This was prepared for presentation at the Global Knowledge Congress Teleconference on "FIN 48: Practical Recommendations" on March 8, 2007. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a great pleasure to speak at today's Teleconference on "Accounting for Uncertainty in Income Taxes." The FIN 48 approach has been the subject of considerable discussion and controversy. My own training is that of a financial and economist theorist rather than as an accountant and since economics offers a useful lens on many policy matters I thought that it would be helpful to offer an outsider's perspective based upon this framework. Incidentally, my own interest in the subject of "uncertainty and income taxes" is further heightened by my being an academic expert in my work as a finance professor on "taxes, uncertainty and asset allocation" in the context of capital gains and estate taxes and retirement fund investing. There the focus concerns how to structure investments across various vehicles to optimize the tax treatment given the investor's desired risk exposure. Of course, in that setting the uncertainty reflects randomness in the returns received from nature rather than uncertainty about the ultimate resolution of disputes with the tax authorities. Here, my focus will be to offer an economic perspective on various aspects of the standard rather than a guide as to "how" firms and auditors should make the types of decisions necessary under FIN 48. Among the issues that I plan to address are what are the nature of the costs associated with alternative formulations of the standard, when does the standard serve the interests of investors and how does the nature of the standard relate to other societal goals, such as producing governmental revenue while minimizing the resulting distortions. At the onset of my remarks I should emphasize, that of course, the views and perspectives that I am expressing today are my own and not those of the Commission or my colleagues on the staff of the United States Securities and Exchange Commission.
2. An Overview of FIN 48
As I begin the substance of my presentation I'd like to first highlight what I view as some of the key features in the new standard, which will be emphasized in the substantive remarks later in my presentation. The probabilistic estimate of the outcome that is crucial to the decision as to how to reserve will now be based upon technical tax law factors. Using these factors, if the probability that the tax authority will prevail ultimately exceeds 50%, then the full exposure, i.e., 100% of the amount, must be reserved under FIN 48. In contrast, the probabilistic estimate can be used if the probability that the tax authority will prevail is below 50%. In contrast, previously the probabilities need not be computed using technical tax law considerations and a reasonable probabilistic assessment could be used for computing the required reserve no matter what that level. In the FIN 48 formulation there is an asymmetry in reserving in that if the probability that the tax authority prevails exceeds 50%, then the total exposure must be reserved. These issues are relevant not just for federal taxes, but those of a large number of potential jurisdictions as the same standard is relevant for state, local and foreign taxes in many jurisdictions. In fact, the standard requires that these all be updated to satisfy FIN 48 for all "open" tax years-i.e., those years for which the tax authority and firm have not finalized the liability. For example, it often takes close to a decade for this process to be finalized with respect to federal income taxes.
While the issue of reserving seems central in the context of tax liabilities because of the uncertainty about the final liability at the time of the financial filing, most goods and services would have a known price rather than a contingent price at the time that financials were due. One exception would be the impact of outstanding legal exposures, where there again could be considerable uncertainty at the time that the current financials were due and therefore, a reserving approach would again seem appropriate for these contingencies.
3. Economic Interpretations of the Changes in the Accounting Standard
There are a few aspects of the new standard that I'd like to highlight. First, the new standard appears to reduce the firm's and indeed, the auditor's discretion. This arises in several manners. For example, the new standard attempts to determine the probability that the tax authority will ultimately prevail in a more "objective" and less discretionary fashion by basing that upon technical tax code factors. In addition, once the probability that the tax authority will prevail exceeds 50 percent the determination of the reserve is insensitive to the probability. This further reduces the taxpayer's and auditor's discretion. On the other hand, there is still relatively more discretion preserved when the probabilistic assessment is below 50 percent, but arguably that would correspond to the cases in which the discretion is least costly or more limited.
Discretion can lead to a number of alternative consequences. For example, on the one hand it could lead firms to under-reserve in order to increase reported income. Of course, such strategies would not appear viable over the long-term as eventually the actual required tax adjustments become evident. Alternatively, reduced discretion could reduce the ability of the firm to use changes in the stated tax reserves to smooth its income and reduce the perceived riskiness of the firm's income stream, heightening the firm's value.
One interesting aspect of the modification of the accounting rule is that under FIN 48 firms are required to restate past reserves for all open tax years. This reflects the view that the modifications to the firm's balance sheet and not just its current income statement are germane to the assessment of the value of the firm (e.g., greater tax obligations from the past reduces the value of the enterprise) and its shares. This would be germane for improvements in the ability of the marketplace to price shares for the purposes of valuing issuances of the firm's securities and for secondary market trading.
While there are potential benefits to the change in the accounting standard, there also are a variety of potential costs. For example, a more sophisticated and technical tax code perspective will be required by the firm to assess the probability that the tax authority will be successful, raising the costs. The transition itself to the new rule itself may be quite complex since as part of the transition the taxpayer and its auditor will need to review the outstanding reserves for open issues going back many years. The annual steady state costs are potentially more limited because there wouldn't be the need to compute reserve estimates for a second standard and just one year at a time would be computed. Computing the required reserves for the income statement would ensure that consistent reserves would be available for the balance sheet.
Besides the direct out of pocket costs associated with compliance with the new standard and the transition to it, there may be a much more fundamental concern about the costs of the standard. Providing publicly more information about the taxpayer's position on salient tax issues may provide a "roadmap" for the tax authority that may undercut the firm's bargaining power in the associated tax disputes.1
Whether investors in the firm are better off from the change in the accounting standard would appear to depend upon the context. The senior executives of the firm may have much better information than the market about the uncertain potential tax obligations of the firm. The new standard is an approach to potentially reduce the manager's reporting discretion, limiting the potential for private information that would undercut the valuation of the firm. On the other hand, the change in the standard could potentially result in greater accounting and auditing costs for the reasons I have described and undercut the tax position of the firm by providing a public roadmap that would be available to the relevant tax authority. How these types of informational frictions and incentive issues trade off would certainly depend upon the specific context.
We traditionally think of accounting standards as reflecting the interests of the investors in the firms. Along these lines, the work product of reputation intermediaries, such as auditors, can reflect the benefits and costs of investors in monitoring employees and management and limiting their discretion as well as the benefits of more efficient pricing. Of course, prospective investors and lenders will offer more favorable terms to the firm if they are more comfortable with the quality of the information provided by the firm's financials.
However, in this context the more precise roadmap about the firm's tax positions also has implications for the efficiency of financing government as different tax policies can influence the overall deadweight loss costs of taxation. Stepping back from the specifics of this context, note that not all alternative ways of raising the same revenue are equivalent. In particular, some patterns of taxation are relatively more efficient because they impose relatively less deadweight losses or distortions to behavior. Differences in the elasticity of demand for different goods will lead to different tax rates being optimal across goods and in fact, a zero tax rate being optimal for goods that would otherwise not be supplied.2
4. Concluding Comments
By limiting discretion in the setting of tax reserves the FIN 48 standard can potentially reduce under-estimation of reserves and also limit the flexibility of management. Managerial flexibility in accounting can be of concern in a variety of settings because it can potentially lead to "cookie jar" accounting in which managerial discretion masks the firm's performance information and smoothes its earnings profile.
Another interesting issue suggested by this context is the potential impact on auditor independence issues caused by the firm's determination of its tax reserves. Because the firm's outside auditor certifies its tax reserves, the firm will typically require tax advice from a different firm than its auditor. This is not a specific consequence of the technical standard under FIN 48, however. Yet it highlights the importance of the small number of very large accounting players and the limited extent of potential competition, a theme reinforced by the auditor independence requirements.
I welcome your questions during the question and answer period.
Bhattacharya, S. and J. Ritter, 1983, "Innovation and Communication: Signaling with Partial Disclosure," Review of Economic Studies 50, 331-46.
Diamond, P. and J. Mirrlees, 1971, "Optimal Taxation and Public Production Efficiency," American Economic Review 61, 8-27.
Mirrlees, J., 1971, "An Exploration in the Theory of Optimal Income Taxation," Review of Economic Studies 38, 175-208.