Firms shape accounting to influence credit ratings

Walid Alissa, Professor of Accounting and Management Control - April 15th, 2013
Graph surrounded by financial ratings

Credit ratings are increasingly essential investment signals, heavily impacting the cost of capital for companies. A new study shows how firms can influence their own credit ratings by exploiting the flexibility of accounting.

Alissa Walid ©HEC Paris

Walid Alissa has been Professor of financial accounting at HEC since 2009. He graduated from Saudi Arabia’s King Fahd University of Petroleum and Minerals. He worked for nearly (...)

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The three first letters of the alphabet, sometimes followed by a plus or minus sign, have taken on inordinate importance in recent years when bestowed upon governments or corporations seeking capital. From virtuous AAAs to dismal B-s or even chastising Cs, credit ratings are used to assess corporate and government credit worthiness, with profound implications for the access of companies and states to capital. For example, market participants use credit ratings from the three global agencies – Moody’s, Fitch, and Standard & Poor’s – to assess default risk. By having its credit rating upgraded a notch, a firm slightly below the investment-grade threshold can attract new investors.


Unsurprisingly, research shows that chief financial officers pay strong attention to credit ratings when making financing and investing decisions. Credit worthiness also sends strong signals of overall quality to suppliers and customers, thus contributing to the maintenance of vital relationships. Credit ratings are crucial not just for individual firms, but also for the economy as a whole, since authorities take them into account when regulating financial markets. Recent financial crises have highlighted the significance of credit ratings. “When the Enron scandal broke, everyone was asking how auditors and ratings agencies could have missed the fraud, but the agencies retreated behind the First Amendment, claiming it was merely opinion!” notes Walid Alissa, researcher in financial accounting. Seeing how crucial these ratings are, he and three co-researchers decided to examine whether firms attempt to decide - or at least influence - their own credit ratings in order to keep analysts and investors happy. Their study focuses on firms that deviate from their expected ratings and examines their level of success at acting to meet their own rating targets.


In a rather straightforward way, credit ratings influence the cost of capital, with higher-graded bonds making investments attractive, and lower-graded companies having to offer higher interest rates to borrow. But more so than the rating itself, it is the consistency with which companies maintain their ratings, whether high or low, that signals stability and inspires investor trust. “Credit ratings are ‘sticky’ in the sense that agencies look at the longterm aspect,” says Walid Alissa. “They don’t like companies to flip-flop.” While a shift up or down one notch within a broad category would not have much of an impact, for example from AA+ to AA (or AA to AA-), the researcher says that changing categories entirely (AA to A or A to BBB, for example) is more damaging. Furthermore, a drop in the speculative-grade category may force investors to liquidate their holdings, since regulations limit mutual market fund investments in lower-rated bonds. The opposite is also true (i.e., a bump up will increase access to investors who cannot otherwise invest in the firm). It may be counter-intuitive to think that an upgrade could have a negative impact; however, Walid Alissa points out that it’s harmful for a firm to be in a position that does not reflect its true value. “If AA is not your true position, you may not be able to sustain that performance,” he says. Not to mention that market over-confidence may in fact come from irrational or unsustainable behavior on the part of economic agents, as was the case during the dot-com and real estate bubbles. In short, firms have strong incentives to match the ratings expected of them.


In order to find out whether companies did act to hit their targets, Walid Alissa and his co-authors empirically modeled expected credit ratings for a sample of large firms. They found these expectations often differed from the actual ratings assigned. The researchers then looked at earnings, since, when assessing firms, rating analysts take them into account (though, unlike auditors, do not check them). For their study, the researchers checked for abnormal accruals, such as liabilities and non-cash-based assets, as well as manipulations of real activities within these companies. They measured abnormal levels of cash flow from operations, abnormal production costs, and abnormal discretionary expenses – in short, all the areas where managers have discretion to smooth out the figures. Walid Alissa and his co-authors found that firms did in fact engage in “earnings management” in order to send the right signals to credit rating agencies. “We found that, on average, firms that were below their target managed their earnings upward to get closer, and those above their target managed their earnings downward,” he says. The behavior was strongest for firms straddling the cut-off between investment-grade and junk categories. Looking at how credit rating agencies responded, adds Walid Alissa, there is evidence that this strategy is often successful.


The catch, of course, is the legality of such “earnings management”: does this not amount to “cooking the books”? Walid Alissa is quick to point out that what they observed is within legal boundaries: “Firms use accounting discretion, play with the flexibility of accounting, so earnings management is what you may call ‘aggressive accounting’ but it is not illegal.” His personal view, though, is that such deception should be illegal. He adds that all credit ratings — whether that of the researchers or of rating agencies — do not amount to auditing, since they are based on figures published by the firms themselves. “We can’t know, for example, whether the companies fabricated their sales figures,” he says.

Based on an interview with Walid Alissa and the article “Firms’ Use of Accounting Discretion to Influence Their Credit Ratings”, co-written with Samuel B. Bonsall, Kevin Koharki and Michael W. Penn (Journal of Accounting and Economics , April-May 2013, vol. 55, no. 2-3, pp.129-147). 

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By shedding light on the importance of credit ratings for the global economy and on the implications for firms and their incentives to play with their books, this research underscores the need for precaution. “Credit rating agencies need to be careful and do due diligence in order to unwind the effects of earnings management,” says Walid Alissa. According to him, regulators should also be concerned about cheating and become less dependent on credit rating agencies. “It would be preferable to make the relationship between agencies and firms more structured, to bring agencies under government perspective to make them more independent.» But, as long as firms are the ones paying auditors credit rating agencies, Walid Alissa admits he is not very optimistic about the possibility of increasing their independence.


The authors study large firms (average market capitalization $5.7 billion) on which the agency Standard & Poor’s has credit rating data available for the 1985-2010 period. Collating stock price information, financial statement data, governance data, and so on, they formed a base sample of 23,909 firm years.