Abstract: This paper examines how capital market pressures and institutional structures shape firms' incentives to report earnings that properly reflect their economic performance. To isolate the effects of reporting incentives, we exploit the fact that, within the European Union, privately held limited companies face the same accounting standards as publicly traded corporations because accounting regulation is based on legal form. We hypothesize that raising capital in public markets rather than from private sources and the institutional environment in which a firm operates have a systematic influence on firms' accounting quality. We focus on the level of earnings management as one dimension of accounting quality that is particularly responsive to firms' reporting incentives. As hypothesized, our results document that raising capital in public markets and the quality of the legal system are associated with the level of earnings management across European countries. We find that earnings management is more pervasive in private firms and that both public and private firms exhibit more earnings management in countries with weak legal enforcement. We also document that private and public firms respond differentially to differences in the tax and accounting rules in the EU.
JEL classification: G14, G15, G30, G32, K22, M41
Key Words: International accounting, Earnings management, Private companies, Legal system, Accounting harmonization, Earnings properties