Product Recalls and Audit Production

Abstract

We examine the impact of product recalls on audit production. Product recalls are events that increase engagement risk associated with greater audit effort, and by extension, greater audit quality. Consistent with this conclusion, we find firm-years with a product recall have a lower likelihood of being subsequently restated and lower levels of accrual error. While a positive association generally exists between audit effort and audit fees, prior literature shows firms experiencing economic stress negotiate lower audit fees and auditors accept lower fees to earn future returns. We expect that to increase the likelihood of retaining a client, auditors will agree to lower fees when the short-term economic stress associated with a recall injects downward pressure into fee negotiations. Supporting this conclusion, we find product recalls are associated with lower audit fees – a relation attributable to differing magnitudes of temporal fee increase. We also show the effects are transitory, the higher levels of audit quality are attributable to specialist audit offices, and the lower levels of fees are attributable to engagements where the client has greater bargaining power. While a positive association typically exists between audit effort and audit fees, our paper identifies a firm-specific event that weakens this relation.