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

Paula Hill, Adriana Korczak*, Shuo Wang

*Corresponding author for this work

Research output: Contribution to journalArticle (Academic Journal)

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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
Number of pages34
JournalAccounting and Business Research
Early online date8 Jun 2018
DOIs
Publication statusE-pub ahead of print - 8 Jun 2018

Keywords

  • accruals-based earnings management
  • credit ratings
  • credit watch
  • firm recovery
  • real earnings management

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