Files
Abstract
Unrecognized tax benefits (UTBs) provide financial statement users with an assessment of the level of uncertainty associated with a firms tax planning strategies. Empirical studies use reported UTBs as a proxy for firms tax aggressiveness, but recent research suggests that a firms financial reporting incentives influence reported UTBs, making inferences based on reported UTBs problematic. In this study, I investigate whether reported UTBs can be partitioned into two components: (i) a component that reflects a firms tax aggressiveness (non-discretionary UTBs), and (ii) the remainder that captures the effects of financial reporting incentives (discretionary UTBs). I compute non-discretionary UTBs as the predicted values from a cross-sectional OLS regression of reported UTBs on known determinants of tax aggressiveness, and use the residuals as empirical estimates of discretionary UTBs. I find statistical and economically significant variation in the under- and over-reporting of UTBs that is not attributable to differences in firms tax aggressiveness. Next, I perform a series of analyses to validate the two proxies. First, I find that non-discretionary UTBs are positively associated with future taxes paid, consistent with non-discretionary UTBs representing firms liabilities. In contrast, discretionary UTBs are (i) negatively associated with future tax expense reported in the financial statements (i.e., discretionary UTBs predictably reverse) and (ii) not associated with future taxes paid, consistent with discretionary UTBs capturing managements financial reporting discretion. I also observe that the magnitude of discretionary UTBs is greater for firms with tax-related internal control weaknesses or firms that restated their financial statements for tax-related reasons. Lastly, I find evidence consistent with managers using discretionary UTBs to meet analysts consensus earnings forecasts. These validation tests provide comfort that discretionary UTBs reflect financial reporting discretion as opposed to an omitted determinant of tax aggressiveness or managements private signal about future taxes paid.