The predictive ability of tax contingencies for future income tax cash outflows

Abstract

Prior research shows that contingent liabilities do not accurately predict future cash payments due to the managerial discretion afforded by accounting standards. We examine the extent to which current accounting guidance for a material contingent liability—the reserve for unrecognized tax benefits (UTBs) under Financial Interpretation No. 48 (FIN 48)—generates accruals that are predictive of future income tax cash outflows. We document that UTBs fully unwind as cash tax payments over the subsequent 5 years, suggesting that managers, on average, accurately incorporate their expectations of future tax liabilities. This result persists for firms that are (1) most affected by the implementation of FIN 48, (2) unable to impound detection risk into their reserves, (3) engaged in relatively more ex ante tax avoidance, (4) suspected to have engaged in earnings management through the tax accounts, and (5) subject to plausibly exogenous shocks to tax reporting. Overall, our results suggest that current accounting guidance under FIN 48 for contingent tax liabilities enables managers to accurately report, and financial statement users to reliably predict, future cash obligations.