Credit Ratings and Taxes: The Effect of Book/Tax Differences on Ratings Changes

Abstract

This paper examines whether credit analysts utilize the information contained in the difference between book and taxable income in analyzing a firm's credit risk. Increased book-tax differences may be informative for credit rating agencies as they may signal decreased earnings quality or changes in the firm's off-balance sheet financing. Results suggest a significant negative association between positive changes in book-tax differences and ratings changes. This evidence is consistent with large positive changes in book-tax differences signaling decreased earnings quality and/or increased off-balance sheet financing. We also find that large negative changes in book-tax differences result in less favorable rating changes, consistent with these changes signaling decreased earnings quality. In additional analyses, we find that the association between changes in book-tax differences and rating changes is attenuated for high tax planning firms (e.g., where book-tax differences more likely reflect tax planning than decreased earnings quality).

Keywords: Credit ratings, taxable income, book income, tax planning

JEL Classification: G29, H25, H32, M41