What Does the Volatility of Tax Reserves Signal about Firms' Tax Positions?

Abstract

We examine whether a previously unexplored facet of firms' unrecognized tax benefits (UTBs)-their volatility-provides a relevant signal to external stakeholders about the uncertainty of a firm's tax positions and strategies. We posit that the volatility of UTB additions (UTB volatility) is indicative of ex ante tax uncertainty because it reflects different, expanded, and/or unfamiliar tax positions. As such, unlike the level of UTBs or ETR volatility, UTB volatility can provide an ex ante signal of changes in tax-related risk. Consistent with expectations, we find that UTB volatility is associated with increased tax authority audit and compliance risk, credit risk, and overall current and future firm risk. Specifically, we find that UTB volatility is associated with greater IRS scrutiny and future tax settlements, lower credit ratings, and lower firm value and greater future return volatility. Consistent with UTB volatility capturing different, expanded, and/or unfamiliar tax positions, we document that R&D expense volatility, operating volatility, and geographic expansion contribute to UTB volatility. We also find that UTB volatility is incrementally more informative about the risk-related firm outcomes that we examine than ETR volatility, the level of UTBs, and other underlying firm activities. Overall, our results suggest that UTB volatility serves as a unique signal of ex ante uncertainty about a firm's tax positions that is relevant for the risk assessment of various stakeholder groups.

Keywords: Unrecognized tax benefits, ASC 740, volatility, tax uncertainty, tax strategy, risk relevance, audit risk, compliance risk, credit risk JEL Codes: G10, M41, H26, ASC 740, volatility, tax uncertainty, tax strategy, risk relevance, audit risk, credit risk, compliance risk