A Commitment to Quality: An Examination of Plant-Level Quality Control Failures and Financial Reporting Weaknesses

• In Event: Regulations and Product Markets

Abstract

In this paper, we investigate the capital market implications of compliance deficiencies across multiple business functions. Specifically, we examine the association between error-related restatements and outcomes from the U.S. Food and Drug Administration’s (FDA) plant inspections in the pharmaceutical and medical device industries. We use the inspection results to proxy for the degree of regulatory non-compliance in firms’ operating and quality control processes. We find that the FDA inspection failures serve as a determinant of contemporaneous financial accounting restatements. We document a more negative stock market reaction to error-related accounting restatements in the presence of higher inspection scores (weaker quality control), indicating that the market imposes a higher cost on those firms with non-compliance across the organization. We also examine the change in audit fees following the error-related misstatement, and find that monitoring costs increase in the presence of multiple compliance deficiencies. Finally, we consider the potential impact on upper management if a firm does not seem to be cultivating a culture of compliance, and the “tone at the top” does not seem to be reducing compliance risks, and provide evidence of higher CEO turnover following an error-related restatement when the quality control process is weaker. This result is consistent with our argument that the stakeholders of the firm hold top management responsible for creating a culture of compliance.

Authors

• Jennifer L.M. Altamuro, The Ohio State University

• John Gray, The Ohio State University

• Haiwen Zhang, The Ohio State University