Earnings Smoothing Activities of Firms to Manage Credit Ratings

Posted: 6 Feb 2008 Last revised: 9 May 2017

See all articles by Boochun Jung

Boochun Jung

University of Hawaii at Manoa - School of Accountancy

Naomi S. Soderstrom

University of Melbourne

Yanhua Sunny Sunny Yang

University of Connecticut - School of Business; University of Connecticut - School of Business

Date Written: March 1, 2012

Abstract

Credit ratings have significant implications for firms, including the cost of future borrowing and immediate impacts on stock and bond valuations. Because of this, managers have incentives to improve or maintain their credit ratings by influencing rating agencies’ perception of credit risk. We focus on earnings smoothing, a long-term strategy that is available to a broad range of rated firms, as one way in which bond issuers affect credit ratings. We hypothesize that firms within broad rating categories (e.g., AA) have differential incentives to smooth earnings, depending on whether their rating is at the top or bottom notch of the rating category (e.g., AA or AA-, respectively) versus in the middle of the rating category (e.g., AA). This increased incentive stems from a higher probability of being upgraded (downgraded) into the next higher (lower) broad rating category for firms in the outer notches relative to firms in the middle notch. Our empirical evidence is consistent with increased earnings smoothing for firms at the top notch of the rating category. We also find that for firms in the top notch, increased earnings smoothness has a favorable impact on the likelihood of a rating upgrade in the subsequent period. Our evidence suggests that managers use long-term financial reporting strategies to impact perceptions of credit risk.

Keywords: Earnings Smoothing, Credit Ratings, Earnings Management

JEL Classification: M41

Suggested Citation

Jung, Boochun and Soderstrom, Naomi S. and Yang, Yanhua Sunny, Earnings Smoothing Activities of Firms to Manage Credit Ratings (March 1, 2012). Jung, B., Soderstrom, N., and Yang, S. Earnings smoothing activities to manage credit ratings. Contemporary Accounting Research Vol. 30, No. 2, 2013, p. 645-676. Available at SSRN: https://ssrn.com/abstract=1089790 or http://dx.doi.org/10.2139/ssrn.1089790

Boochun Jung

University of Hawaii at Manoa - School of Accountancy ( email )

College of Business Administration
Honolulu, HI 96822
United States

Naomi S. Soderstrom

University of Melbourne ( email )

Victoria
Melbourne, 3010
Australia

Yanhua Sunny Yang (Contact Author)

University of Connecticut - School of Business ( email )

2100 Hillside Road
Storrs, CT 06269-1041
United States
8604864696 (Phone)
8604864838 (Fax)

HOME PAGE: http://www.business.uconn.edu/person/yanhua-sunny-yang/

University of Connecticut - School of Business ( email )

2100 Hillside Rd, Unti 1041A
Storrs, CT 06238
United States
8604864696 (Phone)

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