An Examination of FIN 48: Tax Shelters, Auditor Independence, and Corporate Governance

We examine whether the FIN 48 reserve for contingent income tax liabilities reflects a firm's tax sheltering activities, and whether that informativeness depends on monitoring mechanisms. Understanding the relation between tax shelters and the tax reserve is important to researchers, investors, and regulators keen to use the reserve to measure corporate tax aggressiveness. By linking confidential IRS tax shelter data with firms’ tax reserves, we find that, on average, tax shelter incidence is associated with an $11 million increase in the reserve and that each dollar of book-tax differences generated by tax shelters is associated with a 40¢ increase in the reserve. Increased auditor-client bonding, but not strong corporate governance, improves the ability of the reserve to reflect tax shelters. Our results support theoretical predictions on auditor independence that the reputation cost of an audit failure is a significant determinant of client accrual quality.