The Price of Blunders
A blunder can cost a lot. The clients of the multinational auditing and consulting firm PwC know this well, having suffered backlash on the stock market from Envelopegate. Envelopegate was an error at the 2017 Academy Awards ceremony (better known as the Oscars) where a PwC partner mixed up envelopes, resulting in the wrong Best Picture winner being announced live. The effects of the incident on PwC's reputation were examined in the paper “Can a Viral Blunder Damage Auditor Brand Name Reputation? Evidence from Envelopegate“, written by Paul Demeré (Department of Accounting, Bocconi), Beau Grant Barnes (Washington State University), Marc Cussatt and Nancy L. Harp (both of Clemson University, USA) and published in the Journal of Accounting, Auditing & Finance.
Based on intraday stock market data, the research found that PwC audit clients saw returns decline by 0.24-0.36% in the day after Envelopegate, compared to firms that were not clients of the consulting giant. In addition, PwC audit clients were also 55% more likely to see a negative stock return on the Monday following Envelopegate than firms that were not clients of the consulting giant.
The trigger appears to be the impact of the Oscars blunder on PwC’s reputation. Typically, it is difficult to say whether a negative reaction to an auditor’s failure is attributable to the impact on the auditor’s reputation or concerns that the auditor will face lawsuits and fines that will make it harder for client stakeholders to seek similar settlements and fines if an audit failure occurs at their firm. In other words, whether a negative reaction is driven by reputation or “insurance” effects. Given the nature of the Envelopegate event, there were highly visible reputational costs and few significant lawsuits or fines that could follow. This natural experiment thus led to the cleanest possible measurement of the value of the auditor's reputation as independent, free from insurance effects/concerns. The researchers therefore suggest that the decline in the stock market of PwC's clients was due to stakeholders from firms completely unrelated to the Academy Awards responding to the blunder (although not inherent to PwC's core audit business) by downgrading the quality of the audits themselves due to PwC’s reputation impairment. The paper also shows that this negative discount on an audit firm's reputation can lead to negative stock market reactions for clients, even when they are geographically separated and the audit is almost entirely different from the failed service.
The research identifies downside risks associated with engaging in non-audit services. The upside of these engagements, beyond a small fee and the chance for some employees to rub shoulders with celebrities, is that they may be taken by potential audit clients as evidence of the quality of the services, leading to an increase in clients. Competition in the audit market can incentivize auditors to provide non-audit services if it gives them an advantage with potential clients. However, there is a price to pay for these potential benefits: such services make the firm’s reputation vulnerable to negative consequences in the event of a visible engagement failure. The Envelopegate case demonstrates the importance of auditors’ reputations at the firm level in the United States.
