The Importance of Reporting Incentives: Earnings Management in European Private and Public Firms

TLDR

The study investigates how capital market pressures and institutional factors influence firms’ incentives to report earnings that reflect economic performance. The authors isolate reporting incentives by exploiting the EU’s uniform accounting standards for private and public firms, focusing on earnings management as a key indicator of accounting quality. The results show that private firms exhibit higher earnings management, that stronger legal systems reduce earnings management in both private and public firms, and that private and public firms respond differently to institutional factors, with legal and capital market forces often reinforcing each other.

Abstract

This paper examines how capital market pressures and institutional factors shape firms' incentives to report earnings that reflect economic performance. To isolate the effects of reporting incentives, we exploit the fact that, within the European Union, privately held corporations face the same accounting standards as publicly traded companies because accounting regulation is based on legal form. We focus on the level of earnings management as one dimension of accounting quality that is particularly responsive to firms' reporting incentives. We document that private firms exhibit higher levels of earnings management and that strong legal systems are associated with less earnings management in private and public firms. We also provide evidence that private and public firms respond differentially to institutional factors, such as book-tax alignment, outside investor protection, and capital market structure. Moreover, legal institutions and capital market forces often appear to reinforce each other.