Lessons from the First Five Years
Released in 2006, FASB Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109 [Accounting Standards Codification (ASC) 740-10], specifies the accounting and reporting requirements for an entity's uncertain tax positions. Such tax uncertainty arises because of the difficulty in applying ambiguous tax laws to a set of specific circumstances. FIN 48 was prompted by 1) concerns that the diversity in practice regarding uncertain tax positions was resulting in a lack of comparability in the reporting of income tax assets and liabilities, and 2) a desire for increased transparency through formal recognition of the previously unreported income tax reserves maintained by companies. It was assumed that the FIN 48 requirements would improve the disclosure of uncertain tax liabilities and would have a significant-but perhaps unfavorable-impact on financial reporting for many adopting firms.
This study focused on the long-term effects of FIN 48 and investigated the first five years (2007-2011) of FIN 48 reporting for Standard and Poor's (S&P) 100 firms. (The S&P 100 is a subset of the S&P 500 that represents approximately 45% of the maiket capitalization of the U.S. equity market.) Similar to prior research, it found that the FIN 48 cumulative effect adjustment at adoption was insignificant for most companies. It also found that unrecognized tax benefit (UTB) balances, on average, have been slowly rising over time (e.g., UTB balances rose in 2007 for many companies); however, they tend to be small and relatively stable when compared to stockholders' equity and other key financial variables. In addition, there is evidence of industry differences in UTB balances over the five-year observation period. Finally, the authors found that annual average UTB decreases due to prior positions consistently outweighed annual average increases related to prior positions, perhaps indicating a systematic overestimation of tax reserves under FIN 48. These findings provide a long-term perspective on FIN 48 accounting practice that should be helpful to CPAs preparing FIN 48 disclosures.
ASC Topic 740, "Income Taxes" [which superseded Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes] provides companies with a framework for measuring and disclosing the effects of income taxes on U.S. GAAP-based financial statements; however, it offers limited guidance on the recognition and measurement of uncertain tax positions. As a result, prior to the release of FIN 48, many companies recognized uncertain tax positions using the provisions of SFAS 5, Accounting for Contingencies.
A tax position is a stance taken by an entity in a tax return (or expected to be taken in a future return) that is used when measuring current income taxes, deferred income tax assets, or deferred income tax liabilities. Uncertain tax positions arise because companies do not know what the eventual tax liability will be upon review by the 1RS or other tax authorities; the final resolution may not occur for as long as 10 years. Under SFAS 5, companies estimated the amount of taxes for which they might be held liable and charged that additional amount as a tax expense in the current year, thereby creating a tax reserve. FIN 48 outlines a two-step process for recognizing and measuring uncertain tax positions.
Under FIN 48, the recognition of an uncertain tax position requires meeting a "more likely than nof ' threshold, meaning that there is more than a 50% likelihood that the position will be sustained if examined by a tax authority. Once an uncertain position meets the recognition threshold, measurement is defined as the largest amount of tax benefit with more likely than not probability of being realized upon settlement. UTBs associated with uncertain positions result in a reduction in tax refunds receivable or deferred tax assets (or in an increase in taxes payable or deferred tax liabilities), and thereby an increase in income tax expense reported in the current year.
FIN 48 addresses both recognition and derecognition of a position when the threshold criteria are no longer met. FIN 48 requires disclosure of gross UTBs, including a tabular reconciliation of amounts, as well as other details pertaining to UTBs. The desired impact on reporting was increased consistency in recognition, derecognition, and measurement, as well as increased information about the uncertainty in income tax assets and liabilities. FIN 48 required companies to record a cumulative effect adjustment to stockholders' equity at the time of its adoption.
FIN 48 was controversial from the outset, and many groups pushed for its deferral. Some argued that applying the provisions of FIN 48 might result in the violation of debt-equity covenants. Many accountants anticipated that the application of FIN 48 would result in larger income tax liabilities or smaller deferred tax assets. Others were concerned that FIN 48 disclosures would provide a road map for tax authorities to audit specific issues. For example, Chester Spatt, chief economist and director of the SEC's office of economic analysis, stated that "providing publicly more information about the taxpayer's position on salient tax issues may provide a 'road map' for the government that may undercut the firm's bargaining power in the associated tax disputes" ("The Economics of FIN 48: Accounting Uncertainty in Income Taxes," speech by SEC staff, Mar. 8, 2007). In addition, the cost and complexity of implementing FIN 48 raised concerns about compliance and consistency of application issues.
Postimplementation Review of FIN 48
In 2010, the Financial Accounting Foundation (FAF) implemented a postimplementation review process of the accounting and financial reporting standards issued by FASB and GASB. It selected FIN 48 as the first postimplementation review project. (SFAS 109 has also recently undergone the postimplementation review process.)
In January 2012, the FAF issued its postimplementation review report on FIN 48. The objectives were to 1) determine whether FIN 48 is accomplishing its stated purpose, 2) evaluate FIN 48's implementation and continuing compliance costs and related benefits, and 3) recommend ways to improve FASB's standards-setting process. The review indicated the following:
* More information about income tax uncertainties is being reported than before. Moreover, investors are using that information in different ways, such as predicting income tax cash flows and assessing the aggressiveness of income tax strategies.
* Uncertain income tax positions are being recognized and measured more consistently than before. Nevertheless, the review reported that consistently applying FIN 48 guidance might not increase comparability across companies because of the complexity of the Internal Revenue Code (IRC) and differences in management judgment.
* Reported information about income tax uncertainties has become more relevant; however, the review found that this information might not be predictive of future cash flows because FIN 48 employs a benefit-recognition approach. This method recognizes benefits only when they are more likely than not to be sustained based on the technical merits, and it measures those benefits recognized as the greatest amount more than 50% likely to be realized.
* On balance, the benefits of FIN 48's improved consistency and reporting of income tax uncertainty information outweigh its costs.
Prior to completing its review, the FAF commissioned a study of the literature pertaining to FIN 48, with the objective of making this research more accessible to the FAF (Jennifer L. Blouin and Leslie A. Robinson, "Post-implementation review of FIN 48: A Summary of the Academic Literature," working paper, December 2012). Despite this, the FAF report did not include any data on FIN 48's impact beyond the year of its implementation.
This study attempts to fill that gap. It analyzed multiple measures of FIN 48's impact over a five-year period and investigated the magnitude and direction of the cumulative effect, relative to key financial measures in the implementation year; how the UTB ending balances behaved over time; how large the UTB changes were from year to year; and the possibility of differences across industries. The individual components comprising the annual UTB reconciliation were also reviewed to determine if there were any noteworthy patterns.
The FAF report ended hopes by some that the controversial interpretation would be revisited. For, example, the Tax Executives Institute (TEI) filed comments with the FAF in connection with the review ("Post-Implementation Review of FIN 48," Tax Executive, Sep. 30, 2011). It questioned the reasonableness of requiring the disclosure of a gross unrecognized tax benefit number in the notes to financial statements, given that this disclosure might provide a misleading measure of tax risk. It also maintained that the application of FIN 48 is causing a systematic inflation of income tax liabilities. Additional research is needed to address these issues.
Early Information on the Impact of Implementation
Several previous studies have reviewed the financial statements of companies in tie year preceding or during FIN 48 adoption. Two studies by Jennifer Blouin, Cristi Gleason, Lillian Mills, and Stephanie Sikes reported that, companies reported increased settlements with the 1RS in the year preceding adoption of FIN 48 ("What Can We Learn about Uncertain Tax Benefits from FIN 48?," National Tax Journal, September 2007; "Pre-Empting Disclosure? Firms' Decisions Prior to FIN 48," The Accounting Review, May 2010). They also reported that, upon adoption, large companies were just as likely to increase as they were to decrease their unrecognized tax benefits and stockholders' equity.
In addition, Joseph M. Langmead and Kermit O. Keeling looked at companies in the Dow 30 ("How Blue Chip Companies Fared under FIN 48," The CPA Journal, May 2010). They suggested that the perceived effects of FIN 48 were seen as more likely to be negative with respect to stockholders' equity; however, they found the actual impact of adoption to be mostly positive but modest. Similar to the Blouin, Gleason, Mills, and Sikes studies, it was as likely to be positive as negative for individual companies, even though the total unrecognized tax benefits for some firms were substantial. These studies focused on the period before adoption and the cumulative effect at adoption, and they were based on limited samples.
For this study, the authors reviewed the annual financial disclosures for all S&P 100 companies over the first five years of reporting (2007-2011) under FIN 48. To ensure a consistent set of companies during the observation period, those companies in the S&P 100 at the beginning of 2011 were used as the basis for the study. The companies in this sample face a variety of complex tax issues that must be evaluated under FIN 48, due to the nature and size of their operations. Of the companies, 15 were not required to adopt FIN 48 in 2007 because their fiscal year began prior to the December 15, 2006, effective date; these companies made their first FIN 48 disclosures in their fiscal 2008 financial reports.
Effect on Stockholders' Equity
The FIN 48 requirement to disclose the effect of its implementation as a cumulative effect adjustment on stockholders' equity (SE) was met with expectations that this adjustment would be significant and negative (Langmead and Keeling 2010). Exhibit 1 presents an analysis of the cumulative effect of FIN 48 implementation on SE reported in the implementation year. In contrast to expectations, the overall cumulative effect adjustment had an inconsequential effect on SE for the group of companies in this study taken as a whole. Specifically, the adjustment had a positive impact on SE for 31 companies, a negative impact for 40, and no (or immaterial) impact for 14. In addition, when the effect is expressed as a percentage of SE, the median overall change was 0%, or no change. For positive impact companies, the median was 0.1% of SE, and the largest impact was 22.3% of SE. For negative impact companies, the median was -0.1% of SE, and the largest impact was -2.6%.
As was found in the studies discussed previously, the aggregate cumulative effect of FIN 48 implementation on SE was insignificant for the companies contained in this sample. This finding perhaps indicates that accounting for UTBs before and after FIN 48 was not significantly different. An alternative explanation, however, is that the companies decreased their uncertain tax positions prior to implementing FIN 48. It is noteworthy that some individual companies did experience a large cumulative effect upon adoptionfor example, Avon Products experienced a large reduction in SE (-2.6%) and both Altria Group Inc. and Ford Motor Co. experienced large increases in SE (4.5% and 22.3%, respectively).
Analysis of UTB Balances
This study next investigated the magnitude of ending UTB balances in order to determine their materiality. Exhibit 2 com- pares the ending UTB balance for each company to SE, total assets (TA), net income (NI) and total revenues (REV) for all companies by year. The ending UTB averaged 3%-6% of SE and was consistent across all years. The UTB balance averaged about l%-2% of TA and 2%-3% of REV for tie period. Similarly, except for a much higher percentage in 2008 (potentially explained by the economic crisis), UTB balances ranged from 25%-36% of NI. This indicates that UTB balances for most companies were small relative to SE and have been relatively stable when compared to key financial variables. There do not appear to be wide variations in these relationships-for example, ending UTB balances, once established, do not appear to be increasing, as compared to SE and TA. More extreme metrics for a few individual companies were notably contrary to the overall results. Entergy Corp., Ford Motor Co., and Dell Inc. all had UTB to SE relationships in the 30%-40% range.
Annual Changes in UTB Balances
To investigate the stability of UTB balances, the authors examined the annual changes over the five-year period. Exhibit 3 reports the percentage changes in these balances, separated again into increasing, decreasing, no change, and overall impact. The overall annual change for all years was an increasing balance. In each year, approximately half of the companies reported annual increases in their UTB balances, whereas slightly fewer than half reported decreases. For companies with increases (except for 2007), the percentage change in UTB balance ranged from a low of 162% in 2011 to a high of 26.6% in 2010. For companies with decreases, the percentage change in UTB balance ranged from a low of 15.9% in 2007 to a high of242% in 2009.
Most striking is the percentage of companies that reported an increase in their UTB balances in 2007 and the magnitude of these increases on average (47.2%). This may have resulted from difficulties in adjusting to the new FIN 48 standard. If so, it brings into question the total impact of implementing FIN 48 for companies. The absence of significant cumulative effect adjustments by large companies upon adoption reported in earlier studies and confirmed here has led to the conclusion that the measurement methods used previously were consistent with the methods prescribed under FIN 48. But this study found large increases in UTB balances in 2007 that were not reversed in subsequent years. Over a broader implementation window, including both the cumulative effect adjustment and the first year of application, a more positive impact on tax reserves from FIN 48 can be seen.
Although the yearly UTB balance changes for most companies were modest, several had extremely large percentage changes in UTB; this was particularly true in 2007. Exhibit 4 identifies the com- panies with the five largest positive and five largest negative changes in UTB for 2007. CVS Caremark had the largest percentage increase (440%) in UTB in 2007, but this UTB reflected less than 1% of total SE at year-end. McDonald's had the largest percentage decrease in their 2007 UTB (-62%), and their ending UTB was only 1.6% of total SE.
Differences by Industry
Accounting standards frequently differ in their impact on various sectors of the economy; consequently, the authors examined average UTBs and their annual percentage changes by industry using the Standard Industrial Classification (SIC). Exhibit 5 presents this information. Results indicate that the largest changes occurred in 2007 and were positive for most industries; however, one industry (public administration, with two companies) had negative changes in 2007. Three industries (mining and construction; finance, insurance, and real estate; services) had higher average annual increases (in the 15%-26% range). The remaining industries had average positive changes under 12% or slightly negative average changes over the period.
Given the relatively small size of several industries in the sample, some of the annual percentage changes were heavily influenced by one or two companies and should be viewed with care. For example, the 94% change in 2007 for mining and construction is largely due to the 393% change reported by Freeport-McMoRan for 2007. These results suggest that industry differences in UTB balance changes were evident both for individual years (especially 2007) and the five-year period. In addition, there was considerable variability in annual UTB percentage changes within industries. To illustrate, the mining and construction balance changes ranged widely, from 93.9% in 2007 to -15.8% in 2010.
bisights from Reconciliations
The format and content of UTB disclosures was found to be comparable across companies. In addition, the nature of the disclosures was found to be general, and therefore unlikely to be useful in a review by a specific taxing authority. Exhibit 6 presents a summary of the information provided each year by companies to reconcile their beginning UTB balance and their ending UTB balance in accordance with the disclosure requirements of FIN 48. It presents, for each year, the average for all companies of decreases and increases related to current tax positions, decreases and increases related to prior tax positions, and decreases due to settlements with taxing authorities and lapses in statutes of limitations. In all years after 2007, one can see the consistent release of FIN 48 reserves for reasons other than settlements and lapses in the statute of limitations.
The average decrease in unrecognized tax benefits each year related to prior tax positions regularly outweighs the average increase related to prior positions. This finding could indicate that the application of FIN 48 is resulting in a systematic inflation of income tax liabilities as they are initially booked, which must be corrected over subsequent periods (suggested in the TEI's comments to the FAF). In addition, 2010 showed particularly large decreases in UTBs related to prior positions. The 1RS released its own requirements regarding the reporting of uncertain tax positions in 2010. This decrease in UTB balances related to prior-year positions in 2010 might indicate behavior specifically focused on reducing uncertain tax positions in light of the IRS's announcement. This could be similar to the results found in previous studies that indicated increased settlement behavior in the year preceding FIN 48 implementation.
The following are the primary findings of this review of the application of FIN 48 from 2007-2011:
* UTB balances and changes to UTB balances were generally small relative to SE, TA and REV, and have been relatively stable over time; however, UTB balances have tended to rise slowly for most companies and changes to the balance have been large for certain companies in some years.
* Although the cumulative effect on companies' SE at the adoption of FIN 48 was generally insignificant (confirming prior studies), there was a large increase in UTB balances from the beginning to the end of 2007 (the first year of implementation for most). This suggests a steep learning curve for the new standard and perhaps a belated need for a longer implementation period.
* Differences in UTB balance changes by industry were evident both for individual years (especially 2007) and for average annual changes over the five-year period. In addition, there is considerable variability in annual UTB percentage changes within industries. Because certain industries had a small number of companies, however, these results should be interpreted with care; further research is warranted.
* Annual average decreases to the UTB balance related to prior positions, taken consistently, outweigh the annual average increases related to prior positions, perhaps indicating a systematic overestimation of tax reserves under FIN 48.
Patricia Mynatt, PhD, CPA, is a clinical professor of accounting, Richard Schroeder, DBA, is a professor of accounting, and Casper E. Wiggins, PhD, CPA, is a Big Five Distinguished Professor of Accounting, all at the University of North Carolina at Charlotte.