Financial Reporting Choices of Large Private Firms

In recent years, there has been an increase in the number of firms opting to either forgo the public equity market or exit the market in favor of private financing.[1] Increasingly, financing for private firms comes from private funds, such as private equity, venture capital, and hedge funds. In 2015, private funds owned stakes in over 7,500 firms and had over $4 trillion in capital under management.[2] This amounts to a significant portion of the overall economy relative to the total U.S. market capitalization of $25 trillion.[3]

As the privately-held sector of the economy grows, the financial reporting choices of private funds are an increasingly important, but largely understudied, topic. This is because until recently, private funds were generally exempt from Securities and Exchange Commission (SEC) registration under the Investment Advisers Act of 1940. However, Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) imposed significant new reporting and registration requirements on private funds. Dodd-Frank now requires investment advisers to register and disclose detailed information regarding their private funds, including whether the fund prepares financial statements using Generally Accepted Accounting Principles (GAAP), whether the fund engages a Big Four audit firm, and whether the fund obtains an internal controls audit. Dodd-Frank also requires many private funds to obtain an external audit, a requirement previously limited to primarily publicly traded firms. However, some private funds are exempt from this requirement (specifically venture capital funds and funds managed by advisers with less than $150 million in total assets under management). For these exempt funds, the decision to obtain an external audit remains voluntary.

We use the private fund reports required by Dodd-Frank to study the financial reporting decisions made by private funds, as well as the choice by exempt funds to obtain an audit. We assume that funds opt for higher financial reporting quality when they obtain an audit, use GAAP, employ a Big Four auditor, or obtain an internal controls audit. To the extent that these choices are voluntary, the perceived benefit of opting for higher financial reporting quality must exceed the cost. For example, the firm might employ a Big Four auditor because the expected increase in access to capital (benefit) exceeds the higher audit fee (cost). We assess the net benefits of higher quality financial reporting strategies by investigating the relation between financial reporting choices and future growth in fund value and number of investors. Because private funds own stakes of substantial value in a substantial number of private firms, our study has implications beyond the financial reporting choices of private funds and extends to private firms themselves.

Our analysis yields the following results.

Decision to obtain an audit. Overall, 77 percent of private funds voluntarily obtain audits when not required to do so (exempt funds). Funds that voluntarily obtain audits tend to be larger, older, have more owners in general, and have more foreign and sophisticated ownership in particular. Funds opt not to obtain an audit when they have higher insider ownership. These findings suggest that funds obtain audits to meet information demands of equity investors.

Decision to use GAAP. The majority of private funds in our sample prepare GAAP-based financial statements, although the frequency among non-exempt funds (89 percent GAAP) exceeds that of exempt funds (53 percent). Funds opting to use GAAP tend to be larger, with a lower proportion of insider ownership.

Decision to use Big Four auditor. Among funds obtaining an audit, nearly 70 percent use a Big Four auditor. This percentage is consistent across exempt and non-exempt funds. Funds that use Big Four auditors tend to be larger, older, have more foreign and sophisticated ownership, and have more insider ownership. However, funds with more owners in total are less likely to use a Big Four auditor. Thus, while a greater number of owners increases the likelihood of obtaining an audit, these firms do not necessarily engage more reputable auditors. In addition, while higher insider ownership reduces the demand for audits, when these firms do obtain an audit, they engage high reputation auditors.

Decision to obtain an internal controls audit. Among non-exempt funds (our data do not include this information for exempt funds), we find that older funds, and funds with higher foreign and insider ownership, are more likely to obtain an internal controls audit.

Demand from lenders for high quality financial reporting. We do not find differences in financial reporting choices by fund type, despite the fact that debt usage varies considerably across types (e.g., private equity funds are heavily levered whereas hedge funds generally do not use traditional debt). This suggests that information demands of external equity investors, rather than creditors, drive the financial reporting choices of private funds.

Benefits of high quality financial reporting. We investigate whether high quality financial reporting is associated with increased investment in the fund. We find that funds that prepare GAAP financial statements and use Big Four auditors experience increases in the number of fund investors as well as fund size, suggesting that high quality financial reporting choices are rewarded with increased investment in the fund.

Implications. We find that the majority of private funds obtain audits when not required to do so, and that funds generally select high quality financial reporting. Older firms, larger firms, and firms with more external owners are more likely to select higher quality reporting. Investor composition also significantly affects private firms’ financial reporting choices. Further, selecting high quality financial reporting has benefits in terms of growth in firm size and number of owners. Overall, our findings suggest that large, private firms have incentives to use high quality reporting in response to investors’ demands, despite the costs of these choices and even in the absence of regulation. However, we still observe some private firms choosing to provide relatively lower quality financial reporting, indicating that these firms believe the costs of high quality reporting outweigh the benefits. Therefore, regulators may wish to more extensively consider the existing market demands for financial reporting information when designing future regulations.


[1] The University of Chicago’s Center for Research in Security Prices, cited in a recent Wall Street Journal article (Farrell, M. 2017. “America’s roster of public companies is shrinking before our eyes.” January 6), indicates that the number of public companies has declined by over 30 percent since the peak in 1997.

[2] Figures from: “2016 Prequin global private equity and venture capital report”; Mathews, D. 2014. “It’s time for private equity firms to start selling companies.” April 28.

[3] Figures from: World Bank Data Catalog,

This post comes to us from Professor Jennifer J. Gaver at the University of Georgia’s J. M. Tull School of Accounting at the Terry College of Business, Professor Paul Mason at Baylor University, and Professor Steven Utke at the University of Connecticut. It is based on their recent article, “Financial Reporting Choices of Large Private Firms,” available here.

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