Does Income Smoothing Improve Bond Ratings? －Some Empirical Evidence on KOSPI and KOSDAQ Listed Firms－
Asian Tax Journal Vol. 13 No. 2 (2012), pp. 9-47
Abstract
The objective of this study is to investigate the effect of income smoothing on bond credit rating. A handful of descriptive and empirical studies have investigated the issue of income smoothing. For examples, Barnea et al. (1975) argue that smoother earnings allow outsiders to better predict future earnings, and Chaney and Lewis (1995) construct a model based on Spence’s (1973) signaling theory in which income smoothing is used by “high－quality” firms to signal their type. Beidleman (1973) asserts that smoothing is useful for internal budgeting and in reducing perceived riskiness among outsiders. Hunt et al. (2000) find that income smoothing improves price－earnings multiples. Tucker and Zarowin (2006) report that the changes in the current stock prices of higher smoothing firms contain more information about these firms’ future earnings than do the changes in the current stock prices of lower smoothing firms. Meanwhile, in an influential survey article, Graham et al. (2005) report that corporate executives express a strong desire to report smooth earnings paths, holding cash flow volatility constant. Surprisingly,executives also indicate a willingness to sacrifice long－term value to achieve smoother earnings. A primary motivation offered for such behavior is that executives believe that investors perceive firms with smoother earnings to be less risky, and thus demand a lower expected return, or cost of capital. Taken collectively these studies support the notion that income smoothing represents an efficient vehicle for managers to reveal private information. The purpose of the current research is to complement these studies by examining income smoothing using credit market data. If income smoothing is informative, or only firms with good prospects elect to smooth, then smoothing firms may exhibit a higher credit ratings. On the other hand if income smoothing is garbling and credit analysts can recognize smoothing as garbling, then smoothing firms could exhibit a lower credit ratings as credit rating agencies punish managers for gaming earnings. Since credit rating agencies are less likely to be fooled by garbling than equity stakeholders, examining the signaling versus garbling debate through the lens of credit markets may add to our understanding of why firms smooth. Therefore, this study hypothesize that the higher income smoothness more positively affects the credit ratings of the firms based on the belief that credit rating agencies are sophisticated information intermediaries. We measure income smoothing following Tucker and Zarowin (2006) and Leuz et al. (2003), and use them in testing hypothesis. We obtain a final sample that consists of 834 firm－years for KOSPI and 489 firm－years for KOSDAQ listed firms from 2005 to 2009 are gathered from Fn－GuidePro database files. The empirical test results are as follows. Using the Tucker and Zarowin (2006) and Leuz et al. (2003) statistic of income smoothing, we find firms with higher income smoothing rankings exhibit higher credit ratings in both listed－firms (KOSPI versus KOSDAQ) and regardless of the auditor type (Big 4 versus non－Big 4 auditors), and also regardless of the credit rating levels (investing grade versus non－investing grade). In addition, these results do not change in tests where using Clustering－adjusted Ordered Probit regression to consider ranked order attribute of credit ratings. And also t－statistics from Newey and West (1987) are significant, suggesting that our results are robust. Therefore, our credit market results support the notion that income smoothing represents an information－signaling mechanism, rather than a garbling device. The findings of this study contribute to the understanding of how credit rating agencies consider and reflect income smoothing of listed－firms into bond credit rating. Indeed, results reported here indicate that smoothing is perhaps as important as liquidity in the determination of credit rating levels. These results contribute to the literature on income smoothing. Thus, we expect this study to have useful implications for scholars, practitioners, accounting standard setters, and regulators.
Keywords
- Income smoothing
- Bond ratings
- Market’s perception
- KSE listed firms
- KOSDAQ listed firms
Related Articles
A Study on the Relation between Trading Volume and Corporate Bond Ratings based on Income Smoothing Level and Accruals Quality5
16(2) 131-159
Are Income Smooth Associated with a Lower Cost of Capital? －Focuses on KSE and KOSDAQ Listed Firms－
13(1) 33-63
Audit Quality of Big 4 Auditors and Credit Ratings －Focused on Non－listed Firms－
12(3) 275-306
Effect of IFRS9’s Fast Recognition of Loan Loss Provisions on the Management Performance of Banking Industry
24(2) 155-183
An Analysis of the Problem of Revenue Recognition between the Corporate Tax Law and Generally Accepted Accounting Principle for Buyers’ Early Construction
23(4) 37-60