Accounting Quality and Credit Ratingss Ability to Measure Default Risk

Abstract

This study examines whether the quality of borrowers’ accounting information affects the accuracy and timeliness of credit ratings issued by rating agencies. I consider two possible effects. The news effect posits that higher quality accounting provides better information to credit rating agencies, enabling them to develop better ratings. The discipline effect describes how the timely public disclosure of bad news can limit rating agencies’ ability and incentive to issue inflated ratings. I utilize rating data from two major agencies: Standard & Poor’s (SP and Egan-Jones Ratings Company (EJR), an investor-paid agency that relies solely on public information to develop its ratings. The differences between these agencies make EJR an effective control group for the identification of the two accounting quality effects. I find that debt issuers with earnings that exhibit more timely loss recognition have credit ratings that predict default more accurately and are downgraded more promptly. I also find that issuers with upward-managed earnings have less timely rating downgrades. In most settings, these results are comparable for both rating agencies, consistent with the news effect. However, the results are more pronounced for EJR ratings relative to S&P ratings for firms near default and firms issuing restatements, when agency reputation costs are high and conflicts of interest are low. These findings provide evidence in support of the discipline effect of accounting quality.