Financial Reporting Quality of U.S. Private and Public Firms

The following post comes to us from Ole-Kristian Hope, Professor of Accounting at the University of Toronto; Wayne Thomas, Professor of Accounting at the University of Oklahoma; and Dushyantkumar Vyas of the Department of Accounting at the University of Minnesota.

In our paper, Financial Reporting Quality of U.S. Private and Public Firms, forthcoming in The Accounting Review, we use a new database that contains accounting data for a large sample of U.S. private firms and provide an investigation of financial reporting quality (FRQ) of U.S. private versus public firms. Private firms are an important source of economic growth in the United States and elsewhere. In the aggregate, non-listed firms have about four times more employees, three times higher revenues, and twice the amount of assets than do listed firms (Berzins, Bøhren, and Rydland 2008). In 2008, Forbes reported that the 441 largest private companies in the United States accounted for $1.8 trillion in revenues and employed 6.2 million people. Despite their obvious importance to the U.S. economy, there is limited research on private firms in general, and almost no prior research related to the financial reporting quality (FRQ) of such firms.

We first compare FRQ of public and private firms. Our empirical evidence suggests that public firms have on average significantly higher accrual quality than do private firms. This finding is contrary to results in prior research in the U.S., which generally finds that private firms have higher accrual quality. Our finding is consistent with the “demand” hypothesis that investors and other stakeholders of public firms will demand higher quality financial information. Furthermore, the finding is not obvious because public firms face greater pressures to meet benchmarks, and managers’ compensation and personal wealth are often tied to publicly traded equity securities. These factors give public firm managers incentives to report opportunistically. We also find that public firms demonstrate more conservative accounting practices, providing further evidence in favor of the demand hypothesis.

Equally interesting, we perform subsample tests of variation in FRQ of public versus private firms. Specifically, we compare accrual quality for firms that (1) just beat an earnings benchmark by reporting a small profit or a small increase in earnings, (2) obtain external financing in the subsequent year, (3) do not employ a Big 4 auditor, or (4) have no analyst following. For each of these tests, the greater accrual quality of public firms is reduced or eliminated. The evidence is consistent with these public firms either being more likely to act opportunistically by managing earnings or facing reduced demand for their financial information, both of which lead to lower accrual quality.

We also examine variation in tests of conditional conservatism. While we find that public firms are more conservative in general, in some settings one may consider that the incentive to engage in this reporting bias for public firms is reduced. We find that the greater conservatism of public firms relative to private firms decreases for firms that (1) just beat earnings benchmarks, (2) have lower leverage, or (3) do not issue debt in the subsequent year. We also test and find some evidence suggesting that the greater conservatism of public firms in general is reduced in less litigious industries. The results of these tests are consistent with public firms in these settings having an incentive to bias earnings upward (or reduced incentives to report earnings conservatively).

We intend for our study to contribute to the broader literature attempting to understand the determinants of FRQ. Examining how the differential FRQ of public and private firms varies in certain settings provides a strong research design to understand the impact of demand versus opportunistic behavior on FRQ. Our study could also be relevant to standard setters. The issues surrounding private firm accounting have become increasingly relevant as the Financial Accounting Foundation (FAF) announced on May 23, 2012, the establishment of the Private Company Council (PCC). The PCC aims to improve the process of setting accounting standards for private companies. There has been strong push by private firms to ease their reporting burden by allowing exceptions to certain accounting practices required of public firms. To the extent that public firms’ FRQ is driven by higher demand (and thus both public firms and their financial statement users benefit from higher quality financial information), easing the reporting burdens on private firms may be reasonable.

We note that our study has limitations. Perhaps most importantly, we employ four models of accrual quality and two models of conditional conservatism. However, the literature has supplied dozens of variations in these models and therefore future research can consider whether alternative measures affect conclusions. Further, it could be that the differences in FRQ between public and private firms reflect differential GAAP conformity. While this does not reduce the validity of our inferences, readers should be aware of this important difference while making conclusions about the differential reporting incentives of public and private firms. Our tests that exclude non-audited private firms partially address these issues.

Future research, perhaps field studies or survey-based research that has direct access to data regarding audit adjustments for private firms, could be in a better position to refine such inferences. In addition, while our empirical tests include a number of control variables motivated by prior research, our private firm database does have limitations in terms of available firm characteristics. Finally, given that private firms in the database are anonymous, we are not able to merge our dataset with other databases. We hope this study will encourage data providers to make available more complete data sets that will allow the pursuit of additional interesting research questions for private firm accounting.

The full paper is available for download here.

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