An Investigation of Watchlist Additions and Resolutions: The Role of Accounting Information and Performance Management

Abstract

Credit watch has important implications for the measurement and management of credit risk. In this study, we investigate several key aspects of the credit watch process using a sample of 1,494 Moody’s Watchlist reviews from 1992 to 2006. First, we show that accounting earnings and operating cash flows have significant explanatory power in predicting the initial additions and subsequent resolutions of Moody’s Watchlist, after controlling for numerous market variables indicative of credit risk. We then proceed to examine the extent of accounting management during the credit watch period. We document that the average Watchlist firm manages both accruals and operating cash flows upwards to inflate reported profitability and to reduce perceived credit risk. Finally, we find evidence that firms engaging in upward accounting manipulation are less likely to be resolved with a downgrade or are more likely to be upgraded at the end of Moody’s credit watch. Taken together, our findings underscore the critical role of accounting information in the credit watch process. Moreover, our evidence is consistent with the view that credit analysts at Moody’s do not appear to fully understand the implications of accounting management for credit risk analysis.