Earnings Management Contagion through Supply Chain

Abstract

Prior literature documents that earnings management can be contagious among economically related firms either through information externalities or through direct communication. This paper examines whether earnings management is contagious within supply chain relationships where one party has a dominant bargaining power over the other party, especially from major customers to dependent suppliers. Using restatement announcement as a main proxy for earnings management, we find that a firms earnings management is positively and significantly associated with its major customers earnings management. Our main findings are robust to the use of alternative model specifications which control for customer-specific characteristics and relationship-specific characteristics. Also, the inferences remain consistent when we adopt alternative proxies for major customers average earnings management including the use of other weighting methods or the use of accrual-based financial reporting quality measures. The positive association between a firms and its major customers earnings management is pronounced for firms that suffer from bad performance, supporting the possibility that major customers performance pressure is imposed on their dependent suppliers through the slanted bargaining power in the supply chain relationships and leads to the contagion of earnings management incentives. Also, we find that the reported association is mitigated for firms that are audited by external auditors who are industry specialists, emphasizing the importance of auditor competence in understanding the supply chain dynamics and detecting earnings management incentives. In the additional tests which examine the association between a firms and its major customers restatement in the same accounting items, we find that firms tend to have reporting failure on the same accounting items as their major customers do, consistent with the findings from prior literature documenting that firms tend to mimic the earnings management strategies taken by their close business partners. Overall, the empirical results suggest that major customers earnings management incentives and strategies have a contagious effect on their dependent suppliers. Considering that major customers could have a significant effect on dependent suppliers performance, business practicies, and earnings quality, this study encourages the reconsideration about the current disclosure requirement about major customers in Korean firms. While Korean Accounting Standards require firms to disclose the existence of major customers whose sales account for more than 10% of the firms total sales since the introduction of IFRS in 2011, recent studies document that the lack of information about the customers name and their specific sales amount reduces the usefulness of the information to the users. The findings of our study suggest that more detailed disclosure about major customers can provide informative information to various stakeholders of the firms.