The Silent Majority: Private U.S. Firms and Financial Reporting Choices

• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/1475-679X.12306
• Author: MICHAEL MINNIS,PETRO LISOWSKY
• Date: 01 June 2020

DOI: 10.1111/1475-679X.12306

Journal of Accounting Research

Vol. 58 No. 3 June 2020

Printed in U.S.A.

The Silent Majority: Private U.S.

Firms and Financial Reporting

Choices

PETRO LISOWSKY

∗AND MICHAEL MINNIS

†

Received 12 April 2018; accepted 27 March 2020

ABSTRACT

This study uses a comprehensive panel of tax returns to examine the finan-

cial reporting choices of medium-to-large private U.S. firms, a setting that

controls over $9 trillion in capital, vastly outnumbers public U.S. firms across

all industries, yet has no financial reporting mandates. We find that nearly

two-thirds of these firms do not produce audited GAAP financial statements.

∗Questrom School of Business, Boston University and Norwegian Center for Taxation ;

†University of Chicago Booth School of Business.

Accepted by Mark Lang. We thank Mary Barth, Philip Berger, Michael Donohoe, Merle

Erickson, Christian Leuz, Nemit Shroff, Doug Skinner, Jennifer Tucker, Ross Watts, Joe

Weber, Teri Yohn, and participants at the 2017 SEC-NYU Dialogue on Securities Market

Regulation Conference, University of Amsterdam, Chicago, Illinois at Urbana-Champaign,

Illinois at Chicago, Lancaster, Florida, Michigan, Michigan State, Missouri, Penn State, Vrije

Universiteit, and Yale, the FASB/PCC Summer 2014 meeting, the 2014 University of Min-

nesota Empirical Conference, the 2014 American Accounting Association Annual Meeting,

and the 2014 FARS conference for comments. This paper was previously titled, “Financial

Reporting Choices of U.S. Private Firms: Large-Sample Analysis of GAAP and Audit Use” and

“Which Private Firms Follow GAAP and Why?” Lisowsky was approved access to tax return

information through a contractual agreement with the Internal Revenue Service subject to a

nondisclosure agreement. All statistics are presented in the aggregate in accordance with IRS

disclosure rules. Minnis is a member of the Private Company Council (PCC). Any opinions

are those of the authors and do not necessarily reflect the views of the IRS or the PCC. Minnis

gratefully acknowledges support from the ARAMARK Faculty Research Fund at the University

of Chicago Booth School of Business. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

547

CUniversity of Chicago on behalf of the Accounting Research Center, 2020

548 P.LISOWSKY AND M.MINNIS

Guided by an agency theory framework, we find that size, ownership disper-

sion, external debt, and trade credit are positively associated with the choice

to produce audited GAAP financial statements, while asset tangibility, age,

and internal debt are generally negatively related to this choice. Our findings

reveal that (1) equity capital and trade credit exhibit significant explanatory

power, suggesting that the primary focus in the literature on debt is too nar-

row; (2) firm youth, growth, and R&D are positively associated with audited

GAAP reporting, reflecting important monitoring roles of financial report-

ing; and (3) many firms violate standard explanations for financial reporting

choices and substantial unexplained heterogeneity in financial reporting re-

mains. We conclude by identifying opportunities for future research.

JEL codes: M41; M44; M49

Keywords: audit; private firms; accounting choice; financial reporting;

capital allocation

1. Introduction

A significant challenge in accounting research is observing the costs and

benefits of firms’ financial reporting choices. At the most basic level, U.S.

firms are required by the Securities and Exchange Commission (SEC) to

produce audited financial statements in accordance with U.S. GAAP as a

condition for raising publicly traded equity or debt. Moreover, many coun-

tries outside the United States require firms—both public and private—to

prepare audited financial statements in accordance with accounting stan-

dards, such as International Financial Reporting Standards (IFRS). As such,

it is difficult for researchers to study why firms produce audited GAAP fi-

nancial statements because regulation typically masks firms’ endogenous

choices to do so. However, one setting—U.S. firms without publicly traded

securities—has essentially no reporting mandates and thus serves as a fruit-

ful setting to better understand which firms produce audited GAAP finan-

cial statements (Allee and Yohn [2009]). We use a comprehensive panel

data set of confidential business tax returns from the Internal Revenue Ser-

vice (IRS) to understand the propensity of audited GAAP financial state-

ment production of medium-to-large private U.S. firms and to examine the

factors associated with these choices.

Understanding firms’ decisions to produce audited GAAP financial state-

ments is important for several reasons. First, because of the lack of a reg-

ulatory mandate, private firms will only choose to produce audited GAAP

statements if the benefits exceed the costs. This allows us to examine char-

acteristics of firms that presumably derive the most benefits from producing

audited financial statements—and as importantly, can point to mechanisms

that substitute for (and thus reduce the benefit of) such statements. For

example, academics have claimed it should be taken as “given that lenders

[are] the main users of private company financial statements” (Bradshaw

et al. [2014, p. 183]; emphasis added), or that GAAP accounting is less

useful to firms with more intangible, knowledge-based assets (Lev and Gu

PRIVATE U.S.FIRMS AND FINANCIAL REPORTING CHOICES 549

[2016]). We assess these claims by examining the features of firms that en-

dogenously choose to produce audited GAAP statements.

Second, the Financial Accounting Foundation (FAF) recently launched

the Private Company Council (PCC) under the premise that GAAP was not

serving the needs of private firms. In doing so, however, little empirical

analysis has been conducted to understand which firms actually produce

GAAP statements. A baseline understanding of the characteristics of which

firms do so can inform standard setters as GAAP is adjusted to be less costly

and more beneficial to private companies.

Third, beyond understanding the factors related to accounting use, an

important development in the U.S. economy over the last 20 years has been

the steady growth of private firms. Estimates suggest that the number of

private firms increased by more than 10% from 1996 to 2016, whereas the

number of public firms decreased by almost 50% during this same period

(Doidge et al. [2017], Wursthorn and Zuckerman [2018]; U.S. Census Bu-

reau).1Although there are many causes for this trend, our general under-

standing of this growing part of the economy—including financial report-

ing decisions—is lacking, especially outside of small U.S. businesses. Our

study therefore provides not only a baseline understanding of the use of ac-

counting in medium-to-large private firms in particular, but also enhances

our understanding of the nature of this setting overall.

We use confidential tax return data on medium-to-large private U.S. firms

in our analysis. Since 2008, the IRS has required firms with at least $10

million in assets to report on Schedule M-3 the set of accounting stan-

dards they follow for financial reporting, and whether their financial state-

ments are audited. We find that although the firms in our sample are not

small—each has at least $10 million in assets—they are numerous with

about 70,000 each year. Using conservative assumptions, we estimate that in

2010, nonfinancial private U.S. firms outnumber public firms in Compustat

by eighteen-to-one; this ratio remains significant at three-to-one even after

conditioning on revenues of at least $100 million.2Moreover, private firms

are more numerous than public firms across all industries, again, even after

conditioning on only the larger firms in our sample. Collectively, the firms

in our sample deploy over $9 trillion in capital. As a result, the data illustrate

1We define a private firm as one that has neither a publicly traded security nor a require-

ment to file reports with a financial market regulator, such as the SEC (Minnis and Shroff

[2017]). The number of public companies is sourced from CRSP,while the number of private

companies is the number of firms with at least 20 employees (following Doidge et al. [2017])

as reported by the Census Bureau’s Business Dynamics Statistics public data set through 2014.

2These figures exclude firms from the Financial, Insurance, and Real Estate industries and

other firms with data issues. We describe our sample and data validation tests in section3 and

the online appendix. The ratios of private to public firms are based on 2010 data. The number

of public firms is sourced from Compustat and includes firms with at least $10 million in assets;

this figure was 3,885 in 2010. We have 70,425 firms in the IRS data in 2010. Westress that the

IRS data do not provide a comprehensive view of all private firms, but only those with at least

$10 million of assets.