What Drives the Consequences of Intentional Misstatements? Evidence from Rating Analysts’ Reactions

• Date: 01 January 2017
• Published date: 01 January 2017
• DOI: http://doi.org/10.1111/jbfa.12229

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 44(1) & (2), 295–333, January/February 2017, 0306-686X

doi: 10.1111/jbfa.12229

What Drives the Consequences

of Intentional Misstatements? Evidence

from Rating Analysts’ Reactions

Martin Bierey and Martin Schmidt∗

Abstract: This paper aims to identify the mechanisms through which intentional misstate-

ments adversely affect firms by analyzing rating analysts’ reaction to misstatements. In order to

identify the mechanisms through which the misstatement affects firms’ credit ratings, we analyze

the content of rating reports. Rating analysts are concerned about seven different mechanisms.

They are most concerned about misstatement-related violations of debt covenants that increase a

firm’s liquidity risk. We find that, subsequent to an intentional misstatement becoming publicly

known, credit ratings of misreporting firms are adversely affected for up to seven years. The

adverse impact of an intentional misstatement on a firm’s credit rating is most pronounced

in cases in which rating analysts mention concerns about misstatement-related violations of

covenants. Our results suggest that these covenant violations are the most severe mechanism

through which misstatements adversely affect firms’ creditworthiness.

Keywords: credit ratings, misstatements, restatements, liquidity risk, debt covenants, conse-

quences of misreporting

1. INTRODUCTION

Firms that misstate earnings face severe capital market consequences, including higher

cost of equity capital, larger bid-ask spreads, a decline in the credibility of their

accounting information, and a substantial market value loss. There is considerable

controversy, however, about the mechanisms that cause these documented capital

∗The first author is from the School of Business and Economics, Humboldt-Universit¨

at zu Berlin and adjunct

researcher at ESCP Europe Berlin. The second author is from the Department of Financial Reporting &

Audit, ESCP Europe Business School, Berlin, Germany. We thank Ulf Br¨

uggemann, Beatriz Garcia Osma,

Joachim Gassen, David Hillier,Wayne R. Landsman, Mark Nelson, Peter Pope (the editor), William Rees, Ed-

ward Riedl, Thorsten Sellhorn, Florin P.Vasvari, Teri L. Yohn and the participants of the 2016 JBFA Capital

Markets Conference, the 2015 AAA/Deloitte/J. Michael Cook Doctoral Consortium, the 2015 EAA Annual

Congress, the 2015 EAA Doctoral Colloquium, the 2014 IAFD Symposium in Trondheim, the research

seminar at the Humboldt University of Berlin, and the ESCP research workshop for their comments. Access

to restatement data was provided by Karen M. Hennes, Andrew J. Leone and Brian P.Miller, and is gratefully

acknowledged. (Paper received December 2014, revised revision accepted October 2016).

Address for correspondence: Martin Bierey, School of Business and Economics, Humboldt-Universit¨

at zu

Berlin, Dorotheenstr. 1, D-10117 Berlin, Germany.

email: martin.bierey@wiwi.hu-berlin.de

C

2016 John Wiley & Sons Ltd 295

296 BIEREY AND SCHMIDT

market effects.1Previous studies have focused on the observable consequences of

misreporting, but not on the mechanisms that cause these adverse consequences.

More specifically, there is limited knowledge with respect to: (i) which mechanisms

cause the adverse consequences that are observable after misstatements; (ii) which of

these mechanisms have the most severe impact on misstatement firms; and (iii) how

long misstatement firms are adversely affected by these mechanisms.

We use a mixed-methods approach to examine these questions. We first examine

credit rating analysts’ reactions to intentional misstatements qualitatively by conducting

a content analysis of the rating reports that are released after a firm’s intentional

misstatement becomes publicly known. Subsequent to a misstatement becoming

publicly known, rating analysts are most concerned about misstatement-related covenant

violations that lead to an increase in a firm’s liquidity risk. In the majority of these cases, the

misstatement causes a substantial delay in the firm’s 10-K/10-Q filings, and thereby

the firm violates debt covenants under existing loans that specify when financial

statements must be provided to the creditor. This, in turn, entitles creditors to demand

accelerated repayment, or to re-negotiate the terms of the debt agreement, which puts

substantial pressure on a firm’s liquidity situation. Rating analysts are also concerned

about the following mechanisms: (i) the incorporation of a firm’s restated financial

situation, (ii) internal control weaknesses, (iii) legal penalties, (iv) misstatement firms’

distraction from the operating business, (v) firm’s loss of reputation among investors

and other stakeholders, and (vii) the inability to assess a firm’s financial condition due

to the absence of financial statements.

In the second part of our study, we analyze the impact of these mechanisms on

firms’ credit ratings. Our sample consists of 3,619 US firms that have a credit rating

assigned by Standard & Poor’s (S&P). The sample comprises 199 firms with intentional

misstatements, 251 firms with unintentional misstatements, and 3,170 firms without

alleged misstatements. We regress firms’ S&P credit rating on 11 rating determinants

(e.g., firm size, leverage, profitability). Our design allows us to empirically model a

firm’s rating (‘predicted rating’) and to analyze the within-firm variation of credit

ratings and the adverse effect of misstatement-related mechanisms while controlling

for the real consequences of misstatements (e.g., declining profitability, restated

financial situation).

Our findings show that, in the year of the intentional misstatement becoming

publicly known and in the following six years, a firm’s credit rating is significantly

lower than the rating that is predicted by rating determinants. This indicates that the

full range of misstatement-related mechanisms has a persistent adverse effect on firms’

credit ratings. We do not find an adverse impact on credit ratings in the year before

the misstatement becomes publicly known or in cases in which the misstatement

is classified as unintentional, which provides us with confidence that the identified

impact reflects the consequences of the intentional misstatement.

We find that the adverse impact of the intentional misstatement on a firm’s credit

rating is most pronounced in cases in which rating analysts mention concerns about an

increased liquidity risk resulting from misstatement-related debt covenant violations.

In the year of the misstatement becoming publicly known, the mean rating of these

1 In our context, we define mechanisms as the factors that market participants are concerned about subse-

quent to a misstatement becoming publicly known, and which eventually cause the adverse consequences

that are observable.

C

2016 John Wiley & Sons Ltd

EVIDENCE FROM RATING ANALYSTS’ REACTIONS 297

firms is four rating notches lower than their predicted rating. The findings of additional

analyses indicate that it is the delay in filing financial statements subsequent to

an intentional misstatement becoming publicly known (and the associated risk of

violating covenants) that can lead to the most extreme consequences of misreporting.

In contrast, we do not find that the impact of the misstatement on a firm’s credit

rating is significantly driven by the magnitude of the misstatement or by the question

of whether the misstatement led to an Accounting and Auditing Enforcement Release

(AAER) by the SEC.

Our paper contributes to the literature in three respects. First, we shed light on

the types of misstatement-related mechanisms that credit rating analysts (creditors)

are concerned about. In fact, our findings show that they are most concerned about

the increased liquidity risk that results from debt covenant violations. While this

mechanism has not received attention in the misreporting literature, it appears to

be the most severe mechanism through which misstatements adversely affect firms’

creditworthiness.

Second, we contribute to the misreporting literature by documenting that inten-

tional misstatements have a persistent adverse effect on a firm’s creditworthiness.

While Chen et al. (2014) document that equity investors perceive misstatement firms’

accounting information as less credible for three years, our findings illustrate that

firms endure adverse consequences from misstatement-related mechanisms for a

much longer period. In fact, the persistent adverse effect on a firm’s creditworthiness

might be one of the most severe consequences of misreporting, because after an

intentional misstatement becomes publicly known, firms’ access to equity financing

becomes restricted, forcing them to rely heavily on debt financing (Chen et al.,

2013).

Third, we contribute to the literature on debt covenants by illustrating a situation in

which covenant violations are extremely costly. Covenant violations are common and

creditors will not necessarily impose high costs on violating firms (Dichev and Skinner,

2002).2However, the costs of covenant violations increase with the information

asymmetry between creditors and violating firms (Gao et al., 2015). Subsequent to an

intentional misstatement becoming publicly known, firms are adversely affected by a

number of mechanisms that impede creditors’ ability to assess the creditworthiness of

the misstatement firm. This increases the information asymmetry between creditors

and misstatement firms and decreases creditors’ willingness to waive their right of

accelerated repayment. Our findings show that covenant violations in this situation

can substantially endanger firms’ liquidity situation and, in a number of cases, even

lead to bankruptcy.

2. MOTIVATION

The literature on the capital market consequences of corporate misreporting is

broad (for an overview, see Dechow et al., 2010). Studies have typically analyzed

observable consequences resulting from misreporting rather than the mechanisms that

cause these observable consequences (i.e., the factors that market participants are

2 For instance, subsequent to a covenant violation, creditors could simply waive covenant violations (e.g.,

Dichev and Skinner, 2002). In addition, creditors and borrowers can renegotiate covenants and other

contract terms ahead of the covenant violation in order to avoid a technical default (Denis and Wang,

2014; and Bozanic, 2016).

C

2016 John Wiley & Sons Ltd