The Usefulness of Disclosures of Untaxed Foreign Earnings in Firm Valuation

Abstract

Under current accounting rules, U.S. multinationals are not required to record liabilities for future taxes on earnings of foreign subsidiaries, as long as those earnings are deemed to be indefinitely reinvested in those subsidiaries. These rules allow considerable flexibility in the designation of earnings deemed permanently reinvested and the reporting of expected repatriation taxes thereon. Some firms disclose amounts for unrecorded taxes on permanently reinvested earnings, but most do not. We show that while estimated repatriation taxes are relevant in explaining share prices of non-disclosing firms, they are less relevant than firm-disclosed amounts are in explaining share prices of disclosing firms. This result is due to estimated repatriation tax amounts exhibiting downward bias, and less accuracy for actual repatriation tax effects, relative to firm-disclosed repatriation tax amounts. We propose new disclosures designed to improve the relevance of estimated repatriation tax amounts.

Relative Valuation of Alternative Methods of Tax Avoidance

“…In contrast, the coefficient on PRETAX ESTIMATE AVOID3 is insignificant (p=.2609), suggesting that the discount on tax avoidance related to deferral of the residual tax is isolated to disclosure of the estimated amount of tax due upon repatriation. This result is consistent with Bauman and Shaw (2008) Table 9B.…”

“…However, the valuation inferences about the unrecognized liability relate to the disclosure of the liability and not the tax deferral associated with PRE because of the study's assumption that firms that do not disclose the liability will not owe tax upon remission. Bauman and Shaw (2008) show that the positive valuation of PRE declines as the expected residual tax liability increases, although the negative impact is smaller in firms for which the liability is estimated. Investors are found to positively value the tax deferral generated by PRE once the impact of the unrecognized liability on the valuation of PRE is accounted for.…”

“…of an estimate of the residual tax through a deferred tax liability (PROVIDE AVOID) derived from equation 3c. Collins et al (2000) find that investors negatively value the disclosed unrecognized residual tax liability on foreign earnings, while Bauman and Shaw (2008) find that investors positively value the deferral of the residual tax. I address these contrasting results using the following model, expanded from Model 6:…”

“…9 Although the change in the deferred tax liability reported for foreign subsidiaries when the FETR is greater than the statutory rate and estimating the residual tax at 35% for observations with a FETR equal to 0. The mean absolute difference between (standard deviation of) the disclosed and estimated amount is $68.34 million (185.398) and $84.73 million (203.223) for the Bauman and Shaw (2008) and Krull (2004) methods respectively. 9 Unremitted foreign earnings represent only one component of the outside basis difference.…”

“…Bauman and Shaw (2008) state that half of the S&P 500 firms report PRE in their 2003 10-K's and the ratio of PRE to the market value of equity for firms disclosing the unrecognized liability ranges from 3.1% in the first quartile to 10.7% in the third quartile. Albring, Dzuranin, and Mills (2005) report that approximately 41% of corporations disclosing PRE in 2002 have foreign tax rates less than the statutory tax rate, suggesting variation in whether firms reporting PRE would owe tax upon repatriation.…”