Invest in Private Companies: They Display More Reliable Accounts Than Public Ones

A New Study Finds That, When Comparing Companies with Similar Organizational Structures, Public Companies’ Incentive to Over Report Earnings in Order to Boost Shortterm Results Outweighs Market Discipline

Institutional investors tend to put their money largely in public companies, persuaded that market discipline makes their accounts more reliable than private ones’ and most financial literature confirms their beliefs.

A new study by scholars from University of Bolzano, Bocconi University, and Stern School of Business concludes on the contrary that, if you circumscribe the comparison to public and private companies with similar organizational structures, private firms display a higher accounting (earnings) quality.

“Our result implies that investors would better raise the share of private companies in their portfolios”, Bocconi University’s Antonio Marra says.

In considering a sample of 397,386 firm-year observations spanning 2005-2014 in 11 European countries (Belgium, Denmark, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden, and the UK), the scholars note that all the public companies are business groups, while more than two thirds of the private companies are standalone firms. While, in standalone firms, individual financial statements are used for both tax and financial reporting, business groups’ consolidated statements are used only for financial reporting, implying that standalone firms have an incentive to underreport earnings in order to save taxes and business groups don’t. Among private companies, thus, standalone firms’ earnings quality results lower than business groups’.

Less expected is the second result: when comparing only business groups, private companies display more reliable accounts, i.e. their accruals valuation (the valuation of non-cash-based quantities) is more in line with international accounting standards.

Public companies, the authors explain, have a strong incentive to over report earnings to improve their short-term market performance and in the European Union this incentive outweighs market discipline in determining earnings quality.

A notable exception to the rule is the UK, where public companies exhibit more reliable accounts than private ones. “The UK market is the most developed in Europe”, Prof. Marra comments, “with the best protection for investors. When rules are effectively enforced, earnings quality improves”.

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