Organizational Structure and Earnings Quality of Private and Public Firms

We compare the earnings quality of private versus public firms. Prior evidence is mixed and inconclusive as to which is greater. The research question is important, because it examines whether market demand for high quality reporting or managerial opportunism dominates in determining public firms’ quality. We focus on organizational structure, because public and private firms significantly differ along this dimension: public companies are structured as business groups, whereas private firms can be business groups, subsidiaries, or stand-alone entities Based on a comprehensive sample of 11 European Union countries from 2004–2014, we show that stand-alone firms manipulate earnings downward to reduce taxable income, especially in countries with book-tax alignment, and that this causes them to have low earnings quality. However, we find that private business groups have higher earnings quality than public business groups. Our results imply that opportunism trumps demand in determining public firms’ earnings quality and reconcile the inconclusive results in the literature, which are driven by not separating stand-alone from business groups in the analysis.