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Is tax information on financial statements useful for stakeholders?

It has been an important question for accounting scholars as disclosure requirements have increased, and a growing number of companies have taken increasingly aggressive tax positions.

Unrecognised tax benefit (UTB) reserve is one such example of this increased disclosure. Since 2007, publicly traded companies in the United States have been required to disclose in their financial statements any contingent liabilities arising from aggressive tax positions with uncertainties.

My recently published study examines whether UTB disclosures indeed provide helpful information to stakeholders, in particular lenders. While risk arising from uncertain tax positions is expected to increase loan spread, namely the interest rate charged by lenders on loans minus the interest rate paid by them for deposits, what this study found is that when financial statements provide higher quality information about this risk, its impact on loan spread is reduced.

These findings confirm that lenders demand a risk premium for uncertain tax positions, but they also incorporate the quality of disclosures into the calculation of risk. In addition, the impact of quality of disclosures on loan spread is more pronounced when firms report considerable foreign sales or research and development (R&D) expenditures.

Accounting for uncertain tax positions

In the United States, Financial Interpretation No. 48 (FIN 48, mostly codified as Accounting Standard Codification Topic 740-10) requires publicly traded corporations to disclose uncertain tax positions.

In accordance with FIN 48, managers must evaluate, based on its technical merits, each tax position taken by the firm to determine whether it is more likely than not that it will be sustained upon examination by taxing authorities. Firms are not allowed to recognise tax positions in the financial statements if they do not meet the more-likely-than-not threshold.

However, those position will already have been taken in the firm’s returns; hence there may be significant differences between those returns and the tax benefits recognised in the financial statement. Such differences represent a contingent liability, widely known as a UTB.

UTB balance indicates potential cash outflow if the tax positions are denied by the taxing authority, thus it is considered an ideal measure of tax risk in theory.

However, UTB balance should be treated with caution because it is driven not only by tax uncertainties but also by financial incentives. UTBs increase tax expenses, and therefore decrease the net income, in the financial statement. For this reason, managers may be motivated to exclude tax positions from UTB disclosures even though they are more likely than not to be denied by the taxing authorities. Indeed, there is significant variations among firms in how uncertain tax positions are recorded in financial statements, with some deliberately concealing unfavourable information.

Comparability of UTB disclosures

When there is a diversity in UTB recognition practice, we expect that lenders would prefer those firms that disclose all available information regarding uncertain tax positions, and charge them lower risk premiums.

How then can informative UTBs be identified? I posit that UTBs are likely to show high comovement with the UTB disclosures of other firms when they are informative about future tax consequences.

This is based on the idea of ‘earnings comovement’, an empirical measurement of financial statement comparability developed by Gus De Franco and co-authors in a 2011 article. They argue if the accounting is comparable between peer firms, their earnings would have the same direction of impact when they experience a similar set of economic events.

Similarly, I argue if firms have similar uncertain tax positions and disclose all available information about these positions, UTB disclosures of the two firms would be comparable and highly comoved. For example, if a new ruling related to their common tax positions is released, the ruling’s effect on the firms should be in the same direction.

Indeed, this study found that firms with comparable (or comoving) UTBs are less likely to have spikes in their effective tax rates because they have already recognised contingent liabilities (UTBs) in advance.

Impact of accounting for uncertain tax positions on loan spread

In line with previous research, this study found that loan spread is positively associated with UTB balance. However, this association is moderated when a firm’s UTB is comoving with other firms.

These findings suggest that while lenders demand a risk premium for uncertain tax positions, they also incorporate the quality of tax risk disclosures into the risk premium. The risk premium would be lower when firms’ UTB disclosure is informative about future tax consequences.

The impact of UTB disclosure is more prominent when UTBs are more relevant to lenders’ loan decisions. Because UTB disclosures mostly relate to international transfer pricing, business deductions, and R&D credits, they are expected to be more important when firms are involved in foreign sales or R&D activities. Consistent with this expectation, this study found that UTB disclosures have a greater impact on loan spread when firms have a considerable amount of foreign sales or engage in R&D activities.

Implications for tax-related accounting standards

Despite the variations in practice of UTB disclosures among firms, my study suggests that a lender’s perception of a borrowing firm’s tax risk is influenced by the accounting of uncertain tax positions.

We can therefore expect that more tax-related accounting standards, similar to FIN 48 in the United States, would be implemented if there is more demand for tax risk information. Although this may provide potential benefits for stakeholders, there are entailing trade-offs. Such standards tend to be sophisticated and technical by nature, thus may incur direct costs associated with standard compliance.

In addition, firms might be reluctant to provide detailed information about their positions on important tax issues because such information may help tax authorities to identify and assess tax uncertainty.

In light of these considerations, policy makers and regulators must carefully implement tax-related accounting standards and disclosure policy.

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