Risk Agencies, Bond Ratings and Income Smoothing in Public Bond Offering in Brazil

Abstract

Income smoothing has been the subject of extensive accounting and financial research over the past three decades. In this article we use the variables proposed by Eckel (1981) and Leuz, Nanda and Wysocki (2003) as proxies to measure income smoothing and find that Brazilian companies that engage in this behavior receive better ratings from the risk agencies in their public bond issues. The importance of bonds rating has led to extensive research on the determination of ratings. Among economic determinants, the reporting accounting numbers are probably the most important. Few papers have examined the effects of smoothing on the bond market. This paper aims to contribute to the literature by focusing on the role of accounting accruals, and especially the income-smoothing role of accruals, in bond ratings. We focus on managing earnings smoothness as a means to manage credit ratings not only because earnings smoothness is believed to be an important input into the rating methodology, but also because income smoothing can be viewed as a useful device for signaling firms´ superior performance. Using data obtained from the National Bond Registration System and the Economatica database, we evaluated public bond offerings by listed Brazilian corporations in the period from 2005 to 2007. The results of univariate and multivariate analyses and robustness tests show the significance of the income smoothing factor, regardless of the rating agency (Fitch, Moody’s or S&P). The results support the notion that income smoothing in Brazil is an information-signaling mechanism and has an impact on the respective bond ratings. These findings from the bond market complement an extensive literature on the equity market indicating that income smoothing has a positive effect on stock prices. Among the main implications of this study, the most important is the evidence that this type of earnings management can have positive effects (beneficial smoothing), by reducing the cost of debt capital because of better ratings. A word of caution is in order, since less volatile reported earnings affect the ratings given by risk agencies, the practice of pernicious income smoothing can arise, where in a market with asymmetric information, a pooling equilibrium (in the sense of game theory signaling) can occur. This means that firms can practice pernicious smoothing, trying to mimic other firms with genuinely smooth earnings. In this scenario, we believe that it is important to have regulatory instruments to monitor and prevent this type of manipulation from abusively altering the risk perception of the agencies and consequently of bond investors. In the final analysis, the conclusions of this paper are important to shed light on the factors that explain the cost of debt capital and the ratings received by firms in their public bond offerings.