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

Abstract

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 earnings 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 customers 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.