Auditing private companies: what do we know?

The purpose of this article is to provide an overview of the literature on what we currently know about the costs and benefits of auditing private company accounts. Our main conclusions are the following. First, there is much heterogeneity in factors driving audit demand in private companies and the value derived from the audit. Second, research provides support for improved financial reporting quality due to, and real economic benefits from, private company audits. Third, the cost–benefit analysis for private company audits is firm-specific and mandating the audit does not seem to be cost-effective and thus economically optimal for all private companies. Alternative services may better meet the needs of especially smaller private companies. Furthermore, mandating the audit is not necessarily an optimal solution since private companies with low demand for a high-quality audit are able to find an auditor that meets their requirements even under a mandatory regime. Hence, having a mandatory audit in place is no guarantee for universally high-quality audits and this seems most salient for private companies where auditors may be more prone to independence issues. We conclude by providing a number of directions for future research.     

Why Do Companies Go Public? An Empirical Analysis

Using a large database of private firms in Italy, we analyze the determinants of initial public offerings (IPOs) by comparing the ex ante and ex post characteristics of IPOs with those of private firms. The likelihood of an IPO is increasing in the company's size and the industry's market-to-book ratio. Companies appear to go public not to finance future investments and growth, but to rebalance their accounts after high investment and growth. IPOs are also followed by lower cost of credit and increased turnover in control.     

公司声誉、审计师声誉与权益资本成本——基于中国民营上市公司的经验证据

以2009~2013年中国沪深两市 A 股民营上市公司为样本,实证检验审计师声誉、公司声誉与权益资本成本的关系。研究发现：限制其他条件,审计师声誉、公司声誉分别与公司权益资本成本呈显著负相关。进一步研究发现,随着公司自身声誉的逐步建立,审计师声誉对于公司权益资本成本的影响将会逐渐减弱,公司声誉对于审计师声誉具有替代作用。     

The Role of Information Precision in Determining the Cost of Equity Capital

We examine the association between the cost of equity capital and the quality of public and private information. We find an inverse relationship between the cost of capital and the precision of public information, but the effect is more than offset by a positive relationship between the cost of equity capital and the precision of private information. Public and private information precisions are positively correlated, and a model that fails to include both is vulnerable to a correlated omitted variable bias. The association between public and private information combined with their opposing effects on the cost of capital implies mangers should consider the relationship between public and private information when assessing their reporting strategy.     

Loan commitments and the management of uncertain credit demand

We provide an explanation for loan commitments unrelated to borrower creditworthiness. In our model, banks can use loan commitments to reduce uncertainty regarding their own future funding needs. Given a cost advantage to banks that can acquire such information, there exists an equilibrium demand for commitments by riskneutral firms. The purchase of the loan commitment and the choice of contract terms reveals the buyer's private information regarding future credit needs. In order to ensure the sorting of the a priori indistinguishable applicants according to their private information, we show that a usage fee applied to the commitment holder's unused credit line is necessary.     

Money n’ motion—Born to be wild

There are intriguing parallels between motoring and personal investing: the romance, the thrilling movement, and the freedom; the banality, the enervating repetition, and the entrapment; the subconsciously seductive appeal of crashes that ends it all. Consequently, there are intriguing parallels between the automobile and accounting, without which the activities of motoring and personal investing, respectively, would be severely attenuated, if they were possible at all. And there are intriguing parallels between popular media and accounting education, which are responsible for the enculturation processes that perpetuate the beliefs that in motoring and personal investing, by means of automobiles and accounting, we can be independent, we can be free, we can take control of our lives, and we can rise above the barriers of our social classes. The historian George W. Pierson's mobility thesis explains these parallels. Motoring is not merely a fruitful metaphor for personal investing, automobiles for accounting, and popular media for accounting education. Motoring and personal investing are just two among many manifestations of the mobility which is characteristically American. Physically and financially, Americans need to be in motion.     

Long-term care financing: options for the future

The aging of the baby boomers will have an enormous impact on the future of long-term care costs. This article projects the magnitude of that impact, discusses sources of financing, and considers the cost and feasibility of three options for financing future long-term care services. The authors investigate the alternatives of increasing personal savings, raising payroll taxes and expanding employer-sponsored private long-term care insurance coverage, respectively.     

Discussion of “The Role of Information Precision in Determining Cost of Equity Capital”

Botosan, Plumlee, and Xie (this issue) demonstrate an association between a proxy for cost of capital and proxies for public and private information precision. These proxies have limitations that suggest caution in interpreting their results, absent evidence of proxy validity. The proxy for cost of capital is based on Value Line's beliefs about expected returns, not actual expected returns. The proxy for private information measures information revealed by analysts, not information used by inside traders. In this paper, Botosan, Plumlee, and Xie (this issue; hereafter BPX) empirically explore the joint effect that public and private information precision have on the cost of equity capital. Their key findings are that more precise public information lowers the cost of capital, while more precise private information raises the cost of capital. The paper considers whether public and private information are substitutes or complements but finds no evidence of an interactive effect. This is an important question with significant policy implications for firms, investors, and regulators. While there is (as the authors discuss) considerable prior literature on the topic, the matter is empirically unsettled, so further evidence is welcome. Also, the authors make an important point that, given the correlation between public and private information, it is essential to control for one when analyzing the effect of the other. The reliability of the results in BPX depends on whether the proxies used in the paper effectively measure the underlying economic constructs. Cost of equity capital is proxied by a formula using Value Line forecasts, while public and private information measures are based on analyst forecast dispersion and accuracy. Most of the following discussion considers how reliable these proxies might be.     

Cost of capital and valuation in the public and private sectors: Tax,risk and debt capacity

Cost of capital and valuation differ in the private and public sectors, because taxes are a cost to the private sector but are only a transfer to the public sector. We show how to transform the after-tax private sector cost of capital into its pre-tax equivalent, for comparison with the public sector cost of capital. We establish the existence of a tax induced wedge between these two costs of capital. The wedge introduces a preference on the part of the private sector for assets with rapid tax depreciation, high debt capacity and low risk. We show that, in circumstances where an asset has identical public and private sector valuation in the absence of taxes, the tax induced difference in valuation is identical to the change in government tax receipts that results from having the asset owned by the private rather than the public sector. We provide some examples of distortions that result from failure to adjust for changes in tax revenues, and show how to effect such adjustment.     

Information Opacity,Credit Risk,and the Design of Loan Contracts for Private Firms

This paper examines the structure and cost of a large sample of bank loans to private firms. Compared to public firms, private firms are more informationally opaque and riskier. The results suggest that the design of a loan to a private firm is significantly different from that to a public firm. Bank loans to private firms are more likely to be by a sole lender, collateralized, and have sweep covenants than loans to public firms. The cost of borrowing is higher for a private firm than for a public firm, even after holding constant firm and loan characteristics.     

Securitization in Public Sector Finance

Already commonplace in the private sector, the securitization of future income streams is now being promoted in the public sector as a means of accessing investment capital. This article reports on a British university's securitization of 30 years' future rents on its student accommodation. Although the securitization made it possible to refurbish the residences, it has turned out to be costly in other respects. The authors conclude that investment returns in the public sector will rarely be sufficient to cover the finance costs of securitization; that the loss of the securitized income in labour-intensive public services is virtually certain to cost jobs; and that the accounting treatment of securitization needs to incorporate a realistic calculation of the movements in effective debt. Finally the article recommends that the value for money of any proposed public sector securitization should be independently checked by comparing its total cost of capital with the returns on its proposed uses.     

Taking its toll: The private financing of roads in Spain

The article analyses the cost of using private finance to build, finance and maintain toll roads in Spain. Spain is the primary exponent of private finance for roads in Europe, where the case rested on the lack of public finance, in contrast to the UK that has stressed value for money. The evidence shows that more than half of the toll charge represents the cost of finance; the cost of private finance is nearly double the cost of public finance; and financing is underpinned by various forms of public support creating risks for the taxpayers.     

The Role of Infrastructure in Mexican Economic Reform

This article estimates the relationship between the provisionof public infrastructure and private output in sixteen sectorsin Mexico. The sector-specific cost functions depend on wages,the cost of capital, and the nominal values of the stocks ofthree types of infrastructure: electricity, transport, and communications.The article concludes that infrastructure in electricity andcommunications generally reduces the cost of sectoral production,but transportation infrastructure tends to increase costs ofsectoral production. It appears that Mexican public expenditureon electricity and communications has enhanced the productivityof private production, but expenditure on transport may actuallyhave had a detrimental effect on private output. In addition,although in general labor and infrastructure are substitutes,in the case of electricity and communications infrastructure,capital and infrastructure are complements. In the case of transportinfrastructure these conclusions are reversed.     

Conditional Mandates on Management Earnings Forecasts: The Impact on the Cost of Debt

Exploiting a unique conditional disclosure mandate on management earnings forecasts (MEFs) in China, we examine the differential effects of voluntary and mandatory MEFs on the cost of debt. We find that firms providing voluntary MEFs have lower cost of debt than do mandatory forecasters and nonforecasters. The results of the channel analyses reveal that voluntary forecasters have greater commitment to voluntary MEFs in future periods than do mandatory forecasters and nonforecasters, and the precision, accuracy, and timeliness of MEFs are higher for voluntary forecasters than for mandatory forecasters. Additional analyses show that the differential effects of voluntary and mandatory MEFs on cost of debt are stronger for voluntary forecasters operating in opaque information environments, issuing high-quality and confirming forecasts, controlled by private shareholders, and operating in highly competitive product markets. Overall, our results indicate that, compared with mandatory MEFs, voluntary MEFs are more informative for credit investors, particularly for firms facing greater information risk and operating uncertainty.     

The Efficient Mechanism for Downsizing the Public Sector

This article analyzes the efficient mechanism for downsizingthe public sector, focusing on adverse selection in productiveefficiency. Each worker is assumed to have two type-dependentreservation utilities: the status quo utility in the publicsector before downsizing and the utility that the worker expectsto obtain by entering the private sector. The efficient mechanismconsists of a menu of probability (of remaining in the publicsector) and transfer pairs that induces self-selection. A worker'sfull cost is defined by the sum of production cost in the publicsector and reservation utility in the private sector. It isoptimal to start by laying off the agents with higher full cost.When the public sector before downsizing is discriminating asthe differential of private information about productive efficiencysuggests, there are countervailing incentives. This makes thesize of downsizing smaller under asymmetric information thanunder complete information.     

Interest rate changes and the timing of debt issues

There is much recent interest in the role of market timing in firm financial decisions. Using a large detailed sample of corporate public debt issues, private placements, Rule 144A issues and bank loans over the period 1970–2006, we investigate the relationship between interest rate changes and issues of floating and fixed-rate debt. Our results indicate that both past and future rates are associated with issuance decisions. We examine whether firms are able to lower their cost of capital by anticipating future rate changes, controlling for firm characteristics and market conditions. Our findings suggest that evidence of timing success is dependent on the time interval and type of debt examined. Over the longest time intervals available in our data, we do not find evidence of timing ability for fixed-rate or floating-rate debt issues.     

Sign reversal in the relationship between income smoothing and cost of debt

Despite the fact that income smoothing by managers is a pervasive phenomenon that has been widely researched, extant literature provides incomplete evidence on how smoothing is associated with cost of debt in general, and in the private loan market in particular. The institutional factors associated with private loan contracts, combined with the theoretical motivations for smoothing, make it unclear whether smoothing will be positively, negatively, or not associated with loan spread. Using both cross‐country and within‐country analyses on an international sample of private loans, we predict and provide evidence that income smoothing is associated with lower cost of debt when the threat of private benefits consumption by managers is low, but is associated with higher cost of debt when the threat of private benefits consumption by managers is high. We provide the first evidence in the literature that the garbling effect of smoothing can predictably dominate the signaling view of smoothing in debt contract design, and we identify private benefits consumption threat as the feature of the contracting environment that empirically reveals a sign reversal in the relationship between smoothing and cost of debt.     

Folgekosten für Private Krankenversicherungen aus dem zivilrechtlichen Teil des AGG

The Anti-Discrimination Law (AGG) creates particular challenges for private health care insurers. In future, maternity and pregnancy costs will have to be included in the calculation of contributions made by both sexes. This will entail many adaptations for the insuring companies. Through the legal cost-impact model, the contributions are determined by means of a conceptual framework for determining the costs flowing from the law. For private health insurers, the internal costs from the civil law component of the AGG range from approximately €?4.2 million to €?7.7 million. In addition, in the first year, there will be consequential costs from labour laws of €?3.2 million. This very substantial level of bureaucratic cost clearly indicates the need to investigate new laws in the context of a differentiated evaluation process which focuses entirely on the impact of the laws and the consequential costs.     

Ownership and Production Costs: Choosing between Public Production and Contracting‐Out in the Case of Swedish Refuse Collection

Many comparisons of public and private firms use a public/private ownership dummy variable to capture cost differences. If, however, public and private firms use different production technologies, the dummy‐variable approach is misspecified. Data from public and private firms should not be pooled. Secondly, selectivity bias may arise, making it more difficult to identify cost differentials that actually exist. Thirdly, if data should be pooled, the resulting empirical model may be logically inconsistent. This paper compares public and private firms using the refuse collection costs of 170 firms in 115 Swedish municipalities. First, public production costs were 6 per cent lower than private production costs. Secondly, cost differences did not affect producer choice. It is crucial to adjust for selectivity. Data for private and public firms should not be pooled. The dummy‐variable model is misspecified.     

Optimal Disclosure Policy in Oligopoly Markets

This paper examines the private and social optimality of full disclosure of private information in a two-period oligopoly model. An incumbent firm is privately informed about the market demand and its production cost after operating as a monopolist in the first period, and then competes against an entrant in the second period. Two main results are derived. First, it is shown that the incumbent is best off by pre-committing to disclose both the demand and cost information. By disclosing full information, the incumbent nullifies its self-defeating intertemporal incentives, which arise whenever it has private information about the market demand, its cost efficiency, or both. In addition, the equilibrium output variance is the largest under full disclosure, which benefits the incumbent ex ante. Second, the paper shows that the incumbent's full disclosure of the demand and cost information may or may not be desirable from a social efficiency standpoint. In particular, the correlation between the firms' production costs is crucial to the rank of disclosure policies in terms of their impact on social efficiency.