The real earnings management gap between private and public firms: Evidence from Europe

Employing a comprehensive dataset spanning 11 European Union countries, we provide novel insights on how country-level institutional factors affect differences in the extent of real earnings management (REM) activity by publicly listed and privately held firms (the ‘REM gap’). Thus, we explain why the public–private firm REM gap varies systematically across countries. Exploring the impact of country-level governance and legal environment, we observe the REM gap to be greater in weaker market settings and in jurisdictions with higher book-tax conformity, despite REM levels overall typically being lower in such jurisdictions. While overall REM levels are positively related with the strength of investor protection and the extent of disclosure requirements and negatively related with ownership concentration levels, these factors play only a modest role in explaining variations in the REM gap. Our broad-based evidence also provides consistent support for the existence internationally of a ‘partial substitution effect’ where increased (decreased) REM activity is offset to some extent, but not wholly, by reduced (increased) accruals-based earnings management activity. Our findings have important implications regarding the comparability of financial statement information provided by public and private firms.