Do Rating Agencies Fully Understand Information in Earnings and its Components?
50 Pages Posted: 7 Jul 2012 Last revised: 25 Aug 2012
Date Written: August 20, 2012
Abstract
This paper examines whether credit rating agencies fully understand the implications of earnings and its components for future performance. After establishing that earnings are more relevant to the rating process than cash flows, we find that future rating changes can be predicted using current earnings information. This finding suggests that rating agencies underreact to earnings information. When earnings are decomposed into accruals and cash flows, credit rating agencies do not distinguish the differential persistence of these two components of earnings. This inefficiency in ratings with respect to earnings information increases with information uncertainty, the contractual use of ratings, and potential conflicts of interest. Interestingly, the predictability of future rating changes by current earnings has disappeared in the post-crisis period as regulation of the rating industry has been tightened.
Keywords: credit ratings, earnings, accruals, cash flows, efficiency
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
By Patrick Bolton, Xavier Freixas, ...
-
By Patrick Bolton, Xavier Freixas, ...
-
By Patrick Bolton, Xavier Freixas, ...
-
Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation
By Vasiliki Skreta and Laura Veldkamp
-
Ratings Shopping and Asset Complexity: A Theory of Ratings Inflation
By Vasiliki Skreta and Laura Veldkamp
-
Credit Ratings as Coordination Mechanisms
By Arnoud W. A. Boot, Todd T. Milbourn, ...
-
How Did Increased Competition Affect Credit Ratings?
By Bo Becker and Todd T. Milbourn
-
How Did Increased Competition Affect Credit Ratings?
By Bo Becker and Todd T. Milbourn