Earnings quality in UK private firms: comparative loss recognition timeliness

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Abstract

UK private and public companies face substantially equivalent regulation on auditing, accounting standards and taxes. We hypothesize that private company financial reporting nevertheless is of lower quality due to different market demand, regulation notwithstanding. A large UK sample supports this hypothesis. Quality is operationalized using Basu's (1997) time-series measure of timely loss recognition and a new accruals-based method. The result is not affected by controls for size, leverage, industry membership and auditor size, or by allowing endogenous listing choice. The result enhances understanding of private companies, which are predominant in the economy. It also provides insight into the economics of accounting standards.

Introduction

We examine timely loss recognition—an important attribute of financial reporting quality—in a large sample of UK private and public firms. Private company reporting is interesting in its own right, due to the predominance of private companies in the economy.1 The UK setting is particularly interesting, because UK private company reporting is subject to substantially equivalent regulatory provisions as public company reporting, whereas the markets for private and public financial reporting are substantially different. The UK therefore provides a rare opportunity to study the interaction between market and regulatory effects (Ball et al. (2000), Ball et al (2003); Ball, 2001). We argue that the market demands lower quality financial reporting for private companies than for public companies, regulation notwithstanding, and report evidence consistent with that view. The result enhances our understanding of the economic role of accounting standards, an issue that is surprisingly neglected in the literature.

Three principal features of the UK financial reporting regulations are substantially equivalent for private and public companies. First, the UK Companies Act requires all private and public companies to file annual financial statements that comply with the same accounting standards. Second, financial statements filed by UK private companies must be audited (there is an exemption for very small companies, but no firms in our sample qualify). Third, private and public companies are subject to the same tax laws. These are the major regulatory institutions for UK financial reporting, and they are substantially equivalent for public and private companies.

Nevertheless, the market for financial reporting differs substantially between private and public companies. Private companies are more likely to resolve information asymmetry by an “insider access” model. They are less likely to use public financial statements in contracting with lenders, managers and other parties, and in primary and secondary equity transactions. Their financial reporting is correspondingly more likely to be influenced by taxation, dividend and other policies. These differences imply a demand for lower quality financial reporting.

We interpret reporting quality in abstract terms as the usefulness of financial statements to investors, creditors, managers and all other parties contracting with the firm. Following Basu (1997), we measure a single but nevertheless important attribute of reporting quality: timeliness in financial statement recognition of economic losses. Timely loss recognition increases financial statement usefulness generally, particularly in corporate governance and debt agreements. Governance is affected because timely loss recognition makes managers less likely to make investments they expect ex ante to be negative-NPV, and less likely to continue operating investments with ex post negative cash flows. Debt is affected because timely loss recognition provides more accurate ex ante information for loan pricing and more quickly triggers debt agreement rights (such as repricing, and restrictions on leverage, investment and dividends) from violating covenants based on ex post accounting ratios. We therefore argue that timely recognition of economic losses is an important attribute of financial reporting quality.2

Our principal result is that timely loss recognition is substantially less prevalent in private companies than in public companies, despite the groups facing equivalent regulatory rules. The result is apparent in both a test for transitory time-series components in income and a new test based on the relation between accruals and cash flow from operations. It is robust with respect to controls for size, leverage, industry and fiscal year end (which influence the likelihood of experiencing an economic loss) and for auditor firm size. It also is robust with respect to alternative definitions of both income (inclusion or exclusion of exceptional and/or extraordinary items) and operating cash flow (estimated from successive balance sheets or directly from cash flow statements), alternative estimation methods (Fama–MacBeth t-statistics, extent of data Winsorizing) and alternative model specifications (a selection model addressing endogeneity of the public/private choice). This result cannot be attributed to risk or tax differences between private and listed firms. The lower timeliness of loss recognition observed in private companies relative to public companies, despite the substantive equivalence of their reporting rules, supports the view that market demand substantially determines important financial reporting properties.

As financial reporting criteria, quality and usefulness differ from economic efficiency because they do not address optimality. Lower quality does not imply sub-optimality because it can arise from either lower demand for or higher cost of supplying quality. Our findings thus should not be interpreted as supporting stricter regulation of financial reporting by private firms. Quite the contrary, our hypothesis is that lower earnings quality in private firms is an optimal outcome in the market for financial reporting, not a failure in supply.

The following section describes the economic role of timely loss recognition (the attribute of earnings quality we measure), and its relation to conservatism and “value relevance.” The section also outlines our two principal tests of loss recognition timeliness: Basu's (1997) method of identifying transitory loss components in income, and a test we develop that is based on the relation between accruals and cash flow from operations. Section 3 describes the relevant UK institutional features and develops the hypothesis that loss recognition timeliness is substantially affected by the different economic roles of financial reporting in private and public companies. Section 4 describes the data, Section 5 presents the principal results, and Section 6 describes a variety of specification tests to ensure the robustness of the results. The final two sections consider alternative explanations and summarize our conclusions.

Section snippets

Timely loss recognition: hypotheses and tests

This section outlines the economic role of timely loss recognition in accounting, and its relation to conservatism and value relevance. It then describes the two measures of loss recognition timeliness we utilize: Basu's (1997) test for transitory time-series components in income and a new test based on the relation between accruals and cash flow from operations.

Hypothesis: different demand for financial reporting in private and public companies

Private companies have different ownership, governance, financing, management and compensation structures than public companies. They do not have access to public capital markets, and their financial statements are not widely distributed to the public. Consequently, their financial reporting is more likely to be influenced by dividend and retention policies, as well as income tax policies. These important differences between private and public companies can be exploited to further our

Sample selection

Data are obtained from the March 2000 and earlier versions of the “Financial Analysis Made Easy” (FAME) database supplied by Bureau Van Dijk. The database provides financial statement information on over 100,000 public and private British companies for fiscal years ending between January 1989 and December 1999. It is compiled from records filed at the Companies House in Cardiff, London and Edinburgh, and supplemented with information taken from the London and Edinburgh Gazettes. Its coverage is

Results: timely loss recognition in private and public companies

The descriptive statistics provide preliminary evidence that listed public companies recognize larger loss components in book income than private firms. This section investigates whether they are more likely to report loss components of income that are transitory in time, and whether their accrual behavior is consistent with transitory loss recognition.

Fama–Macbeth t-statistics

The estimated standard errors in the pooled regressions likely are affected by cross-sectional correlation, particularly since the data are concentrated in a small number of years. We therefore estimated Fama–Macbeth t-statistics derived from annual cross-sectional regressions, for all years that have non-trivial sample sizes. These t-statistics are not affected by cross-correlation or skew (or other departures from normality) in the residuals, since they are based on the sampling distribution

Are public firms more risky?

Watts and Zimmerman (1983) argue that because firms can self-select their organizational type for efficient risk sharing, listed firms might be higher risk. They thus could experience a higher frequency and magnitude of economic losses. Even under the alternative hypothesis of equal accounting behavior, they thus could report more and larger transitory losses. An alternative interpretation of our results thus is that listed firms simply face greater economic risk. We believe there are several

Conclusions

In spite of their economic importance and likely differences from public companies, little is known about financial reporting by private firms, including their reporting quality. We attribute this to the difficulty of obtaining financial data, and to the absence of market-based measures of quality such as association with stock prices or returns. We address these limitations with a large sample of UK private-firm data and by using two time-series measures of timely loss recognition that do not

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    We are grateful for helpful comments from Sudipta Basu, Martin Casey, Greg Clinch, Gilad Livne, Jim Seida, Michelle Yetman, Jim Wahlen, Gregory Waymire (the referee), Jerold Zimmerman (the editor), and participants at the 2002 Annual Meeting of the American Accounting Association, University of Chicago, Indiana University, London Business School, Massachusetts Institute of Technology, New York University, University of Notre Dame and University of Toronto. Ball gratefully acknowledges financial support from the University of Chicago, Graduate School of Business.

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