The use of earnings and operations management to avoid credit rating downgrades

Paula Hill, Adriana Korczak, Shuo Wang

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    Abstract

    Firms placed on negative credit watch face the threat of a credit rating downgrade. At the same time, they are given the opportunity to put recovery efforts in place to retain their current credit rating. In this paper, we test to what extent firms use earnings management as a short-term recovery strategy. We find that both accruals-based and real earnings management are associated with firms avoiding credit rating downgrades, and that these alternative earnings management strategies tend to be complements rather than substitutes. However, following the passage of the Sarbanes–Oxley Act, only real earnings management is significantly associated with the credit watch outcome. We find evidence that firms which maintain their rating via earnings management are better able to afford the inevitable earnings reversals, and that in the year following the credit watch period, the credit rating performance of these
    firms is significantly better than firms which undergo a downgrade, with fewer downgrades and more upgrades in this period. Our results also imply that credit rating agencies are not misled by earnings management but rather allow for some discretion in reporting earnings that facilitates the dissemination of private information about future firm performance.
    Original languageEnglish
    Pages (from-to)147-180
    Number of pages34
    JournalAccounting and Business Research
    Volume49
    Issue number2
    DOIs
    Publication statusPublished - 23-Feb-2019

    Keywords

    • REAL ACTIVITIES
    • AGENCIES
    • BOND

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