Materiality and Contingent Tax Liability Reporting

Abstract

We investigate factors that explain firms' decisions to disclose and record contingent tax liabilities. Our findings are based on confidential Internal Revenue Service audit data and financial statement footnotes for 100 large industrial firms from 1987 to 1995. Descriptive statistics indicate that these firms often fail to disclose IRS claims for tax deficiencies that exceed a 5-percent-of-income rule of thumb. We find that the probability of disclosure increases in the relative amount of the claim or the expected loss, although the largest claims drive this result. Our evidence is consistent with firms using a stable measure of size, such as assets or normal income, to gauge materiality, rather than relying only on current period reported income. We also find that the amount accrued for the contingent liability increases in the amount of the expected loss. However, our inferences may not generalize beyond a population of large, frequently audited firms.

Audit Fees and Book-Tax Differences

“…Another example is the tax contingency reserve (i.e., the tax cushion) recorded when firms have taken an aggressive tax position and need to record a reserve for the potential future costs associated with the position being overturned. 11 Management can manipulate earnings through these accounts (Gleason and Mills 2002;Miller and Skinner 1998;Schrand and Wong 2004;and Dhaliwal, Gleason, and Mills 2004). Thus, the use of total book-tax differences as measured from financial statements will incorporate earnings management using these methods, earnings management in pre-tax earnings, and tax aggressiveness.…”

“…They also find that the information content of the tax-to-book ratio is lower for high tax planning firms, based on long-run current ETRs. Tax expense can also represent a source of audit risk, either as a source of internal control weakness (Gleason, Rego and Pincus 2008) or due to challenges in estimating tax reserves and related earnings management (Dhaliwal, Gleason andMills 2004, Gleason andMills 2002 Changes in financial accounting methods also affect book-tax differences (Seidman 2009), although many of the provisions, such as accounting for goodwill impairment, require management judgment. Thus, although including accruals largely controls for 'mechanical' book-tax differences (Desai and Dharmapala 2005), we believe that even some of the "mechanical" differences are not as mechanical as they might seem and can at times be informative about managers' discretion in financial and tax reporting.…”

A review of tax research

“…See also Visvanathan (1998) for more evidence on valuation allowances and earnings management. Unlike the valuation allowance, the tax contingency reserve is not limited by the amount of deferred tax assets, was very rarely disclosed prior to FIN 48 (Gleason and Mills, 2002), and 23 FIN 48 became effective in the first quarter of 2007 for most calendar-year companies. This interpretation was issued because the FASB was concerned that "diverse accounting practices had developed resulting in inconsistency in the criteria used to recognize, derecognize, and measure benefits related to income taxes" (FIN 48).…”

Research on the Effect on Tax Burden of Earning Management Based on Lipschitz Theory

“…Intuitively, a Lipschitz continuous function is limited in how fast it can change: there exists a definite real number such that, for every pair of points on the graph of this function, the absolute value of the slope of the line connecting them is not greater than this real number; this bound is called the function's "Lipschitz constant" (or "modulus of uniform continuity") [6].…”