Did FIN 48 Limit the Use of Tax Reserves as a Tool for Earnings Management?

Abstract

We utilize new income tax reserve disclosures required under FIN 48 to examine whether managers use discretion over this accrual to manage earnings to meet the consensus analyst forecast. We find that firms with pre-managed earnings (i.e., earnings before the change in the tax reserve) that are below the consensus analyst forecast are far more likely to reduce their tax reserves and thus report higher net income. In fact, we find that 37 percent of firm-years with pre-managed earnings below the consensus forecast meet the forecast when the change in the tax reserve is included in earnings. In contrast, only 9.8 percent of firm-years with pre-managed earnings above the consensus forecast increased their tax reserves to the extent that it caused them to miss the consensus forecast. This asymmetric result is consistent with managers using their discretion over tax reserves to meet consensus analyst forecasts. Using a proxy for changes in tax reserves developed by Blouin and Tuna (2007), we also document a decline in the use of tax reserves to meet the consensus analyst forecast following the adoption of FIN 48. Nonetheless, our results using both estimated and actual changes in tax reserves clearly suggest that managers continue to use their discretion over this account to meet the consensus analyst forecast, although at a lower rate of recurrence than during the pre-FIN 48 time period.

Keywords: Tax reserves, unrecognized tax benefits, FIN 48, earnings management, analyst forecasts

JEL Classification: M40, M41, M49