Virtually every business gets materials and goods from other organizations, typically referred to as suppliers. These suppliers vary in the types of goods they provide, from raw materials to finished products ready for sale or use. In recent years, due to pandemic supply chain issues and concerns about sustainability, supplier visibility has become a reporting concern.
A company’s choice of suppliers can affect their financial risk and revenue predictability, as well as their ESG reporting and other regulatory disclosures. As such, investors and regulators are more likely to scrutinize these connections when they review regular filings. Understanding supplier tiers, particularly the distinctions in tier 1 vs tier 2 vs tier 3 suppliers, can help businesses to provide stronger financial reporting.
What Are Supplier Tiers?
Supplier tiers are classified by the types of goods and services they provide, more generally by their stage in the supply chain. Imagine a company that sells puzzles and board games. Their suppliers would be classified into these tiers:
Tier 1: A direct supplier providing partially finished products, such as cardboard sheets ready for printing and cutting
Tier 2: An indirect supplier selling partially processed materials, like wood pulp processed into cardboard
Tier 3: A producer selling raw materials, like lumber turned into wood pulp
From the tree to the puzzle piece, the material flows upstream through the chain until it reaches the end consumer. Since many of these tiers involve distinct suppliers, it can be difficult for businesses to have supplier visibility beyond Tier 1 or understand the dependencies between these tiers.
What is a Tier 1 Supplier?
The tier 1 supplier is the organization that a company is most likely to interact with, as they are a direct supplier. These suppliers may provide components that are nearly ready for sale or finished products, like a supplier that sells loaves of bread to a bistro. Tier 1 suppliers are the primary source of concentration risk, highlighting the importance of supplier diversity at this level. Implications of this supplier relationship include:
Tracking cost of goods sold and other expenses
Timing of revenue recognition
Contractual obligations and payment terms
For financial reporting, these details play a critical role in the way that businesses describe MD&A, risk factors, contract disclosures and other factors related to a 10-K filing.
What is a Tier 2 Supplier?
Tier 2 suppliers connect a company’s direct suppliers to the producers of raw materials. For example, a company that bakes loaves of bread for restaurants might use a supplier that turns raw grains into processed flour ready for baking. These suppliers can be a critical element of supply chain management and diversity, as they often rely on factories that may shut down or have limited production due to labor concerns. Production delays affect a company’s revenue, since the cost volatility is passed through the tier 1 suppliers. For reporting, businesses may need to look at this supply chain tier in terms of indirect risk, assumptions about supply chain continuity or the sensitivity analysis in the MD&A.
What is a Tier 3 Supplier?
A tier 3 supplier is often a producer, taking raw materials and providing minimal processing before sending them to the next step in the chain. For example, a farmer growing grain may harvest the grain and send it to a tier 2 supplier for processing into flour for baking. This tier also includes mining operations and chemical processing and may feature low regulation and broad regional diversity.
Raw materials create exposure to a number of risks for businesses, including:
Geopolitical instability
Environmental risks
Concerns related to labor, ethical sourcing and responsible harvesting
Given the nature of these concerns, supply chain visibility at this tier is important for ESG reporting requirements, such as climate disclosures and reporting related to human rights, sustainability and transparency.
How Supplier Tiers Impact Financial Reporting
Supplier tiering shows up in financial disclosures through various ways, depending on the tier and the types of products or services provided. These impacts might include:
Disclosures related to supplier concentration, especially for businesses relying on few suppliers in each tier
Valuation of inventory, including risk for inventory impairment
Continuity of the supply chain, requiring analysis of each supplier as a going concern
For the company, these impacts translate into necessary reporting on revenue forecasts, cost assumptions and margin volatility. Businesses may need to perform restatements or adjustments as part of supplier statement reconciliation or expand their risk factor disclosures when a critical supplier is struggling.
Supplier Tiers and Risk Disclosure Requirements
The diversity of the supply chain can help companies reduce their risks or increase the risk exposure they need to account for in their disclosures. Risks related to supplier relationships include:
Single-source suppliers that cannot or will not source materials or components from other organizations
Suppliers that are concentrated in a single geographic area, especially regions that are prone to political, economic or climate-related instability
Suppliers that are subject to low regulatory exposure, which may affect the quality of goods sold or other aspects of the supplier relationship
Consistent, transparent language is key in these disclosures, as regulators and investors look carefully at the way businesses assess their own risks.
Supplier Tiers, ESG and Regulatory Reporting
Reporting related to Environmental, Social, and Governance disclosures calls for greater scrutiny on the different tiers companies use for supplies. National and local governments are increasing their focus on Scope 3 emissions, which describe the greenhouse gas emissions derived from the supply chain as the business creates the final product. ESG reporting requires an analysis of the environmental impact tied to upstream suppliers, as well as human rights and compliance with labor regulations.
Regulations in this arena increasingly affect a company’s tier 2 and tier 3 suppliers, specifically ESG metrics and other types of statutory reporting. Commitment to supply chain transparency and sustainability reporting can improve results and compliance in this area.
Best Practices for Managing Supplier Tier Risk in Financial Reporting
Understanding the various factors and dependencies related to the supply chain is a critical task for long-term business success and regulatory compliance. Best practices involve:
Creating a cross-functional collaboration between finance, procurement, legal and ESG teams, to ensure transparency and compliance
Ensuring a diverse supplier list to improve consistency and provide buffers during periods of economic, political or climate instability
Performing regular supplier risk assessments and documenting results
Centralizing reporting and disclosure workflows, using SEC filing software and other technology
Implementing version control for effective and accurate audit trails
DFIN provides software tools to help businesses streamline and automate their processes. Learn more about how DFIN can support your financial reporting needs.
