The effect of conservative financial reporting and tax aggressiveness on the market valuation of unrecognized tax benefits

Abstract

PurposePrior studies document a positive relation between stock prices and tax-related contingent liability, unrecognized tax benefits (UTBs) and interpret the finding as evidence that investors reward tax aggressiveness. The purpose of this paper is to explore the nature of this puzzle finding by considering a link between UTBs and financial reporting strategy and propose that financial reporting conservatism may explain the positive association between UTBs and stock prices.Design/methodology/approachTo estimate the incremental valuation weights on UTBs, the authors employ the Ohlson (1995) valuation model and regress stock prices on UTBs and its interactions with the proxies for financial reporting conservatism and tax aggressiveness. Further, the authors adopt a UTB estimation model to decompose its balance into the predicted and unpredicted components.FindingsThe authors find that the reporting conservatism has a positive effect on the market valuation of UTBs. The authors also find some evidence that tax aggressiveness increases the valuation weight of UTBs. When UTBs are decomposed into predicted and unpredicted components, the authors find that the effect of financial reporting conservatism is more pronounced for the market valuation of predicted UTBs. Collectively, the evidence suggests that conservative financial reporting is a major driver of the positive valuation of UTBs and that tax aggressiveness plays a less significant role in investors' valuation decisions.Originality/valueWhile prior studies focus on how UTBs are associated with stock prices, this paper is the first attempt to explain why UTBs are positively valued by investors.