Distinctive Features of BBB- and BB-Graded Firms Using Earnings Management and Conservatism: Evidence from the Korean Market

Abstract

The purpose of this paper is to inform investors of differences in opportunistic behavior between managers of BBB- and BB-graded firms as measured by earnings management and accounting conservatism. Previous studies investigate the gaps between grades and between investment and speculative grades by grouping together the various characteristics of investment and speculative firms, assuming that the incentives to make significant economic changes are homogeneously the same. However, this study demonstrates that this is not the case. Using 1,225 Korean firm-year observations, we identify noteworthy features distinguishing BBB- and BB-graded firms. More specifically, in BBB-graded firms, discretionary accruals (DACC) (a proxy used to represent earnings management) are larger than those in BB-graded firms. As for accounting conservatism, BB-graded firms exhibit a higher degree of conservatism than BBB-graded firms. According to the conventional credit rating scenario, higher-graded firms have fewer DACC and are more conservative in comparison with firms of lower grades. However, the results of this study imply that the reverse is true for firms of grades BBB and BB, which are commonly accepted as straddling the border between investment and speculative grades.