Customer-Supplier Relationships and Abnormal Accruals

Abstract

We examine the relationship between customer and supplier firms’ abnormal accruals. We propose “earnings management” hypothesis and “customer demand shock” hypothesis. We find that customer firms’ demand shocks link customer and supplier abnormal accruals as they propagate along the supply chain, via the “bullwhip” effect. Our evidence supports “customer demand shock” hypothesis. The evidence that a customer’s abnormal accruals transmit and magnify down the supply chain suggests that suppliers imperfectly predict new orders from their customers and that improving predictions would mitigate this bullwhip effect. Consistent with this view, we find that a customer’s abnormal accruals have a much smaller impact on those of its suppliers whose auditors have expertise in the customer’s industries. Overall, our results suggest that the supply chain is an important transmission channel of abnormal accruals, and auditor expertise serves to reduce information opaqueness during this process.