Customer-Supplier Relationships and Strategic Disclosures of Litigation Loss Contingencies

In a customer-supplier relationship, when a third party sues the supplier, the resulting litigation loss contingency may trigger the principal customer’s concern regarding supply chain risks. We find that customers are likely to hedge such supply chain risks by weakening or terminating relationships when suppliers are mired in litigation. To avoid the significant adverse impact on the operating and stock performance as an outcome of relationship termination, suppliers being sued adopt strategic disclosure strategies regarding loss contingencies in their financial statements. Our results suggest that proprietary costs involving supply chain discontinuation lead to strategic disclosure decisions by dependent suppliers such that firms tend to promptly reveal their good news and strategically withhold their bad news. This disclosure behavior, while classic in nature, has yet to be demonstrated in the context of supply chain relationships. Our findings are useful to the SEC, which has recently put registrants on notice that it would like to see clearer disclosures of potential losses from litigation in financial statements. The findings are also potentially useful to the auditors of dependent suppliers being sued, since audit risk increases with undetected noncompliance with GAAP disclosure requirements.