2. The vertical information transfer effects of earnings restatements along the supply
2.2. Literature review and hypothesis development
2.2.3. Vertical information transfer hypotheses
Given the significant valuation implications of earnings restatements, it seems plausible that there could be an impact on related firms in supply chain. For example, the day WorldCom announced it will restate earnings to the tune of $3.8 billion, suppliers in equipment markers such as Juniper Network Inc., Nortel and Cisco Systems Inc., experienced noteworthy crashes in their stock prices (e.g., Berman 2002). In particularly, Juniper Networks’ stock drops more than 18 percent.10 The anecdotal evidence supports the notion that earnings restatements could induce the vertical information transfer effects along the supply chain.
This vertical information transfer occurs when earnings restatements convey information useful to investors in pricing the value of related firm in the supply chain. In this paper, I consider two potential reasons for vertical information transfers: (1) earnings prospect concerns; and (2) accounting quality concerns.
Earnings Prospect Concerns
One potential reason is restatements will induce future earnings prospect
10 WorldCom accounted for 10% or more of Juniper Networks' quarterly revenue.
concerns about the restating firms’ suppliers, and thus alter investors’ future earnings expectation about the restating firms’ suppliers. On the one hand, the correlation in the economic activities of the restating firm and its suppliers is likely to be positive because the restating firms are important source of revenue to a supplier. With a positive correlation in the economic activities between restating firm and its suppliers, earnings restatements which convey bad news about a restating firm’s economic prospects will also convey bad news about the economic prospects of suppliers (e.g., Olsen and Dietrich 1985).
On the other hand, earnings restatements may impose spillover costs on a given supplier that has made an implicit/explicit commitment. Extant implicit contracting studies (Brown et al. 1995, Cornell and Shapiro1987, Maksimovic and Titman 1991) suggest that one firm’s financial health affects its incentives and abilities to fulfill the implicit/explicit commitments to customers and suppliers. Prior research finds that restating firms have weaker financial health than non-restating firms (Kinney and McDniel 1989; DeFond and Jiambalvo 1991; Sennetti and Turner 1999). In addition, a restating firm’s management attention and financial resource may be diverted around the litigation caused by the restatement (Palmrose et al.
2004). In these cases, the restating firm may reduce current levels of business to its suppliers, postpone the payment for suppliers, or cut corners in other ways to response litigation penalties caused by the restatement as well as to attempt to improve its financial health. Accordingly, the future earnings prospects of suppliers are perceived to be worse, such that suppliers also suffer negative stock price effects at the restatement announcement.
Accounting Quality Concerns
The second reason is that restatements detected at one firm might induce investors to question over the financial reporting quality of restating firm’s suppliers.
Recent research documents that earnings restatements prompt investors to question whether rival firms in the same industry also adopt similar accounting practices as the restating firm (e.g., Raman and Shahrur 2008). Anecdotal evidence also suggests that earnings restatements induce accounting concerns for non-restating firms. For example, comment on WorldCom’s restatement, one analyst stated that “The rotten egg here is not WorldCom and the telecom sector, but the accounting practices that are highly susceptible to interpretation” (Dignan 2002). This suggests that accounting quality concern is not restricted in the same industry as the restating firm.
In the customer-supplier relationship, accounting information plays an important role in firms’ dealing because the terms of trade are determined in part by reputation considerations. Financial image is important to supply chain partners in assessing a related firm’s reputation for explicit and/or implicit contract performance (Cornell and Shapiro 1987). Accordingly, the explicit and/or implicit claims have an effect on supply chain partners’ choice of accounting methods (e.g., Bowen et al. 1995;
Burgstahler and Dichve 1997). Specifically, firms with higher implicit claims have stronger incentive to use income-increasing accounting methods (Matsumoto 2002).11 Applying this idea, I argue that the restating firm’s suppliers may have stronger incentives to use income-increasing accounting methods to signal a good financial health to the restating firm, so that they could obtain better terms of trade before the restatement. In addition, restating firm and its suppliers may collude and use similar accounting practice to manage their financial statements. Supply chain relations are potentially important information channels as investors infer value relevant information from such economic links (Cohen and Frazzini 2006). The stock prices of these stakeholders then changes as investors alter their perceptions about the
11 Matsumoto (2002) finds that implicit claims are positively related to the frequency of positive abnormal accruals.
credibility of suppliers’ past financial statements based on the information revealed by earnings restatements.
Overall, both arguments imply that earnings restatements convey the information about the economic prospects and/or accounting quality of suppliers. This leads to changes in stock prices of suppliers at the time of earnings restatement announcement.
Thus, the first hypothesis, stated in alternative form, is as follows:
H1: Earnings restatement announcements will induce significant stock price
effects on suppliers of the restating firm at the restatement announcement.The focus of H1 is on whether investors update their valuation for the restating firms’ suppliers based on the information revealed by the restatements. An important issue to consider is whether such vertical information transfer is signaling future earnings prospects of suppliers. If earnings restatements have implication for future earnings prospects of restating firms’ suppliers, one should observe changes in analyst earnings forecast revisions for the restating firms’ suppliers following the restatement announcements and such revisions should be related to the information in the restatement. This suggests that investors and analysts adjust their earnings forecasts for customers and suppliers based on the news revealed by restatements of the restating firm. Examining the extent to which investors and analysts use this information provides further insights into how earnings restatements influence the earnings expectations for suppliers, thus determining stock prices of suppliers. This leads to my second hypothesis:
H2: Changes in analyst forecast revisions for suppliers following earnings
restatement announcements are associated with the information in earnings restatements.As discussed above, earnings restatements will induce supply chain accounting quality concerns, and therefore affect the stock prices of the restating firm’s suppliers.
If earnings restatements of one firm provide information that alters investors’ beliefs about the accounting quality of the restating firms’ suppliers, one would expect that the abnormal returns of the restating firm’s suppliers surrounding restatement announcement are positively related to the measure for difference in earnings quality of the suppliers. This lead to my third hypothesis (in alternative form):