Earnings Smoothing Activities of Firms to Manage Credit Ratings*

This paper explores how incentives to maintain or improve credit ratings affect corporate financial reporting. Credit ratings have significant cost implications for companies because they are directly related to companies’ borrowing cost and ratings changes are reflected in both stock returns and bond yields. Managers therefore have incentives to maintain or improve their companies’ credit ratings. Both managers and rating agencies view earnings smoothness as an important input into the rating process. We thus argue that firms have incentives to manage credit ratings through smoothing earnings and the degree of earnings smoothing activity is larger for those with greater incentives. We hypothesize that firms within broad rating categories (e.g., AA) have differential incentives to smooth earnings, depending on whether their rating is at the top or bottom notch of the rating category (e.g., AA+ or AA-, respectively) versus in the middle of the rating category (e.g., AA). This increased incentive stems from a higher probability for firms in the outer notches of being upgraded (downgraded) into a higher (lower) broad rating category. Our empirical evidence is consistent with increased earnings smoothing for these firms. Further, we hypothesize and find that those firms in the outer notches who rely more heavily on debt financing, smooth earnings to a larger extent than firms who do not rely as much on debt financing. Finally, in our analysis of the effectiveness of earnings smoothing behavior, we examine whether smoothing behavior has an impact on subsequent credit ratings. We find that increased earnings smoothness reduces (raises) the likelihood of a rating downgrade (upgrade) in subsequent periods.