Earnings Management upon a Sovereign Downgrade
62 Pages Posted: 30 Jan 2020 Last revised: 20 Jul 2021
Date Written: July 15, 2020
We examine the effect of sovereign credit rating downgrades on firms’ earnings management. Using the exogenous variation in credit ratings caused by sovereign rating downgrades from 61 countries, we show that firms reduce discretionary accruals after sovereign downgrades and are likely to experience a reversal of earnings subsequent to the accrual reduction. The reduction in discretionary accruals is more significant in countries with a better institutional environment and when the sovereign rating falls into a lower bin. Our study provides new evidence that managers strategically employ downward earnings management in response to the negative shock on sovereign credit ratings.
Keywords: Sovereign downgrade, Ceiling rule, Credit rating, Earnings management, Big bath accounting
JEL Classification: G34, G24, M41
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