Auditor Quits: Warning Sign of Stock Risk

Public companies that have had auditors recently resign may not be a good stock investment. The stock prices of these companies dip by about three percentage points following the announcement of an auditor’s resignation, according to a study by Professor Paul Griffin and co-author David Lont of the University of Otago, New Zealand. Their research paper, “Do Investors Care about Dismissals and Resignations?” found that stock prices of companies drop not because an auditor’s resignation is tied to disagreements over accounting and financial reporting but, rather, because the resignation signals a riskier client with a gloomy profit outlook. One example is the Fedders Corporation. The company announced in an SEC filing that Deloitte and Touche LLP would not stand for reelection as their auditor. According to Griffin, “the claim was that there were no disagreements on accounting and auditing matters and indeed, there weren’t.” However, two days following the company’s announcement, Fedders’ shares plummeted by nearly a third. Griffin and Lont compiled records of auditor changes over the past seven years—about 2,500 changes. They found that investors ignored news that a company dismissed its auditor, but the markets reacted when an auditor resigned.  “Resignation” is the operative word as it signals a riskier company because of a general uncertainty regarding how the financial statements are put together. It is a common assumption among investors that accounting firms typically do not resign as auditor from their lucrative clients without a good reason, according to Griffin. Following the initial negative reaction to a resignation, stock prices regained only about one-half of the stock price drop within about two weeks. Griffin recently presented these findings in New Zealand at the University of Otago and the Victoria University of Wellington. Lont will be a visiting professor at the Graduate School of Management through the end of June, working closely with Griffin on research. Griffin and Lont plan to present another joint research paper, “Agency Problems and Audit Fees: Further Tests of the Free Cash Flow Hypothesis” (with Yuan Sun) at the Accounting & Finance Association of Australia and New Zealand Conference, in Brisbane in July, and at the national meetings of the American Accounting Association in Chicago in August.