Book Description

One of the most fundamental questions in accounting research is how do different market participants interpret and use the information provided by accountants. Credit rating agencies are major users of financial statements that generate contemporary attention in the accounting literature. As noted by Standard and Poor's, accounting information is a critical element of the credit rating process. In addition, the recent credit crisis has generated increased scrutiny of the credit rating process and the ratings agencies. These issues motivate this study, which examines the effect of accrual quality, real activities earnings management, and corporate governance on credit ratings. The effects of the Credit Rating Agency Reform Act of 2006 (CRARA) and the Dodd-Frank Act (DFA) of 2010 on these associations are also examined. Following the established practice in the literature, accrual (earnings quality) models are used as proxies for the level of accrual quality. Specifically, the modified Jones model (Dechow, Sloan, and Sweeney 1995), the Dechow and Dichev cash flow model (Dechow and Dichev 2002), and Stubben's discretionary revenue model (Stubben 2010) are utilized. Real activities earnings management is measured based on variables used by Roychowdhury (2006) and Cohen and Zarowin (2010). Finally, this study measures corporate governance using the variables outlined in Byard, Li, and Weintrop (2006) and Bebchuk, Cohen, and Ferrell (2009). The results demonstrate that accrual quality is a significant factor in the rating of firms. Firms with lower accrual quality receive lower credit ratings. Real activities earnings management and a firm's level of corporate governance also determine the rating of a firm. Specifically, the results indicate that real activities earnings management related to discretionary expenses (SG&A, advertising, and R&D) are positively associated with ratings. Real activities earnings management related to abnormal production is negatively associated with ratings. Board size, board independence, and the CEO serving as the chairman of the board are positively associated with credit ratings. The relationship between accrual quality and credit ratings decreases in the post CRARA period, which surprisingly may indicate lower reliance on accounting information by the rating agencies during the recent economic recession. Determining the effect of the DFA on the credit rating process seems to be inconclusive and too early to detect.