Abstract

The objective of this study is to investigate the effect of earnings management on corporate credit rating. Although several studies have examined the relation between earnings management and credit ratings, this research is limited to listed firms and corporate bond ratings. Therefore, the results of those studies are limited to large firms’ cases because corporate bond ratings are collected only when those large firms raise funds. On the contrary, this study expands sample firms by using corporate credit ratings instead of bond ratings. Therefore, this study tries to examine, in general, how accrual－based earnings management(AM) and real earnings management (RM) are evaluated by credit rating agencies by including not only listed－firms but also private firms in testing the effect of earnings management and by comparing the results of them. This study hypothesize that the higher earnings management more negatively affects the credit ratings of the firms based on the belief that credit rating agencies are sophisticated information intermediaries. To test this hypothesis, we estimate AM and RM and use credit ratings produced by NICE Credit Information Service. Specifically, we estimate discretionary accruals (DA) as a measure of accrual－based earnings management following Dechow et al. (1995) and Kothari et al. (2005), non－performance－adjusted and performance－adjusted measures, respectively. RM is measured using three proxies developed by Roychowdhury(2006)：abnormal cash flows of operations (abCFO), abnormal production costs (abPROD), abnormal discretionary expenditures (abDE). Using those proxies, we calculate two comprehensive measures of the three measures (RM1[＝abPROD＋adDE×(－1)], RM2[＝abCFO×(－1)＋abDE×(－1)]) following Cohen and Zarowin(2008). We also measure performance－adjusted RM following Cohen et al. (2011) and use them in testing hypothesis. The sample period is from 2005 to 2009. The sample includes 11,519 listed－firms (firm/year) and 61,454 private firms (firm/year) data. The empirical test results are as follows. First, in the tests using non－performance－adjusted measures, we find significantly negative relation between DA (RM1, RM2) and credit ratings in both listed－firms and private firms samples. Second, in the tests using performance－adjusted measures, the results show that DA and RM2 are significantly and negatively related with credit ratings in both listed－firms and private firms samples while RM1 does not show significant relation with credit ratings. Third, in the additional tests of listed－firms subsample where using three proxies of RM, respectively, the results show that abCFO and abPROD are significantly and negatively related with credit ratings while abDE does not show significant relation with credit ratings. In contrast, the results of private－firms subsample show that abCFO and abDE are significantly and negatively related with credit ratings while abPROD is significantly and positively related with credit ratings. These results suggest that credit rating agencies fail to properly incorporate earnings management activities through RM (i.e., abPROD) for private firms. In addition, these results do not change in additional tests where using Ordered Probit regression to consider ranked order attribute of credit ratings. This paper contributes to the credit rating literature by investigating the effects of AM and RM on credit ratings and by comparing the results of listed－firms and private firms. The findings of this paper contribute to the understanding of how credit rating agencies consider and reflect earnings quality of listed－firms and private firms into credit ratings. So, we expect this paper to have useful implications for scholars, practitioners, accounting standard setters, and regulators.

Keywords

• Listed firms
• Private firms
• Corporate credit ratings
• Accrual－based earnings management
• Real earnings management

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