3. The impact of earnings restatements on suppliers’ relationship-specific investments 37
3.2.2. Earnings restatements and relationship-specific investments by suppliers 42
formulate my main hypothesis regarding the effect of earnings restatements on relationship-specific investments by suppliers following the restatement. The firm’s trading in input and output market often involves relationship-specific investments by supply chain partners. Relationship-specific investments are assets that have design characteristics specific to the transaction with the firm and which have lower values in alternative uses (Williamson 1975; Sansing 1999). Therefore, the value of relationship-specific investments by suppliers depends on one firm’s future prospects.
Earnings restatements would influence the incentives of supply chain partners to undertake relationship-specific investments following the restatement announcement for two reasons. First, some earnings restatements convey unfavorable information about the restating firm’s current and future prospects, which induces the restating firm’s suppliers to concern about the expected revenues from relationship-specific investments. For example, some earnings restatements often lead to downward analysts’ revisions in future expected earnings (e.g., Griffin 2003) and are subsequently delisted or eventually filed for bankruptcy protection (e.g., Palmrose
and Scholz 2004). This suggests that earnings restatements represent a deterioration in general operating health (and possible bankruptcy), which would trigger lower operating performance. Since the size of supplier future business transactions is positively correlated with the restating firm’s future prospects, the suppliers’ expected revenues from such investments will be lower if the restating firm’s future prospects are less favorable. As a result, suppliers would be less willing to undertake relationship-specific investments.
Second, some earnings restatements convey unfavorable information about the restating firm’s accounting practices, which damages trust between the restating firm and its suppliers, thereby affecting post-restatement relationship-specific investments by customers and suppliers. Earnings restatements represent improper accounting practices, which exposes managers and directors to greater litigation risks and stiffer penalties (Karpoff et al. 2004).27 An increase in litigation risk leads to changes in management’s risk-taking behavior, which affects the restating firm’s investments and operation strategies, thereby adversely affecting future growth of the restating firms (Wallison 2003).28 Additionally, the firm’s management attention and financial resource may be diverted around the litigation caused by the restatement (Palmrose et al. 2004). In this context, the uncertainty about the terms of future transitions will be higher if the restating firm reduces incentives and financial resources to continue to invest in upholding its reputation for dealing honestly with suppliers and customers and for its overall integrity (Bowen et al. 1995; Maksimovic and Titman 1991).
Consequently, the suppliers’ investments will loss value when earnings restatements adversely affect the credibility and ability of the restating firm in contracting with
27 Karpoff et al. (2004) find that individuals involved in financial misrepresentations in the 1978-2002 periods were assessed about $16 billion in fines.
28 Consistent with this, Ribstein (2002) also argues that litigation risks of management could discourage CEOs from value-increasing risky investment.
customers and suppliers (e.g., Klein and Leffler 1981; Jarrell and Peltzman 1985;
Karpoff and Loott 1993).
Overall, both arguments suggest that earnings restatements convey unfavorable information about the value of relationship-specific investments by suppliers. Thus, suppliers of the restating firm would change their relationship-specific investments following the restatement.
3.2.3. Hypotheses
Once a firm’s financial statements are detected to contain inaccurate, incomplete, or misleading financial reporting, they have to be restated. At the restatement announcement, suppliers learn new information about the misstatements in the restating firm’s financial statements. If earnings restatements are informative about the value of the relationship-specific investments by suppliers following the restatement, one would expect to observe that changes in relationship-specific investments are related to proxies for information in earnings restatements. This is because the information in earnings restatements influences the suppliers’ perceived revenue from relationship-specific investments following the restatement, thereby affecting their subsequent relationship-specific investments. The first hypothesis, stated more formally, is as follows (in alternative form):
H1: The changes in suppliers’ relationship-specific investments are related to
news in earnings restatements.I now turn to cross-sectional variations in the link between changes in suppliers’
relationship-specific investments and information in the earnings restatement. I hypothesize that the strength of economic bond between the restating firm and its suppliers will affect suppliers’ relationship-specific investment decisions following the restatement. The idea here is that the more a supplier depends on a given restating firm, the more likely the supplier is making a substantial relationship-specific
investments, and, consequently, the greater will be concerns about the future prospect of the restating firms (Fee et al. 2006). If earnings restatements are informative about the value of relationship-specific investments by customers and suppliers, one would expect to observe greater changes in relationship-specific investments by suppliers following the restatement when the economic dependence between the restating firm and its suppliers is elevated. I therefore hypothesize that (in alternative form):
H2: The association between the changes in suppliers’ relationship-specific
investments following the restatement and information in the restatement is stronger when the strength of economic bond between the restating firm and suppliers is higher.Earnings restatements could also affect the incentives of suppliers to continue the business relationship with the restating firms. This is because earnings restatement announcements could hurt the restating firm’s reputation and ultimately lead to the termination of the business relationship. Consistent with this argument, anecdotal evidence supports the idea that suppliers would terminate their business relationship after the restatements. A Wall Street Journal article on the WorldCom’s restatements documented that “Just short of two years ago, Nortel Networks Corp. announced a multibillion-dollar extension on a purchase agreement with WorldCom Inc., calling itself a “strategic vendor” of the rapidly growing long-distance telephone carrier. But, Nortel dispatched a news release this week noting that it “has no material exposure to WorldCom” and no customer financing arrangement with it” (Sender 2002). The above discussions lead to the following hypothesis: