Invest in Private Companies: Their Accounts Are More Reliable

Institutional investors tend to put their money largely in public companies, persuaded that market discipline makes their accounts more reliable than those of private ones. But a new study with Massimiliano Bonacchi and Paul Zarowin finds that, if you compare public and private companies with a similar organizational structure, private firms display a higher accounting quality.

In our study, we consider a total sample of nearly 400,000 firm-year observations of public and private firms spanning 2005-2014 in 11 European countries. Note that all the public companies are organized as business groups, while two-thirds of the private companies are standalone firms.

Business groups’ and standalone firms’ accounts are scarcely comparable because the financial statements play different functions. Business groups’ consolidated statements are used only for financial reporting while, in standalone firms, individual financial statements serve both tax and financial reporting needs. Standalone firms, in other words, have an incentive to underreport earnings in order to save taxes.
A first finding reported by our work is that among private companies, standalone firms’ earnings quality results lower than private business groups’.
Less expected is the second result: when comparing only business groups, private companies display more reliable accounts relative to their public peers, meaning that their accruals valuation - to make it intuitive “the valuation of non-cash-based items, therefore, more subjective” - is more in line with fundamentals of the business transaction.

Overall, public companies 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.

Our result implies that investors might be better off if they gave a closer look to private companies in building up their investments portfolios.

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

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