What can we learn about uncertain tax benefits from FIN 48?

INTRODUCTION

What are public corporations recording and disclosing about their tax expense during 2006 in advance of the effective date of Financial Interpretation No. 48's Accounting for Uncertainty in Income Taxes (FIN 48) requirement to disclose reserves for uncertain tax benefits? FIN 48 standardizes accounting for uncertain tax benefits and requires that companies disclose the amounts of their tax reserves.

When a corporation files its tax return, it often pays less tax than the Internal Revenue Service (IRS) and the courts might require if various positions related to exclusions, deductions, credits and valuations were challenged. In its financial statements, the corporation must estimate how much tax expense and tax liability to record, taking into account the uncertainty of the tax benefit related to these positions. The reserve represents the firm's estimate of additional tax expense the firm expects to owe after audit and the resolution of any litigation. (1) The reserve reduces its current period income and/or net assets. In this way, some of the uncertain benefit claimed on the current year tax return is not recognized in the financial statements.

We provide descriptive evidence of firm accounting and disclosure before and after adoption of FIN 48. We also investigate firm behavior in 2005 and 2006 prior to the adoption of FIN 48. If firms have previously recorded excess tax reserves, they face two incentives to release any excess reserves through earnings outside of FIN 48's adoption adjustment. We think large firms are more likely to have excess reserves than small firms because the 100 largest firms are subject to continual audit by the Internal Revenue Service. Small firms that are infrequently audited might not have recorded any tax reserve prior to FIN 48.

Firms should want to reduce reserves prior to FIN 48 adoption to reduce potential IRS scrutiny. In discussing the Financial Accounting Standards Board's (FASB) issuance of FIN 48, Robert Willens of Lehman Brothers commented, "[It] would not be overstating the case to conclude that FIN 48 may prove to be one of the most significant enforcement tools the IRS has been presented with in recent years (Willens, 2006)." (2) On May 9, 2007, KPMG surveyed approximately 4,000 webcast participants with the question, "Is FIN 48 likely to increase audits by tax enforcers?" Eighty-nine percent thought it was at least likely. (3) If corporate managers think the IRS will use the amount of the disclosed tax reserve as one of many signals about tax aggressiveness, then they would generally prefer to disclose less tax reserve. Since firms are required to provide full disclosure of their reserves during 2007, decreasing the reserve during 2006 reduces its visibility to the IRS.

The regulatory environment could prevent firms' opportunistic behavior, however. The tax expense accounts are under additional scrutiny following Sarbanes-Oxley. Internal control audits under SOX (the Sarbanes-Oxley Act of 2002) Section 404 revealed widespread material control weaknesses in the tax accounting systems. (4) In addition, tax directors are concerned about restatements. KPMG's 2006 Tax Department Survey indicates that tax departments place a higher priority on accurate and timely financial reporting and SOX 404 compliance than on effective tax rate (ETR) management or cash tax savings, which were the higher priorities in 2001. (5) Thus, it is possible that large firms did not have excess reserves when the FASB issued FIN 48.

We gather and describe disclosures related to tax reserves and FIN 48 during 2005, 2006 and the first quarter of 2007 for a small sample of 200 firms with December 31 fiscal-year ends. We examine the 100 largest and the 100 smallest non-regulated and non-financial public companies that are covered by at least five analysts on the Institutional Brokers Estimate System (I/B/E/S). (6) As expected, small firms were less likely to discuss the effect of FIN 48 in 2006, although the disclosures increase throughout 2006. Nearly all discussions of tax reserve changes involved decreases to tax reserves that increase income typically attributed to settlements with tax authorities. We find that the frequency of material decreases in tax reserves increased in 2006, relative to 2005.

We also review firms' FIN 48 disclosures during the first quarter of 2007. We observe both increases and decreases in reserves that corporations post to stockholders' equity as required by FIN 48. In parallel work in progress, we conduct regression analysis to consider whether decreases in reserves pre- and post-adoption are associated with decreases in reserves at adoption. (7)

For the largest 100 non-financial, non-regulated firms, the unrecognized tax benefit (UTB) at January 1, 2007 is $78 billion, excluding any accrued interest. Reserves represent 1.8 percent of total assets as of December 2006. Of the total unrecognized tax benefit, approximately $58 billion would affect earnings favorably if recognized. Accrued interest and penalties are $13 billion. To adopt FIN 48, firms increased stockholders' equity to reflect a decrease in the reserve of approximately $2 billion. Individually, several firms have reserves exceeding $5 billion at January 1, 2007, and five firms have reserves that exceed five percent of assets. The largest increase to the reserve at adoption exceeded one percent of assets, and the largest decrease to reserves exceeded 0.5 percent of assets.

Untabulated disclosures of 100 small firms show that few small firms decreased reserves. Only five of the 100 firms decrease reserves and increase stockholders' equity as a result of adopting FIN 48. As expected, small firms are more likely to increase reserves (39) or not change reserves (56).

Several inconsistencies remain in the disclosures. Notably, it is often unclear whether the gross reserve for unrecognized tax benefits includes or excludes the accrued interest payable. Further, the disclosure of the amount of the reserve that would affect earnings (via the effective tax rate) is likewise unclear about whether it includes interest expense. Disclosures of interest expense are sometimes made gross and sometimes net of tax benefit. We hope that the FASB, Securities and Exchange Commission (SEC), and/or Big 4 and other auditing firms clarify this uncertainty, resulting in a best practices approach. We are optimistic that future quarters in 2007 or year-end disclosures in the SEC Form 10-K for 2007 will add clarity and improve comparability.

BACKGROUND

Until recently, financial-statement users had little information to assess the riskiness of tax positions a corporation claimed. Although large firms are generally audited by the IRS every year and often face material claims, Gleason and Mills (2002) find that even the largest 100 industrial corporations seldom disclose any information. When firms do disclose information, it is generally limited, such as a mention of years under audit or a boilerplate statement that contingencies include contingent tax losses. Such information asymmetry permits corporations to use the judgment inherent in recording contingent losses for earnings management purposes. Dhaliwal et al. (2004) show that firms often achieve analysts' forecasts through tax expense decreases, and Blouin and Tuna (2007) find evidence suggesting that firms use tax reserves to smooth earnings. The information asymmetry is made worse by lack of comparability.

Until recently, corporations and external auditors applied a variety of accounting methods to estimate uncertain tax benefits (FIN 48, Summary). One reason for this may be that Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, does not indicate how to address uncertainty in accounting for income tax assets and liabilities (FIN 48, Summary). FIN 48 standardizes the method of accounting for uncertain tax benefits and requires that companies disclose reserves. We briefly discuss two key features of FIN 48: recognition and disclosure.

Recognition of Uncertain Tax Benefits

FIN 48 requires a firm to take two steps to evaluate an uncertain tax position:

(1) Determine whether it is more likely than not that the tax position will be sustained upon examination, including related appeals or litigation, based on its technical merits. In making this determination, a company must assume that the appropriate taxing authority will audit the company's books and will have knowledge of all relevant information.

(2) If the company determines that the more-likely-than-not standard is met, the company must measure the tax position to determine the amount of the benefit that should be recognized on its financial statements. It is measured as the largest amount of benefit that is more than 50 percent likely of being realized upon settlement.

If an uncertain tax position fails the more-likely-than-not test of step (1), the firm must establish a tax reserve for 100 percent of the benefit. (8) Because step (1) requires a company to assume that it will be audited by the taxing authority, infrequently audited (i.e., smaller) firms are more likely to require additional reserves when they implement FIN 48, all else equal.

FIN 48 requires a company to report the effect of adopting FIN 48 as a "change in accounting principle" and the resulting cumulative--effect adjustment is reflected as an adjustment to the opening balance of the company's retained earnings account for the fiscal year of adoption. In addition, there will likely be adjustments within the balance sheet to correctly classify tax assets and liabilities in applying FIN 48.