Rev Account Stud (2014) 19:456–472
DOI 10.1007/s11142-013-9257-4
Distilling the reserve for uncertain tax positions:
the revealing case of black liquor
Lisa De Simone • John R. Robinson
Bridget Stomberg
•
Published online: 1 October 2013
Springer Science+Business Media New York 2013
Abstract We examine the extent to which management discretion affects the
reserve for unrecognized tax benefits. We analyze the financial statement disclosures of 19 paper companies that received a total of $6.4 billion in refundable excise
taxes during 2009. All of these companies included the refunds in financial income,
but 14 excluded all or part of the refunds from taxable income. Despite the magnitude and unprecedented nature of the exclusion, we find that only five of the
excluding firms accrued a full reserve for an uncertain tax position, three firms
accrued a partial reserve, and six firms did not accrue any reserve. This variation
suggests managers enjoy wide latitude in applying the more likely than not standard
for determining additions to the reserve. Our findings suggest that financial statement users should exercise caution when comparing tax reserves across companies.
In addition, we find some evidence that income-increasing tax accrual decisions are
related to characteristics generally associated with weak corporate governance.
Keywords
avoidance
Uncertain tax positions FIN 48 Financial accounting Tax
JEL Classification
H25 M41 M48
L. De Simone
Stanford Graduate School of Business, 655 Knight Way, Stanford, CA 94305, USA
e-mail: LNDS@gsb.stanford.edu
J. R. Robinson (&)
University of Texas at Austin, 2100 Speedway, Austin, TX 78712-0211, USA
e-mail: John.Robinson@mccombs.utexas.edu
B. Stomberg
University of Georgia, 255 Brooks Hall, Athens, GA 30602-6252, USA
e-mail: Stomberg@uga.edu
123
Distilling the reserve for uncertain tax positions
457
1 Introduction
Regulators and investors have long been interested in measuring the extent of
corporate income tax avoidance and estimating the uncertain portion. Historically,
however, the extent of uncertain tax avoidance was difficult to assess because firms
were not required to make disclosures regarding the merits of income tax positions.
The Financial Accounting Standards Board (FASB 2006) promulgated Accounting
Standards Codification (ASC) Topic 740-10 (FIN 48) to address this lack of
disclosure about uncertain tax avoidance as well as inconsistencies in accruing tax
contingency reserves. FIN 48, effective in 2007, provides criteria for accruing and
disclosing reserves for unrecognized tax benefits (UTB) arising from tax positions
that managers deem to be uncertain.
Our paper is the first to examine the comparability of FIN 48 accruals across
firms. In doing so, we address the concern from the FIN 48 Post-Implementation
Report (FAF 2012) that ‘‘judgments required to recognize and measure income tax
uncertainties result in reporting information that is not comparable.’’ Complementary to concurrent work by Robinson and Schmidt (2012), who document
inconsistencies in the clarity and completeness of FIN 48 disclosures, we explore
whether management discretion in estimating accruals for UTBs weakens the
comparability of FIN 48 reserves. We exploit an extraordinary setting in which a
small group of firms in the same industry and during the same year entered into a
unique and material transaction lacking direct legal authority as to the appropriate
tax treatment. Although our research design sacrifices the breadth associated with
large sample empirical studies, this near ceteris paribus setting allows us to better
isolate the effect of management discretion on financial reporting under
uncertainty.
Understanding whether management discretion influences UTB accruals is
important for several reasons. First, managers must exercise judgment to determine
whether tax positions are uncertain, as well as the amount of uncertain tax benefits
most likely to be sustained upon audit. Under FIN 48, a tax position is uncertain if
management cannot conclude that the associated benefits are ‘‘more likely than not’’
to be sustained upon audit. If these judgments vary in consideration of a nearly
identical transaction, then even a faithful application of a more likely than not
standard will result in a wide range of reporting outcomes, potentially resulting in
financial statements that reflect managerial incentives rather than the facts and
circumstances of the transaction (Fields et al. 2001). Because the FASB uses a more
likely than not standard to gauge uncertainty in many contexts other than taxes, our
findings have implications for whether managers’ latitude to manipulate accruals
allows them to disguise the nature of a transaction.
Second, our evidence highlights the interplay between tax and financial reporting
aggressiveness to help investors, regulators, and researchers better evaluate
corporate tax avoidance. Our unique setting offers insights into whether firms that
report aggressively for tax purposes also report aggressively for financial purposes
(Frank et al. 2009) and allows us to empirically explore the conjecture that UTB
accruals depend jointly on tax avoidance and financial reporting behaviors (De
Waegenaer 2010; Hanlon and Heitzman 2010). Finally, the Internal Revenue
123
458
L. De Simone et al.
Service (IRS) should be interested in understanding how latitude in management
judgment affects the accuracy and completeness of the UTB reserve because this is
the basis for recently required tax return disclosures.
We identify 19 public companies that claimed a refundable excise tax credit for
alternative fuel mixtures during 2009. The credit generated over $6.4 billion of total
benefits for our sample firms, all of which increased reported financial income. The
materiality and singular nature of these benefits necessitated disclosure of detailed
information that reveals firms’ reporting choices. We examine these companies’
SEC filings to determine (1) the amount of refunds related to the alternative fuel
mixture credit included in taxable income and, for firms excluding some or all of the
refunds, (2) the amount of the UTB reserve established for this uncertain tax
position. Because our setting allows us to hold constant potential sources of
variation such as the nature of the transaction, industry, time, and economic
environment, we posit that any variation in UTB reserves results from differences in
management discretion.
FIN 48 indicates that managers must evaluate any position not based on ‘‘clear
and unambiguous tax law’’ before recognizing any corresponding benefit in the
financial statements.1 Because no direct authority exists addressing the proper tax
treatment of excise tax credit refunds, we conclude that excluding these amounts
from taxable income is an uncertain tax position subject to FIN 48. This
conclusion is supported by the wide variation we document in firms’ tax reporting
of the refunds: five companies include the entire alternative fuel mixture credit
refund in taxable income while the remaining 14 firms exclude all or part it.
Therefore, we expect firms excluding the refunds from taxable income to reserve
for some portion of the associated tax benefits, even if they do not reach identical
conclusions about the amount of reserve to accrue. However, despite holding the
economics of the transaction and the relevant legal authorities (nearly) constant,
we document considerable variation in whether these 14 firms accrue a UTB
reserve. Six firms establish a reserve for the entire tax benefit, five firms do not
accrue any reserve, and three firms accrue a reserve for only a portion of the tax
benefit.2 Because our setting controls for other potential sources of variation, we
conclude management discretion is the source of the inconsistency in accruals for
uncertain tax positions.
We explore potential sources of variation in management discretion regarding the
refunds. Firms had the option to receive the refund either as a credit against income
taxes, a direct cash payment, or a mix of credit and cash. We find some evidence
1
Taxpayers often face ambiguity in applying the tax law even when engaging in routine transactions. For
example, Congress permits an income tax credit for qualified research and development expenditures. Yet
the precise definition of which expenditures qualify has been a matter of extensive litigation (for example,
see Union Carbide Corp. v. Comm. (2nd CIR, 2012) 110 AFTR 2d 2012-5837 affm TC Memo 2009-050).
Additionally, prior to the July 2006 temporary regulations governing intercompany service transactions,
there were no prescribed methods to determine arm’s length transfer prices for services. Thus
multinational entities faced tax law ambiguity when pricing routine intercompany service transactions.
2
We do not take any position on the proper income tax treatment of the credit refunds. Rather, we argue
that there is an absence of legal authority for excluding the refunds. Also, note that the amount of the
excise tax refund is not uncertain because all firms in our sample received IRS approval to quality for the
credits.
123
Distilling the reserve for uncertain tax positions
459
that the form of payment influenced the tax treatment of the refunds: all of the firms
that received the entire refund as a credit excluded the amount from taxable income,
whereas only five of the 10 firms that received the refunds in cash excluded them
from taxable income. We also find that firms excluding the refunds from taxable
income have smaller net operating loss carryforwards.
We explore potential sources of variation based on corporate governance,
expecting firms with weak corporate governance in the form of strong, highly
compensated CEOs to be associated with aggressive reporting. Consistent with
expectations, firms that excluded the refunds from taxable income but did not
establish a full reserve have, on average, lower levels of management and block
ownership, greater analyst following, and more highly compensated, stronger CEOs
than firms that did establish a full UTB reserve. This evidence is consistent with a
positive association between weak corporate governance and aggressive financial
reporting. Finally, despite our expectation that external auditors would require
uniform application of the more likely than not standard for their clients, we
document significant variation in UTB accruals among firms with the same financial
statement auditor, surprisingly even among auditors working from the same office
location. Overall, our findings suggest that UTB accruals do not comparably reflect
uncertain tax avoidance across firms.
This research provides a unique window for understanding and illustrating
problems in applying an important accounting standard. We contribute to the
growing literature on discretion in financial reporting and disclosure by offering
direct evidence that the discretion afforded by FIN 48 allows managers to reach
conflicting conclusions about the appropriate recognition of tax benefits, even when
faced with a nearly identical set of facts and circumstances. We also provide
evidence on the interaction between tax and financial reporting aggressiveness. Not
all firms that reported aggressively for tax purposes also reported aggressively for
financial reporting purposes. Therefore financial statement users must jointly
consider tax and financial reporting incentives when evaluating the merits of a
company’s tax disclosures. As with all small sample studies, we recognize the
limitations of our analysis and urge readers to exercise caution when interpreting or
generalizing our empirical results.
2 Background
2.1 Alternative fuel mixture credits
The American Jobs Creation Act of 2004 created the alternative fuel mixture credit
to encourage the development of alcohol and biodiesel fuels. This credit is a
refundable excise tax credit equal to 50 cents per gallon of alternative fuel produced.
Beginning in late 2008, paper companies recognized an opportunity to qualify for
the credit by modifying a byproduct of paper pulp processing called black liquor.
Firms began receiving IRS approvals for the refunds in early 2009, and by mid-2009
every company in the paper processing industry was receiving refunds. Because
Congress has enacted very few refundable credits, no statutory or regulatory
123
460
L. De Simone et al.
guidance exists to prescribe, or even address, the proper income tax treatment of
refunded excise taxes. Therefore, although all 19 firms in our sample reported the
refunds in financial income, the companies did not consistently include these
amounts in taxable income.
In the absence of direct guidance, the relevant legal authorities suggest that
refunds should be included in taxable income.3 However, two arguments exist for
excluding refunds from taxable income, both of which are subject to criticism. The
first relies on treating the refundable tax credits as nontaxable ‘‘overpayments’’ in
accordance with IRC Section 6401(b)(1). The second argument analogizes the
credit to the earned income credit, another refundable credit the tax treatment of
which has never been addressed by the IRS or the courts. Firms receiving refunds
related to alternative fuel mixtures could interpret the absence of administrative
authority regarding the earned income credit as evidence of an informal IRS policy
excluding all refundable credits from taxable income. Given the absence of direct
legal authority and the competing interpretations of existing statutes, we conclude
that excluding refunds from taxable income is an uncertain tax position.
2.2 UTB as a measure of tax avoidance
FIN 48 requires firms to (1) identify uncertain tax positions, (2) recognize tax
benefits associated with only those positions that are more likely than not to be
sustained upon audit, and (3) measure the benefit to be recognized in the financial
statements as the ‘‘largest amount of tax benefit that is greater than 50 % likely of
being realized upon ultimate settlement.’’ There can be uncertainty about whether a
position is allowed or about the amount of the tax benefit derived from the position
that the taxpayer will retain upon audit. A tax position can also be uncertain because
the relevant tax law is ambiguous or undeveloped. Alternatively, the sustainability
of a position may hinge on the unique facts and circumstances surrounding the
transaction.
When determining whether uncertain tax positions are more likely than not to be
sustained, management must evaluate the technical merits of each position and
assume the relevant taxing authority will audit each position with full knowledge of
all pertinent information.4 The difference between the cash benefits generated from
the tax return position and the amount recognized in the financial statements is the
unrecognized tax benefit. If the position does not meet the more likely than not
threshold, no benefit is recognized (i.e., none of the claimed tax benefit is reflected
in financial income).
Accounting researchers have begun to examine the merits of using the current
year addition to UTB as a measure of uncertain or aggressive tax avoidance with
mixed results (e.g., Cazier et al. 2010; Frischmann et al. 2008; Lisowsky and
3
IRC Section 61 states that taxpayers must include ‘‘income from all sources derived’’ in taxable
income. Treasury Regulation Section 1.61-1(a) emphasizes that this presumption applies to all forms of
income ‘‘unless excluded by law.’’
4
FIN 48 permits management to consider a wide range of possible factors when assessing the probability
that a position will be sustained, including tax opinions from outside advisors and widely understood
administrative practices (ASC topic 740-10-25-7b).
123
Distilling the reserve for uncertain tax positions
461
Schmidt 2012). As with other empirical measures of tax avoidance derived from
financial statements, the primary drawback of using components of the UTB to
measure tax avoidance is that they are self-reported numbers subject to accounting
choice and potential manipulation by management (Fields et al. 2001). Tax accruals
are especially attractive for earnings management because of their discretionary
nature and timing of calculation just prior to earnings announcements (Dhaliwal
et al. 2004). Robinson and Schmidt (2012) examine the completeness and clarity of
FIN 48 disclosures and find that, although larger firms have more complete
disclosures, the disclosures lack clarity. Hence, given the role of management
judgment in assessing the more likely than not threshold for UTBs, it remains to be
seen whether UTBs consistently depict tax uncertainty.
3 Empirical method and results
3.1 Determining the magnitude of refunds
We identify 19 public companies that disclosed receipt of alternative fuel mixture
credit refunds during 2009 in their SEC filings.5 The IRS notified all firms in 2009
that their alternative fuel mixtures qualified for the credit and firms began
submitting refund claims. To facilitate our analysis, we divide the sample firms into
three groups. The Taxable Group consists of five firms that claimed the most
conservative (certain) tax position and treated the refunds as taxable income. The
Reserve Group consists of six firms that excluded the refunds from taxable income
but accrued a full UTB reserve. This group took an aggressive (uncertain) tax
reporting position but a conservative financial reporting position. Finally, the
Benefit Group consists of eight firms that excluded the refunds from taxable income
and recognized some or all of the tax benefits from the exclusion in their financial
statements. This group took aggressive tax and financial reporting positions. We
compare the information across these three groups to isolate the factors that
contribute to reporting behavior but urge caution when generalizing from these
small sample descriptive data.
Column (1) of Table 1 presents the magnitude of the refunds, which was material
for all 19 firms in our sample. Sample firms received over $6.4 billion in total
refunds, ranging from a high of $2.1 billion (International Paper) to a low of $18
million (Wausau Paper). The financial statement benefit of these refunds was
significant for companies in the struggling paper industry where, in 2008, 12 firms
in our sample reported financial losses. Columns (2) and (3) of Table 1 present
information on the materiality of the refunds. On average, refunds comprised over
88 % of the increase in pre-tax income from 2008 to 2009 and over 10 % of sales in
5
We identify 21 firms by searching the Edgar database for ‘‘alternative fuel mixture credit’’ and ‘‘black
liquor,’’ and by examining public filings for firms in pulp paper SIC and NAICS industry codes. We
exclude Appleton, an S corporation not subject to taxation, and Sappi, which reports using IFRS, thereby
making it impossible to ascertain the tax status of the refunds. For Rock-Tenn and Buckeye Technology,
two companies with fiscal years not ending on December 31, we estimate financial information over the
12 months ending on December 31, 2009, using quarterly and annual reports.
123
462
L. De Simone et al.
2009. Notably, six firms would have reported a pre-tax loss in 2009 if not for the
alternative fuel mixture credit refunds.
3.2 Tax treatment of the refunds
Column (4) of Table 1 presents the payment form and Column (5) presents the tax
treatment of refunds for each firm. In SEC filings, all firms disclosed the payment
form but not all firms explicitly disclosed the tax treatment. For firms that did not
explicitly disclose the tax treatment of the refunds, we determine the tax treatment
by examining tax footnote disclosures, particularly the effective tax rate reconciliation. We classify firms failing to disclose a reconciling item related to the
alternative fuel mixture credit as having included the refunds in taxable income.6
Consistent with the absence of legal authorities and the uncertain nature of tax credit
benefits, we find a wide disparity in the tax treatment of the refunds: five firms
treated refunds as fully taxable while the remaining 14 firms excluded all or part of
the refunds from taxable income.
The form of payment influenced the tax treatment of refunds and reflects the
apparent weakness of the legal arguments for excluding cash payments from taxable
income. All firms that received at least some portion of the refunds as income tax
credits excluded these amounts from taxable income. In contrast, only half of the
firms that received refunds exclusively in cash excluded the amounts from taxable
income. Moreover, every firm that elected to receive a mix of cash and credits
initially opted to receive only cash payments but switched to credits during the year.
Perhaps firms made this decision strategically to maximize the probability of
retaining some portion of tax benefits upon IRS audit. Alternatively, the decision
could be related to diminished liquidity needs.
3.3 Uncertain tax treatment for refunds
Table 1 also presents information about the tax and financial statement benefits
realized. Specifically, Column (6) presents the amount of credit excluded from
taxable income for the 14 firms that did not treat the refunds as taxable. In Column
(7), we calculate the Maximum federal tax benefit associated with excluding the
refunds from taxable income as 35 % of the amount excluded. Column (8) reveals
the amount of UTB addition firms accrued related to excluding the refunds. Eight of
these 14 firms explicitly disclose the amount of UTB addition related to the
exclusion of refunds, and two firms (Abitibibower and Glatfelter) state that ‘‘there is
uncertainty’’ regarding the income tax status of the refunds. For the six firms that
did not disclose the portion of the UTB addition related to the refunds, we estimate
6
Excluding the credits from taxable income would result in a permanent book-tax difference reducing
the effective tax rate. Under Regulation S-X Rule 4-08(h)(2), reconciling items must be itemized if the
item is ‘‘significant in appraising the trend of earnings’’ or if it exceeds 5 % of the amount computed by
multiplying the income before tax by the applicable statutory federal income tax rate. Only Newpage
Holding disclosed that it currently intends to include credits in gross income (Newpage 2009 10K filing,
p. 81).
123
Refund
amount
(1)
Refund/
sales (%)
(2)
Refund/
DPTI (%)
(3)
18
Wausau Paper
7
2
4
18
10
17
28
102
224
a
Cash
Cash
Cash
Cash
Cash
T
T
T
T
T
Tax
treatment
(5)
276
218
212
178
171
Abitibibowater
Temple Inland
Boise
Kapstone
Paper
Clearwater
Paper
14
28
11
6
6
6
66
178
90
65
76
128
Cash
Mix
Cash
Mix
Cash
Cash
503
215
Rayonier
654
Smurfit Stone
Container
Domtar
2,063
International
Paper
18
9
12
9
119
47
22
88
Credit
Mix
Cash
Mix
Benefit Group—firms excluding refunds and recognizing tax benefits
380
Meadwestvaco
TF
TF
TF
PT
TF
TF
TF
TF
TF
TF
Full Reserve Group—firms excluding refunds and accruing a full UTB reserve
239
147
Graphic
Packaging
304
Newpage
Holding
Verso Paper
344
Weyerhaeuser
Form of
refund
(4)
Magnitude and reporting of alternative fuel mixture credits
Taxable Group—firms including refunds in taxable income
Table 1
215.0
503.0
654.0
379.0
170.6
178.3
211.5
218.0
276.0
380.0
Excluded
refund
(6)
75.3
176.1
228.9
132.7
59.7
62.4
74.0
76.3
96.6
133.0
Maximum federal
tax benefit
(7)
15.0
162.0
0.0
0.0
59.7
62.4
74.0
76.3
96.6
133.0
N/A
Refund UTB
addition
(8)
60.3
14.1
228.9
132.7
0.0
0.0
0.0
0.0
0.0
0.0
Tax benefit
recognized
(9)
80
8
100
100
0
0
0
0
0
0
Percent
recognized (%)
(10)
Distilling the reserve for uncertain tax positions
463
123
123
127
108
76
Buckeye
Technologies
Glatfelter
Rock-Tenn
3
9
18
8
Refund/
sales (%)
(2)
40
174
50
164
Refund/
DPTI (%)
(3)
Credit
Mix
Mix
Credit
Form of
refund
(4)
TF
TF
PT
TF
Tax
treatment
(5)
76.3
107.8
85.9
176.3
Excluded
refund
(6)
26.7
37.7
30.0
61.7
Maximum federal
tax benefit
(7)
0.0
10.6
0.0
0.0
Refund UTB
addition
(8)
26.7
27.1
30.0
61.7
Tax benefit
recognized
(9)
100
72
100
100
Percent
recognized (%)
(10)
a
Newpage Holding experienced a decrease in pre-tax income from 2008 to 2009. The absolute value of Newpage Holding’s credit as a percent of the change in pre-tax
income is 126 %
Refund amount is the alternative fuel mixture credit refund ($M) accrued during calendar 2009. Refund/sales is the ratio of refund to sales. Refund/DPTI is the ratio of
refund to the change in pre-tax income from 2008 to 2009. In Column (4), Cash (Credit) indicates that all refunds were received in cash (income tax credits), and Mix
indicates a mix between Cash and Credit. In Column (5) T (TF) indicates that refunds were included in (excluded from) taxable income, and PT indicates that a portion was
included in taxable income and a portion excluded. Column (6) reports the estimated amount of refund excluded from taxable income. Maximum federal tax benefit is the
excluded refund times the statutory tax rate of 35 %. Refund UTB addition was either explicitly disclosed or determined by comparing the 2009 UTB addition to the
maximum tax benefit and UTB additions in prior years. Tax benefit recognized is the Maximum federal tax benefit less refund UTB addition, and Percentage recognized is
the ratio of the tax benefit recognized to the maximum tax benefit
176
Refund
amount
(1)
Packaging
Corporation
Table 1 continued
464
L. De Simone et al.
Distilling the reserve for uncertain tax positions
465
the amount by comparing the 2009 UTB addition to the potential tax benefit of
excluding the refunds and to prior year UTB additions.7
The wide disparity in the portion of tax benefits recognized in the financial
statements is apparent in Table 1. Column (9) shows the tax benefit recognized in
the financial statements as the difference between the tax savings from excluding
the refunds from taxable income and the portion of the UTB addition related to the
refund exclusion. Of the 14 firms that excluded the refunds from taxable income,
five did not establish any UTB reserve and therefore recognized 100 % of the tax
benefit claimed in their financial statements. On the opposite end of the spectrum,
six firms fully reserved for the tax benefits related to excluding the refund and
therefore recognized no financial statement benefits associated with the refund
exclusion. The remaining three firms established partial reserves. This disparity
exists despite holding constant the form of the payment and tax treatment. Smurfit
Stone and MeadWestvaco both claimed cash refunds and excluded the amounts
from taxable income. Yet Smurfit Stone did not accrue any reserve for the tax
benefits while MeadWestvaco accrued a full reserve.
The information presented in Table 1 reinforces four important conclusions.
First, the variation in the tax treatment of the refunds is consistent with the
conclusion that excluding these amounts from taxable income is an uncertain tax
position. Second, the disparity between the tax benefits claimed and those
recognized in the financial statements illustrates the wide latitude management
has in applying the more likely than not standard in FIN 48. Third, the amount of tax
benefits recognized in the financial statements is the joint result of tax and financial
reporting decisions. Hence UTB reserves reflect both the uncertainty (riskiness) of
the tax position and the extent to which managers are unwilling to vouch for the tax
position by claiming the benefits for financial reporting purposes. Finally, not all
firms that reported aggressively for tax purposes (i.e., excluded the refunds) also
reported aggressively for financial purposes (i.e., recognized the uncertain tax
benefits).
3.4 Analyses of firm characteristics
Because we observe variation in firms’ tax and financial reporting of the refunds, we
examine factors that could have influenced managers’ decisions. Table 2 illustrates
that the primary differences in the financial characteristics between the three groups
relate to cash flows and tax attributes. Firms in the Taxable Group were severely
cash constrained, as evidenced by an average free cash outflow of $425 million in
2008 reported in Column (1).8 Alternative fuel mixture credit refunds represented a
much larger portion of 2009 cash flows from operations for these firms (mean of
248 %) than other firms. Taxable Group firms also reported the highest average
NOL carryforwards in 2008 (mean of $1,050 million) and increased reported NOL
7
For example, Packaging Corporation discloses in its effective tax rate reconciliation that $62 million of
tax benefits were due to excluding credit refunds. However, the 2009 UTB addition was only $0.6 million,
and this amount is comparable to the 2008 UTB addition of $1.4 million. Therefore we conclude that
Packaging Corporation did not record any UTB addition for the credit refund in 2009.
8
We define free cash flows as cash flow from operations less capital expenditures.
123
466
Table 2
L. De Simone et al.
Financial characteristics
FCF 2008
(1)
Refund/CFO (%)
(2)
NOLs 2008
(3)
D NOLs
(4)
Taxable Group—firms including refunds in taxable income
Weyerhaeuser
Newpage Holding
Verso Paper
Graphic Packaging
Wausau Paper
Average
-1,942
a
405
1,110
-105
691
2,906
243
-27
135
413
-1
1
150
1,524
-88
-51
16
-425
248
0
0
1,050
253
Full Reserve Group—firms excluding refunds and accruing a full UTB reserve
Meadwestvaco
88
43
517
-63
Abitibibowater
-606
600
1,471
434
Temple Inland
-346
34
0
0
17
46
37
114
Boise
Kapstone Paper
24
89
0
0
Clearwater Paper
21
76
0
1
-134
148
338
81
-37
Average
Benefit Group—firms excluding refunds and recognizing tax benefits
International Paper
1,667
44
762
Smurfit Stone Container
-196
61
520
976
34
64
734
-192
5
Domtar
Rayonier
1
70
13
Packaging Corporation
136
58
0
0
Buckeye Technologies
43
92
69
-2
1
66
96
-4
157
18
0
0
230
59
274
93
Glatfelter
Rock-Tenn
Average
FCF is free cash flows, defined as cash flow from operations less capital expenditures. Refund/CFO is the
ratio of refund to cash flow from operations, where refund is alternative fuel mixture credits ($M) accrued
during calendar 2009. NOLs are net operating loss carryovers ($M and excluding foreign NOLs, except
for Abitibibowater) reported for fiscal year 2008. DNOLs is the change in NOL carryovers from 2008 to
2009
a
Weyerhaeuser reported negative cash from operations of $2.123 million in 2009. Absent the credits
Weyerhaeuser would have reported negative $2.467 million of cash from operations
carryforwards in 2009 despite including the refunds in taxable income. Thus the
decision to treat the refunds as taxable was likely jointly motivated by both liquidity
concerns and the ability to use an NOL carryover to absorb the additional taxable
income.
To assess possible determinants of the tax and financial reporting decisions, we
also consider corporate governance and managerial incentives following Desai et al.
(2007) and Cazier et al. (2010). Table 3 focuses on external monitoring and
managerial incentive alignment. Blockholders and financial analysts can both serve
as external monitors. Blockholdings represent total common stock held by
123
Distilling the reserve for uncertain tax positions
Table 3
467
Corporate monitoring and incentives
Block
(%)
(1)
Analysts
(2)
CEO
(%)
(3)
D&O
Group (%)
(4)
Audit
firm
(5)
Auditor
city
(6)
KPMG
Seattle
Taxable Group—firms including refunds in taxable income
Weyerhaeuser
29.9
18
0.1
2.6
Newpage Holding
96.7
0
1.6
3.5
PwC
Dayton
Verso Paper
69.8
3
0.9
2.8
Deloitte
Memphis
Graphic Packaging
91.8
1
0.2
19.4
E&Y
Atlanta
Wausau Paper
38.9
3
1.6
9.0
Deloitte
Milwaukee
65.4
5.0
0.9
7.5
Average
Full Reserve Group—firms excluding refunds and accruing a full UTB reserve
Meadwestvaco
33.3
12
1.9
2.5
PwC
Richmond
Abitibibowater
45.5
0
0.9
2.1
PwC
Montreal
Temple Inland
10.0
13
0.0
8.1
E&Y
Austin
Boise
34.8
3
2.2
17.2
KPMG
Boise
E&Y
Chicago
KPMG
Seattle
Kapstone Paper
Clearwater Paper
Average
9.9
0
9.5
18.0
22.1
0
0.3
1.2
25.9
4.7
2.5
8.2
Benefit Group—firms excluding refunds and recognizing tax benefits
International Paper
27.7
15
0.4
1.1
Deloitte
Memphis
5.4
0
0.7
1.5
E&Y
St. Louis
Domtar
35.5
21
0.1
0.5
PwC
Charlotte
Rayonier
16.6
7
0.3
2.3
Deloitte
Jacksonville
Packaging
Corporation
21.5
10
0.6
1.8
E&Y
Chicago
Buckeye
Technologies
29.6
3
1.2
7.5
E&Y
Memphis
Glatfelter
26.2
2
1.3
2.9
Deloitte
Philadelpia
6.4
5
0.8
7.3
E&Y
Atlanta
7.9
0.7
3.1
Smurfit Stone
Container
Rock-Tenn
Average
21.1
Block is total stock ownership by institutional investors owning 5 % or more of common stock. Analysts
are the number of equity analysts listed on IBES. CEO and D&O Group represent stock ownership by the
CEO and directors and officers, respectively. Ownership data collected from 2008 and 2009 proxy
statements. Auditor information collected from 2008 and 2009 proxy statements
institutional investors owning 5 % or more of common stock. The mean
blockholdings varies across the sample, with Taxable firms having the highest
average level of blockholdings (65 % of outstanding shares). Benefit Group firms
and Reserve Group firms have similar average blockholdings of 21 and 26 %
respectively, suggesting that aggressive tax reporting may be mitigated by high
levels of institutional ownership. Financial analysts can influence financial reporting
in two different ways. First, similar to blockholdings, analyst following can
represent outside monitoring (Jensen and Meckling 1976; Healy and Palepu 2001).
123
468
L. De Simone et al.
Second, analyst following has been used to represent external pressure to manage
earnings (Lin and McNichols 1998; Michaely and Womack 1999). The average
number of analysts is similar for Taxable and Reserve firms (5.0 and 4.7,
respectively) but is markedly higher for Benefit firms (7.9). This pattern is
consistent with the conjecture that pressure from analysts to meet earnings
expectations results in more aggressive financial reporting.
Columns (3) and (4) present information about the ownership of the CEO and the
directors and officers, which also influences managerial discretion because errors in
judgment can have serious wealth consequences for these individuals. In our
sample, the average stock ownership levels for the CEO, directors, and officers are
lowest for the firms recognizing credit tax benefits in their financial statements
(Benefit Group). When ownership of the CEO, directors, and officers are
aggregated, firms in the Benefit Group have an average of 3.8 % compared to
8.4 % for the Taxable Group and 10.7 % for the Reserve Group. This difference is
consistent with Warfield et al. (1995) who report a positive association between
managerial ownership and financial reporting quality.
In Columns (5) and (6), we examine the role of the financial statement auditor in
constraining management discretion. Although auditors are not responsible for
determining whether their clients’ tax return positions are supported by substantial
authority, they likely played an important role in management’s tax and financial
reporting decisions regarding the alternative fuel mixture credit refunds. This is
clear from Rock-Tenn’s response to an SEC inquiry about the uncertainty of the
credit tax position. Management noted in a letter to the SEC dated March 3, 2010:
Our conclusion to exclude [alternative fuel credit refunds] from taxable
income … is supported by the opinion we received from our tax advisor, the
review of this conclusion by our outside tax counsel and the concurrence of
our external auditor.
Despite the material amounts involved and the absence of legal precedent, we
document inconsistency in both the tax and financial reporting decisions of the
sample firms with the same Big 4 auditor. For example, Graphic Packaging and
Smurfit Stone are both audited by E&Y, and both received cash refunds, yet while
Graphic included the refunds in taxable income, Smurfit Stone did not. Each audit
firm had at least one client that included refunds in taxable income and multiple
clients that excluded these refunds. Moreover, every audit firm had at least two
clients that excluded refunds despite receiving all or part of the refunds in cash.
Regarding the financial reporting decision, auditors allowed managers significant
latitude in determining whether the exclusion of refunds required the accrual of a
UTB. We find the most consistent financial reporting decisions among firms audited
by PwC and KPMG. Notably, none of the firms audited by KPMG recognized any
tax benefits related to the refunds in their financial statements. This pattern
corroborates anecdotal evidence suggesting that KPMG imposed more conservative
financial reporting requirements due to recent tax shelter litigation.9 Of the three
9
We thank Ryan Wilson for helpful comments resulting from discussions with a tax department
employee at one of the sample firms.
123
Distilling the reserve for uncertain tax positions
Table 4
469
CEO compensation
CEO also chairman?
Total CEO compensation
CEO bonus
(1)
2008
(2)
2009
(4)
2009
(3)
CEO/CFO
(5)
Taxable Group—firms including refunds in taxable income
Weyerhaeuser
No
4,877
4,871
0
3.37
Newpage Holding
No
6,918
2,249
200
0.54
Verso Paper
No
3,444
1,467
225
2.60
Graphic Packaging
No
2,900
4,061
1,780
2.36
Wausau Paper
Yes
2,526
4,751
1,161
3.83
1:4
4,133
3,480
673
2.54
Average
Full Reserve Group—firms excluding refunds and accruing a full UTB reserve
Meadwestvaco
Yes
6,720
6,108
2,216
3.18
Abitibibowater
Yes
3,365
1,095
0
1.85
Temple Inland
No
1,905
5,616
1,401
2.32
Boise
No
1,397
2,555
1,320
2.69
Kapstone Paper
No
917
934
0
1.99
Clearwater Paper
Yes
844
3,832
1,537
2.45
3:3
2,525
3,357
1,079
2.41
Average
Benefit Group—firms excluding refunds and recognizing tax benefits
International Paper
No
5,866
12,164
2,727
4.95
Smurfit Stone Container
Yes
5,693
5,614
2,079
10.02
Domtar
Yes
5,396
4,665
1,944
2.99
Rayonier
Yes
4,799
6,104
1,313
3.19
Packaging Corporation
Yes
6,691
6,318
1,707
4.05
Buckeye Technologies
Yes
1,369
1,366
235
3.19
Glatfelter
Yes
2,135
4,196
952
4.01
Rock-Tenn
Yes
8,049
11,010
1,472
4.76
7:1
5,000
6,430
1,554
4.64
Average
Column (1) indicates whether the CEO and chairman of the board positions are combined. Total CEO
Compensation is the amount paid to the CEO ($Thousands) for the fiscal year. CEO bonus includes cash
bonus and other non-equity incentive compensation awarded to the CEO in 2009 ($ in Thousands). CEO/
CFO is the ratio of total compensation paid to the CEO to total compensation paid to the chief financial
officer (CFO) in 2009. All data collected from 2008 and 2009 proxy statements
companies audited by PwC that excluded refunds, only Domtar failed to accrue a
UTB for the full tax benefit. Even then, Domtar recognized only $14 million of the
$176 million tax benefits claimed. In contrast, firms audited by Deloitte that
excluded the refunds (International Paper, Glatfelter, and Rayonier) recognized all
or a substantial portion of the tax benefit in their financial statements. Finally,
although two of E&Y’s clients (Temple Inland and Kapstone Paper) accrued a full
UTB for excluded refunds, the other four clients recognized the maximum tax
benefit from the exclusion. The most aggressive of these reporting decisions was
Smurfit Stone, which recognized all of the tax benefits claimed ($229 million)
123
470
L. De Simone et al.
despite receiving the refunds in cash. Indeed, Smurfit’s net tax benefits allowed the
company to report an after-tax profit in 2009 rather than a pre-tax loss.
Differences in CEO strength and compensation can also influence tax and
financial reporting choices. Table 4 presents CEO characteristics taken from the
2008 and 2009 proxy statements. Although governance is a complex mix of
incentives and monitoring (Brickley and Zimmerman 2010), combining the CEO
position and board chairmanship is often portrayed as one indicator of ‘‘weak’’
governance (Jensen 1993). These positions are combined in seven of the eight
Benefit Group firms as compared to three of the six Reserve Group firms and only
one of the five Taxable Group firms. This pattern suggests that the CEO’s ability to
influence the board is associated with less conservative financial reporting and
perhaps less conservative tax reporting.
Benefit firms also report the highest average CEO total compensation for both
2008 and 2009 and the highest average cash bonus in 2009. These relations hold if
we deflate compensation by sales or assets to control for firm size, or if we calculate
the mean after dropping firms with the highest amount from each group. Benefit
firm CEOs also earn more than four times as much as their CFOs, and this multiple
is almost twice as large for Benefit firms than for Reserve or Taxable firms. The
systematic differences in executive compensation patterns for the Benefit firms are
consistent with a positive relation between aggressive financial reporting and CEO
incentives (e.g., Bergstresser and Philippon 2006). The similarity in compensation
patterns for Reserve firms and Taxable firms does not indicate a relation between
aggressive tax reporting and management incentives (Armstrong et al. 2012).
4 Conclusion
We investigate whether a small group of firms in the same industry consistently
applied the more likely than not standard of FIN 48 when confronted with a unique
transaction of substantial economic magnitude. This powerful setting allows us to
address the extent to which management discretion influences tax accruals while
holding nearly constant the facts and relevant legal authority underlying the
transaction. We identify 19 public paper companies that claimed the same
refundable excise tax credit during 2009. In spite of the FASB’s specific intent that
FIN 48 would improve transparency and comparability in reporting for uncertain tax
positions, we find that the financial reporting of the refunds varies greatly among the
firms in our sample. We conclude that FIN 48 provides managers with sufficient
latitude to reach dramatically different conclusions regarding the uncertainty of a
tax position and the subsequent accrual of the UTB.
Firms recognizing a financial statement benefit related to excluding the refunds
from taxable income have lower levels of institutional ownership, lower combined
levels of CEO and directors and officer ownership, greater analyst following, and
greater likelihood of having CEOs who are also chairman of the board. We also
provide evidence that management compensation appears positively related to
aggressive financial reporting but unrelated to aggressive tax reporting. Our
evidence also suggests that not all firms are simultaneously aggressive for both tax
123
Distilling the reserve for uncertain tax positions
471
and financial reporting purposes. Of the 14 firms that took the uncertain (aggressive)
position of excluding refunds from taxable income, only eight firms also reported
aggressively for financial purposes by not accruing a reserve for the associated
uncertainty. Finally, we demonstrate that Big 4 audit firms did not require their
clients to take consistent positions regarding the UTB reserve, even in the same
office. Thus it appears that external auditors do not constrain the latitude provided
by FIN 48. Although limited to a small sample, this study suggests that the UTB
reserve does not consistently reflect the extent of corporate income tax avoidance.
Instead, managers appear to have sufficient latitude to apply their discretion to
manipulate the reserve in a manner consistent with their incentives as constrained
by the existing corporate governance structure.
Acknowledgments We appreciate comments and helpful suggestions from an anonymous reviewer,
Ben Ayers, Devan Mescall (discussant), Lillian Mills, D.J. Nanda, Ed Outslay, Sundaresh Ramnath, Jeri
Seidman, Ryan Wilson (discussant), and Peter Wysocki as well as those made by participants in the AAA
annual meeting, the ATA midyear meeting, and in accounting colloquiums at Michigan State University,
the University of Texas at Austin, and the University of Miami. We also gratefully acknowledge research
support provided by Red McCombs School of Business, the C. Aubrey Smith Professorship, and the
Accounting Doctoral Scholars program. Robinson worked on this topic while serving as the academic
fellow for the Division of Corporation Finance of the Securities and Exchange Commission, but all
information presented here is available from public sources. The Securities and Exchange Commission as
a matter of policy, disclaims responsibility for any private publication or statement by any of its
employees. Therefore the views expressed in this paper are those of the authors and do not necessarily
reflect the views of the commission or the other members of its staff of the commission.
References
Armstrong, C. S., Blouin, J. L., & Larcker, D. F. (2012). The incentives for tax planning. Journal of
Accounting and Economics, 53, 391–411.
Bergstresser, D., & Philippon, T. (2006). CEO incentives and earnings management. Journal of Financial
Economics, 80, 511–529.
Brickley, J., & Zimmerman, J. (2010). Corporate governance myths: Comments on Armstrong, Guay, and
Weber. Journal of Accounting and Economics, 50, 235–245.
Cazier, R., Rego, S., Tian, X., & Wilson, R. (2010). Early evidence on the determinants of unrecognized
tax benefits. Working paper: University of Iowa.
De Waegenaer, A., R. Sansing, and J.Wielhouwer. 2010. Financial accounting measures of tax reporting
aggressiveness. Working paper, Tuck School of Business at Dartmouth.
Desai, M., Dyck, A., & Zingales, L. (2007). Theft and taxes. Journal of Financial Economics, 84, 591–641.
Dhaliwal, D., Gleason, C., & Mills, L. (2004). Last-chance earnings management: Using the tax expense
to meet analysts’ forecasts. Contemporary Accounting Research, 21, 431–459.
Fields, T. D., Lys, T. Z., & Vincent, L. (2001). Empirical research on accounting choice. Journal of
Accounting and Economics, 31, 255–307.
Financial Accounting Standards Board (FASB) (2006). Financial Interpretation No. 48 (FIN 48),
Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109,
Norwalk, CT.
Frank, M. M., Lynch, L. J., & Rego, S. O. (2009). Tax reporting aggressiveness and its relation to
aggressive financial reporting. The Accounting Review, 84, 467–496.
Frischmann, P., Shevlin, T., & Wilson, R. (2008). Economic consequences of increasing the conformity
in accounting for uncertain tax benefits. Journal of Accounting and Economics, 46, 261–278.
Hanlon, M., & Heitzman, S. (2010). A review of tax research. Journal of Accounting and Economics, 50,
127–178.
Healy, P., & Palepu, K. (2001). Information asymmetry, corporate disclosure, and the capital markets: a
review of the empirical disclosure literature. Journal of Accounting and Economics, 31, 405–440.
123
472
L. De Simone et al.
Jensen, M. (1993). The modern industrial revolution, exit, and the failure of internal control systems.
Journal of Finance, 48, 831–880.
Jensen, M., & Meckling, W. (1976). Theory of the firm: managerial behavior, agency costs, and
ownership structure. Journal of Financial Economics, 3, 305–360.
Lin, H., & McNichols, M. (1998). Underwriting relationships, analysts’ earnings forecasts, and
investment recommendations. Journal of Accounting and Economics, 25, 101–127.
Lisowsky, P., L. Robinson, Schmidt, A. (2012). What Does FIN 48 Tell Us About Tax Shelters? Working
paper. University of Illinois at Urbana-Champaign.
Michaely, R., & Womack, K. (1999). Conflict of interest and the credibility of underwriter analyst
recommendations. Review of Financial Studies Special, 12, 653–686.
Robinson, L., Schmidt A. (2012). An examination of mandatory disclosure quality: Evidence from FIN
48. Working Paper.
Warfield, T. D., Wild, J. J., & Wild, K. L. (1995). Managerial ownership, accounting choices, and
informativeness of earnings. Journal of Accounting and Economics, 20(1), 61–91.
123