Materiality and Contingent Tax Liability Reporting

TLDR

The study focuses on large, frequently audited industrial firms, limiting the generalizability of its conclusions. The authors examine which factors influence firms’ decisions to disclose and record contingent tax liabilities. They analyze confidential IRS audit data and financial statement footnotes for 100 large industrial firms from 1987 to 1995. They find that firms often fail to disclose IRS claims exceeding a 5‑percent‑of‑income rule, yet disclosure probability rises with larger claim amounts or expected losses—especially the largest claims—while firms appear to assess materiality using stable size measures rather than current income, and the accrued liability amount increases with expected loss.

Abstract

We investigate factors that explain firms' decisions to disclose and record contingent tax liabilities. Our findings are based on confidential Internal Revenue Service audit data and financial statement footnotes for 100 large industrial firms from 1987 to 1995. Descriptive statistics indicate that these firms often fail to disclose IRS claims for tax deficiencies that exceed a 5-percent-of-income rule of thumb. We find that the probability of disclosure increases in the relative amount of the claim or the expected loss, although the largest claims drive this result. Our evidence is consistent with firms using a stable measure of size, such as assets or normal income, to gauge materiality, rather than relying only on current period reported income. We also find that the amount accrued for the contingent liability increases in the amount of the expected loss. However, our inferences may not generalize beyond a population of large, frequently audited firms.