Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Bond Yields

Abstract

Using a dataset of financial statements that are adjusted by Moody's for its credit analysis, I document extensive and large differences between firms' reported U.S. GAAP numbers and firms' adjusted numbers. Off-balance sheet financing accounts for the largest difference. The adjusted leverage ratio exceeds the reported leverage ratio by 20% (70%) for the median (average) firm. Adjusted profitability ratios and cash flow to debt ratios differ from their U.S. GAAP equivalents primarily because of greater adjusted interest expense and greater adjusted debt numbers. This implies that essentially all firms in the sample understate their leverage. In addition to adjusting reported accounting numbers, credit analysts adjust ratings down by an average of 0.38 notches due to credit risk from qualitative factors. I predict and find that rating agency adjustments are associated with greater credit spreads and a flatter credit spread term structure. This implies that credit ratings are a function of quantitative adjustments to U.S. GAAP numbers and the rating agency's qualitative assessment of credit risk arising from soft factors. The results suggest that rating agency's quantitative and soft adjustments capture true default risk and rating agencies efficiently process accounting and soft information. Thus ratings can serve as a contracting device to incorporate off-balance-sheet debt adjustments and credit-risk increasing soft factors.