Effect of Customers Risk Factor Disclosures on the Suppliers Relationship-specific Investment and Investment Efficiency

Description

In 2005, the Securities and Exchange Commission (SEC) issued a new disclosurerequirement mandating risk factor disclosures (RFDs) in firms’ 10-K filings (Section 1A)to discuss “the most significant factors that make the company speculative or risky”(SEC 2005). A few recent papers examine the consequence of this new disclosurerequirement on the equity market and find that mandatory RFDs are informative anduseful to equity investors (e.g., Kravet and Muslu 2013; Campbell et al. 2014).Given the strong economic link along the supply chain, firms’ annual reports are likelyto contain useful information to their supply chain partners. Prior studies find that thequality of firms’ annual reports matters to firms’ suppliers and the suppliers’stakeholders (e.g. Dou et al. 2013). Similarly, although the mandatory RFDs are intendedby the SEC to assist equity investors in understanding firms’ fundamental risks, they arealso likely to benefit firms’ suppliers in assessing their customers’ risk exposures if thedisclosures are informative.The proposed study will examine the effect of major customers’ RFDs on suppliers’relationship-specific investments and investment efficiency. SFAS Nos. 14 and 131require a firm to disclose any customer that accounts for more than 10% of its sales. Forfirms that depend on a few large customers, their relationships with those principlecustomers are likely to be bilateral and they must invest in relationship-specific assetsto support their unique transactions with those customers (Banerjee et al. 2008). Thevalue of such relationship-specific investments depends critically on the supply chainpartner’s future risk prospects. Thus, it is reasonable to expect supplier firms to decreasetheir relationship-specific investments if their major customers’ RFDs reveal unexpectedrisk and increase their risk perception. However, the availability of these RFDs shouldreduce a supplier’s uncertainty about its customers’ operational risk and allow thesupplier to make more optimal investment decisions, resulting in better investmentefficiency.The proposed study will first provide additional evidence on the consequence of theSEC’s new regulatory requirement for risk factors. The findings will have policyimplications for the SEC and regulatory authorities of other countries that are concernedabout firms’ risk disclosures. Second, the proposed study will add to the accountingliterature on supply chain information transfers and the emerging textual analysisliterature.