Credit Ratings Conservatism and Earnings Management.

Abstract

I examine whether ratings conservatism influences a firm’s earnings management. First, total earnings management, calculated as the sum of real and accrual-based earnings management measures, increases in response to ratings conservatism. Ratings conservatism leads to a substitution between real and accrual-based earnings management, indicating that the increase in real earnings management is greater than the decrease in accrual-based earnings management. Next, the negative relation between ratings conservatism and accrual-based earnings management is more pronounced for firms with low credit quality than for those with high credit quality. However, the positive relation between ratings conservatism and real earnings management does not apply to both investment- and speculative-grade firms. The results are robust to sample selection bias, alternative measures of accrual-based earnings management, alternative industry classifications, alternative cut-off years employed when measuring ratings conservatism, the effect of external events, omitted variable bias, and different specifications for ratings models. In addition, there is no evidence of earnings smoothing and asymmetric timeliness loss recognition relating to ratings conservatism. Overall, this study finds that ratings conservatism affects a firm’s incentive to manage its reported earnings. This study also represents the first step towards understanding how ratings conservatism influences the earnings management behaviors of managers.