Initial credit ratings and earnings management

AuthorKimberly Rodgers Cornaggia,K. Ozgur Demirtas
Published date01 November 2013
DOIhttp://doi.org/10.1016/j.rfe.2013.05.003
Date01 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 nancial 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 rms can utilize the discretion
afforded by GAAP to obtain the most favorable credit ratings. Consistent with our expectations, we nd
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
signicantly 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
rms issuing debt and equity simultaneously.
© 2013 Elsevier Inc. All rights reserved.
1. Introduction
There is compelling evidence suggesting that rmsmanage 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 nd 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 inuence 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 nancing. 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 nancing,
managersacting in the interest of currentshareholders have incentives
to inate 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 benet, at least in the
near term, from aggressive earnings management if inating earnings
leads to superiordebt ratings. Becausecorporate reliance on debt capi-
tal exceedsequity nancing, 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 rms 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 rms man-
age earnings to obtain favorable ratings.
2
Issuers expect to benet
from aggressive reporting because credit rating agencies reportedly
rely on issuer-reported nancial information (Blume, Lim, & Craig
MacKinlay, 1998).
We concentrate on earnings and its inuence on debt ratings be-
cause prot 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) 135145
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
Contents lists available at ScienceDirect
Review of Financial Economics
journal homepage: www.elsevier.com/locate/rfe

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