Do managers manipulate earnings to influence credit rating agencies’ decisions?

Abstract

PurposeThis study aims to investigate whether firms engage in earnings management behavior that attempts to manipulate Credit Rating Agency (CRA) perceptions during the Watchlist process and, if so, whether earnings management behavior appears to influence CRAs’ decisions.Design/methodology/approachTo measure earnings management activities, this paper computes accrual-based and real earnings management measures in the year or in the quarter immediately before the Watchlist resolutions for all negative and positive Watchlist firms. To examine the association between the levels of earnings management and Watchlist resolutions, a logit model is applied to the data obtained from a sample of Watchlist firms.FindingsSome evidence suggests that managers in Watchlist firms manage earnings in attempts to gain favorable Watchlist treatment. The findings are consistent with the Graham et al.’s (2005) survey evidence, which shows that one of the primary reasons for earnings management is to gain (or preserve) a desirable rating. In addition, CRAs appear to be misled by these attempts during the negative Watchlist process period.Research limitations/implicationsThe findings support SEC’s (2011, 2013a, 2013b) rules to reduce its reliance on credit ratings and the recent regulation reforms concerning the competition in the rating industry [the Credit Rating Agency Reform Act (2006)], and concerning conflicts of interest of CRAs among others [Dodd–Frank Wall Street Reform and Consumer Protection Act (2010)].Originality/valueWhile many studies examine whether managers use discretionary accruals as a tool to manage earnings to obtain favorable ratings, those studies do not consider manipulation of real operating activities to manage earnings and CRA perceptions.