Private company finance and financial reporting

Abstract

This article provides a comprehensive assessment of private firms’ financing sources and their relation with financial reporting practices. We consider debt financing (bank financing, leasing, and government guarantees), equity financing (family ownership, government ownership, employee ownership, and private-equity financing), and trade credit (supplier credit and factoring). Our primary conclusions are that there is significant heterogeneity in the way in which private companies are financed that is influenced by their specific business contexts, and that this heterogeneity in financing is associated with differential demand for and supply of financial reporting.

Keywords:

• private firms
• financing
• financial reporting quality
• demand and supply factors

Acknowledgements

We acknowledge useful help from Muhammad Azim and Stephanie Cheng.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. http://www.aicpa.org/PRESS/PRESSRELEASES/2010/Pages/CouncilAdoptsResolutionSupportingBRP.aspx.

2. We caution readers about this conclusion as it is difficult to compare such different sets of firms. First, private and public firms tend to be significantly different in terms of size and ownership concentration, so if the researcher attempts to match on these dimensions the comparison is between a small subset of either set of firms (either the largest private firms or the smallest public firms, or a combination of both). Second, most prior research assumes that the FRQ measures developed for public firms are also relevant for private firms. We consider this latter issue an interesting avenue for future research.

3. In an earlier version of that paper, the authors also showed a positive association between FRQ and investment efficiency for the same sample of firms.

4. Other stakeholders (that do not provide financing, at least not directly) may also affect firms’ financial reporting choices, such as lobby groups, media, competitors, tax authorities, and domestic and foreign regulators (e.g. Akamah et al. 2016, Hope et al. 2013a). We do not discuss these non-finance determinants of variations in FRQ in this article.

5. Papers such as Francis et al. (2005) and Bharath et al. (2008) have studied the relation between FRQ and price- and non-price debt contractual terms for public firms.

6. Note that loan covenants are common even among small private firms (Niskanen and Niskanen 2004).

7. Relationships between management and bankers are often also very important, perhaps especially in less-developed countries. For example, Hope et al. (2017d) find a substitute relation between political connections (a form of relationship) and FRQ. Peek et al. (2010) document that, compared to public firms, creditors of European private firms rely more on relationship lending, and less on financial-reporting information to mitigate shareholder-creditor conflicts of interest.

8. Bigus et al. (2016) find that unincorporated German firms have a lower incentive to use financial reporting as a means of maintaining their relationship with lenders compared to their incorporated counterparts (this result is attributed to the fact that lenders of unincorporated firms have an additional layer of security via recourse to owners’ assets).

9. A number of other studies infer FRQ using audit-related measures. See, for example: Van Caneghem and Van Campenhout (2012), Karjalainen (2011), Koren et al. (2014), Kausar et al. (2016), Lisowsky and Minnis (2013), Lennox and Pittman (2011), and Dedman and Kausar (2012).

10. Which of these three views dominates surely depends upon specific institutional context. However, Berger and Udell (2006) summarize a large empirical literature that, at least in stable economic times, is suggestive of an on-average negative effects of state-ownership in terms of non-performing loans of the banks and overall effects on credit availability and economic performance.

11. In addition to greater security, Sharpe and Nguyen (1995) and Eisfeldt and Rampini (2009) argue that lessors receive a higher priority in bankruptcy due to legal ownership of the asset.

12. The spectrum of risks and rewards of ownership that are transferred to the lessee increases from leases that are classified for accounting purposes as ‘operating leases’ to those that are classified as ‘financing’ or ‘capital leases.’

13. Examples of these studies that examine the value relevance of operating leases include Ro (1978), Bowman (1980), El-Gazzar (1993), Ely (1995), Sengupta and Wang (2011), Cotten et al. (2013), Dhaliwal et al. (2011), Andrade et al. (2014), and Altamuro et al. (2014).

14. Che and Langli (2017) report a U-shaped relation between family ownership and performance for a sample of Norwegian privately-held family firms. Che and Langli (2017) also find that firm performance is positively related to the ownership of the second-largest owner, percentage of family members on the company’s board, and the power of the family. Arosa et al. (2010) analyze Spanish private firms and document that the relation varies with the family generation (first or subsequent) that is managing the business.

15. Another form of government support that is more pertinent to smaller privately-held companies pertains to government programs that are meant to ease firms’ access to financing such as small-business financing guarantee programs We discuss research on such programs in the section on debt financing.

16. With regard to differences in managerial incentives between SOEs and non-SOEs in China, Kato and Long (2006) find that pay-performance sensitivity is lower for SOEs compared to other firms. Firth et al. (2006) document that SOEs are likely to have CEOs who are former bureaucrats and exhibit lower management quality. Conyon and He (2011) find that SOEs have a lower level of CEO compensation and incentives and are less likely to fire CEOs for poor performance.

17. Similarly, Wang et al. (2008) finds that Chinese SOEs controlled by local governments are more likely to hire small local auditors, consistent with the local geographic incentives of these SOEs.

18. See Hope et al. (2017b) for an in-depth examination of how news related to tunneling problems is censored in China.

19. Numerous studies using samples of U.S. publicly-listed companies have reported an on-average positive association between employee ownership and various measures of firm performance (Beatty 1995, Chang and Mayers 1992, Park and Song 1995, among others) – see Rosen (2011) for a comprehensive review. Empirical evidence also suggests that employee ownership is negatively related to firm risk (Bova et al. 2015b), and reduces frictions during labor disputes and contract renegotiations (Cramton et al. 2008).

20. The public-policy argument in favor of venture capital suggests that investments in SMEs exhibit a greater likelihood of spurring innovation in the economy compared to similar-sized investments by large corporates (e.g. Kortum and Lerner 2000). If growth in the SME sector and concomitant economic benefits are a public-policy objective, then it seems natural that government intervention in the venture/growth capital markets has been suggested as a way to increase supply of capital to SMEs.

21. However, empirical evidence remains mixed – Lerner et al. (2011) report on the underperformance by public-backed funds both in the U.K. and the U.S., and NAO (2009) for U.K.-based public funds. Grilli and Murtinu (2012) do not find such disparities in a multi-country European context, and Collewaert et al. (2010) report inconclusive evidence from Belgium. It is possible, however, that while government intervention may appear inefficient in the short-run, it may lead to desirable systemic consequences in the long-run by fostering growth and leading to self-sufficiency once funding is withdrawn (Avnimelech and Teubal 2002).

22. A number of other empirical studies examine firm characteristics, product characteristics, and bank–firm relationships as determinants of supplier credit and its terms to support the above theoretical arguments (e.g. Cheng and Pike 2003, Cuñat 2007, Danielson and Scott 2004, Deloof and Jegers 1996, 1999, Giannetti et al. 2011, Huyghebaert 2006, Kim 2016, Mian and Smith 1992, Petersen and Rajan 1997, Pike et al. 2005).

23. A natural conjecture is that suppliers are more likely to rely on financial statements of their customers the more readily available such information is. For example, in the Nordic countries all firms’ financial statements are easily available and customers’ ‘payment remarks’ can also be accessed easily (Che et al. 2017).

24. On the demand side, Smith and Schnucker (1994) and Mian and Smith (1992) highlight the importance of asset specificity. Sopranzetti (1998) adds more nuance to the factoring decision by developing and finding support for an equilibrium model that predicts the use of factoring without recourse for high-quality receivables, recourse factoring for riskier accounts, and inability of borrowers with high bankruptcy risk to factor their riskiest accounts. Summers and Wilson (2000) is another empirical study that uses data from surveys of U.K. credit managers and finds that smaller firms are more likely to use factoring, and that asset specificity is negatively related to factoring. Asselbergh (2002) reports evidence from Belgium that suggests the use of factoring by small companies that have high-growth potential and investment needs. Carretta (2009) finds that while adoption of International Accounting Standards by firms did not bring about a significant change in their factoring use, it brought about an improvement in their balance-sheet ratios.

25. Several papers examine the motives of capital-providers (i.e. crowdfunders) and capital-seekers (i.e. investees). Crowdfunders are generally heterogeneous in their motivations, and are often motivated by social and other non-pecuniary considerations in addition to the direct financial motive (Allison et al. 2015, Lin et al. 2014).