Do Rating Agencies Fully Understand Information in Earnings and its Components?

50 Pages Posted: 7 Jul 2012 Last revised: 25 Aug 2012

See all articles by Sunhwa Choi

Sunhwa Choi

Sungkyunkwan University

Lee-Seok Hwang

Seoul National University - College of Business Administration

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

Choi, Sunhwa and Hwang, Lee-Seok, Do Rating Agencies Fully Understand Information in Earnings and its Components? (August 20, 2012). Available at SSRN: https://ssrn.com/abstract=2101608 or http://dx.doi.org/10.2139/ssrn.2101608

Sunhwa Choi (Contact Author)

Sungkyunkwan University ( email )

Sunkyunkwan University Business School
25-2, Sungkyunkwan-ro, Jongno-gu
Seoul, 03063
Korea, Republic of (South Korea)

Lee-Seok Hwang

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

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