Managers at public companies are under immense pressure to meet analysts’ forecasts of earnings. These pressures, combined with vague accounting standards, can give companies opportunities to engage in “earnings management”—painting an overly positive picture of performance.
After several high-profile accounting scandals, one practice that has come under scrutiny is the way companies account for uncertain tax positions, aka tax reserves.
In response to concerns that the disparity in how firms accounted for these tax positions resulted in earnings management opportunities, in 2007, the Financial Accounting Standards Board issued FIN 48. This interpretation of the rules for accounting for uncertain tax positions attempted to provide a more uniform measurement process for tax reserves, increase transparency of companies’ tax positions, and improve the overall information environment.
My colleagues Sanjay Gupta of Michigan State University, Rick Laux of Pennsylvania State University, and I studied whether companies used tax reserves to manage quarterly earnings to meet analysts’ expectations prior to the new standards and whether this behavior changed following the implementation of the new standards under FIN 48.
We examined 100 firms across two time periods, before and after implementation of FIN 48, and found companies used tax reserves to manage earnings before FIN 48 was in place, providing policymakers justification for their concerns about this issue from the outset. We also found that in the two years following the enactment FIN 48, firms did not use tax reserves to meet analysts’ forecasts. This result suggests that FIN 48 was effective in constraining managers’ ability to use tax reserves to manage earnings.
There’s a lot of uncertainty around accounting, and many times firms use that uncertainty to their advantage. Sometimes policymakers can recognize these issues and reduce that uncertainty which can potentially lead to better information for investors. If the effects of FIN 48 continue, perhaps investors can be more confident in the accuracy of firms’ earnings reports.
For more on this topic, see our paper “Do Firms Use Tax Reserves to Meet Analysts’ Forecasts? Evidence from the Pre- and Post-FIN 48 Periods” in Contemporary Accounting Research.
Dan Lynch is assistant professor of accounting & information systems at the Wisconsin School of Business.