Earnings Smoothing Activities of Firms to Manage Credit Ratings
Posted: 6 Feb 2008 Last revised: 9 May 2017
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: Suggested Citation
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