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For many investors, corporate taxes are a virtual black box. Large companies often face taxes due a variety of existing tax legislation (regulations, interpretation, statutes, etc.) in diverse jurisdictions (local, state, national and international). The complexity of tax law renders the income tax return for each company potentially subject to scrutiny by the IRS (or a similar tax authority).
In July 2006, the Financial Accounting Standards Board (FASB), an organization designated by the SEC for setting the standard accounting principles, enacted Financial Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes in an effort to increase transparency. FIN 48 required that a firm disclose in its quarterly and annual reports that it had filed with the Securities and Exchange Commission (SEC). The amount a particular company reserves (against a particular tax benefit) comes from a subjective management estimate. Different companies could reserve different amounts for the same transaction. The magnitude of tax reserves can be quite significant. One report detailed for the largest 100 non-financial, unregulated firms that their reserves at adoption (of FIN 48) amounted to approximately two percent of total assets.
The purpose of this project is to examine whether the disclosed amounts of tax reserves, which FIN 48 calls “uncertain tax benefits” (UTBs), are the best publicly available measure of tax risk. An unrecognized tax benefit is the difference between the tax benefit reflected on the income tax return and the amount of the benefit recorded on the financial statements. For example, a taxpayer deducts $100 on its return but believes that a $60 deduction will be the most likely outcome in a negotiated resolution with the IRS on audit. The $40 difference is the unrecognized tax benefit. The primary focus of my work was data collection, and the 10-K disclosures between fiscal years 2007-2010 were examined in order to collect information related to UTBs. In addition to accruing the tax, FIN 48 requires disclosures in footnotes to the financial statements.
Since there is no standardized format for 10-K disclosures, collecting the footnotes required careful reading in order to ensure the integrity of their data. Anomalies, such as errors in the tabular reconciliation, were flagged for later examination. Throughout the data collection, several observations have been made:
• Companies have developed their own categories for UTBs (acquisitions, foreign currency translation)
• Firms often underestimate increases in the liability of UTBs in the fiscal year
• A number of firms did not disclose the amount of permanent UTB
Professor Sikes plans to use the data collected and coded to answer the following research questions: (1) Are disclosed amounts of UTBs a good measure of tax risk, despite firms’ incentive to manipulate the disclosed amounts due to pressures to manipulate net income? (2) Are a firm’s disclosed UTBs positively related to other types of risky investments in which the firm engages?