Management Turnover Following Auditor Resignations*

An auditor's resignation from an engagement creates financial reporting uncertainties.Financial reporting uncertainties in turn potentially increase the cost of capital.If the directors hold managers responsible for the failure to satisfy auditors, we expect them to respond to the auditor's resignation by dismissing the responsible managers and finding more competent replacements.Replacing top managers also signals investors of the directors' intention to restore reporting credibility.A firm that changes auditors is required to file an 8-K report with the SEC indicating whether there has been an accounting or auditing disagreement between the auditor and the managers.The 8-K must note any "reportable event", that is, whether the auditor believes the client's internal control system is so weak as to generate unreliable financial statements (internal control reportable events), or the representations made by managers with respect to the financial statements are not credible, or the scope of the audit needs to be expanded (reliability reportable events).Whisenant, Sankaraguruswamy, and Raghunandan (2003) show that the market reacts adversely to the disclosure of accounting and auditing disagreements and reportable events.If directors view disagreements and reportable events to be evidence of poor managerial performance, we should observe a disproportionately high incidence of managerial turnover following their disclosure.We employ two control samples in this study.The first control sample consists of firms that do not experience an auditor resignation.The second control sample consists of firms that experience a client-initiated auditor change.We find that the frequency of CEO and CFO turnover increases following auditor resignations.The likelihood of a CEO or CFO change is even greater when there is a reportable event.Our paper makes several contributions.We add to the auditing literature by showing that auditor resignations result in higher management turnover, and resignations accompanied by disclosures of reportable events increase the likelihood of management turnover further.Our paper also contributes in providing evidence specifically on CFO turnover.Most other studies have only looked at CEO turnover or the turnover in top management as a group.It is useful to understand the penalties incurred by the CFO for poor performance related to accounting issues because the CFO generally has primary responsibility for financial reporting.Finally, we add to the literature on the consequences of financial reporting problems for managers.The extant evidence on this issue is mixed.Our study, using a larger sample than has been used previously, suggests that directors penalize managers for failing to satisfy auditors.The remainder of the paper is organized as follows.The next section discusses the link between auditor resignations and management turnover and develops the research questions tested in this paper.The third section presents the empirical analysis.The final section concludes the paper. Management turnover and auditor resignationsMany studies have documented an inverse relationship between CEO turnover and firm performance (Warner et al. 1988;

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