Supply Chain Power and Real Earnings Management: Stock Market Perceptions, Financial Performance Effects, and Implications for Suppliers

• DOI: http://doi.org/10.1111/jscm.12186
• Author: William F. Wempe,Morgan Swink,Danny Lanier
• Published date: 01 January 2019
• Date: 01 January 2019

SUPPLY CHAIN POWER AND REAL EARNINGS

MANAGEMENT: STOCK MARKET PERCEPTIONS,

FINANCIAL PERFORMANCE EFFECTS, AND

IMPLICATIONS FOR SUPPLIERS

DANNY LANIER JR.

Elon University

WILLIAM F. WEMPE AND MORGAN SWINK

Texas Christian University

This study examines supply chain power in the context of real earnings

management (REM), instances in which executives execute (or forego)

operations transactions for the sole purpose of meeting or beating earn-

ings targets. We examine whether powerful major customers in supply

chains exploit their positions to engage in REM to a greater degree than

less powerful firms. We also examine (1) whether the stock market

reacts differently to major customers’and nonmajor customers’REM,

(2) whether any difference exists between major customers’and nonmajor

customers’post-REM financial performance, and (3) how suppliers are

impacted by their major customers’REM behavior. Results suggest that

major customers exploit their supply chain power to engage in more REM.

In contrast to the skeptical stock market reaction when other firms engage

in REM, we find no evidence that major customers’earnings are discounted

when there is evidence of REM. Instead, the market appears to interpret

major customers’behavior as “legitimate”uses of power in supply chain

management, rather than REM typically considered to be value-destroying.

Further, we find that in post-REM periods, major customers that engage in

REM exhibit better operating cash flow performance than nonmajor cus-

tomers who do so. These findings suggest that the consequential costs of

REM are lower for major customers than for nonmajor customers. Finally,

we report evidence that the particular form of major customers’REM

appears to determine the impact on their suppliers. Suppliers’financial

performance deteriorates when major customers’REM entails discretionary

expense cuts. These findings offer new insights into the benefits and uses

of power in supply chain relationships, in a previously unexplored context.

We discuss the implications of the findings for future research.

Keywords: interorganizational relationships; power; archival research; regression

analysis

INTRODUCTION

Interorganizational relationships create both oppor-

tunities and risks in supply chain management

(SCM). Prior research on relationships examines the

performance effects of firm power, supply chain (SC)

membership, and SCM competence, where power

refers to the ability of one SC partner to influence the

actions of another (Emerson, 1962; French & Raven,

1959). Research studies show that occupying a power-

ful position in a trading relationship generally

enhances performance. However, such studies mainly

focus on power in the contexts of innovation, collabo-

ration, procurement, and “normal exchange situa-

tions” (Cox, Ireland, Lonsdale, Sanderson & Watson,

2001; Reimann & Ketchen, 2017, p. 6; Terpend &

Krause, 2015). Little attention has been given to

Volume 55, Number 1

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Journal of Supply Chain Management

2019, 55(1), 48–70

©2018 Wiley Periodicals, Inc.

complexities surrounding power, and instances in

which power is exercised (Reimann & Ketchen, 2017).

In this study, we consider the possibility that SC

power influences buying firms’ operational decisions

regarding their short-term financial reporting needs. We

first examine whether powerful firms are more inclined

to manipulate real, operational transactions with their

SC partners in order to meet or beat earnings targets at

the ends of financial reporting periods—a behavior

known as real earnings management (REM). We then

examine three performance implications of powerful

SC firms’ REM, including stock market reactions, future

financial performance for buying firms, and financial

performance consequences for their captive suppliers.

Prior research persuasively shows that executives use

REM to meet or beat earnings targets. For example,

Gunny (2010), Chen, Rees and Sivaramakrishnan

(2010), and Roychowdhury (2006) provide evidence

that managers manipulate sales, production levels, and

discretionary expenses to meet or beat earnings targets.

In fact, Graham, Harvey and Rajgopal (2005) report

that 78 percent of executives have used REM to this

end,

1

executing (or foregoing) transactions that would

not be executed (or forgone) in the absence of earnings

targets. Some firms engage in income-increasing REM

by simply increasing production, which charges more

fixed production costs to the balance sheet as year-end

inventory, rather than to the income statement as cost

of goods sold.

2

Ramping up production may require

unplanned, increased, and expedited shipments of

materials from suppliers, thus raising costs. Alterna-

tively, buying firms may decrease, postpone, or cancel

planned purchases, or demand price concessions from

suppliers in order to manage earnings upward. Finally,

in another form of REM a firm might offer price dis-

counts or lenient credit terms to its customers in efforts

to increase earnings via increased sales. Such a move

has considerable impacts on suppliers if the firm also

negotiates related purchase price discounts or demands

increased and/or expedited shipments of inputs.

Prior research has explored some of these types of

REM actions. But some forms of REM are subtler. For

example, Crosby (2017) describes how Hormel beat

an earnings forecast by cutting advertising $25 mil-

lion, an action that undoubtedly affected one or more

of its trading partners. Our study examines whether

actions of this type are unusually prevalent in the con-

text of powerful buying firms attempting to beat earn-

ings targets, and how such actions affect stock market

returns, subsequent financial performance, and suppli-

ers’ performance.

Powerful SC firms use various bases of power (e.g.,

mediated and nonmediated) to influence suppliers’

actions and commitment (Chae, Choi & Hur, 2017;

French & Raven, 1959; Maloni & Benton, 2000),

thereby extracting favorable terms from their trading

partners (Galbraith & Stiles, 1983; Kim, 2017).

Recently, researchers have pointed out that our under-

standing of how and when firms use or restrain use of

power is unclear (Reimann & Ketchen, 2017). Our

study responds to Reimann and Ketchen’s (2017, p. 6)

call for research that examines conditions under which

weaker SC members might be exploited. We demon-

strate that financial benefits of SC power extend beyond

those realized in steady state operating conditions. Fol-

lowing methods validated in previous SC and account-

ing research, we measure the SC power and REM

actions of firms in multiple ways (Chen et al., 2010;

Gunny, 2010; Roychowdhury, 2006) and then analyze

associations between these variables and outcomes for

the firms and their captive suppliers.

Our findings suggest that powerful major customers

exert power episodically to manage earnings for the

benefit of financial reporting. In other words, major

customers are better able to execute REM transactions

by virtue of their power over SC partners. The findings

also point to a previously unexplored benefit of SC

power—stock market investors’ and analysts’ favorable

perceptions of powerful SC firms’ REM-aided earnings.

Because they occupy powerful positions in the SC,

major customers appear to be able to execute REM

with lower consequential costs both in the stock mar-

ket and for financial returns. Finally, results suggest

that while some forms of REM may be harmful to

major customers’ suppliers, other forms may benefit

them. Overall, our study’s findings have implications

for managers of firms that occupy either powerful or

weak SC positions, and may suggest additional con-

siderations for sourcing and procurement strategies.

Finally, our findings have implications for future

research of the broader benefits and contexts of power

in SC relationships.

PRIOR LITERATURE AND RESEARCH

HYPOTHESES

We rely on literature from both SCM and account-

ing to develop four hypotheses. SCM researchers often

employ resource dependence theory (RDT; Pfeffer &

Salancik, 1978) to explain a firm’s performance based

on its ability to obtain resources, in part through its

1

Many studies (e.g., Ayers, Jiang & Yeung, 2006; Jones, 1991)

show that firms manipulate accruals to manage earnings. Accru-

als manipulation requires no transaction, only an accounting

entry. The behavior we examine, REM, requires transactions with

SC partners.

2

If fixed production costs are $5 million and a firm produces

10,000 units and sells 8,000 units, then $4 million of cost is

charged to cost of goods sold, with $1 million charged to the

balance sheet. Overproduction decreases the unit cost of goods

sold, thereby increasing earnings by $1 million, relative to what

earnings would have been had 8,000 units been produced.

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