To better understand how equity investors influence earnings quality, we compare the quality of accounting numbers produced by two types of public firms – those with publicly-traded equity and those with privately-held equity that are nonetheless considered public by virtue of having publicly-traded debt. We develop and test two hypotheses. The “demand” hypothesis holds that earnings of public equity firms are of higher quality than earnings of private equity firms due to the stronger demand by investors and creditors stemming from, among other concerns, higher litigation risk. The “opportunistic behavior” hypothesis posits that public equity firms have lower earnings quality than their private equity peers due to management intervention in the earnings process as a result of capital market considerations as well as their own equity-based compensation. We identify a number of attributes associated with the notion of earnings quality – persistence and estimation error of accruals, prevalence of earnings management, timeliness of loss versus gain recognition (conditional conservatism) and the extent of conservatism due to the use of asset-decreasing accounting principles (unconditional conservatism). The results indicate that, consistent with the “opportunistic behavior” hypothesis, private-equity firms have higher quality accruals and a lower propensity to manage income than public equity firms. However, in line with the “demand” hypothesis, public equity firms’ financial reports are generally more
conservative.
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