Credit Rating Agencies and Accounting Fraud Detection

Abstract

This study examines whether and when credit rating agencies take negative rating actions against issuers that commit accounting fraud before the fraud is publicly revealed and investigates the economic effects of such rating actions. After controlling for firms’ economic fundamentals and other sources of information, we find that Standard & Poor’s (S&P), an issuer-paid rating agency, takes negative rating actions against fraud firms, including downgrades and negative credit watches, as early as four quarters before the revelation of fraud. Egan-Jones, an investor-paid rating agency with no access to management and material nonpublic information, is slower than S&P to downgrade fraud firms, especially when information uncertainty is high and when fraud firms are subject to private SEC investigations. Last, we find that S&P’s negative rating actions against fraud firms are informative to the market and are associated with a shorter fraud duration. Taken together, our results suggest that credit rating agencies use their information advantage to detect accounting fraud.