Asymmetry in Earnings Management Surrounding Targeted Ratings

Abstract

This study examines earnings management among financial institutions attempting to achieve a target financial strength rating. We find empirical evidence that firms with an actual rating below their target rating use income-increasing earnings management, however we find no evidence that firms above their target rating manage earnings. Our result is consistent with financial institutions facing less pressure from unions and suppliers, but more pressure from regulators, relative to non-financial institutions. Our findings are robust to a variety of alternative definitions of target rating. Notably, we examine a subset of firms with an exogenously determined target rating and find consistent results. We also find evidence that firms can influence ratings agencies, as firms that underestimate their initial claims are more likely to receive a rating upgrade.