003*** (4.28) (0.58) (0.88) Year FE Included Included Included Adj. R Obs. 5,469 5,469 5,469 F-test: β 1 =1 2,078.69*** *** *** Panel B: Four-year horizon (1) (2) (3) (4) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β ** 0.114** 0.182** 0.304** (2.18) (2.02) (2.05) (2.25) TXPD 0.840*** 1.617*** 2.420*** 3.307*** (39.88) (34.30) (31.36) (29.16) ΔTXPD 0.177*** 0.413*** 0.657*** 0.920*** ( 6.25) ( 7.52) ( 7.39) ( 7.35) ΔPI 0.021*** 0.037*** 0.056*** 0.073*** (5.31) (4.79) (4.88) (4.85) DEFTAX (0.48) ( 0.17) ( 0.24) ( 0.05) NOL ** 0.004*** 0.005** ( 1.59) ( 2.24) ( 2.79) ( 1.97) Constant 0.002*** (2.83) ( 0.03) (0.61) (0.74) Year FE Included Included Included Included Adj. R Obs. 3,611 3,611 3,611 3,611 F-test: β 1 =1 1,351.00*** *** 84.85*** 26.62*** 42

44 Panel C: Five-year horizon (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β *** 0.232*** 0.311** 0.450** 0.667** (2.71) (2.68) (2.35) (2.32) (2.50) TXPD 0.746*** 1.458*** 2.201*** 3.032*** 3.828*** (27.14) (24.54) (23.45) (22.15) (21.48) ΔTXPD 0.079** 0.223*** 0.368*** 0.558*** 0.743*** ( 2.09) ( 2.94) ( 3.16) ( 3.45) ( 3.55) ΔPI 0.033*** 0.059*** 0.091*** 0.124*** 0.162*** (4.85) (4.70) (4.89) (4.83) (5.03) DEFTAX (1.06) (0.50) ( 0.04) ( 0.20) (0.18) NOL ( 0.21) ( 0.38) ( 0.50) (0.15) (0.30) Constant 0.004*** ** 0.001** 0.016*** (4.27) (1.43) (2.09) (2.14) (2.77) Year FE Included Included Included Included Included Adj. R Obs. 2,060 2,060 2,060 2,060 2,060 F-test: β 1 = *** 78.45*** 27.11*** 8.01*** 1.56 This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. 43

45 TABLE 3 Regression of Single-Year Future Income Tax Cash Outflows on UTBs Panel A: Three-year horizon (1) (2) (3) TXPD t+1 TXPD t+2 TXPD t+3 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β ** 0.056** 0.079** (2.09) (2.13) (2.36) TXPD 0.827*** 0.773*** 0.810*** (46.71) (30.85) (23.95) ΔTXPD 0.156*** 0.205*** 0.239*** ( 6.60) ( 7.57) ( 7.16) ΔPI 0.021*** 0.013*** 0.013*** (6.186) (3.97) (3.83) DEFTAX ( 1.29) ( 0.57) (0.64) NOL 0.001*** 0.002*** 0.002*** ( 2.82) ( 4.05) ( 4.34) Constant 0.003*** 0.002** (4.28) ( 2.20) (1.33) Year FE Included Included Included Adj. R Obs. 5,469 5,469 5,469 F-test: β 1 =1 2,082.50*** *** *** Panel B: Four-year horizon (1) (2) (3) (4) TXPD t+1 TXPD t+2 TXPD t+3 TXPD t+4 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β ** 0.060** 0.088** 0.102** (2.18) (1.78) (2.11) (2.11) TXPD 0.840*** 0.768*** 0.813*** 0.836*** (39.88) (26.34) (21.24) (19.55) ΔTXPD 0.177*** 0.228*** 0.246*** 0.248*** ( 6.25) ( 6.666) ( 5.84) ( 6.08) ΔPI 0.021*** 0.015*** 0.017*** 0.017*** (5.31) (3.82) (3.87) (3.77) DEFTAX (0.48) ( 1.19) ( 0.21) (0.17) NOL *** 0.002*** ( 1.59) ( 2.79) ( 2.72) ( 1.35) Constant 0.002*** 0.002* ** (2.83) ( 1.92) (1.10) (2.04) Year FE Included Included Included Included Adj. R Obs. 3,611 3,611 3,611 3,611 F-test: β 1 =1 1,354.49*** *** 72.47*** 26.59*** 44

46 Panel C: Five-year horizon (1) (2) (3) (4) (5) TXPD t+1 TXPD t+2 TXPD t+3 TXPD t+4 TXPD t+5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β *** 0.118** 0.111** 0.154** 0.181** (2.71) (2.24) (1.83) (2.25) (2.18) TXPD 0.746*** 0.705*** 0.753*** 0.784*** 0.802*** (27.14) (18.94) (16.21) (15.76) (14.46) ΔTXPD 0.079** 0.138*** 0.141*** 0.192*** 0.196*** ( 2.09) ( 3.07) ( 2.69) ( 3.87) ( 3.34) ΔPI 0.033*** 0.024*** 0.031*** 0.033*** 0.045*** (4.85) (3.46) (4.05) (4.02) (4.69) DEFTAX (1.06) ( 0.54) ( 0.66) ( 0.41) (0.67) NOL ( 0.21) ( 0.62) ( 0.47) (0.34) (0.35) Constant 0.004*** ** 0.004*** 0.008*** (4.27) ( 0.70) (2.13) (2.64) (4.55) Year FE Included Included Included Included Included Adj. R Obs. 2,060 2,060 2,060 2,060 2,060 F-test: β 1 = *** 75.45*** 21.45*** 6.35** 1.50 This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD t+k is future income tax cash outflows for year t+k (i.e., not summed across years) where k varies from one to five, scaled by lagged total assets. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. 45

47 TABLE 4 Standardized Regression of Future Income Tax Cash Outflows on UTBs Panel A: Three-year horizon (1) (2) (3) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND 0.023** 0.027** 0.030** (2.09) (2.23) (2.36) TXPD 0.795*** 0.798*** 0.785*** (46.71) (39.51) (34.98) ΔTXPD 0.109*** 0.132*** 0.142*** ( 6.60) ( 8.16) ( 8.41) ΔPI 0.090*** 0.079*** 0.074*** (6.186) (5.54) (5.51) DEFTAX ( 1.29) ( 0.64) ( 0.03) NOL 0.020*** 0.026*** 0.032*** ( 2.82) ( 3.68) ( 4.33) Year FE Included Included Included Adj. R Obs. 5,469 5,469 5,469 Panel B: Four-year horizon (1) (2) (3) (4) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND 0.029** 0.030** 0.032** 0.039** (2.18) (2.02) (2.05) (2.25) TXPD 0.797*** 0.799*** 0.790*** 0.782*** (39.88) (34.30) (31.36) (29.16) ΔTXPD 0.125*** 0.151*** 0.159*** 0.162*** ( 6.25) ( 7.52) ( 7.39) ( 7.35) ΔPI 0.094*** 0.086*** 0.085*** 0.081*** (5.31) (4.79) (4.88) (4.85) DEFTAX (0.48) ( 0.17) ( 0.24) ( 0.05) NOL ** 0.023*** 0.021** ( 1.59) ( 2.24) ( 2.79) ( 1.97) Year FE Included Included Included Included Adj. R Obs. 3,611 3,611 3,611 3,611 46

48 Panel C: Five-year horizon (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND 0.055*** 0.060*** 0.053** 0.056** 0.064** (2.71) (2.68) (2.35) (2.32) (2.50) TXPD 0.729*** 0.745*** 0.740*** 0.739*** 0.721*** (27.14) (24.54) (23.45) (22.15) (21.48) ΔTXPD 0.056** 0.082*** 0.089*** 0.098*** 0.101*** ( 2.09) ( 2.94) ( 3.16) ( 3.45) ( 3.55) ΔPI 0.131*** 0.123*** 0.125*** 0.123*** 0.124*** (4.85) (4.70) (4.89) (4.83) (5.03) DEFTAX (1.06) (0.50) ( 0.04) ( 0.20) (0.18) NOL ( 0.21) ( 0.38) ( 0.50) (0.15) (0.30) Year FE Included Included Included Included Included Adj. R Obs. 2,060 2,060 2,060 2,060 2,060 This table reports standardized ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. 47

49 TABLE 5 IRS Settlement Validation Tests Panel A: Univariate statistics for IRS settlements ( IRS_SETTLE>0) Mean Std. Dev. Q1 Median Q3 N Raw ($M) IRS_SETTLE t IRS_SETTLE t+1 to IRS_SETTLE t+1 to Scaled IRS_SETTLE t IRS_SETTLE t+1 to IRS_SETTLE t+1 to Panel B: Regression of IRS settlements ( IRS_SETTLE>0) on UTBs Balanced Sample Balanced Sample of Domestic-only Firms (1) (2) (3) (4) (5) (6) IRS_SETTLE t+1 IRS_SETTLE t+1 to 2 IRS_SETTLE t+1 to 3 IRS_SETTLE t+1 IRS_SETTLE t+1 to 2 IRS_SETTLE t+1 to 3 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND * 0.016* 0.021* 0.037* 0.040* (1.14) (1.30) (1.36) (1.48) (1.49) (1.51) TXPD (0.77) (0.13) (0.17) (0.73) (0.32) (0.38) ΔTXPD (0.44) ( 0.07) ( 0.08) (0.11) ( 0.54) ( 0.53) ΔPI * 0.003* 0.003** 0.006*** 0.007*** (0.87) (1.43) (1.44) (1.76) (2.42) (2.53) DEFTAX ( 0.07) ( 0.17) (0.10) (0.88) (0.25) (0.41) NOL 0.001** 0.002** 0.002** 0.001* 0.002* 0.002** ( 1.75) ( 1.92) ( 2.06) ( 1.41) ( 1.59) ( 1.71) Constant 0.001*** 0.002*** 0.002*** 0.001*** 0.001*** 0.001*** (4.38) (4.51) (4.46) (3.33) (3.18) (3.20) Year FE Included Included Included Included Included Included Adj. R Obs Note: *, **, *** denotes statistical significance levels of 0.10, 0.05, and 0.01, respectively (one-tailed). Reported t-statistics are based on robust standard errors clustered by firm (Petersen 2009). Variables are defined in Appendix B. 48

50 TABLE 6 Regression of Future Income Tax Cash Outflows on UTBs by Auditor-Provided Tax Services Panel A: Largest three annual quartiles of positive tax fees (APTS1) APTS1 = 1 APTS1 = 0 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) UBEND β ** 0.395*** 0.557** 0.782** 0.914** (2.46) (2.67) (2.45) (2.35) (2.13) (0.56) (0.35) ( 0.01) (0.05) (0.80) TXPD 0.748*** 1.480*** 2.193*** 3.012*** 3.789*** 0.741*** 1.465*** 2.237*** 3.068*** 3.879*** (22.04) (19.93) (16.57) (15.53) (14.12) (15.98) (15.17) (15.47) (14.75) (15.30) ΔTXPD ** 0.386** 0.599** 0.782** * 0.312* 0.463* 0.622** ( 1.29) ( 2.43) ( 2.20) ( 2.43) ( 2.39) ( 1.58) ( 1.68) ( 1.86) ( 1.95) ( 1.99) ΔPI 0.031*** 0.051*** 0.080*** 0.117*** 0.164*** 0.033*** 0.060*** 0.090*** 0.118*** 0.149*** (3.41) (3.63) (3.95) (4.15) (4.48) (3.28) (2.98) (3.03) (2.83) (2.83) DEFTAX 0.027* ** (1.62) (0.92) (0.64) (0.52) (0.53) ( 1.09) ( 0.85) ( 1.59) ( 1.99) ( 1.40) NOL ( 1.07) ( 0.79) ( 1.11) ( 1.10) ( 0.18) (0.50) (0.13) (0.08) (0.64) (0.50) Constant 0.003** *** 0.006** 0.012*** 0.017*** 0.024*** (2.43) ( 0.32) (0.27) (0.52) (1.16) (3.52) (2.00) (2.62) (2.65) (2.80) Year FE Included Included Included Included Included Included Included Included Included Included Adj. R Obs. 1,057 1,057 1,057 1,057 1, F-test: β 1 = ** 49

51 Panel B: Largest three annual quartiles of tax fees to total fees paid to the auditor (APTS2) APTS2 = 1 APTS2 = 0 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) UBEND β ** 0.380*** 0.523** 0.742** 0.951** (2.42) (2.59) (2.33) (2.23) (2.15) (0.58) (0.41) (0.09) (0.19) (0.84) TXPD 0.737*** 1.452*** 2.183*** 3.017*** 3.768*** 0.750*** 1.489*** 2.248*** 3.065*** 3.909*** (22.50) (20.09) (18.22) (17.17) (15.18) (15.79) (15.28) (14.86) (13.93) (14.51) ΔTXPD * 0.323* 0.530** 0.713** 0.120* 0.259** 0.387** 0.554** 0.720** ( 0.77) ( 1.84) ( 1.93) ( 2.27) ( 2.32) ( 1.96) ( 2.18) ( 2.19) ( 2.21) ( 2.19) ΔPI 0.030*** 0.052*** 0.086*** 0.130*** 0.176*** 0.033*** 0.059*** 0.085*** 0.110*** 0.145*** (3.38) (3.74) (4.24) (4.45) (4.61) (3.31) (3.00) (2.94) (2.71) (2.84) DEFTAX * (1.34) (0.74) (0.43) (0.39) (0.53) ( 0.66) ( 0.69) ( 1.39) ( 1.77) ( 1.41) NOL ( 1.05) ( 0.93) ( 1.00) (0.48) (0.79) (0.70) (0.56) (0.46) (0.36) ( 0.07) Constant 0.004*** *** ** 0.013** 0.018** (2.81) (0.42) (0.87) (0.92) (1.55) (3.17) (1.36) (1.99) (2.11) (2.23) Year FE Included Included Included Included Included Included Included Included Included Included Adj. R Obs. 1,042 1,042 1,042 1,042 1, F-test: β 1 = ** Panel C: Chow (1960) tests of UBEND across model specifications TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 F-stat F-stat F-stat F-stat F-stat APTS1 4.27** 6.18*** 6.42*** 5.79*** 1.94* APTS2 3.85** 5.60*** 5.46*** 4.96** 2.35* This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, *** denotes statistical significance levels of 0.10, 0.05, and 0.01, respectively (two-tailed in Panels A and B, one-tailed in Panel C). 50

52 Panel A: Smallest quartile of five-year Cash ETR (TA_CASH) TABLE 7 Regression of Future Income Tax Cash Outflows on UTBs by Tax Avoidance TA_CASH = 1 TA_CASH = 0 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) UBEND *** 0.430*** 0.649*** 0.878*** 1.194*** (1.26) (0.05) ( 0.33) (0.14) (0.50) (3.09) (3.61) (3.41) (3.09) (3.07) TXPD 0.546*** 1.111*** 1.703*** 2.364*** 3.024*** 0.774*** 1.484*** 2.260*** 3.148*** 3.984*** (9.92) (9.39) (8.11) (7.69) (7.40) (22.76) (20.13) (19.83) (18.16) (18.16) ΔTXPD ** 0.242*** 0.413*** 0.690*** 0.897*** ( 0.08) ( 1.17) ( 1.42) ( 1.45) ( 1.56) ( 2.43) ( 2.75) ( 3.13) ( 3.50) ( 3.45) ΔPI 0.038*** 0.059*** 0.088*** 0.113*** 0.154*** 0.058*** 0.101*** 0.148*** 0.208*** 0.275*** (4.10) (4.07) (3.99) (3.26) (3.38) (5.30) (5.62) (5.78) (5.91) (5.87) DEFTAX 0.025* 0.081*** 0.131*** 0.184*** 0.218** 0.025* ( 1.86) ( 2.85) ( 2.73) ( 2.72) ( 2.42) (1.79) (1.49) (0.55) (0.15) (0.46) NOL ** 0.035** 0.046* (0.18) ( 0.97) ( 0.74) ( 0.67) ( 0.57) (2.51) (2.01) (1.91) (1.61) (1.05) Constant 0.009*** 0.016*** 0.026*** 0.033*** 0.044*** * (4.70) (5.03) (4.95) (4.22) (4.21) (1.05) ( 1.83) ( 1.29) ( 1.00) ( 0.33) Year FE Included Included Included Included Included Included Included Included Included Included Adj. R Obs ,112 1,112 1,112 1,112 1,112 F-test: β 1 =1 5.14***

53 Panel B: Smallest quartile of five-year GAAP ETR (TA_GAAP) TA_GAAP = 1 TA_GAAP = 0 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD TXPD t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 t+1 t+1 to 2 t+1 to 3 t+1 to 4 t+1 to 5 Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) UBEND β *** 0.369*** 0.561*** 0.821*** 1.223*** (1.44) (1.55) (0.90) (0.92) (0.69) (3.08) (3.01) (2.92) (2.88) (3.24) TXPD 0.727*** 1.286*** 2.097*** 2.716*** 3.370*** 0.763*** 1.466*** 2.235*** 3.127*** 3.970*** (9.91) (8.41) (8.35) (7.66) (6.73) (22.08) (19.66) (19.50) (17.94) (18.06) ΔTXPD * 0.600* *** 0.273*** 0.452*** 0.721*** 0.962*** ( 0.30) ( 0.96) ( 1.87) ( 1.84) ( 1.55) ( 2.86) ( 3.17) ( 3.46) ( 3.70) ( 3.77) ΔPI 0.025*** 0.042*** 0.064*** 0.100*** 0.141*** 0.064*** 0.111*** 0.163*** 0.218*** 0.288*** (2.71) (2.81) (3.23) (3.81) (4.09) (6.07) (6.33) (6.51) (6.24) (6.40) DEFTAX 0.048* (1.66) (1.40) (1.28) (0.99) (0.46) (0.75) (0.32) ( 0.47) ( 0.72) ( 0.20) NOL (1.52) (1.12) (1.02) (0.87) (0.81) (1.42) (0.31) (0.38) (0.39) ( 0.10) Constant 0.005** 0.007* 0.013** 0.022** 0.036*** 0.003* (2.46) (1.95) (2.15) (2.59) (2.97) (1.84) ( 0.60) ( 0.27) ( 0.41) ( 0.05) Year FE Included Included Included Included Included Included Included Included Included Included Adj. R Obs ,117 1,117 1,117 1,117 1,117 F-test: β 1 =1 3.18* 0.35 Panel C: Chow (1960) tests of UBEND across model specifications TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 F-stat F-stat F-stat F-stat F-stat TA_CASH *** 9.90*** 6.12*** 4.65** TA_GAAP ** 2.98** 4.41** This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, *** denotes statistical significance levels of 0.10, 0.05, and 0.01, respectively (two-tailed in Panels A and B, one-tailed in Panel C). 52

54 TABLE 8 Regression of Future Income Tax Cash Outflows on UTBs by IRS Audit Scrutiny (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coefficient Coefficient Coefficient Coefficient Coefficient (t-stat) (t-stat) (t-stat) (t-stat) (t-stat) UBEND 0.111*** 0.235*** 0.315** 0.447** 0.656** (2.68) (2.65) (2.33) (2.25) (2.40) AUD 0.000* ** 0.003*** (1.82) (1.45) (1.59) (2.36) (2.87) UBEND AUD 0.015*** 0.028*** 0.039*** 0.055*** 0.081*** (3.11) (3.20) (2.97) (2.96) (3.18) TXPD 0.745*** 1.457*** 2.199*** 3.029*** 3.822*** (27.11) (24.53) (23.43) (22.13) (21.47) ΔTXPD 0.079** 0.224*** 0.369*** 0.560*** 0.745*** ( 2.11) ( 2.96) ( 3.17) ( 3.47) ( 3.57) ΔPI 0.033*** 0.060*** 0.092*** 0.124*** 0.163*** (4.90) (4.75) (4.95) (4.89) (5.09) DEFTAX (1.09) (0.52) ( 0.02) ( 0.19) (0.17) NOL (0.34) (0.09) ( 0.03) (0.63) (0.82) Constant 0.006*** 0.006*** 0.011*** 0.015*** 0.024*** (6.27) (3.33) (3.82) (3.94) (4.80) Year FE Included Included Included Included Included Adj. R Obs. 2,060 2,060 2,060 2,060 2,060 This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. Variables are defined in Appendix B. Because AUD and UBEND are both continuous, we center these variables at the mean to ease interaction interpretations (Cronbach 1987; Jaccard et al. 1990). t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, *** denotes statistical significance levels of 0.10, 0.05, and 0.01, respectively. 53

55 TABLE 9 Regression of Future Income Tax Cash Outflows on Tax Reserve Changes Pre- and Post-FIN 48 Panel A: Changes in tax cushion (ΔCUSH): Pre-FIN 48 (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) CUSH β *** 0.688** 0.799** 0.816** 0.915* (3.562) (2.51) (2.20) (1.65) (1.45) TXPD 0.996*** 1.888*** 2.631*** 3.464*** 4.485*** (27.70) (18.38) (15.66) (13.74) (13.28) ΔTXPD 0.184*** 0.356** 0.485* 0.730** 1.048*** ( 2.62) ( 2.38) ( 1.95) ( 2.04) ( 2.24) ΔPI 0.084*** 0.210*** 0.317*** 0.416*** 0.512*** (5.05) (5.45) (5.55) (5.20) (5.04) DEFTAX (0.53) ( 0.28) ( 0.54) ( 0.79) ( 1.27) NOL (0.22) ( 0.07) (0.14) (0.69) (0.99) Constant 0.011*** 0.031*** 0.050*** 0.056*** 0.066*** (6.54) (6.59) (8.02) (6.90) (6.36) Year FE Included Included Included Included Included Adj. R Obs. 1,188 1,188 1,188 1,188 1,188 F-test: β 1 = *** Panel B: Changes in unrecognized tax benefits (ΔUBEND): Post-FIN 48 (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) UBEND β * 0.388* 0.735** 1.388** 1.867** (1.52) (1.43) (1.81) (2.39) (2.34) TXPD 0.762*** 1.512*** 2.356*** 3.273*** 4.206*** (17.74) (14.69) (14.36) (14.00) (13.36) ΔTXPD 0.124*** 0.271*** 0.490*** 0.890*** 1.287*** ( 2.60) ( 2.84) ( 3.43) ( 3.90) ( 4.12) ΔPI 0.046*** 0.090*** 0.131*** 0.175*** 0.217*** (5.75) (6.06) (6.49) (6.46) (6.20) DEFTAX ( 0.01) (0.17) ( 0.31) ( 0.46) ( 0.254) NOL (0.06) (0.63) (0.81) (1.18) (1.07) Constant ** 0.015*** 0.023*** 0.031*** (0.93) (2.55) (3.24) (3.68) (3.78) Year FE Included Included Included Included Included Adj. R Obs. 1,188 1,188 1,188 1,188 1,188 F-test: β 1 = *** 5.08**

56 Panel C: Chow (1960) tests of differences in tax reserve changes pre- versus post-fin 48 TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 F-stat F-stat F-stat F-stat F-stat CUSH UBEND This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. ΔCUSH is the change in tax cushion, scaled by total assets ( ). ΔUBEND is the ending balance of unrecognized tax benefits less the beginning balance, scaled by total assets ( ). Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. 55

57 TABLE 10 Regression of Future Income Tax Cash Outflows on FIN 48 Cumulative Equity Adjustment (1) (2) (3) (4) (5) TXPD t+1 TXPD t+1 to 2 TXPD t+1 to 3 TXPD t+1 to 4 TXPD t+1 to 5 Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) Coeff. (t-stat) CEA (0.20) ( 0.29) (0.71) (0.67) (0.78) TXPD 0.701*** 1.304*** 1.875*** 2.534*** 3.208*** (13.05) (16.23) (12.82) (11.87) (11.88) ΔTXPD ** 0.431* 0.659* 0.825* ( 0.85) ( 2.04) ( 1.78) ( 1.91) ( 1.92) ΔPI 0.045** 0.066* 0.129** 0.184** 0.230** (2.05) (1.71) (2.16) (2.05) (2.07) DEFTAX (0.40) (0.28) (0.51) ( 0.20) ( 0.20) NOL ( 0.15) (0.81) (0.69) (0.70) (0.50) Constant 0.008*** 0.009*** 0.015*** 0.024*** 0.037*** (4.18) (3.03) (3.12) (3.27) (3.92) Year FE Included Included Included Included Included Adj. R Obs This table reports ordinary least squares regressions of Eq. (1). The dependent variable TXPD 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. CEA is the FIN 48 Cumulative Equity Adjustment in millions (obtained from Audit Analytics) multiplied by 1, scaled by lagged total assets. Variables are defined in Appendix B. Reported t-statistics (in parentheses) are estimated with robust standard errors clustered by firm (Petersen 2009). *, **, and *** denote statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. 56