Estimating Downside Tax Risk Using Large Unfavorable Tax Payments

Abstract

We examine the financial statement disclosures that accompany settlements of uncertain tax benefits (UTB). We use textual analysis to develop a measure of the similarity between tax footnotes and a tax settlement-specific list of terms intended to capture unfavorable outcomes. This proxy represents settlements involving additional, unanticipated payments or tax expense in excess of the UTB accrual. After demonstrating that this proxy is associated with a subset of manually verified unfavorable settlements, we examine whether the market reacts to disclosure of these negative events. Evidence from short-window abnormal returns analyses supports that stockholders negatively value the unfavorable settlements, as captured by our proxy. Our research adds to the emerging literature that examines the tax outcomes within firms by developing a measure that captures disclosure of plans that fail to be upheld by tax authorities. Our research also provides a method to classify routine but ambiguous financial statement disclosures, and demonstrates specifically the value relevance of certain UTB information.