Auditing private firms in a civil law context: an exploratory analysis of the impact on form and substance quality

ABSTRACT

This study examines to what extent auditors increase financial reporting quality in a civil law private firm context. Although such context provides little incentives to focus on financial reporting quality, the signalling role remains important. Therefore, we argue that auditors will also increase the quality of the financial statements in this context but will primarily focus on the form quality of the statements (i.e., the extent to which the required disclosures are made) while the substance quality (i.e., the extent to which the financial statements faithfully represent the economic reality) might become a smaller concern. A new measure for form quality is developed, and two matched samples of 278 and 316 Belgian private firms respectively are used to test our hypotheses. Our results confirm that having an auditor significantly increases the form quality of the financial statements while the effect on substance quality is more ambiguous.

KEYWORDS:

• Audit quality
• private firms
• civil law context
• form quality
• substance quality

JEL CODES:

• M42
• M48

Acknowledgments

We thank the associate editor and two anonymous reviewers for their constructive feedback during the entire review process. We also thank Brent Wagemans for his research assistance in developing the form quality measure and collecting the data.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. By external accountants, we mean members of the Belgian Institute for Tax Advisors and Accountants (ITAA) while external auditors have to be a member of the Institute of External Auditors (IBR). While both auditors and external accountants can have an influence on the financial statements quality, only external auditors are entitled to perform an external audit (Sarens et al., 2015).

2. While ‘substance over form’ is not considered a separate component of faithful representation anymore because it was considered redundant (FASB, 2010), we still consider the labels substance and form relevant for the purposes of our study to make a distinction between the two constructs of quality that we focus on in this study. Please note, however, that what we mean by these labels slightly deviates from the traditional definition of ‘substance over form’. While substance quality covers the overall ‘substance over form’ concept, form quality only focuses on whether all required information is provided in the financial statements, irrespective of the legal or economic reality besides GAAP.

3. These thresholds apply to all Belgian limited-liability firms. Firms exceeding these thresholds therefore always have to appoint an auditor. There is no exemption, for example, for firms that are part of a group.

4. The thresholds were changed after the focus period of this study. The current thresholds are: annual average workforce of 50 employees, balance sheet total of 4,500,000 EUR and turnover of 9,000,000 EUR.

5. However, firms may also refrain from hiring an auditor because they consider their accountant to provide all services regarding financial statements quality and thus think an auditor does not add value, or they may simply consider an auditor too expensive in comparison to its value.

6. We chose 2012 as reference year because using data of more recent years might lead to noise due to recent regulatory changes in the Belgian audit environment: a) As from 2014, the International Standards on Auditing (ISAs) should be applied when auditing Belgian financial statements, which might have led to differences in audit quality just before and after the ISA adoption due to anticipation and interpretation bias; b) The thresholds to be legally required to hire an auditor slightly changed in 2015, which might have had several demand and supply effects just before and after this change; and c) In 2016, a different more independent public body became responsible for the supervision of auditors, which led to some anxiety from the date this change was communicated, and this might also be reflected in the level of audit quality. (Branson et al., 2017)

7. For variable definitions of SIZE, ROA, LEVERAGE and CASHFLOW, please refer to the control variables paragraph in the methodology section. PROFIT is defined as net income in euros, EQUITY is the level of equity in euros, QUICK is defined as the ratio of current assets to current liabilities and AGE is the firm’s age in years.

8. 7 cases relate to companies that stopped their activities before 2018; for 2 cases, the FORM_QUALITY_SHORT measure could not be applied since none of the items of this measure were applicable; for 31 cases, the level of substance quality could not be calculated since these observations did not report their revenue and therefore the level of discretionary accruals could not be calculated for these observations; for 22 cases, information regarding the control variables (mainly CASHFLOW and/or LEVERAGE) was not available; 4 observations were outliers.

9. The average size of non-audited firms amounts to 3.8 million in total assets while it amounts to 5.1 million for audited firms, indicating that the difference in size is not that large. Moreover, the actual impact of this difference in size will be limited since we also control for firm size in the regression models.

10. A template of Belgian financial statements can be found via the following link: https://www.cbn-cnc.be/system/files/2020-01/Annual%20accounts%20Companies%20with%20share%20capital_Complete%20model_1.pdf.