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    Earnings Smoothing Activities of Firms to Manage Credit...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior 
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    Title:
    Earnings Smoothing Activities of Firms to Manage Credit Ratings
    Practical Implications:

    This paper provides fresh empirical evidence on long-term financial reporting strategies that managers use to impact perceptions of credit risk. It is among the first to examine reporting strategies in a setting where companies with stronger incentives to manage earnings to affect debt ratings can be identified. The authors find evidence that earnings smoothing activities appear to be affectively employed by managers to improve firm credit ratings.

    For more information on this study, please contact Boochun Jung.
     

    Citation:

    Jung, B., N. Soderstrom, and Y. S. Yang. 2013. Earnings Smoothing Activities of Firms to Manage Credit Ratings. Contemporary Accounting Research 30 (2).

    Keywords:
    credit ratings; risk assessment; rating agencies; financial disclosure
    Purpose of the Study:

    This study focuses on earnings smoothing, a long-term strategy that is available to a broad range of credit rated firms, as one way in which bond issuers affect credit ratings. Credit rating agencies such as Standard & Poor’s (S&P) and Moody’s evaluate credit risk and assign credit ratings to issues, issuers, or both. These ratings can have significant implications for companies by impacting the cost of future borrowing and affecting stock and bond valuation. Rating agencies often examine the earnings volatility of firms to identify credit risk. Firms can often improve or maintain their credit ratings by reducing the volatility of their earnings. This study attempts to identify mangers’ efforts to alter the rating agencies’ perception of credit risk through these earnings smoothing activities.

    Design/Method/ Approach:

    To test the hypotheses developed, the authors examine discretionary earnings smoothing activity by firms relative to their notch ratings (e.g. AA+, AA-, etc.). The primary measure of earnings smoothing activity is based on earnings smoothness associated with discretionary accruals. Earnings smoothness is measured as the standard deviation of earnings scaled by the standard deviation of cash flows from operating activities. The earnings smoothing activity is measured by subtracting smoothness based on earnings adjusted for performance-matched discretionary accruals from smoothness based on reported earnings. To test additional hypotheses, similar techniques are used in conjunction with descriptive statistics.

    Findings:
    • Earnings smoothing via earnings management is more concentrated in firms with a plus notch rating, particularly in investment grade firms.
    • Earnings smoothing activity increases the likelihood of a subsequent rating upgrade for firms with a plus notch rating.
    • Earnings smoothing activities appears to be an effective tool in managing credit ratings.
       
    Category:
    Corporate Matters, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Earnings Targets & Management Behavior