Credit Ratings and Earnings Management around IPOs

This study examines the impact of having a credit rating on earnings management (EM) through accruals and real activities manipulation by initial public offering (IPO) firms. We find that firms going public with a credit rating are less likely to engage in income‐enhancing accrual‐based and real EM in the offering year. The monitoring by a credit rating agency (CRA) and the reduced information asymmetry due to the provision of a credit rating disincentivise rated issuers from managing earnings. We also suggest that the participation of a reputable auditing firm is crucial for CRAs to effectively restrain EM. Moreover, we document that for unrated issuers, at‐issue income‐increasing EM is not linked to future earnings and is negatively related to post‐issue long‐run stock performance. However, for rated issuers, at‐issue income‐increasing EM is positively associated with subsequent accounting performance and is unrelated to long‐run stock performance following the offering. The evidence indicates that managers in unrated firms generally manipulate earnings to mislead investors, while managers in rated firms tend to exercise their accounting and operating discretion for informative purposes.     

INTRA-INDUSTRY EFFECTS OF BOND RATING ADJUSTMENTS

Several studies find that bond rating downgrades cause negative valuation effects. Other studies find that signals conveyed by earnings releases, earnings forecasts, bankruptcies, and stock offerings of individual firms can be transmitted to their corresponding industries. By combining the two sets of studies, we hypothesize that bond rating changes may contain relevant information not only about the firm, but also about the corresponding industry. We find significantly negative valuation effects for rating downgrades, which are transmitted throughout the industry. Furthermore, we find that intra-industry effects depend on particular characteristics of the bond downgrade, the downgraded firm, and industry rivals. Specifically, the negative intra-industry effects are more pronounced when (1) the downgraded firm experiences a more severe share price response to the bond rating downgrade, (2) the downgraded firm is dominant in the industry, (3) the downgraded firm is more closely related to its rivals in the industry, and (4) the downgrade is due to a deterioration in the firm's financial prospects.     

Measuring the effect of watch-preceded and direct rating changes: a note on credit markets

This paper analyzes the importance of distinguishing between watch-preceded and direct rating changes for the credit default swap (CDS) market by examining a total of 2991 rating change announcements, 1526 watchlist placement announcements, and 430 rating affirmations following watchlist placements. The results show that watch-preceded downgrades do not lead to significant CDS market reactions, while direct downgrades are associated with a significant increase in CDS spread levels. Likewise, we document that watchlist placements for downgrade lead to increases in firms’ CDS spreads. CDS markets do not react to rating upgrades but watchlist placements for upgrade result in an immediate decrease in CDS spreads. Rating affirmations following watchlist placements for downgrade lead to slight reductions in CDS spreads, while affirmations following watchlist placements for upgrade have no effect on CDS spreads. These findings demonstrate the importance for empirical research on the interaction between credit markets and rating announcements to differentiate between watch-preceded and direct rating changes, particularly for rating downgrades.     

Characteristics and Information Value of Credit Watches

We analyze credit watch and rating actions to better understand the role of credit watches in the credit rating process. We find that watch actions are more frequently prompted by specific, publicly known events than are rating actions. The likelihood that a watch action precedes a rating action varies systematically with proxies for investor demand for credit quality information and the adverse consequences of issuing a rating change prematurely. Credit watches occur more often in response to deterioration in credit quality, and issuers make concerted efforts to address the concerns that prompted down watches. Down watches are less likely than up watches to indicate the direction of the subsequent rating change. Watch announcements are associated with abnormal stock returns, indicating that credit watch actions are significant information events. Our results suggest that credit watches are informative and facilitate the stability of ratings by allowing firms to correct deficiencies and prevent downgrades.     

Corporate financing and anticipated credit rating changes

Firm circumstances change but rating agencies may not make timely revisions to their ratings, thereby increasing information asymmetry between firms and the market. We examine whether firms time the securities market before a credit rating agency publicly reveals its decision to change a firm’s credit rating. Using quarterly data, we show that firms adjust their financing structures before credit rating downgrades are publicly revealed. Specifically, firms on average increase their debt financing by 1.29 % before the disclosure of a rating downgrade, and this increase is due to the issuance of debt rather than the repurchase of equity. In contrast, firms do not take significant financing actions before credit rating upgrades.     

信用评级变动能反映企业真实财务信息吗?——基于财务重述的视角

本文以2007-2018年拥有主体信用评级的A股上市公司为研究对象,利用企业财务错报在未来被重述这一场景,检验主体信用评级变动能否反映企业真实财务信息。研究发现,评级机构在发债企业财务错报年显著下调了主体信用评级,而在重述公告发布年没有上述现象,这表明主体信用评级下调反映了企业的真实财务信息。在控制内生性影响后,结论仍然成立。进一步研究发现,发债企业当期财务错报涉及盈余时,主体信用评级被下调的幅度更大,说明评级机构更加关注与盈余相关的财务信息。机制分析表明,评级机构维护自身声誉是主体信用评级变动能够反映企业真实财务信息的主要机制。此外,主体信用评级被下调还导致了资本市场投资者的负面反应。本文的研究结果为主体信用评级变动反映企业真实财务信息提供了直接的证据支持,揭示了主体信用评级的信息含量,也对理解中国情境下评级机构调整主体信用评级的行为动机提供参考。     

The Impact of a Rating Agency's Private Information and Disclosed Causes of Rating Downgrades on Insurer Stock Returns

Existing studies document that bond and insurer rating downgrades are associated with negative abnormal returns but generally do not consider the reasons for the downgrade disclosed or implied in the downgrade announcement. Using hand-collected press releases (downgrade announcements) of A.M. Best Company (Best) for a sample of publicly traded insurance firms during the period 1996–2012, we classify and analyze downgrades based on the disclosed causes of the downgrades and whether the rating agency has implied reliance upon unfavorable private information or opinion. We find that during the three-day event window (?1, +1), rating downgrades overall generate a statistically significant cumulative average abnormal return (CAAR) of negative 7.76%. A significantly more negative CAAR of negative 11.46% is found for “financial-prospects-deterioration” downgrades with the perceived presence of Best's private information or opinion. For downgrades without any indication of Best's private information or opinion, the CAAR is negative 3.35%, which is significantly different from zero but significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Downgrades with reported causes other than deterioration of a firm's fundamental financial performance or condition, such as increases in financial leverage and increased business risk taking, produced statistically significant CAAR of negative 3.19% during the (?1, +1) three-day event window, which is also significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Our results provide evidence that downgrades where private information or opinion is likely and downgrades due to a decline in fundamental financial profiles contain more value-relevant information than other types of downgrades.     

Firm Accrual Quality Following Restatements: A Signaling View

We consider whether and how firms improve their financial reporting credibility following a restatement by comparing two alternative views. The compliance view predicts that firms simply correct errors to comply with regulations; the signaling view predicts that improvements are broader to allow firms to signal higher reporting quality and thereby reduce information uncertainty. We find that accrual quality improves significantly following the restatement and that this improvement is observed for both earnings and non‐earnings error restatements. We also find that the extent of real earnings’ management decreases significantly. Further, we find that improvements in accrual quality are higher for firms with CEO turnover and higher incentives to improve, but lower for firms switching to an auditor of lower quality. Collectively, our findings suggest that firms signal improved reporting credibility following a restatement through higher accruals quality and lower real earnings management.     

Do Managers Use Meeting Analyst Forecasts to Signal Private Information? Evidence from Patent Citations

This study examines whether firms manage earnings to meet analyst forecasts to signal superior future performance. Prior research finds that firms use earnings management to just meet analyst forecasts and that these firms have a positive association with future performance (Bartov et al., 2002). There are two potential explanations for the positive association – signaling and attaining benefits that allow for better future performance (i.e., the real benefits explanation). Prior studies cannot provide evidence of signaling because they do not control for the real benefits explanation. Our research design enables us to control for the real benefits explanation because we can identify potential signaling firms within the sample of firms that just meet analyst forecasts. We use a unique database from the National Bureau of Economic Research to construct a proxy for the manager's belief about future firm value due to patents. We find that firms with more patent citations are more likely to just meet the analyst forecast and manage earnings to achieve this goal. We also find firms that just meet analyst forecasts with more patent citations have significantly better performance than firms with fewer patent citations, which is consistent with signaling and not the real benefits explanation.     

How do stock-for-stock acquirers manage earnings? The accruals feature of real earnings management

This paper investigates whether stock-for-stock acquirers undertake real activities to manage earnings before merger announcements. Our results show that stock-for-stock acquirers present unusually high levels of credit sales and overproduction in the quarter immediately before the merger announcement. We also find that the accruals feature of real earnings management can explain the stock-for-stock acquirers’ high discretionary current accruals. In addition, stock-for-stock acquirer firms that accelerate their credit sales experience subsequent market underperformance. Overall, we provide a novel insight into the accruals feature of real earnings management.     

Overvaluation and earnings management: Does the degree of overvaluation matter?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued (SOV) and relatively overvalued (ROV) firms, we find that SOV firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of ROV firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of ROV firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with ROV firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.     

Firms' use of accounting discretion to influence their credit ratings

This paper examines whether firms that deviate from an empirically modeled (“expected”) credit rating engage in earnings management activities, as measured by abnormal accruals and real activities earnings management. We find evidence that firms use income-increasing (-decreasing) earnings management activities when they are below (above) their expected ratings. We then test whether such actions are successful in helping these firms move toward their expected credit ratings. The results suggest that firms below or above their expected credit ratings may be able to move toward expected ratings through the use of directional earnings management.     

Accruals Management to Avoid Losses

This study examines whether firms engage in accruals management to beat the zero earnings benchmark from the perspective of earnings per share (EPS). Based on net income scaled by lagged market value of equity (E/MV) to define just‐miss and just‐beat test bins, previous studies provide no or inconclusive evidence of accruals management to beat the zero earnings benchmark. I conjecture that because managers focus on shares scaled earnings performance rather than market value scaled earnings performance, forming test bins based on EPS instead of E/MV is a better approach to detect accruals management. As expected, I find evidence of accruals management to beat the zero EPS benchmark. I also find that firms are more likely to manipulate accruals when managers have stronger incentives to beat the zero EPS benchmark. In addition, accruals of firms just beating the zero EPS benchmark are more likely to reverse the next year, resulting in relatively lower future earnings for firms just beating the benchmark compared with firms just missing the benchmark.     

Salient anchor and analyst recommendation downgrade

We find that analysts are more likely to downgrade stocks when prices approach the 52-week high. The results are stronger for stocks with higher information asymmetry but moderated by analysts' reputation, work experience, and educational background. We also find a strategy that shorts stocks with recommendation downgrades is less profitable for the downgrades near 52-week high than for other downgrades. Moreover, these downgraded firms with prices near 52-week high subsequently experience relatively less negative earnings forecast revisions. These results suggest that these downgrade decisions are less likely to be information-driven and consistent with our anchoring interpretation.     

Forecasts in IPO Prospectuses: The Effect of Corporate Governance on Earnings Management

Prior research suggests that managers may use earnings management to meet voluntary earnings forecasts. We document the extent of earnings management undertaken within Canadian Initial Public Offerings (IPOs) and study the extent to which companies with better corporate governance systems are less likely to use earnings management to achieve their earnings forecasts. In addition, we test other factors that differentiate forecasting from non‐forecasting firms, and assess the impact of forecasting and corporate governance on future cash flow prediction. We find that firms with better corporate governance are less likely to include a voluntary earnings forecast in their IPO prospectus. In addition, we find that while IPO firms use accruals management to meet forecasts; the informativeness of the discretionary accruals depends on whether or not the firm would have missed its forecast without the use of discretionary accruals.     

The Information Content of Ratings: An Analysis of Australian Credit Default Swap Spreads

We examine the information content of Australian credit rating announcements by measuring the abnormal changes in credit default swap (CDS) spreads. CDS spreads provide a direct view of credit quality and thus should impound information quickly when investors receive new credit risk related information via a rating event. Using an event study methodology, we show that watch downs and rating upgrades contain valuable information even after controlling for sources of contamination. We find that watch downs elicit statistically significant market reactions, while subsequent downgrades are anticipated. Upgrades are associated with a significant but small abnormal reduction in CDS spreads, whereas watch ups appear to contain no new information.     

Asset Disposal as a Method of Real Earnings Management: Evidence from the UK

We examine asset sales as a method of real earnings management around the benchmarks of loss avoidance and last year's earnings. Evidence is reported of asset sales to boost or reduce earnings near the benchmark of last year's earnings. For the zero earnings benchmark our results are moderated by the opening balance of accruals: only firms with high levels of accruals use asset sales to boost earnings to avoid a loss and only firms with low levels of accruals use asset sales as part of a big bath. We suggest that firms with high accrual balances find it difficult to use additional income-increasing accruals but find it more convenient to write off accruals rather than sell assets to artificially reduce earnings. International Financial Reporting Standards (IFRS) are associated with reduced use of asset sales for gains and especially with reduced asset sales for losses. We ascribe this to IFRS introducing additional judgement and estimation in relation to the valuation of both long-lived and current assets on a recurring basis.     

Do bond rating changes affect the information asymmetry of stock trading?

Using a sample of 279 upgrades and 310 downgrades from 1996 to 2004, we find that bond rating changes affect the information asymmetry of stock trading and other measures of information risk. Specifically, when a firm's bond rating is upgraded, its stock information asymmetry and its analysts' earnings forecast dispersion are significantly reduced, while the institutional equity holdings of its shares are significantly increased. The reverse is true for a downgrade. In addition, the degree of change in stock information asymmetry is positively associated with the magnitude of the bond rating changes.     

Quarterly earnings guidance and real earnings management

We examine if quarterly earnings guidance induces real earnings management. Quarterly guidance may cause myopia and inefficient decision-making, if managers become overly concerned with setting and beating short-term earnings targets. We test these associations on a large sample of US firms. Our evidence suggests that quarterly guidance is informative and lowers myopic incentives. However, our analyses also reveal endogenous associations exist between guidance and real earnings management. In contrast with existing concerns over frequent guiders, we find that guidance appears problematic in infrequent guiders, and in firms that issue good news earnings guidance and that operate in settings where earnings pressures are high.     

New debt issues and earnings management

We empirically examine the influence and effects of real earnings management (REM) procedures on the debt market by investigating the bond rating and actual market price of a firm's new debt offerings. Extant research provides conflicting representations concerning the effects of REM techniques on equity shareholders and debt market participants. Our results indicate a negative association between all three REM manipulation methods and perceived credit risk resulting in a lower bond rating, and higher market yield of the firm's debt at issuance. Additional analyses exploring the use of REM techniques to achieve analyst's earnings forecasts indicates that this negative effect is particularly significant for firms who only achieve the earnings forecast by utilizing REM methods. Our research adds to the literature by empirically describing the effects of REM techniques on new debt issuances, and contributes to the ongoing debate regarding the efficacy of engaging in real earnings management to achieve known targets.