Organizational Structure and Earnings Quality of Private and Public Firms

Abstract

We examine how heterogeneity in organizational structure affects private firm earnings quality in the European Union. Organizational structure refers to whether the firm is organized as a single legal entity (standalone) or as a business group: the former are firms not controlling or controlled by another firm, while the latter are firms that own a majority stake in one or more subsidiaries. Private firms can be either groups or standalone firms, while public firms are de facto groups. Even though private firms are not affected by market forces, we show that private business groups face greater stakeholder pressure for earnings quality than do standalone firms, while standalone firms have stronger tax minimization incentives. Due to these differences in nonmarket forces, private business groups have higher earnings quality than standalone firms. This heterogeneity among private firms is an important unexplored factor in the study of private firms, affecting the comparison between public and private firm earnings quality. This comparison matters, because it attests to the net effects of market forces (i.e., demand versus opportunism) on public firms. We find that overall, public firms have higher earnings quality than private firms, but this relation reverses when we control for nonmarket forces by examining business groups only. Our findings suggest that, in the European Union, the negative effects of opportunism outweigh the positive effects of market demand in determining public firms’ earnings quality, and reconcile past conflicting evidence on public versus private earnings quality.

Keywords: private firms; business groups; standalone; stakeholder incentives, earnings quality; non-market forces

JEL Classification: D22; G15; G32 K22; M41