The Real Effects of Financial Statement Recognition: Evidence from Corporate Credit Ratings

49 Pages Posted: 5 Jun 2017 Last revised: 8 Nov 2018

See all articles by Riddha Basu

Riddha Basu

George Washington University - School of Business; Northwestern University - Department of Accounting Information & Management

James P. Naughton

University of Virginia, Darden School of Business

Date Written: October 10, 2018

Abstract

We examine whether the recognition versus disclosure of identical accounting information affects the credit rating process and ultimately corporate credit ratings. The primary input into corporate credit ratings is adjusted financial statements, which the rating agencies create by modifying reported financial statements to reflect credit-relevant items not recognized under U.S. GAAP. The rating agencies have claimed that this process means that accounting changes that move previously disclosed information onto firms’ financial statements have virtually no effect on firms’ adjusted financial statements or their credit ratings. We show that this claim is incorrect using the implementation of Financial Accounting Standards Board Statement No. 158 (“SFAS158”). This standard did not prescribe any new financial information. Rather, it simply required the balance sheet recognition of a previously disclosed item. We find that firms recognizing an additional pension liability due to SFAS158 had lower leverage on the rating agency adjusted financial statements and received higher corporate credit ratings. This counterintuitive result occurs because the rating agency adjustments made pre-SFAS158 were punitive relative to the combination of the SFAS158 changes and the rating agency adjustments made post-SFAS158. The difference in rating agency adjustments pre- and post-SFAS158 was primarily due to rating agency adjustments in the pre-SFAS158 period that did not account for minimum liability adjustments, an aspect of pension accounting eliminated by SFAS158. Overall, our results indicate that SFAS158 generated real changes in rating agency adjustments, and that these changes had real consequences for firms’ credit ratings.

Keywords: corporate credit ratings, rating agency, off-balance-sheet finance, recognition, pension accounting, SFAS158

JEL Classification: G24, G34, D43

Suggested Citation

Basu, Riddha and Naughton, James P., The Real Effects of Financial Statement Recognition: Evidence from Corporate Credit Ratings (October 10, 2018). Available at SSRN: https://ssrn.com/abstract=2980510 or http://dx.doi.org/10.2139/ssrn.2980510

Riddha Basu

George Washington University - School of Business ( email )

Washington, DC 20052
United States

Northwestern University - Department of Accounting Information & Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

James P. Naughton (Contact Author)

University of Virginia, Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

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