Do firms manage earnings after a downgrade in their credit rating?

Abstract

Purpose This paper aims to examine whether firms engage in earnings management immediately after experiencing a downgrade in their credit rating. Design/methodology/approach This paper uses fixed-effects regression models to examine real- and accrual-based earnings management after firms experience a downgrade in their credit rating. Findings Inconsistent with prior studies where firms are reported to opportunistically increase their earnings prior to a credit rating event, this paper finds that firms use income-decreasing earnings management after their ratings are downgraded. This paper also finds that firms downgraded to below the investment grade rating not only significantly reduce both abnormal cash flows and discretionary accruals but also report larger asset impairments, suggesting that these firms exploit the rating downgrade to employ a big bath accounting. Practical implications The results of this paper have practical implications for investors fixating on firm earnings after a credit rating downgrade, for shareholders of downgraded firms and regulators such as credit rating agencies. Originality/value The findings of this study contribute to the thin literature on earnings management after changes in credit rating by shedding lights on earnings management after a rating downgrade and complement the literature on the accounting choice of financially distressed firms. The empirical evidence documented in this study suggests that the occurrence of income-decreasing earnings management is not limited to only after a sovereign country rating downgrade as documented in a prior study but also occurs after a rating downgrade not associated with this event.