Auditor Resignation versus Dismissal and Earnings Management Through Real Activities Manipulation

In this study, we examine whether clients' earnings management through real activities manipulation helps explain auditor resignations. Unlike earnings management through accounting estimates and methods (e.g., accrual-based earnings management), real activities manipulation is typically beyond the auditors' control. We predict that incumbent auditors react to clients' real activities manipulation passively by resigning from engagements in which they perceive a high potential for litigation risk. Consistent with our prediction, we find that auditors whose clients aggressively engage in abnormal operating activities are more likely to resign than be dismissed. We also present evidence that the association between real activities manipulation and the likelihood of resignation is more pronounced when insiders are net sellers following the earnings announcement and when it is in the post-SOX period. Utilizing a sample of auditor litigations and the industry-matched control sample, we further find that the clients' abnormal operating decisions significantly influence the litigation against auditors. Our evidence is consistent with the argument that auditors recognize clients' earnings management through real activities manipulation, thereby withdrawing from engagement because of its effect on their litigation risk.