۱- Introduction

۲- Background, literature review, and hypothesis development

۳- Research design, sample, and descriptive statistics

۴- Multivariate results

۵- Conclusion

References

Abstract

We examine whether firms respond to settlements of their uncertain tax benefits (UTBs) by adjusting the related UTB reserve. A reported UTB settlement indicates that the tax authority challenged at least one of the firm’s uncertain tax positions, thereby providing information to managers regarding the sustainability of similar tax strategies and outstanding UTBs. Consistent with expectations, our results suggest that UTB settlements are negatively related to the accrual for new uncertain tax positions. Further, we demonstrate that managers make less downward adjustments to the UTB reserve related to existing uncertain tax positions following settlements with tax authorities. Finally, additional analysis suggests that the valuation of UTBs is lower in the year subsequent to a UTB settlement. Collectively, our results suggest that the information gathered from tax audit outcomes influences firms to be more conservative in their tax reporting, and possibly their future tax planning as well.

Introduction

The primary purpose of this study is to examine how tax enforcement mechanisms alter tax planning and reporting behavior. To carry out this objective, we focus on changes to the reserve for unrecognized tax benefits (UTBs). In the annual disclosure of the UTB reserve, firms are required to provide a reconciliation between the beginning and ending balance of the reserve. One component of the reconciliation is the decrease to the reserve due to settlements. The presence of a settlement indicates that a tax authority challenged at least one of the firm’s uncertain tax positions. Given that the goal of any enforcement mechanism is to increase cooperation, we test whether the occurrence of a settlement in the current period alters UTB reporting behavior. Specifically, when a tax audit results in a settlement, firms receive new information regarding the sustainability of similar tax strategies and existing uncertain tax positions. As such, we posit that firms experiencing UTB settlements will: 1) engage in less new uncertain tax positions going forward; and 2) revise their expectations regarding the realizability of similar uncertain tax positions taken in prior periods by increasing the related reserve. In addition, given that UTB settlements, our proxy for audit settlements with tax authorities, are disclosed to financial statement users through the UTB rollforward, we investigate whether reported settlements influence the capital market’s valuation of the remaining reserve. We contend that these tax audit outcomes are a signal to investors about the realization of cash tax savings stemming from a firm’s uncertain tax avoidance activities. All else equal, firms entering into UTB settlements are retaining less of their cash tax savings relative to firms without settlements. Hence, we posit that the valuation of a company’s UTB reserve will decrease in the presence of a settlement. We test our hypotheses using a sample of firms from 2008 to 2015. To examine the effect of UTB settlements on adjustments to the related reserve, we estimate a series of UTB component models following Drake, Goldman, and Lusch (2016) and include a variable that captures the magnitude of settlements as a percentage of the total UTB reserve in the current period. Consistent with our conjecture, we find that UTB settlements are negatively related to the accrual for new uncertain tax positions. Furthermore, we demonstrate that UTB settlements are positively associated with the UTB accrual related to uncertain tax positions assumed in prior periods. Taken together, our results suggest that the information gathered from tax audit outcomes influence firms to become more conservative in tax reporting, and possibly their future tax planning as well.