Abstract
We examine whether the regulatory changes required by the Sarbanes–Oxley Act of 2002 (SOX) and Financial Accounting Standards Board Interpretation No. (FIN) 48 reduced the propensity for earnings management through the reserve for income taxes. Given prior evidence that firms use this reserve to manage earnings to beat the consensus analyst forecast, the regulatory changes implemented by both SOX and FIN 48 allow us to study the effects of accounting regulation on earnings management. We find that neither SOX nor FIN 48 reduced earnings management through the reserve for income taxes. Thus, in contrast to research that examines whether SOX affected nontax, accrual-based earnings management, our results suggest managers continue to take advantage of their discretion over the accounting for income taxes to beat the consensus analyst forecast in both the post-SOX and post-FIN 48 periods.
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Notes
The SEC complaint alleged that Dell improperly accounted for $17 million in excess Japanese consumption tax reserves. Under GAAP, Dell should have released the entire reserve at the end of the 2003 fiscal year. Instead, Dell allegedly released only $5 million of the tax reserve in 2003 into earnings. Dell then released an additional $7.1 million into earnings during 2004 to prop up earnings and offset the effect of an unrelated legal settlement (http://www.sec.gov/litigation/litreleases/2010/lr21634.htm).
Dhaliwal et al. (2004) base their tests on a sample of firms in the Large and Mid-Size Business Program of the Internal Revenue Service from 1986 to 1999. Thus their tests are prior to the Sarbanes–Oxley Act and FIN 48.
Miller and Skinner (1998) primarily investigate whether managers set the valuation allowance in accordance with the provisions of SFAS No. 109. Their earnings management tests are supplemental analyses based on a sample of 200 firms in the two years following the implementation of SFAS No. 109. Miller and Skinner do not examine whether the propensity for earnings management through the valuation allowance decreased from the pre- to the post-SFAS No. 109 period.
The term “tax benefit” typically refers to any item that reduces a taxpayer’s income tax liability, including expenses, losses, and tax credits. Negative tax expense is also sometimes referred to as a tax benefit.
There must be a greater than 50 % likelihood that a tax position will be sustained upon audit based on its technical merits, for any tax benefit to be recognized in the financial statements.
In some cases, uncertain tax benefits may relate to deferred taxes, and in those cases, increases in the contingency for uncertain tax benefits would not affect the reported tax expense. See Dunbar et al. (2007) for detailed examples of the journal entries necessary to record contingencies for unrecognized tax benefits.
Only firms with profitable foreign operations have the opportunity to designate earnings as permanently reinvested abroad (and thus avoid the recognition of deferred tax expense), and only firms with significant deferred tax assets have the opportunity to increase (and subsequently decrease) a valuation allowance. In contrast, most firms face uncertainty in their tax positions and thus require tax reserves.
Reductions after FIN 48 adoption also increase net income; thus, the impact of tax reserve reductions on retained earnings upon FIN 48 adoption was a one-time event.
This expectation is based on a 10 % significance level to reject the null hypothesis.
An example of an uncertain tax benefit that would affect a firm’s ETR is the claiming of a research and development tax credit that management did not feel met the “more likely than not” criterion of FIN 48. In that case, the firm would claim the credit on the tax return but would increase the tax reserve for the amount of the credit resulting in an increase in the firm’s current tax expense and an associated increase in the ETR. An example of an uncertain tax benefit that would not affect a firm’s ETR would be if a firm made the decision to depreciate an asset over three years, when it is certain the asset should be depreciated over five years. The decision to depreciate over three years does not meet the “more likely than not” standard. The temporary difference in the amount of depreciation from using three- versus five-year recovery period would lead to an increase in the tax reserve but would not affect the firm’s total tax expense (or ETR).
Blouin et al. (2010) find evidence consistent with firms having discretion over the timing of their settlements with tax authorities, but the amounts of such settlements are largely nondiscretionary.
Ideally we could identify the discretionary portion of tax reserve changes that affect a firm’s ETR. Unfortunately, firms are not required to disclose the portion of tax reserve changes that affect a firm’s ETR for each category of tax reserve changes (e.g., those related to current and prior year tax returns, settlements with tax authorities, and statute of limitations expirations). Thus we consider ∆TAXRES_ETR and DISCR_∆TAXRES as alternative proxies for the same underlying construct.
Recall that we calculate estimated tax reserve changes (QTR4_ΔCUSHION) as current tax expense less cash taxes paid less the change in income taxes payable. Changes in net operating loss (NOL) carryforwards add measurement error to QTR4_ΔCUSHION because changes in NOL carryforwards cause current tax expense to differ from cash taxes paid but are typically unrelated to tax reserve changes.
As a robustness test we re-estimate the analyses in Table 5 but include control variables that are calculated for the fourth fiscal quarter (rather than on an annual basis), to mirror our calculation of the estimated change in tax reserves from the third-to-fourth fiscal quarter (QTR4_∆CUSHION). That is, we calculate DACC, ∆CFO, and DTE for just the fourth fiscal quarter. Our results for this new model specification are again qualitatively similar to those presented in Table 5. Thus the differing periods for our variable of interest (QTR4_∆CUSHION) and the control variables (DACC, ∆CFO, and DTE) do not account for our Table 5 findings.
As a robustness test, we re-estimate our analyses in Table 6 and require firms to have observations in both the pre-SOX and post-SOX/pre-FIN 48 periods (columns 1 and 2) and in both the post-SOX/pre-FIN 48 and post-FIN 48 periods (columns 2 and 3). Although our sample sizes decrease by approximately 15 percent, the coefficient estimates are qualitatively similar in both size and significance levels. These results suggest that the results in Table 6 are not driven by different sample compositions in the pre- and post-regulation periods.
In untabulated analyses, we re-estimate Tables 7 and 8, which are based on the portion of the change in tax reserves that would affect a firm’s ETR (∆TAXRES_ETR), to be based instead on the total change in tax reserves as reported under FIN 48 (∆TAXRES). We perform this robustness check because the sample size for tests based on ∆TAXRES_ETR is significantly smaller than the sample size for tests based on ∆TAXRES. Specifically, there are 3,586 observations in Table 8 analyses that are based on ∆TAXRES_ETR but 6,193 observations when the Table 8 analyses are based on ∆TAXRES. We find that the estimated coefficients for regressions of Eqs. (1) and (2) that include ∆TAXRES (instead of ∆TAXRES_ETR) are qualitatively similar in both size and significance levels as those tabulated in this paper.
See Dunbar et al. (2007) for examples of specific journal entries related to changes in the tax reserve.
Expiration of the statute of limitations eliminates the possibility that the firm would be required to pay any additional income tax related to that tax return and thus allows the firm to currently recognize the previously unrecognized tax benefit (by reducing the tax reserve and reporting higher after-tax income).
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Appendices
Appendix 1: The relationship between tax reserve changes and the total tax accrual
This appendix illustrates how the change in the reserve for income taxes (ΔTAXRES) relates to other components of the accrual for income taxes (i.e., the tax accrual) and how the components of the tax accrual map into the balance sheet. Following Choudhary et al. (2014), we represent the tax accrual (TAX_ACCR) as the difference between total tax expense (TXT) and cash taxes paid (TXPD) during the year. This definition is consistent with the Hribar and Collins’s (2002) definition of an accrual as the difference between the revenue/expense and its related cash in/outflow (i.e., their Eq. 4).
Equation (3) can be decomposed by splitting total tax expense (TXT) into current tax expense (TXC) and deferred tax expense (TXDI).
The change in income taxes payable (ΔTAXPAY = TXP t − TXP t-1 ) is equivalent to the difference between current tax expense (TXC) and cash taxes paid (TXPD) less the change in the tax reserve (ΔTAXRES).
Equation (5) forms the basis of the Blouin and Tuna (2007) measure of the change in the tax reserve (ΔCUSHION) used in this study. Specifically, Eq. (5) can be re-arranged as ΔTAXRES = (TXC − TXPD − ΔTAXPAY). This equation is equivalent to the definition of ΔCUSHION presented in “Appendix 2”.
Based on Eq. (5), if a firm does not change its tax reserve then, similar to other accrued liabilities, the change in income taxes payable is equal to the difference between the expense on the income statement (i.e., current tax expense TXC) and the corresponding cash outflow (i.e., cash taxes paid TXPD). However, if a firm records an increase in reserves for uncertain tax positions taken in the current period, this increase will generate offsetting changes to current tax expense (TXC) and cash taxes paid (TXPD) in Eq. (5) above. Re-arranging Eq. (5) yields the following:
Substituting Eq. (6) into Eq. (4) and re-defining TXDI as the change in deferred tax liabilities less the change in deferred tax assets (ΔDTL − ΔDTA) yields Eq. (7).
Equation (7) illustrates how the tax accrual maps into the balance sheet. The total tax accrual consists of three separate components: the change in income taxes payable (ΔTAXPAY), deferred tax expense (as measured by changes in the deferred tax asset and liability accounts, i.e., ΔDTL − ΔDTA), and the change in tax reserves (ΔTAXRES)). Based on Eq. (7), we also note that, if a firm decreases its reserve for income taxes (ΔTAXRES), it will report a smaller tax accrual (TAX_ACCR) and thus lower tax expense and higher after-tax income. This is the phenomenon that we expect to find around the consensus analyst forecast.
We note that mergers and acquisitions, below-the-line items, and stock option accounting also affect the tax accrual but, for simplicity, are not incorporated into the analysis above. Mergers and acquisitions have a particularly distortive effect on the tax accounts and cause a loss of comparability with prior year tax information. These distortions increase the opacity of the tax accrual and thus provide managers greater flexibility to manipulate income tax expense.
The table below illustrates the components of tax reserve changes (ΔTAXRES) that firms must disclose in the tax footnote of their financial statements following the implementation of FIN 48.
Tax reserve—tabular reconciliation | |
|---|---|
Unrecognized tax benefits, opening balance (TXTUBBEGIN) | $XX |
Plus: Gross increases—Tax positions in prior periods (TXTUBPOSPINC) | XX |
Less: Gross decreases—Tax positions in prior periods (TXTUBPOSPDEC) | (XX) |
Plus: Gross increases—Current period tax positions (TXTUBPOSINC) | XX |
Less: Settlements with tax authorities (TXTUBSETTLE) | (XX) |
Less: Expirations of statute of limitations (TXTUBSOFLIMIT) | (XX) |
Unrecognized tax benefits, ending balance (TXTUBEND) | $XX |
Examples of specific changes in tax reservesFootnote 18:
If on the current year tax return a firm claims an R&D tax credit that is subject to some uncertainty with respect to its ultimate treatment by the relevant tax authority, then the firm would increase its unrecognized tax benefits as “Gross increases—Current period tax positions.”
If in the current fiscal year a tax authority starts pursuing particular tax issues that are relevant for a firm’s prior year tax returns (e.g., transfer pricing issues), then the firm may increase its unrecognized tax benefits as “Gross increases—Tax positions in prior periods.”
If in the current fiscal year the tax authority loses a court case with another taxpayer regarding a particular issue that is relevant to a firm’s prior year tax returns, then the firm may decrease its unrecognized tax benefits as “Gross decreases—Tax positions in prior period.”
If in the current fiscal year a firm settles an uncertain tax position with a tax authority (either favorably or unfavorably) and the firm had previously accrued a contingent tax liability for this tax position, the firm would decrease its tax reserves as “Settlements with tax authorities.”
If in the current fiscal year the statute of limitations expires with respect to a specific tax return (e.g., the U.S. federal tax return for tax year 2012) for which the firm had previously accrued a contingent tax liability, the firm would decrease its tax reserves as “Expirations of statute of limitations.”Footnote 19
Appendix 2
See Table 10.
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Cazier, R., Rego, S., Tian, X. et al. The impact of increased disclosure requirements and the standardization of accounting practices on earnings management through the reserve for income taxes. Rev Account Stud 20, 436–469 (2015). https://doi.org/10.1007/s11142-014-9302-y
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DOI: https://doi.org/10.1007/s11142-014-9302-y