Discretion in accounting for tax reserves: evidence from mergers and acquisitions

I examine the extent to which acquirers exercise discretion in the application of FIN 48 when estimating target tax reserves. By examining the change in target tax reserves recorded through purchase accounting, I am able to hold constant the underlying tax positions, and any changes can be attributed to differences in how the managers of the target and acquirer apply the recognition and measurement principles of FIN 48. For a sample of large public-for-public M&A transactions in which the amount of target tax reserves is observable pre- and post-acquisition, approximately one third (half) of the acquirers adjust target tax reserves by more than half (a quarter) of the preexisting balance. Substantially more acquirers increase rather than decrease target tax reserves, and the average change in target tax reserves recorded through purchase accounting is $25 million. I also find evidence that the change in tax reserves recorded through purchase accounting is increasing in short-term financial reporting pressures and decreasing in the costs of overstating goodwill.