Earnings Volatility and Auditor Risk Assessments: Evidence from Auditor Resignations

Abstract

SYNOPSIS This study proposes that auditors incorporate earnings volatility into their risk assessments such that volatility is associated with auditor resignations. Because volatile earnings are less predictable, they create larger deviations from the auditor's expectation of earnings and could increase auditor risk assessments. Higher earnings volatility could also signal underlying conditions that increase risk because accounting estimates become less reliable. Alternatively, auditors may perceive lower earnings volatility as riskier if auditors view it as an indication of more earnings management. We find a positive association between earnings volatility and auditor resignations, consistent with auditors viewing volatile earnings as riskier. This association is stronger for non-industry-specialists and auditors without long tenure. Finally, after the resignation of a Big 4 auditor, firms in the top quartile of earnings volatility are more likely to switch to a non-Big 4 auditor. Overall, our results show that earnings volatility plays an important role in auditor-client realignments.

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