Time to reconsider your investments.
Investors have long put most of their money in public companies, assuming that public ventures must be secure. You know, less shenanigans. More eyes. Lots of regulations. Safer, right?
Not so. Financial reporting can be wildly inaccurate! Researchers from the NYU Stern School of Business, Bocconi University, and the University of Bolzano looked at the books of companies in 11 European countries from 2005-2014 (400,000 firm-year observations!), and found that private companies have more reliable financial statements than public companies. “Investors might be better off if they gave a closer look to private companies in building up their investment portfolios,” said coauthor Antonio Marra, a professor of accounting at Bocconi University, in a statement.
One reason is that public companies have strong incentives to overreport earnings to improve their stock performance, while private companies do not. The researchers found much more accurate reporting of private companies’ accrual valuations, which are non-cash-based assets, and therefore somewhat subjective.
Pro tip: It’s pivotal to pay attention to whether a company is a stand-alone firm or a business group. In most cases, stand-alone firm reporting is used for both financial reporting and tax purposes, providing an incentive to underreport earnings to save taxes, while business group reporting is used only for financial reporting and therefore is often more accurate. (See: Amazon, public reporting of $11.2 billion in 2018 profits; tax rebate.) Which is all to say that if you want to know whose financial statements to trust, private business groups are the way to go.
The exception is in countries with extensive reporting regulations protecting investors, which in Europe is the U.K., where public companies do indeed have more reliable accounts. “This means that when rules are effectively enforced, earnings quality improves,” says Marra.