Income smoothing through R&D management and credit ratings

Abstract

Purpose Prior studies generally focus on income smoothing through discretionary accruals and document that managers have incentives to smooth earnings due to various reasons. This paper aims to focus on income smoothing through research and development (R&D) management and examine whether and how income smoothing through R&D management affects credit rating agencies’ perception of firm risk. Design/methodology/approach The authors use financial statement data from the CRSP/Compustat Merged data set universe for the period from 1992 to 2019 after excluding financial and utility industries. The authors follow the model for credit ratings used in previous literature to test the hypothesis. Specifically, the authors use an ordered probit model to express credit ratings as a function of income smoothing attributes. Findings The authors find that R&D-based income smoothing improves a firm’s credit rating. However, the positive effect of R&D-based income smoothing on credit ratings is less than that of accruals-based income smoothing. This study also shows that the positive effect of R&D-based income smoothing is more pronounced for firms less subject to opportunistic incentives, further strengthening the notion that managers smooth earnings through R&D management to provide more informative earnings. Originality/value This study contributes to the income smoothing literature in several ways. First, the authors contribute to the research by showing that managers’ income smoothing activity through R&D management positively affects firms’ credit rating. Second, the authors also document the relative benefits of the two different income smoothing techniques in terms of improving credit agencies’ perception of firms’ creditworthiness.