Kraft - Rating Agency Adjustments to GAAP Financial...

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Electronic copy available at: Rating Agency Adjustments to GAAP Financial Statements and Their Effect on Ratings and Bond Yields Pepa Kraft * New York University Stern School of Business September 4, 2010 Abstract Rating agencies have been criticized for underestimating default risk (subprime mort- gage crisis, Enron). Using a new dataset of U.S. GAAP and adjusted financial statements, I document that a major rating agency (Moody’s) extensively modifies reported financial state- ments. The major quantitative adjustment incorporates off-balance-sheet financing activity (operating leases and securitizations), causing the adjusted leverage ratio (interest coverage ratio) for the median firm to increase (decrease) by 15%. Adjustments for off-balance-sheet debt and soft adjustments are significantly associated with yields. Thus ratings can serve as a contracting device to incorporate off-balance-sheet debt adjustments and credit-risk in- creasing soft factors. The evidence is consistent with the view that rating agencies are, for the most part, efficient processors of accounting information for credit risk assessments of corporate issuers. However, soft adjustments may not be sufficiently conservative. * I am especially grateful to the members of my dissertation committee for guidance and feedback: Ray Ball (chair), Philip Berger, Doug Diamond, Christian Leuz and Doug Skinner. I also thank Joseph Gerakos, April Klein, Andrei Kovrijnykh, Christian Laux, Richard Leftwich (the editor), Ningzhong Li, Christian Opp, Jayanthi Sunder, Shyam Sunder, Sarah Zechman, Bill Zhang, the anonymous referee and participants at the University of Chicago’s accounting workshop, at the FARS mid-year meeting 2009 and at the AAA annual meeting 2009 for helpful suggestions, discussions, and comments. I thank Andrew Tan for excellent research assistance. I am grateful for the financial support provided by the University of Chicago Booth School of Business, NYU Stern School of Business and the Deloitte Foundation. E-mail address: [email protected] . 1
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Electronic copy available at: 1 Introduction Credit rating agencies have provided ratings for a century. Ratings are used for valuation purposes, in contracts, and in regulation and reduce duplication of information-processing (Wakeman (1984), Beaver et al. (2006)). Bond investors rely on the rating agencies’ reputation not to renege on their promised rating production (White (2002), Klein and Leffler (1981), Shapiro (1983), Strausz (2005)). Under their business model, rating agencies collect fees from the very issuers they rate, creating a basic tension between providing accurate and upward biased ratings (Partnoy (1999), Bolton et al. (2010), Becker and Milbourn (2010), Mason and Rosner (2007)). Upward biased ratings have been observed for structured finance products, such as mortgage-backed and asset- backed securities (Ashcraft et al. (2010), Benmelech and Dlugosz (2009)). For structured finance products, wrong model assumptions and optimistic subjective adjustments coupled with incentives
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Kraft - Rating Agency Adjustments to GAAP Financial...

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