We develop a model to examine the effects of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), on the strategic interaction between publicly traded corporate taxpayers and the government. Several of our findings contradict conjectures voiced by members of the business community regarding the economic effects of implementing FIN 48. Specifically, taxpayers with strong facts obtain higher expected payoffs from uncertain tax benefits and some disclosed liabilities understate the expected tax liability. Consistent with the common conjectures, however, some taxpayers are more likely to be audited or are deterred from entering into transactions that generate uncertain tax benefits because of FIN 48.

FIN No. 48, Accounting for Uncertainty in Income Taxes (FASB 2006), requires firms to disclose tax reserves and to record changes in tax reserves at adoption of FIN No. 48 as cumulative effect adjustments in stockholders’ equity. We predict that between the enactment and adoption of FIN No. 48, relative to historical levels, firms settle disputes more often to potentially decrease visibility to the IRS and release reserves more often to reduce scrutiny and increase earnings (as opposed to retained earnings). We analyze 2005 and 2006 10-Qs and 10-Ks for the 100 largest nonfinancial, nonutility firms followed by analysts. Between enactment and adoption of FIN No. 48, relative to historical levels, firms report more settlements with tax authorities and release reserves more frequently. In addition, firms with higher IRS deficiencies are more likely to settle disputes. Between enactment and adoption of FIN No. 48, firms increased earnings by releasing $4.4 billion of tax reserves, nearly equaling the $4.5 billion released at adoption.