Chapter 1　Introduction

1.1　Background information and motivation

Financial reports，and specifically earnings numbers，are of interest to various stakeholders including managers，investors，analysts and board members，since they provide relevant information when important decisions，i.e.，financing，investing and operating，are made （Walker，2013；Dichev et al.，2016；Naranjo et al.，2016）.Providing high quality financial reporting information is important because it would positively influence capital providers and other stakeholders in making investment，credit and similar resource allocation decisions enhancing overall market efficiency （IASB，2006；IASB，2008）.High quality of earnings is always viewed as “the absence of earnings management （EM）”.

Research on EM has a long history （Healy and Whalen，1999；Dechow and Skinner，2000；Walker，2013）.Previous definitions of EM include：

“Earnings management occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

（Healy and Whalen，1999）

“The active manipulation of earnings towards a predetermined target.”

（Mulford and Comiskey，2002）

“The use of managerial discretion over （within GAAP） accounting choices，earnings reporting choices，and real economic decisions to influence how underlying economic events are reflected in one or more measures of earnings.”

（Walker，2013）

One of the most widely accepted definitions of EM is that of Healy and Wahlen （1999），and according to Healy and Wahlen （1999，p.380） EM may occur for a variety of reasons，including “to influence stock market perceptions，to increase management’s compensation，to reduce the likelihood of violating lending agreements and to avoid regulatory interventions”.Graham et al.（2005） found that managers want to meet or beat earnings benchmarks to build credibility with the capital market，maintain or increase stock price，improve the external reputation of the management team and convey future growth prospects.A recent paper by Dichev et al.（2013） estimated that approximately 20% of public firms manage their earnings figures，and the typical management is approximately 10% of the earnings per share.

Thus far，empirical studies examining the degree of EM have focused almost exclusively on the experience of public firms，while private firms play a vital role in the world economy and contribute substantially to income，output and employment （e.g.Asker et al.，2015）.To illustrate this point，99% of firms are registered as private firms in Europe，and considered as the backbone of the European economy （FEE，2016）.Similarly，there are around 29 million private firms in the U.S.，which account for 86% of U.S.firms and generate almost onehalf of the nation’s GDP （Asker et al.，2015）.Despite the importance of private firms to the economy and capital markets，surprisingly little is known about these firms’ EM.

Private firms are firms which do not have publicly traded debt or equity，whilst the opposite is true for public firms （Hope et al.，2013）.They tend to be very different from public firms in several ways （ibid）.Firstly，private firms are generally smaller in size and have fewer employees.Secondly，ownership of private firms is more concentrated than public firms.In this case，large owners typically sit on the board and are often directly involved in the firm’s management，communicating its performance via financial statements （Leuz，2006）.Due to their higher ownership concentration，owners can more easily resolve any information asymmetry through insider access，thus have less need to rely on public disclosure （Katz，2008）.This insider system may cause more potential for opportunistic management.Last but not least，private firms are not under the same pressure from capital markets as are public firms.For the managers of public firms，they may be forced to resign if they are unable to satisfy the market （Haga et al.，2015）.Therefore，comparing public firms with private firms could help to assess the influence of capital market pressures on EM.

The extant studies provide contrasting and inconclusive evidence on EM behaviour of private firm versus public firms.Givoly et al.（2010） summarize these opposing sets of views as “opportunistic behaviour” and “demand”hypotheses.The “demand” hypothesis predicts that market demand causes public firms，which access the capital markets，to have a lower EM than private firms.The “opportunistic behaviour” hypothesis predicts that managers’ manipulation of earnings for bonuses，stock option compensation and remunerations，causes public firms to have a higher EM than private firms （Ball and Shivakumar 2005；Givoly et al.，2010；Hope et al.，2013）.The research questions regarding which is superior is important in EM studies，because it examines whether or not market demand for high quality reporting or managerial opportunism dominates in driving firms’ EM.

Indeed，EM is an important research agenda in financial accounting for both private and public firms，since the corporate accounting scandals，such as WorldCom，Microsoft and Tesco，have changed the world of accounting.[1]Firms may produce financial reporting information but potential users may not necessarily believe it：

“I do not rely on official facts and figure.You know they are affected by the tax strategy.Asset value，work in progress，and inventory — all rubbish.They are always adjusted.You know there are costs and revenues that are not recorded in the books，entrepreneurs disclose them if you exert some pressure，but you have no proof.”

Bank manager in north-east Italy，Howrth and Moro （2012，p.102）.

The financial report users’ concerns emphasize the need for high quality accounting standards.Much of the discussion considers accounting standards as the primary input for high quality accounting （e.g.，Levitt，1998）.In line with this view，many countries have adopted or plan to adopt International Financial Reporting Standards （IFRS） in an attempt to improve accounting quality.Similarly，harmonization efforts within the European Union （EU） have largely focused on eliminating differences in accounting standards across countries （e.g.，Van Hulle，2004），to bring about a more transparent reporting regime.[2] Since the global movement towards IFRS，many institutions from several countries have requested the International Accounting Standards Board （IASB） to develop a tailored set of IFRS for private companies.However，some argue that the improvement of accounting systems cannot be achieved by simply adopting common standards，and there are many other determinants of accounting quality，such as a country’s legal system，ownership concentration and economic situation （Ding et al.，2007；Leuz and Oberholzer-Gee，2006）.If a high-quality standard cannot improve the quality of earnings，then what are the factors driving EM？ Are those factors the same for both private and public firms？

The traditionally accepted theoretical explanation for the determinants of EM is either the effect of public capital markets，or managerial opportunism.To attest whether market demand for high quality reporting or managerial opportunism dominates in determining firms’ quality，Burgstahler et al.，（2006）compares levels of EM in European firms by a sample covering the period between 1997-2003，and found that raising capital in public markets and strong legal enforcement may constrain firms from manipulation，and cause private firms to exhibit lower accrual quality.Hope et al.（2013），using new database of information on US private firms，provided an investigation into the financial reporting quality （FRQ） of US private versus public firms.They found that the market demands high FRQ，as public firms have higher accrual quality and report more conservatively.In the light of prior literature，this book uses a European database to compare private and public firms，and extends these studies by considering the impact of IFRS and financial crisis.Such an investigation is of interest，because it not only provides meaningful results for an important set of firms，but also deepens the understanding of factors which drive EM in general.It examines European firms for the following two main reasons.Firstly，the lack of evidence for private firms is most likely due to a lack of publicly available data.Europe provides a unique setting in which audited financial statements of private firms are readily available （Geurts，2010）.This feature allows us to use more updated data to study the EM of private firms.Secondly，a European based study could provide more comprehensive results concerning EM in private firms，because European data has more cross-country variance than those of a single country.