Do auditor resignations reduce uncertainty about the quality of firms’ financial reporting?

We assess the conditions under which auditor resignations reduce uncertainty about the quality of financial reporting of former and continuing clients of the resigning auditor. Our analysis is based on a sample of 109 auditor resignations in the period 1994–1998. Approximately one-quarter of these resignation announcements are accompanied by disclosure of a disagreement over accounting treatment or over the adequacy of internal controls—factors that point toward diminished credibility of former client’s financial statements—and are associated with negative abnormal returns for the former client. In contrast, we find no stock market effect for the remaining firms (i.e., three-quarters of our sample) for which the auditor resignations are “unexplained”, suggesting that the act of resignation, by itself, is not informative. Further, we find that these unexplained resignations, which likely result from auditors’ periodic risk-related reviews of their client portfolios, transfer value-relevant information to another class of investors. In particular, we find that industry matched continuing clients of the auditor that also have poor performance experience positive abnormal returns in the days surrounding media-announced resignations from former clients. This suggests that in an environment where poorly performing, high-risk audit clients are screened contemporaneously, an auditor’s unexplained resignation from one client, but not from a similar client in its portfolio, helps reduce uncertainty about the credibility of continuing clients’ financial reporting.