Does Public Ownership of Equity Improve Earnings Quality?
Executive Summary — The quality of accounting information is influenced by an array of factors, most of which stem from the demand for such information for use in contractual arrangements and from the incentives and opportunities of management to manage the reported numbers. Both the demand for quality accounting information for contractual purposes and management incentives to adjust the reported earnings are likely to be influenced by whether the equity of the company is privately held or publicly traded. This study examines the differential earnings quality of private equity and public equity firms in order to shed light on how public ownership of equity affects the quality of firms' earnings. The research highlights how the presence of public equity investors affects management's reporting behavior. Key concepts include:
- While public equity and private equity firms differ along various quality and financial attribute dimensions, neither type of firm "dominates" the other as having the highest quality of financial reports.
- Management of firms whose equity is publicly traded has stronger incentives to manage earnings, thus reducing the reliability and usefulness of financial reports.
- Public equity firms report more conservatively than privately held firms, although this result does not necessarily imply a higher quality of reporting for the former group of firms.
We compare the quality of accounting numbers produced by two types of public firms - those with publicly-traded equity and those with privately-held equity that are nonetheless considered public by virtue of having publicly-traded debt. We develop and test two hypotheses. The "demand" hypothesis holds that earnings of public equity firms are of higher quality than earnings of private equity firms due to stronger demand by shareholders and creditors for quality reporting. In contrast, the "opportunistic behavior" hypothesis posits that public equity firms, because their managers have a greater incentive to manage earnings, have lower earnings quality than their private equity peers. The results indicate that, consistent with the "opportunistic behavior" hypothesis, private equity firms have higher quality accruals and a lower propensity to manage income than public equity firms. We further find that public equity firms report more conservatively, in line with their greater litigation risk and agency costs. Keywords: accruals, conservatism, earnings management, earnings quality, private and public firms. 51 pages.