Legal Form and Earnings Properties

Abstract

We investigate whether the financial accounting choices made by German private firms depend on legal form. Legal form determines dividend rights, liability status and the owners' obligations to run the business and, thus, influences agency problems of debt and equity. Consequently, we find that earnings properties depend on legal form. We expect, and find, that corporations exhibit higher levels of income smoothing and conservatism than partnerships and one-person businesses. Corporations are also more likely to disclose small profits. However, generally, there are no significant differences in earnings properties between one-person businesses and partnerships. The results are robust to different econometric specifications including endogeneity concerns (e.g. propensity score matching). Earnings properties of private firms seem to be driven to a considerable extent by agency problems of debt.

Acknowledgements

We gratefully acknowledge the helpful comments provided by an anonymous referee and Guochang Zhang. We thank the Deutsche Bundesbank Research Center, especially Dr Liebig and Dr Heid, for giving us access to the Bilanzdatenbank, and Dr Stein and Dr Memmel (both from the Deutsche Bundesbank) for the valuable advice they provided on how to use it. We thank Harris Dellas (Bern), Joachim Gassen (Humboldt, Berlin), Al Ghosh (Baruch College, New York), Jörg Werner (Frankfurt) and seminar participants at the European Accounting Association Conference, Rome 2011 and Paris 2013; the EUFIN Conference, Bamberg 2011; and those at the universities of Bern, Leipzig and Leuven for their valuable comments.

Notes

1 See Mach and Wolken (2006), BIS (2011) and Statistisches Bundesamt (2009) (German Statistics Agency).

2 For instance, with unlimited liability, problems of risk-shifting and underinvestment are considerably mitigated.

3 For instance, with regard to income smoothing we have 3859 firm-year observations in 1996 and 983 in 2004. However, the proportion of unlimited liability firms remains relatively stable, at a level between 28% and 32%.

4 The NSSBF database includes ownership data on US private firms (Mach & Wolken, 2006, p. A171). The average number of owners is 1.2 and 2.9 with proprietorships and partnerships, respectively; it is 2.0 and 10.2 with S corporations and C corporations, respectively. The average number of owners is 3.

5 The industries are manufacturing; construction; transport and communication; real estate, renting and business activities; and wholesale and retail trade, garages.

6 We considered , and where SD: standard deviation. We also used the ‘discretionary' level of income smoothing according to Barth, Landsman, Lang, and Williams (2012) and Lang, Lins, and Maffett (2012), and performed Fama–MacBeth tests. The qualitative results remain the same (the results are not tabulated).

7 A fractional ranking is the raw rank divided by the number of observations. For example, the fractional rankings of 1 and 10 among numbers 1–10 are 0.1 and 1, respectively (see Tucker and Zarowin, 2006, p. 255).

8 Givoly and Hayn (2000) do not consider depreciation expenses since they are largely affected by the level of net investments. Hence, depreciation expenses may not reflect the level of accounting conservatism accurately.

9 Another reason may be tax related. While a managing partner may have to share the benefits of tax-decreasing efforts with other (limited) partners, the owner of a one-person business does not need to do so. Thus, a one-person business may have stronger incentives for conservatism to reduce current tax obligations.

10 We are grateful to the editor in charge for this valuable insight.

11 We are grateful to the referee for this valuable comment.

12 The explanatory power of the Ball and Shivakumar models – with varying sample size from 50,000 to 96,000 observations − is similar to that of our model; adjusted R² is in the range of 6.5–8%.

13 We also had to omit the TAX variable due to multicollinearity.

Additional information

Funding

We gratefully acknowledge research support by the German research foundation (Deutsche Forschungsgemeinschaft), grant No.BI 777/3-1.