The Moderating Role of Tax-Related Internal Control Weaknesses in the Market Valuation of Unrecognized Tax Benefits

Abstract

This paper examines the effect of tax-related material weakness in internal controls on investors’ valuation of unrecognized tax benefits (UTBs). Firms are required to record a UTB when their uncertain tax positions are unlikely to be sustained upon tax return audit. While Koester (2012) finds that investors positively value UTBs, we posit that a tax-related material weakness in internal controls over financial reporting (MWIC) represents information risk in the tax account, reducing the value-relevance of UTBs. We predict that the positive relation between market value of equity and UTBs is attenuated when firms report a tax-related MWIC, and our empirical tests reveal that the relation is completely mitigated in the presence of a tax-related MWIC. Falsification tests confirm that non-tax related MWICs do not attenuate the positive relation between market value of equity and UTBs, consistent with tax-related MWICs capturing low information quality specific to the tax account.