Wisconsin School of Business study shows FASB standard on reporting of tax reserves promotes greater transparency and gives investors more reliable earnings reports
When companies engage in earnings management—scrambling to line up their financial reporting with analysts’ forecasts of earnings—it can lead to false accounting and a lack of transparency for investors. Corporate reporting scandals at Enron, WorldCom, and other high-profile companies led to greater scrutiny of the accounting information provided to investors and prompted the Financial Accounting Standards Board (FASB) to clarify the rules governing how companies report tax reserves and to prevent firms from using the uncertainty of their tax positions to engage in earnings management.
A new study from the Wisconsin School of Business at the University of Wisconsin-Madison examined financial records of 100 firms before and after the 2007 passage of FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, to evaluate the impact of the new standard in providing greater transparency and consistency around the reporting of tax reserves.
Daniel P. Lynch, assistant professor of accounting and information systems at the University of Wisconsin-Madison’s Wisconsin School of Business, and his co-authors Sanjay Gupta of Michigan State University, and Rick C. Laux of Pennsylvania State University found companies had used tax reserves to manage quarterly earnings to meet analysts’ expectations before the implementation of FIN 48. They also found that in the two years following the enactment of FIN 48, firms did not engage in this practice, suggesting the standard was effective in constraining the ability of managers to use tax reserves to portray earnings in a more beneficial light.
“Before FIN 48, there was a concern that tax reserves could be used to manage earnings because the prior accounting standard lent itself to different interpretations and lacked clear guidance. As a result, there was a significant disparity in how firms accounted for tax reserves,” says Lynch at the Wisconsin School of Business. “Since reporting decreases in tax reserves allowed firms to make adjustments that showed higher income, this lack of clear accounting guidance suggests firms could make adjustments to tax reserves in a manner that could allow them to meet a particular earnings target.”
Lynch adds, “FIN 48 was designed to address the lack of guidance in terms of accounting practices around tax reserves, and our findings suggest it was effective in that regard, while providing more transparent and reliable information for investors.”
Lynch and his co-authors reviewed data from quarterly and annual financial statements, management’s disclosure and analysis (MDA), and income tax footnotes in a random sample of Fortune 500 companies from 2003-2005, the period after the passage of the Sarbanes-Oxley Act and prior to the passage of FIN 48, and from 2007-2008, the period immediately after passage of FIN 48.
In the period before FIN 48 regulation, the researchers looked at firms’ quarterly earnings data absent tax expense and found that 66.4 percent of the quarterly reports that disclosed a tax reserve decrease had missed analysts’ earnings forecasts. However, including the benefit of the tax reserve decrease enabled approximately 78 percent that originally missed the analysts’ forecasts to then meet the target.
The review of tax reserve disclosures from the pre-FIN period found that managers had wide discretion over the timing of how to report decreases in tax reserves and income-increasing adjustments. Managers recognized tax reserve decreases based on:
- the status of audits;
- proposed audit adjustments;
- the completion of the audit, which may be several years after receiving proposed audit adjustments;
- multiple quarters for the same audit; and
- a change in facts and circumstance.
However, in the review of documents after FIN 48, the study found no evidence or significant pattern to suggest firms were using tax reserves to manage earnings around analysts’ forecasts under the new regulation.
“There was a significant lack of clarity in accounting practices related to tax reserves in the pre-FIN 48 era and no direct guidance in terms of how to recognize, measure, and disclose uncertain tax positions,” says Lynch. ”FIN 48 regulation provided that guidance and reduced the uncertainty around earnings reports, something which can potentially lead to better information for investors.”