Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Credit Spreads

Abstract:     
Using a new dataset of U.S. GAAP and adjusted financial statements, I document that Moody's, a major rating agency, extensively modifies reported financial statements. The major quantitative adjustment incorporates off-balance-sheet financing activity (operating leases and securitizations), causing the adjusted leverage ratio for the median firm to increase by 19%. Assessments of off-balance-sheet debt and assessments of qualitative factors ("soft adjustments'') are significantly associated with lower ratings and higher CDS spreads. The relation is more pronounced for shorter CDS maturities. Thus ratings can serve as a contracting device to incorporate off-balance-sheet debt adjustments and credit-risk increasing soft factors. Firms with greater opacity in their financial statements (measured by greater degree of absolute adjustments) exhibit greater rating dispersion and likelihood of triggering a rating change.

Number of Pages in PDF File: 47

Keywords: Rating agencies, off-balance sheet finance, corporate credit risk

JEL Classification: G33, G32, G10, D82

working papers series