Initial credit ratings and earnings management
Author | Kimberly Rodgers Cornaggia,K. Ozgur Demirtas |
Published date | 01 November 2013 |
DOI | http://doi.org/10.1016/j.rfe.2013.05.003 |
Date | 01 November 2013 |
Initial credit ratings and earnings management
K. Ozgur Demirtas
a,
⁎, Kimberly Rodgers Cornaggia
b,c
a
School of Management, Sabanci University, Tuzla, Istanbul, Turkey
b
Kelley School of Business, Indiana University, United States
c
American University, United States
abstractarticle info
Article history:
Received 13 April 2012
Received in revised form 14 July 2012
Accepted 19 September 2012
Available online 14 May 2013
Credit rating agencies assert that they rely on financial information provided by issuers and that they value
rating stability as well as accuracy. In an environment where rating agencies depend on issuer-reported in-
formation and are reluctant to adjust ratings promptly, managers of issuing firms can utilize the discretion
afforded by GAAP to obtain the most favorable credit ratings. Consistent with our expectations, we find
that current accruals are unusually positive and high around initial credit ratings. The increase in abnormally
high accruals leading up to the initial credit rating year is followed by a reversal in the subsequent years. Mul-
tivariate regression analyses suggest that accounting accruals, abnormal current accruals in particular, are
significantly positively related to initial credit ratings after controlling for several issue- and issuer-related
characteristics indicative of default risk. Our results are robust to additional tests that account for
endogeneity between credit ratings and earnings management, adjust for performance, and account for
firms issuing debt and equity simultaneously.
© 2013 Elsevier Inc. All rights reserved.
1. Introduction
There is compelling evidence suggesting that firmsmanage earnings
around initial and seasoned public equity offerings(e.g., Rangan, 1998;
Teoh, Welch, & Wong, 1998a, 1998b; Teoh, Wong, & Rao, 1998).
1
Given that prior studies find that creditratings play a key rolein deter-
mining bond yields (Bhojraj & Sengupta, 2003; Campbell & Taksler,
2003; John, Lyn ch, & Puri, 2003), our study investigates two related is-
sues:(1) whether managersmanipulateearnings when obtaining initial
credit ratings on publiclyissued debt and (2) theextent to which earn-
ings management affects credit ratings.Considering that credit ratings
play a prominent role in the cost of debt and serve as a basis for regula-
tion, recognizing the potential influence of earnings management on
credit ratings is importantfor investors, raters, and regulators.
In the United States,debt markets are by far the primary source of
corporate financing. The total value of straight corporate debt under-
written in 2004 was $1278.4 billion. In contrast, net common stock is-
sues totaled $169.6 billion. Given the magnitude of debt financing,
managersacting in the interest of currentshareholders have incentives
to inflate earningsaround the time of credit ratingsusing the account-
ing discretion afforded by GAAP. Since more favorable credit ratings
lower the cost of debt, existing shareholders benefit, at least in the
near term, from aggressive earnings management if inflating earnings
leads to superiordebt ratings. Becausecorporate reliance on debt capi-
tal exceedsequity financing, and debt costsare legally binding cashob-
ligations, reductions in debt costs from superior debt ratings improve
future earnings. Therefore, the incentives for earnings management
should matchor exceed those at equity issuance.
Public firms typically receive ratings from credit rating agencies
(CRAs) around the time of a public debt offering. Over time, existing
ratings are revised as rating agencies observe changing circum-
stances. However, because credit rating agencies reportedly value sta-
bility of credit ratings as well as accuracy (see Cantor & Mann, 2003a,
2003b), ratings are not continuously updated. Obtaining the most fa-
vorable initial credit rating is thus crucial because (1) initial ratings
become the benchmark for ratings of future debt issues, and (2) rat-
ings are potentially ‘sticky’. Therefore, we believe that initial credit
ratings provide the most powerful setting to test whether firms man-
age earnings to obtain favorable ratings.
2
Issuers expect to benefit
from aggressive reporting because credit rating agencies reportedly
rely on issuer-reported financial information (Blume, Lim, & Craig
MacKinlay, 1998).
We concentrate on earnings and its influence on debt ratings be-
cause profit potential is considered a critical component of ratings.
According to Standard and Poor's (2006a, 2006b),“a company that
Review of Financial Economics 22 (2013) 135–145
⁎Corresponding author. Tel.: +90 216 483 9985.
E-mail addresses: ozgurdemirtas@sabanciuniv.edu (K.O. Demirtas),
kcornagg@american.edu (K. Rodgers Cornaggia).
1
Researchers typically conclude that this form of earnings manipulation leads inves-
tors to overvalue newly issued securities, which reduces the cost of equity capital for
existing shareholders.
2
Moreover, as the debt structure becomes more complex and issuers receive several
credit ratings on various issues, the distinction between issue rating and issuer rating
becomes a potential source of concern with seasoned issues.
1058-3300/$ –see front matter © 2013 Elsevier Inc. All rights reserved.
http://dx.doi.org/10.1016/j.rfe.2013.05.003
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Review of Financial Economics
journal homepage: www.elsevier.com/locate/rfe
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