Do firms engage in earnings management to improve credit ratings?: Evidence from KRX bond issuers

In this paper, we examine the relationship between credit ratings, credit ratings changes and earnings management. Since the 1997 Asian Financial Crisis, many listed firms collapsed, leading investors to suffer losses. As a result, credit ratings have become a very important indicators of firms’ financial stability for investors, government agencies and debt issuers and other stakeholders. Firms with a similar credit rating are grouped together as firms of similar credit quality (Kisgen 2006) because credit ratings provide an ‘economically meaningful role’ (Boot et al. 2006). Numerous studies find that managers care deeply about their credit ratings (Graham and Harvey 2001; Kisgen 2009; Hovakimian at al. 2009). Firms that borrow equity in the form of bonds may have incentives to increase credit ratings with opportunistic earnings management. A change in a firm’s credit ratings has a direct impact on a firm’s profitability. Firm’s benefit from better terms from suppliers, enjoy better investment opportunities and have lower cost of capital when their credit risk is lower. Firms incur a higher cost of debt and experience additional costs when their credit risk is higher. American studies find that firms use earnings management to influence credit ratings (Ali and Zhang 2008; Jung et al. 2013; Alissa et al 2013). Credit rating agencies have stated they assume financial statements to be reasonable and accurate (Securities and Exchange Commission, 2003; Standard and Poor’s, 2006) and they do not consider themselves to be auditors. They take the information in the financial statements as accurate. Therefore, there is a potential for managers to engage in earnings management to influence credit ratings. In South Korea, there have been numerous experiments with auditor legislation because of financial collapses due to earnings management in the 2000s. Therefore, a decomposition of the relation between opportunistic earnings management and credit ratings is an important consideration for Korean accounting academia. Previous Korean studies have examined whether credit ratings in period t are significantly related to level of earnings management in the same period; however, those studies fail to find the consistent results. It is widely known that credit rating agencies allow one year credit watch period to assess default risk before credit rating decision. Firms with an incentive to increase their credit ratings through earnings management will only realize if earnings management positively influences credit ratings in the following year. Therefore, we focus on establishing a relationship between the levels of earnings management at time t and credit ratings / changes at time t+1. Our study provides a more robust analysis by establishing if both accrual based and real earnings management in period t influences credit ratings and credit rating changes in period t+1. Using a sample of 1,717 Korean KRX firm-years from 2002 to 2013, we find a negative relation between earnings management in period t and credit ratings in period t+1, suggesting that firms with higher credit ratings have lower levels of earnings management. Moreover, we find that firms that experience a credit ratings change in period t+1 are less likely to engage in opportunistic earnings management in period t, suggesting that firms do not have the potential to increase credit ratings. We also find that firms that experience a credit rating increase in period t+1 have a negative association with opportunistic earnings management for accruals measures. Moreover, when we split our sample into firms that experience 1) a credit rating increase, 2) decrease and 3) remaining the same, we find that firms that engage in earnings management are more likely to remain unchanged or experience a credit rating decrease. Thus, taken together, we find no evidence of relationship between opportunistic earnings management and an increase in credit ratings in the South Korean public debt market. Our results may be of interest to regulators, credit rating agencies, market participants and firms that question whether level of earnings management in current year influences credit ratings in the subsequent period

Does Financial Performance Influence Credit Ratings? An analysis of Korean KRX Firms

Credit rating agencies offer information about default risk. Previous literature suggests that firm’s credit ratings are influenced by various metrics, specifically, numerous risk considerations such as size, leverage and growth. However, there is limited evidence to support the relationship between credit ratings and financial performance. Our research is motivated by this caveat. The purpose of this paper is to discover if financial performance measures can be included as an indicator for default risk since the relation between financial performance and default risk/credit rating is a question left unanswered in a South Korean context. In this paper, we empirically test if financial performance measures can provide additional information about credit ratings and credit rating changes. We perform a battery of tests to establish if the following financial performance measures: EPS, CPS, ROA, ROE, and ROS have any explanatory power in explaining credit ratings levels and credit rating changes. Using a sample from 2002 to 2013, we find that EPS and CPS has a statistically positive relation to credit ratings, suggesting that firms with higher credit ratings have higher levels of EPS and CPS compared to firms with lower credit ratings. Moreover, we find that firms with positive performance measured by EPS and CPS in period t have the potential to experience a credit ratings change in period t+1. However, in South Korea, the majority of firms do not experience a credit ratings change. When we estimate the financial performance of the firms that do not experience a credit ratings change, we find a statistically significant relation between credit rating and financial performance for EPS and CPS. The results suggest that credit ratings for firms with positive financial performance remain stable Finally, we examine the relation between performance in period t and credit ratings increase and decrease in period t+1. The results suggest that the credit ratings of firms with high level of financial performances increase or remain the same. We do not find a relation between financial performance and credit rating decreases; this result may be due to our small sample size. The previous literature has largely ignored the association between credit ratings and performance. Taken together, our results suggests that EPS and CPS can be used as financial performance measures by investors, government agencies and debt issuers as additional information about a firms credit rating levels, and subsequent changes. We contribute to the literature by providing empirical evidence of a relationship between performance metrics and credit ratings, specifically the link between EPS

Default, currency crises, and sovereign credit ratings

Sovereign credit ratings play an important part in determining countries’ access to international capital markets and the terms of that access. In principle, there is no reason to expect that sovereign credit ratings should systematically predict currency crises. In practice, however, in emerging market economies there is a strong link between currency crises and default. Hence if credit ratings are forward-looking and currency crises in emerging market economies are linked to defaults, it follows that downgrades in credit ratings should systematically precede currency crises. This article presents results suggesting that sovereign credit ratings systematically fail to predict currency crises but do considerably better in predicting defaults. Downgrades in credit ratings usually follow currency crises, possibly suggesting that currency instability increases the risk of default.default debt crisis currency crisis credit ratings interest rates

Sovereign credit ratings

This paper describes sovereign credit ratings in emerging markets both for a specific year and over time, using quantitative explanatory variables. It turns out that rating adjustments have been worse than what economic fundamentals justify for some countries and also more frequently altered, questioning the long-term properties of sovereign ratings. The results support the view that rating changes during the Asian crisis have been procyclical rather than counter-cyclical. Omitted variables, such as soundness of banking sector, social and political factors, can be one reason for this misalignment but cannot explain all. --Dynamic model,panel data,sovereign credit ratings,emerging markets

What Promotes Japanese Regional Banks to Disclose Credit Ratings Voluntarily?

This paper examines what types of Japanese regional banks are more likely to obtain credit ratings at the present time when disclosures by financial institutions are becoming more and more important. We found that banks in more competitive markets, those that have larger assets, and those whose bad ratio is lower are more likely to disclose credit ratings. It was also revealed that regional banks in the same region (prefecture) as other banks that go bankrupt often feel it necessary to actively demonstrate their own solidness in the market by obtaining foreign credit ratings. We also analyzed whether regional banks that disclose more credit ratings succeed in obtaining financing from depositors. Our results indicate that regional banks that obtain more credit ratings, in particular foreign ratings, succeed in increasing their bank balances.disclosure, credit ratings, market disciplines, scale of economies, bank balances.

What Promotes Japanese Regional Banks to Disclose Credit Ratings Voluntarily?

This paper examines what types of Japanese regional banks are more likely to obtain credit ratings at the present time when disclosures by financial institutions are becoming more and more important. We found that banks in more competitive markets, those that have larger assets, and those whose bad debt ratio is lower are more likely to disclose credit ratings. It was also revealed that regional banks in the same region (prefecture) as other banks that go bankrupt often feel it necessary to actively demonstrate their own solidness in the market by obtaining foreign credit ratings. We also analyzed whether regional banks that disclose more credit ratings succeed in obtaining financing from depositors. Our results indicate that regional banks that obtain more credit ratings, in particular foreign ratings, succeed in increasing their bank balances.disclosure, credit ratings, market disciplines, scale of economies, bank balances.

Sovereign credit ratings

Sovereign ratings are gaining importance as more governments with greater default risk borrow in international bond markets. But while the ratings have proved useful to governments seeking market access, the difficulty of assessing sovereign risk has led to agency disagreements and public controversy over specific rating assignments. Recognizing this difficulty, the financial markets have shown some skepticism toward sovereign ratings when pricing issues.Credit ; Debts, External ; Corporate bonds

Divergence in credit ratings

During the recent credit crisis credit rating agencies (CRAs) became increas- ingly lax in their rating of structured products, yet increasingly stringent in their rating of corporate bonds. We examine a model in which a CRA operates in both the market for structured products and for corporate debt, and shares a common reputation across the two markets. We find that, as a CRA s reputation becomes good enough, it can be optimal for it to infl ate its ratings with probability one in the structured products market, but in flate its ratings with a probability zero in the corporate bond market

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.http://deepblue.lib.umich.edu/bitstream/2027.42/39841/3/wp457.pd

Credit Ratings as Coordination Mechanisms

In this paper, we provide a novel rationale for credit ratings. The rationale that we propose is that credit ratings can serve as a coordinating mechanism in situations where multiple equilibria can obtain. We show that credit ratings provide a "focal point" for firms and their investors. We explore the vital, but previously overlooked implicit contractual relationship between a credit rating agency and a firm. Credit ratings can help fix the desired equilibrium and as such play an economically meaningful role. Our model provides several empirical predictions and insights regarding the expected price impact of ratings changes, the discreteness in funding cost changes, and the effect of the focus of organizations on the efficacy of credit ratings.coordination, credit ratings, multiple equilibria