The Use of Accounting Numbers by Information Intermediaries in the Pre-Sec Era

Abstract

We examine the extent to which financial statement ratios in the pre-SEC era were associated with Moody's securities ratings. A lack of association in this unregulated era would be consistent with subsequent accounting regulation improving the informativeness of financial reporting, whereas significant associations in predicted directions would indicate a need to quantify the incremental benefit, if any, of accounting and securities regulation. Because Moody's reported ratings components in addition to the overall ratings during our time period, we are also able to explore the structure underlying overall ratings. In particular, we examine the weights given to the components in the overall rating, as well as the accounting, contractual and market variables that determine each component. Our analysis indicates that bond ratings exhibit a significant positive association between income statement (ROE) and balance sheet (Current Ratio) ratios and overall Moody's bond ratings. Additional findings suggest that income statement and balance sheet ratios link structurally to the overall rating through differing components, as predicted. ROE is positively related to Moody's bond Safety rating (a measure of fixed charge coverage) while the Current Ratio links to Moody's bond Security rating (a measure of asset backing). Moody's third bond rating component, Salability, reflects the ease with which the bond can be readily sold. As predicted, we document that accounting ratios exert less influence over Salability compared to Safety and Security. However, unlike for Safety and Security, we document a significant positive between Salability and a measure of the extent of disclosure by the firm. Several of these findings extend to Moody's ratings of preferred and common stocks.