The Moderating Role of Reporting Quality

Abstract

This paper examines whether credit rating agencies' sensitivity to external signals about the local economy varies with the quality of local governments' financial reports. We find the credit ratings of governments that are required to comply with Generally Accepted Accounting Principles (GAAP) are less sensitive to changes in local home values than similarly-affected governments that are not required to comply with GAAP. To attribute these results to reporting quality, we confirm in a difference-in-difference-in-differences analysis that GAAP's moderating role increased after the adoption of GASB 34, which substantially improved the quality of GAAP-compliant issuers' financial reports. To understand the mechanism, we study positive and negative economic signals separately. The results are pronounced when the change in home values is negative, consistent with reporting quality decreasing the rating agency's uncertainty about issuers' pre-existing likelihood of default. We conclude that credit rating agencies are less sensitive to local economic signals when the government's financial reports are of higher quality.

Keywords: Reporting quality, transparency, cost of debt, credit ratings, municipal debt

JEL Classification: D80, G24, H74