Skip to main content
SpringerLink
Log in

Did FIN 48 improve the mapping between tax expense and future cash taxes?

  • Published:
Review of Accounting Studies Aims and scope Submit manuscript

Abstract

The Financial Accounting Standards Board introduced FIN 48 (ASC 740-10) to increase relevance and comparability in the reporting of uncertain tax positions. The extant literature has found mixed results when examining the effects of FIN 48 using research designs that lack a counterfactual. Using a difference-in-differences design, we examine the effect of FIN 48 on the mapping between GAAP tax expense and future cash taxes paid over the next three years. We find that the mapping for US firms improved under FIN 48, and the improvements are strongest among domestic firms, which are less affected by the inability to offset positions under FIN 48. We find no difference in the change in mapping for firms that expect higher or lower ex ante audit and detection risk. We find no evidence that FIN 48 reduced the mapping for firms with a low likelihood of being audited or for multinational firms. Our results are robust to the use of multiple control groups. Our findings suggest that FIN 48 improved the relevance of tax expense for some US firms.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Data Availability

Data are publicly available from the sources identified in the paper.

Notes

  1. Starting in 1997, the Canadian Institute of Chartered Accountants (CICA) adopted a balance sheet approach to accounting for income tax liabilities under Section 3465, which was in practice until Canada adopted IFRS starting January 1, 2011. We are grateful to Shari Mann, CPA, CA, for discussions and resources about the details of Canadian GAAP.

  2. Under SFAS 5, Accounting for Contingencies, a reserve for uncertain tax positions is only required to be accrued if it is “probable” that the tax position would not be sustained upon audit and if the amount of tax liability is “reasonably estimable.” Tax contingencies are required to be disclosed, but not accrued, if it is “reasonably possible” that they will not be sustained on audit (FASB 1975).

  3. Robinson et al. (2016) find that, on average, approximately $0.39 of UTBs adjusted for prior-year additions are paid out through settlements over five years, while Ciconte et al. (2016) estimate that, on average, $0.67 of UTBs are paid out over five years. Robinson et al. (2016) note that their estimate falls within the 95% confidence interval of the Ciconte et al. (2016) estimate ($0.13–$1.20). Given that the width of the 95% confidence interval in Ciconte et al. (2016) implies there is an equally likely chance that 13% or 120% of each dollar of UTBs is paid out in five years, we argue that more evidence is needed to assess the benefits of FIN 48.

  4. Under Canadian GAAP, guidance for accounting for income taxes is governed by Section 3465 of the Canadian Institute of Chartered Accountants (CICA) Handbook. Adopted in 1997, Section 3465 generally requires recognition of a deferred tax asset or liability for temporary differences in the carrying values of balance sheet items if it is “probable” that the amount will eventually be recovered or settled. Unlike ASC 740, Section 3465 did not explicitly prescribe how to account for uncertain tax positions. In practice, firms reporting under Canadian GAAP applied guidelines from Section 3290 (“Contingencies”) to measure uncertain tax positions (Doucet et al. 2011). Under Section 3290, a contingent liability is recognized for each tax position that will “likely” not be sustained, where “likely” is typically defined as a 70%–80% chance of occurrence (Doucet et al. 2011). In contrast, US GAAP pre FIN 48 generally applied the “probable” and “reasonably possible” thresholds of SFAS No. 5 (which assume a likelihood of 50%–75%), and FIN 48 requires firms to record a liability when taxes are “more likely than not” (> 50%) to be owed. As a result, US GAAP often records a more conservative reserve for uncertain tax positions than Canadian GAAP. Under Section 3290, firms may consider the likelihood of audit and detection in deriving their estimate. This contrasts with FIN 48, which explicitly requires firms to assume that they will be audited and that tax authorities will have “full knowledge of all relevant information.” (FASB 2006) See Appendices 2 and 3 for more detail about the differences between US and Canadian GAAP.

  5. We test the tax expense–cash flow mapping rather than the explanatory power of tax expense for taxes paid because we are interested in whether $1 of tax liability results in $1 of eventual cash taxes paid (e.g., Ciconte et al. 2016). It is possible that the explanatory power of $1 of tax liability for future cash taxes remains the same after FIN 48 even if, for instance, payments were now only $0.50 per dollar of liability. Thus, we focus on changes in the cash flow realization of tax liabilities rather than explanatory power.

  6. We cannot rule out the possibility that improvements in the mapping after FIN 48 are due to increased external auditor scrutiny of tax reserves. However, the evidence in Gleason et al. (2018) suggests that external auditor scrutiny itself does not account for differences in the quality of the mapping. Additionally, external auditor scrutiny likely increased for all US firms following FIN 48, resulting in more comparable reporting of reserves.

  7. Leone et al. (2019) advocate for adjusting the effect of outliers using the following methods, in order of effectiveness: 1) using robust regressions (via a Stata command), which reweight observations with unusual leverage; 2) removing outliers with a Cook’s D that exceeds 4/N to remove observations with high leverage; 3) winsorization at an ad hoc percentile; and 4) truncation at an ad hoc percentile. Because we reweight observations through entropy balancing to increase the comparability of our treatment and control groups, we do not employ robust regression to reweight influential observations. Instead, we remove highly influential outliers using method (2), which allows us to preserve sample size without changing the underlying data structure.

  8. In untabulated robustness tests, we also utilize propensity-score matching to identify appropriate control firms. We match US firms to Canadian firms (with replacement) that have a propensity score within a caliper of 0.2 based on the similarity of their control variables. Because our treatment sample (US firms) is significantly larger than our control sample (Canadian firms), matching with replacement can result in reduced bias because multiple treatment observations can be matched to a single similar control rather than being forced to be matched to dissimilar controls (Dehejia and Wahba 2002). Our results remain robust to using propensity-score matching.

  9. In additional analyses, we include Canadian firm-year observations that use IFRS as the reporting standard (ACCSTD = “DI”). Our results remain unchanged. However, to maintain a cleaner setting, we limit our main control sample to only Canadian firms reporting on Canadian GAAP. We also use alternate non-Canadian control samples in additional tests. See Sec. 5.4 for details.

  10. Our sample period for time t spans from 2001 to 2010. For each time t observation, we examine cash taxes paid over the next three years (t + 1 to t + 3). Therefore, for 2010 observations, the dependent variables are cash taxes paid in 2011, 2012, and 2013.

  11. Using confidential IRS data, Ayers et al. (2019) estimate the likelihood of being assigned to the CIC audit program for a sample of firms from 2000 to 2011. Following their methodology, we assign the probability of being in the CIC program based on the coefficient estimates in their prediction model from Table 3, Panel A, Column 1, as follows: CIC Likelihood Score = -5.822 + 0.339*AssetPoints + 0.502*GrossReceiptsPoints + 0.221* GeoSegPoints + 0.154*BusSegPoints + 0.052*ForeisnSalesPoints + 0.224*ForeignTaxPoints. The “points” assigned to each criterion are computed using Compustat variables following the definitions in Appendix 2 in Ayers et al. (2019).

  12. See the discussion of Canadian audit criteria in the PwC worldwide tax summary: “Traditionally, all corporations with gross income over CAD 250 million, and their affiliates, are assigned a large case file team and undergo an annual risk assessment. Corporations rated as high risk are generally audited annually” (PricewaterhouseCoopers 2021). We also appreciate helpful discussions about CRA audit criteria with Nick Pantaleo, former tax partner at PricewaterhouseCoopers in Ontario, confirming that this threshold was consistent throughout our sample period.

  13. Because participation in the CIC program only identifies the risk of audit by the IRS, we also use an asset size-based threshold to define total audit risk for US firms in untabulated tests. Based on prior literature and IRS practice, we define US firms as having high audit risk if their total assets are at least $250 million and low audit risk if their total assets are below this threshold (see Robinson et al. 2016; Hoopes et al. 2012). Robinson et al. (2016) point out that, while the IRS does not define a specific size threshold for likely audit, multiple practitioner and administrative sources, including the former IRS Deputy Commissioner Steven Miller, identify large taxpayers as those with at least $250 million in assets, which are targeted by the CIC program. The untabulated results using this threshold are consistent with our tabulated results. Using the asset threshold to classify audit risk for US firms, we find that firms with high audit risk experience a significantly positive incremental association between tax expense and cash taxes paid for t + 2 and t + 3. The tax expense of firms with low audit risk assignment also exhibits a marginal positive association with t + 3 taxes paid relative to the control sample. As in our tabulated results, we also do not find that the coefficient on the interaction of interest between high and low audit risk groups is significantly different.

  14. Inferences are unchanged if we split the US sample at the median or alternatively define high/low audit risk using the extreme quartiles or quintiles of the CIC likelihood score.

  15. We thank Scott Dyreng for making Exhibit 21 data publicly available on his website.

  16. Although it is possible that cross-listed Canadian firms also have a set of Canadian GAAP financial statements, we observe very few that do. We manually inspect the financial filings of a random sample of cross-listed Canadian firms and find that roughly 3% have Canadian GAAP financial statements, which does not provide a large enough sample to conduct within-firm accounting standard comparisons.

  17. The sample of Canadian cross-listed firms in the tests amounts to approximately 120 observations. Power tests indicate that the sample size is sufficiently large to detect an effect at a 10% alpha level.

  18. Non-Canadian worldwide firm observations are obtained from Compustat Global and span 81 countries in group (2) and 99 countries in group (3). Group (3) includes both voluntary and mandatory IFRS adopters. Due to the significant heterogeneity of the worldwide firms and the variance in data reporting quality, we winsorize variables at the 1st and 99th percentiles and include country fixed effects in regressions with these samples. As in previous tests, we also utilize entropy balancing on the same covariates in each specification.

  19. Results are also robust to dropping 2007 as the FIN 48 transitional year.

References

Download references

Acknowledgements

We appreciate helpful comments and suggestions from Jennifer Blouin (discussant), Will Ciconte, Paul Demeré, Shari Mann, Lil Mills, Michelle Nessa, David Samuel, Erin Towery, Jaron Wilde, Ryan Wilson, meeting participants at the 2017 NTA Annual Conference, and workshop participants at the Ohio State University, Purdue University, the University of Connecticut, and the University of Illinois.

Author information

Authors and Affiliations

  1. Henry B. Tippie College of Business, The University of Iowa, Iowa City, IA, USA

    Cristi A. Gleason

  2. Eli Broad College of Business, Michigan State University, East Lansing, MI, USA

    Kevin S. Markle

  3. J.M. Tull School of Accounting, University of Georgia, Athens, GA, USA

    Jane Z. Song

Authors
  1. Cristi A. Gleason
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Kevin S. Markle
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Jane Z. Song
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Cristi A. Gleason.

Additional information

Publisher's note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Appendices

Appendix 1: Variable definitions

Variables

Description (Compustat variables shown in brackets)

Variables of interest

\(Tax\_pd\)

Cash taxes paid [TXPD], scaled by total assets [AT] over the next 1, 2, and 3 years

\(Tax\_exp\)

Total tax expense [TXT], scaled by total assets [AT]

\(US\)

 = 1 if the firm is domiciled in the US; 0 if the firm is domiciled in Canada and reports under Canadian GAAP (where [ACCTSTD] is not “DI” or “US” or “DU”)

\(Postf48\)

 = 1 for fiscal years starting after December 15, 2006; 0 otherwise

Controls and other

\(Size\)

Log of lagged total assets [AT]

\(Leverage\)

The sum of long-term debt [DLTT] and the current maturity of long-term debt [DLC], scaled by lagged total assets [AT]

\(Ptroa\)

Pre-tax income [PI], scaled by lagged total assets [AT]

\(Intangibles\)

Intangible assets [INTAN], scaled by lagged total assets [AT]

Foreign_inc

Pre-tax foreign income [PIFO], scaled by lagged total assets [AT]. Foreign income is set to zero if missing

\(CV\_ptinc\)

The coefficient of variation of pre-tax income, computed as the standard deviation of annual pre-tax income [PI] over the prior 3 years over the absolute mean of pre-tax income over the prior 3 years

Audit risk = Hi

 = 1 for US observations in the top tercile of the likelihood of being assigned to the CIC IRS audit program as defined in Ayers et al. (2019) and Canadian observations with at least CAD250 million in revenues; 0 otherwise

Audit risk = Lo

 = 1 for US observations in the lowest tercile of the likelihood of being assigned to the CIC IRS audit program as defined in Ayers et al. (2019) and Canadian observations with less than CAD250 million in revenues; 0 otherwise

MNC

 = 1 if the firm reports a value for pre-tax foreign income [PIFO] or (in the case of US firms) report foreign sales in Compustat Segment data or foreign subsidiaries on Exhibit 21; 0 otherwise

Appendix 2: Comparison of accounting for income taxes between US GAAP and Canadian GAAP (Pre-IFRS)

This table summarizes key elements in accounting for income taxes under US GAAP and Canadian GAAP as of 2010. In general, under US GAAP, accounting for income taxes is governed by ASC 740, which includes the provisions of FIN 48 (ASC 740-10). Under Canadian GAAP, accounting for income taxes is governed by Section 3465 of the CICA Handbook.

Topic

US GAAP

Canadian GAAP

Tax basis

Tax basis is defined by law

Tax basis is defined by law

Tax rates

Enacted tax rates are used

Enacted or “substantively enacted” tax rates are used, where “substantively enacted” means only perfunctory actions are required for the measure to become law

Recognition of deferred tax assets

Deferred tax assets are recognized in full and reduced by a valuation allowance for the amount of the asset that is not more likely than not (greater than 50% likely) to be recognized

Unrecognized deferred tax assets are recognized if it is “more likely than not” that a taxable profit will be available against which the deductible temporary differences can be utilized. Section 3465.30 permits an alternative presentation of all deferred tax assets and a valuation allowance sufficient to reduce the net to an amount that will more likely than not be realized

Foreign nonmonetary assets and liabilities remeasured from local currency to functional currency

No deferred tax is recognized on the remeasurement of foreign nonmonetary assets and liabilities from local currency to functional currency

No deferred tax asset or liability is recognized with regard to the temporary difference resulting from the difference between the translations to the historic exchange rate and the current exchange rate of the cost of non-monetary assets or liabilities of integrated foreign operations

Reconciliation of actual and expected tax rate

Required for public companies only. Expected tax expense is computed by applying the federal statutory rate to pretax income from continuing operations. Non-public companies must disclose the reconciling items but not the amounts

Required for public companies only. The effective rate is obtained by dividing current and deferred tax expenses by the company’s income before taxes

Intercompany sales

Tax expense from intercompany sales is deferred until the related asset is disposed of, and no deferred taxes are recognized for the purchaser's change in tax basis

Under Section 3565.35, no deferred tax asset or liability can be recognized in the consolidated financial statements for a temporary difference between the asset’s tax base for the purchaser and the cost indicated in the consolidated financial statements

Balance sheet classification

The classification of deferred tax assets and liabilities as current or noncurrent depends on the classification of the underlying that generated the temporary difference

Deferred tax assets and liabilities are classified in the current or long-term section on the basis of the asset or liability to which the deferred taxes are related

Uncertain tax positions

ASC 740–10 (FIN 48) establishes a 2-step recognition and measurement approach. A benefit is recognized if it is more likely than not that the underlying tax position will be upheld based on its technical merits. The benefit is measured as the greatest amount that is more likely than not to being realized upon settlement, and a reserve is recorded for the rest

Section 3465 does not provide formal guidance addressing the accounting for tax uncertainties. The guidance in Sect. 3290 (“Contingencies”) is commonly applied because an uncertain tax position may generate a liability of uncertain timing and amount. Recognition and measurement are based on the amount of loss that is “likely” to be realized, where “likely” is accepted to mean a 70–80% chance of occurrence

Special deductions (tax benefits for specific jurisdictions or circumstances)

Special deduction tax benefits should be recognized in the year in which they are available to reduce taxable income on the tax returns. They should not be anticipated by offsetting a deferred tax liability

No similar guidance in Canadian GAAP

Undistributed earnings of investees

Deferred tax is recognized on undistributed earnings of domestic subsidiaries and joint ventures. Deferred US tax, net of foreign tax credits, is also recognized on undistributed earnings of foreign subsidiaries and joint ventures, except when the earnings are designated as indefinitely reinvested

As foreign income is generally exempt from Canadian tax, deferred taxes on foreign income is minimal

Share-based compensation

Deferred tax is computed on the same basis as the share-based compensation expense recognized

Canadian GAAP do not contain any guidelines on this matter

Subsequent changes in deferred taxes that were originally charged or credited to equity (backward tracing)

Subsequent changes to deferred taxes originally charged or credited to equity are generally allocated to continuing operations, not to equity

Subsequent changes to deferred taxes originally charged or credited to equity are recognized in the income statement (3465.63)

Appendix 3: Accounting for uncertain tax positions under US GAAP and Canadian GAAP (Pre-IFRS)

Under US GAAP, uncertain tax positions are accounted for under FIN 48, which requires a two-step recognition and measurement process. Canadian GAAP does not provide specific guidance for the accounting for uncertain tax positions in Section 3465. As a result, guidance in Section 3290 is used to recognize and measure uncertain tax positions. A contingent liability is recognized for each tax position that will likely not be sustained (where “likely” is defined in practice as a 70%–80% chance), i.e., tax positions that have less than 30% chance of being sustained.

To illustrate, suppose management has undertaken a tax position that provides a total possible tax benefit of $100.

Under US GAAP after FIN 48, a two-step process is applied. First, in the recognition step, it is determined if the entire tax position is more likely than not (> 50%) to be sustained. If the position falls below this threshold, a reserve is booked for the entire amount of the tax benefit ($100). If the position is more likely than not to be sustained, the taxpayer proceeds to the measurement step. As illustrated in the table below, management first identifies distinct possible amounts of benefit that could be retained (A). Management then evaluates the likelihood of each amount on the technical merit of the position (B).

In this example, management believes there is a 90% likelihood that the overall tax position will be sustained, passing the recognition hurdle. However, management expects just a 5% chance that the entire $100 will be sustained, a 45% chance that $60 will be sustained, and a 40% chance that $20 will be sustained, resulting in a cumulative 90% chance that at least $20 will be sustained. Therefore, $20 (the greatest amount of benefit having a cumulative probability over 50%) is the recognized benefit, and the amount of the reserve is $80.

(A)

Amount of tax benefit management believes will be sustained

(B)

Percentage likelihood tax benefit will be sustained

(C)

Cumulative probability tax benefit will be sustained

US GAAP

(FIN 48)

Greatest cumulative probability over 50% recognized (reserve for the rest)

Canadian GAAP

Single best estimate of loss

$100

5%

5%

$20 recognized;

$80 tax reserve

$100 recognized;

$0 tax reserve

$60

45

50

$20

40

90

Under Canadian GAAP, if the likelihood of the tax position being sustained is at least 20%–30%, no reserve is booked; otherwise a reserve is booked for the full amount of the tax position. This is similar in spirit to the recognition step under FIN 48, but with a higher likelihood threshold and no measurement step. In this case, because the likelihood of the tax position being sustained is 90%, the amount of reserve booked is $0.

US and Canadian GAAP will record the same reserves for all positions with likelihoods of being sustained of less than 20%–30% (full reserve) and of 100% (no reserve). For positions with overall likelihoods between 30 and 50%, US GAAP will record a full reserve, and Canadian GAAP will record no reserve. For likelihoods above 50%, US GAAP will record a reserve following the measurement step, and Canadian GAAP will record no reserve.

Rights and permissions

Springer Nature or its licensor (e.g. a society or other partner) holds exclusive rights to this article under a publishing agreement with the author(s) or other rightsholder(s); author self-archiving of the accepted manuscript version of this article is solely governed by the terms of such publishing agreement and applicable law.

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Gleason, C.A., Markle, K.S. & Song, J.Z. Did FIN 48 improve the mapping between tax expense and future cash taxes?. Rev Account Stud 29, 1794–1830 (2024). https://doi.org/10.1007/s11142-022-09751-8

Download citation

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11142-022-09751-8

Keywords

JEL classification

Search

Navigation