Do companies ‘mind the GAAP’ when they aren’t required to?

Emily Lambert | Apr 04, 2017

Sections Accounting

In the US economy, private companies are taking on a bigger role. The number of privately held companies rose by about 5 percent from 1997 to 2012, by one calculation. Meanwhile the number of publicly traded companies has fallen by half over that same time.

As this private portion of the economy grows, researchers would like to know more about it. For one thing, unlike public companies, private companies aren’t required to publicly disclose their financial results, have their financial statements audited, or even follow generally accepted accounting principles (GAAP). Audited GAAP financial statements facilitate capital allocation, helping companies divvy up their resources and invest wisely, decades of research suggests—but do private companies bother with audited GAAP statements when they’re not required to do so?

The short answer is: rarely. Research by University of Illinois’s Petro Lisowsky and Chicago Booth’s Michael Minnis demonstrates that almost two-thirds of medium-to-larger private companies choose not to produce audited GAAP statements. But the private companies that do adhere to GAAP do so for somewhat unexpected reasons, the research suggests.

As an increasingly large share of the market comprises private companies, understanding why and how the companies report can help equity investors trying to value a company.

Lisowsky and Minnis gathered data from 2008 to 2010 from the US federal income tax returns of 91,000 medium-sized and large nonfinancial companies. In total, the companies in the study controlled more than $10 trillion in capital, with the average having $70 million in revenue. Some 37 percent of large, private companies in the sample produced audited financial statements, using the same financial reporting standards as their publicly traded counterparts.

The researchers were surprised to see which companies chose to hire auditors to produce financial statements. For example, while prior research frequently focused on the debt-contracting benefits of financial reporting, Lisowsky and Minnis find that many companies with relatively high levels of debt—42 percent of companies with at least $20 million in revenue and $5 million in debt—didn’t produce audited statements, suggesting lenders relied on other things, such as prior relationships and collateral, to safeguard their loans. Meanwhile, many smaller, debt-free companies did produce audited statements.

Companies in the “information industry”—including media, technology, and other companies that produce, process, and disseminate information—were most likely to have audited financials (62 percent of them). High-growth, knowledge-based companies, which include pharmaceutical and other companies that invest in intellectual capital, were also likely to produce audited statements, while businesses with physical capital—more-tangible assets such as buildings and machinery—were less likely to.

Even though intangible assets are more difficult to observe and value, growth companies appeared to find audited GAAP statements useful, and the researchers surmise that the statements helped the companies raise outside equity capital. Thus the “stewardship” role of accounting appears to take a prominent role in private firms, helping equity investors monitor the performance of their investments.

When companies have more owners, there’s a higher likelihood of starting audited reporting. Also, “young firms adding owners are substantially more likely to begin an audit,” write Lisowsky and Minnis. “Young firms—which typically lack history, tangible assets, or management reputation—seem to use audited GAAP statements to credibly communicate with new equity owners, even when lacking a government mandate to do so.”

As an increasingly large share of the market comprises private companies, understanding why and how the companies report can help equity investors trying to value a company.