Better earnings quality: Public or private equity firms?

University Park, Pa. — Managers of public companies are under constant pressure from investors and stakeholders to meet certain earnings thresholds and, at the same time, uphold high quality reporting standards. In addition, these managers may have a personal stake in their firm’s stock price due to stock ownership or compensation tied to stock performance. This increases the likelihood of earnings management due to management's opportunistic behavior.

Managers of private companies, in contrast, are less subject to pressures from investors to meet short-term earnings targets and less likely to be influenced by stock-based compensation. At the same time, these managers are under less pressure to improve the quality of their companies' financial reporting.

In recent research, Dan Givoly, Ernst & Young professor of accounting at the Penn State Smeal College of Business, and coauthors Carla Hayn of the University of California, Los Angeles, and Sharon Katz of Harvard University, compare the earnings quality of privately owned firms with those of publicly owned firms in order to understand how public ownership affects earnings quality.

For the purpose of this study, the researchers used a unique sample of privately owned companies that report their financial results to the public. This sample consists of privately owned companies that issued debt (bonds) to the public. These firms, by virtue of having publicly traded debt, are subject to the same reporting and filing requirements by the Securities and Exchange Commission as their publicly owned counterparts.

Although these private firms are not under pressure from shareholders to produce high quality reports, the researchers note that there is still pressure from the public debt holders.

"Public debt holders of privately owned firms are likely to demand high accounting quality since the financial statements are their primary source of information about the firm," they write.

Demand and Opportunistic Behavior

In their study, "Does Public Ownership of Equity Improve Earnings Quality," published in The Accounting Review, the researchers examine two hypotheses: the "demand" hypothesis and the "opportunistic behavior" hypothesis.

There is demand from investors and pressure on the company to produce high quality reporting. Additional monitors, like regulators and auditors, increase the importance of high quality reporting.

"If investors believe that you are not straightforward in your financial reporting, they don't have to invest in your company," said Givoly. "As a result, the company's cost of capital (cost of doing business) will increase."

At the same time, managers are under pressure to produce bottom line results. "Investors are often myopic, focusing on the next quarter's results," Givoly said. "Managers want to show investors they are doing well in the short term, so there is pressure to manipulate income to produce good results."

In order to relieve this pressure, managers could either take actions that would maximize their short-term profitability, potentially at the expense of long-term profits (for example, by cutting R&D expenditures), or simply manipulate the numbers.

The researchers find that both management incentives and demand by investors for earnings quality are important factors that shape the financial reporting of public equity firms. Public equity firms are found to have a higher quality of earnings in the sense that the earnings reported by these companies are more predictive of future performance than are the earnings reported by private equity firms. Further, public equity firms tend to report more conservatively.

Givoly added that while the study finds that the overall quality of earnings produced by public equity firms is higher, their management appears to be more prone to engage in earnings management to meet earnings thresholds (such as avoidance of a loss or an earnings decrease).

He and his coauthors concluded that "neither type of firm dominates the other as having the higher quality of financial reports."

Last Updated November 09, 2010