The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants.
Because our lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large.
A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times our research may look at stock prices generally, though from a fundamental and not technical point of view.
Understanding Unrecognized Tax Benefits
In this study, we examine unrecognized tax benefits for the firms comprising the S&P 100. Our objective is to clarify their accounting and measure their significance relative to assets, income tax expense and net income.
While the median unrecognized tax benefit liability for our sample is approximately .8% of total assets, there are some firms with significant amounts of unrecognized tax benefit liabilities approaching ten percent of total assets. One required disclosure is the portion of the unrecognized tax benefit liability that, if recognized, would affect income tax expense. The median measure for this metric calculated across the sample is 77.7%. In effect, for the median firm, if unrecognized tax benefits were to be recognized, 77.7% of the unrecognized benefit would serve to reduce income tax expense and raise net income. Measured as a percentage of net income, the median amount of the portion of the unrecognized tax benefit liability that, if recognized, would affect income tax expense and net income is 11.8%. Given the level of judgment that must be employed in accounting for unrecognized tax benefits, the unrecognized tax benefit liability serves as an after-tax reserve. Adjustments to this reserve can have a material effect on net income.
During 2012, 90 sample firms reported a change in the unrecognized tax benefit liability. For the 50 companies that raised the liability, the median increase in income tax expense is 5.7%, leading to a median reduction in net income of 1.8%. For the 40 companies that lowered the liability, the median reduction in income tax expense is 1.9%, leading to a median increase in net income of 1.0%.
For analysts and investors these findings highlight the potential material effects that changes to unrecognized tax benefits can have on income tax expense and net income. For CFOs, these results offer benchmarking data for evaluating uncertain tax positions relative to other firms. For regulators and accounting standard setters these results offer insight into how accounting and disclosure rules for unrecognized tax benefits are being applied. Finally, for tax authorities, the data compiled here provide insight into the magnitude of uncertain tax positions.
Earnings Quality: Reports on Individual Companies
In these reports we examine one or more dimensions of earnings quality: the cash flow support of earnings, the sustainability of earnings, or the quality of the balance sheet.