Whether – and how – firms with borderline credit ratings manage earnings

“Earnings management” choices make a company’s results appear better on paper, without affecting its underlying business.

Research has shown that businesses sometimes choose accounting policies to make themselves look good. A firm may change how it counts inventories, or when it reports sales. These “earnings management” choices make a company’s results appear better on paper, without affecting its underlying business.

Earnings management becomes more dangerous when firms change their real operations. They might temporarily increase production rates to spread fixed costs over more products. Or they may cut spending in advertising and product development. These decisions make their accounting numbers look better in the short run. But they could harm the business in the long run.

Associate Professor Kareen Brown recently decided to investigate this issue. She and her co-authors investigated whether and how firms with borderline credit ratings manage earnings. They examined financial statements between 1989 and 2009 for 835 American manufacturers.

The analysis revealed that some firms do apparently alter their operations to manage their earnings. Manufacturers with borderline credit ratings are more likely to make such operational changes. This could help their ratings increase to the next higher category, or avoid them dropping to a lower one. This means that credit rating procedures might indirectly encourage poor operational decisions.

Curiously, credit rating agencies seem to accept these operational alterations at face value. By contrast, the agencies typically notice any accounting alterations and challenge them.

Brown’s work shows that credit rating pressures can influence companies’ real operational decisions. It therefore supports recent American efforts to eliminate government use of credit ratings in rules and regulations.

 Kareen Brown is an associate Professor of Accounting. Her research examines how various factors influence earnings management. She also studies how mandatory stock ownership affects firms’ investment, reporting and disclosure choices. Brown teaches introductory and intermediate accounting, and accounting theory. She is the 2015 recipient of Goodman’s Untenured Researcher of the Year Award.

Kareen Brown, Vincent Y.S. Chen and Myungsun Kim. 2015. Earnings Management Through Real Activities Choices of Firms Near the Investment-speculative Grade Borderline. Journal of Accounting and Public Policy 34, 74-94.