Authors: Charalampos Brilakis, Efthimios Demirakos

Title: The Relationship Between Restatements and Key Audit Matters in the Context of Business Combinations

Abstract

The primary research purpose of the current study is to examine the predictive value of Key Audit Matters (KAM) in relation to subsequent Restatements in the context of Business Combination activity: mergers and acquisitions, consolidation, investment in non-consolidated subsidiaries and disposals. We add to the limited previous literature by conducting KAM and Restatement content analysis, followed by a quantitative assessment of their relationship. Our research includes the LSE-AIM market segment that is underrepresented in analysts’ coverage.

We focus on companies listed on the London Stock Exchange (Main and AIM market) and extract restatement data filed between 01.01.2016 and 31.12.2021 as well as KAM-related data for the fiscal years ending between 01.01.2016 and 31.12.2020. The source of data in both cases is the Audit Analytics database. From these two datasets, we examine those entries that are related to “structure events”, as defined and captured in the Audit Analytics taxonomy: Mergers and Acquisitions, Consolidation, Investment in non-consolidated subsidiaries and Disposals, to which we collectively refer as “Business Combination” (or BC) activity.  In the period from 2016 to 2021 we observe the occurrence of 127 BC-related restatement filings from 112 distinct companies, and 1.421 BC-related KAM from 677 distinct companies. We note that the BC-related restatement filings represent 29.20% of the total restatement filings of the examined period.

With respect to our sample characteristics, we note that 64.30% of the companies with restatements are listed in the AIM market segment and 50% of the companies have market capitalization less than 99.12 mil GBP, thus in their majority companies that filed such restatements are of small size.

Focusing on the “Business Combination”-related Restatements and KAM, our empirical study yields some interesting descriptive statistics:

(i) 74.02% of the restatements had a negative impact on the company’s profitability.

(ii) The annual number of restatements linearly increased between 2016 to 2021.

(iii) Approximately 91% of restatements corrected the financial statements of the prior 1 to 3 fiscal years, whereas approximately 50% of the restatements corrected the financial statements of exactly two prior years. Hence a lag of 3 years should be considered for the joint review of restatements and relevant preceding KAMs.

(iv) The annual number of KAM logarithmically increases between 2016-2019 and then slowly decreases in 2020-2021.

(v) Further subsampling to allow for the time lag between KAM and subsequent restatements, results to 84 restatements filed in 2019-2021. These correspond to 71 distinct companies.

(vi) In this subsample of 84 restatement filings of 78 distinct companies, 47 KAM preceded restatements. Thus, we conclude that for 55.95% of the restatement filings, a KAM classified by Audit Analytics in a relevant category precedes the restatement.

(vii) We further perform KAM and Restatement content analysis, to assess if KAM were directly referring to uncertainties that were later corrected by the Restatement. For 15 restatement filings, there was a preceding KAM that appeared 1 to 3 years before the restatement, with KAM narrative that is directly related to the following restatement.

Thus, we conclude that KAM presence could signify that restatement probability is higher, however KAM content infrequently hints for the subsequent restatement.