We examine whether there is a relationship between conditional conservatism and credit ratings.
Credit rating levels are the ‘opinion‘ of credit rating agencies about a firm’s default risk based on financial statements
data and corporate governance information. In South Korea, credit rating levels are issued by National
Information & Credit Evaluation (NICE), Korea Investor Services (KIS), Korea Ratings (KR) and Seoul Credit
Rating & Information (SCI), and are used by bond investors, debt issuers, and governmental officials for decision
making and legislative purposes. Accounting practices such as conditional conservatism have the potential to signal
low default risk and financial stability. Accounting conservatism reflects a manager’s tendency to recognize
“bad news” in a timelier manner than “good news” (Basu, 1997). The academic community continues to debate
the merits of conservatism. However, the majority of studies suggest that conditional conservatism is an accounting
practice with the potential to increase accounting quality (Watts, 2003; Roychowdhury and Watts, 2007; Ball
and Kothari, 2008). In the U. S., numerous studies find an association between level of conservatism and credit
ratings (Ahmed et al., 2002; Moerman (2006); Nikolaev (2007); Bauwhede (2007): Zhang, 2008; Peek 2010).
Therefore, in the U.S., there is evidence to suggest that credit ratings agencies care about conditional conservatism
as an accounting practice with the potential to influence default risk.
In South Korea, there is evidence of a positive relation between accounting conservatism levels and credit ratings
(Park et al., 2011). However, the association between credit rating changes and financial conservatism is a
question left unanswered. Our motivation is to address this caveat. To our knowledge, our study is the first to
analyze the association between conditional conservatism and credit ratings and credit rating changes using the
two most popular conditional conservatism measures. We contribute to the literature by providing an evidence
that conditional conservatism may influence a credit rating agency’s perception of default risk.
We examine if conditional conservatism is associated with credit ratings based on the following; conditional
conservatism is an accounting practice associated with reducing a manager‘s ability to 'inflate' net income; hence,
constraining dividend has the potential to reduce a credit rating agency’s perception of risk. Credit rating agencies
issue higher credit ratings to firms with lower default risk. Thus, because firms care deeply about maintaining
or increasing their credit ratings, conservative reporting should have a positive a relation with credit rating
levels / credit ratings changes. We perform numerous tests to establish the relation between conditional conservatism
and credit ratings / credit rating changes. We investigate the relationship between a firm's credit ratings
/ credit ratings changes and conditional conservatism using a KRX firm sample of 1,310 firm-years from
2002 to 2013. First, we establish the levels of conditional conservatism using the accruals based Ball and
Shivakumar (2005) and the market based Basu (1997) models. The results suggest that firms borrow equity in
the form of public debt are conservative, consistent with previous studies. Next, we use a dummy variable approach to examine the relationship between conservatism and credit ratings for investment / non-investment
grade firms. We find that investment and non-investment grade firms have statistically insignificantly different
levels of financial conservatism.
Thirdly, we test if conditional conservatism has a statistically significant relation with credit rating changes.
We find that firms that experience an increase or a decrease in their credit rating levels from period t to t+1 are
marginally more conservative compared to firms with consistent credit rating levels. Next, we test the relation
between conditional conservatism and credit rating increases. Firms with higher levels of conservatism may benefit
from a credit rating increase because an increase in conservatism indicates lower risk. We use a dummy variable
approach to capture if conservatism in period t has the potential to influence a credit rating period in t+1.
We do not find a statistically significant relation between conservatism and credit ratings for our entire sample.
However, we find that there is a positive relation between conservatism in period t and a credit rating increase
in period t+1 for investment grade firms. Credit ratings have significant implications for a firm’s access to capital.
Firms below the investment grade level (BBB+ and below) are expected to face higher capital costs and face
limited access to investor equity because of legislative restrictions compared to firms with investment grade
bonds (A- to AAA). Credit ratings agencies may reward financially conservative firms above the investment
grade threshold with a credit rating’s increase because conditional conservatism is considered an important risk
metric for firms above the investment grade. Other metrics may be more critical to firms below the investment
grade cut-off.
Finally, we perform robustness checks for our main hypothesis. We find that firms that experience a credit
rating increase in period t+1 have statistically significantly higher levels of conservatism in period t compared to
firms experience a credit rating decrease or remain constant in period t+1, supporting our previous findings.
Taken together, our results suggest that credit ratings agencies consider conditional conservatism when issuing
credit ratings. Firms with higher credit ratings are generally more conservative. Moreover, conditionally conservative
firms above the investment grade threshold can be rewarded with a credit rating increase