Review of Accounting Studies

, Volume 18, Issue 3, pp 783–823 | Cite as

Financial statement comparability and credit risk

Article
First Online:

Abstract

Prior research shows that firms’ financial statement comparability improves the accuracy of market participants’ valuation judgments and thus may reduce firms’ costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody’s adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) to non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants’ uncertainty about and pricing of firms’ credit risk.

Keywords

Comparability Corporate credit risk Credit rating agency Bond market liquidity 

JEL Classification

M41 G32 G24 
This is a preview of subscription content, log in to check access.

Notes

Acknowledgments

We thank Brian Akins, Navneet Arora (the discussant), Karthik Balakrishnan, Anne Beatty, Gus De Franco, Mirko Heinle, Cathy Schrand, Minye Tang, Lakshmanan Shivakumar (the editor), and Rodrigo Verdi. We also thank participants at the RAST 2012 conference and at the CFEA 2012 conference, as well as workshop participants at the University of Missouri, the University of Pennsylvania, Tel Aviv University, New York University summer camp, and Quantitative Management Associates for constructive feedback, questions and suggestions. We gratefully acknowledge the financial support provided by NYU Stern School of Business and University of Pennsylvania Wharton School of Business. Kim gratefully acknowledges financial support from the Samsung Scholarship.

References

  1. Akins, B. (2012). Financial reporting quality and uncertainty about credit risk among the ratings agencies. Working Paper.Google Scholar
  2. Akins, B., Ng, J., & Verdi, R. (2012). Investor competition over information and the pricing of information asymmetry. The Accounting Review, 87(1), 35–58.CrossRefGoogle Scholar
  3. Altman, E. I. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, 23(4), 589–609.CrossRefGoogle Scholar
  4. Armstrong, C. S., Core, J. E., Taylor, D. J., & Verrecchia, R. E. (2011). When does information asymmetry affect the cost of capital?. Journal of Accounting Research, 49(1), 1–40.CrossRefGoogle Scholar
  5. Arora, N., Richardson, S., & Tuna, I. (2011). Asset measurement uncertainty and credit term-structure. Working Paper.Google Scholar
  6. Baiman, S., & Verrecchia, R. E. (1996). The relation among capital markets, financial disclosure, production efficiency, and insider trading. Journal of Accounting Research, 34(1), 1–22.CrossRefGoogle Scholar
  7. Ball, R., Jayaraman, S., & Shivakumar, L. (2012). Mark-to-market accounting and information asymmetry in banks. Working Paper.Google Scholar
  8. Ball, R., Robin, A., & Wu, J. S. (2003). Incentives versus standards: Properties of accounting income in four east asian countries. Journal of Accounting and Economics, 36(1-3), 235–270.CrossRefGoogle Scholar
  9. Ball, R., & Shivakumar, L. (2006). The role of accruals in asymmetrically timely gain and loss recognition. Journal of Accounting Research, 44(2), 207–242.CrossRefGoogle Scholar
  10. Bao, J., Pan, J., & Wang, J. (2011). The illiquidity of corporate bonds. Journal of Finance, 66(3), 911–946.CrossRefGoogle Scholar
  11. Barth, M., Hodder, L. D., & Stubben, S. E. (2008). Fair value accounting for liabilities and own credit risk. The Accounting Review, 83(3), 629–664.CrossRefGoogle Scholar
  12. Barth, M., Landsman, W. R., Lang, M., & Williams, C. (2012). Are IFRS-based and US GAAP-based accounting amounts comparable?. Journal of Accounting and Economics, 54(1), 68–93.CrossRefGoogle Scholar
  13. Batta, G., Ganguly, A., & Rosner, J. (2012). Financial statement recasting and credit risk assessment. Working Paper.Google Scholar
  14. Beaver, W. H. (1966). Financial ratios as predictors of failure. Journal of Accounting Research, 4, 71–111.CrossRefGoogle Scholar
  15. Beaver, W. H., Correia, M., & McNichols, M. F. (2010). Financial statement analysis and the prediction of financial distress. Foundations and Trends in Accounting, 5(2), 99–173.CrossRefGoogle Scholar
  16. Berger, P. G., & Hann, R. N. (2007). Segment profitability and the proprietary and agency costs of disclosure. The Accounting Review, 82(4), 869–906.CrossRefGoogle Scholar
  17. Bharath, S. T., Sunder, J., & Sunder, S. V. (2008). Accounting quality and debt contracting. The Accounting Review, 83(1), 1–28.CrossRefGoogle Scholar
  18. Bhojraj, S., & Lee, C. (2002). Who is my peer? A valuation-based approach to the selection of comparable firms. Journal of Accounting Research, 40(2), 407–439.CrossRefGoogle Scholar
  19. Blume, M. E., Lim, F., & Mackinley, A. C. (2006). The declining credit quality of US corporate debt: Myth or reality?. Journal of Finance, 53(4), 1389–1413.CrossRefGoogle Scholar
  20. Bradshaw, M. T., Bushee, B. J., & Miller, G. S. (2004). Accounting choice, home bias, and US investment in non-US firms. Journal of Accounting Research, 42(5), 795–841.CrossRefGoogle Scholar
  21. Bradshaw, M. T., Miller, G. S., & Serafeim, G. (2009). Accounting method heterogeneity and analysts’ forecasts. Working Paper.Google Scholar
  22. Cantor, R., & Packer, F. (1997). Differences of opinion and selection bias in the credit rating industry. Journal of Banking & Finance, 21(10), 1395–1417.CrossRefGoogle Scholar
  23. Chen, L., Lesmond, D. A., & Wei, J. (2007). Corporate yield spreads and bond liquidity. Journal of Finance, 62(1), 119–149.CrossRefGoogle Scholar
  24. Cheng, L. (2012). Loan loss provisioning and differences of opinion. Working Paper.Google Scholar
  25. Collin-Dufresne, P., Goldstein, R. S., & Martin, J. S. (2001). The determinants of credit spread changes. The Journal of Finance, 56(6), 2177–2207.CrossRefGoogle Scholar
  26. Copeland, T. E., & Galai, D. (1983). Information effects on the bid-ask spread. The Journal of Finance, 38(5), 1457–1469.CrossRefGoogle Scholar
  27. Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (2 ed.). Hoboken, NJ: Wiley.Google Scholar
  28. De Franco, G., Kothari, S., & Verdi, R. S. (2011a). The benefits of financial statement comparability. Journal of Accounting Research, 49(4), 895–931.CrossRefGoogle Scholar
  29. De Franco, G., Wong, F., & Zhou, Y. (2011b). Accounting adjustments and the valuation of financial statement note information in 10-K filings. The Accounting Review, 86(5), 1577–1604.CrossRefGoogle Scholar
  30. Dechow, P. M., & Dichev, I. D. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77, 35–59.CrossRefGoogle Scholar
  31. Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1995). Detecting earnings management. The Accounting Review, 70(2), 193–225.Google Scholar
  32. Diamond, D. W., & Verrecchia, R. E. (1991). Disclosure, liquidity, and the cost of capital. The Journal of Finance, 46(4), 1325–1359.CrossRefGoogle Scholar
  33. Dichev, I. D., & Piotroski, J. D. (2001). The long-run stock returns following bond ratings changes. Journal of Finance, 56(1), 173–203.CrossRefGoogle Scholar
  34. Dick-Nielsen, J. (2009). Liquidity biases in TRACE. Journal of Fixed Income, 19(2), 43–55.CrossRefGoogle Scholar
  35. Dick-Nielsen, J., Feldhuetter, P., & Lando, D. (2012). Corporate bond liquidity before and after the onset of the subprime crisis. Journal of Financial Economics, 103(3), 471–492.CrossRefGoogle Scholar
  36. Doidge, C., Karolyi, G. A., & Stulz, R. M. (2004). Why are foreign firms listed in the US worth more?. Journal of Financial Economics, 71(2), 205–238.CrossRefGoogle Scholar
  37. Duffie, D., & Lando, D. (2001). Term structures of credit spreads with incomplete accounting information. Econometrica, 69(3), 633–664.CrossRefGoogle Scholar
  38. Ederington, L. H. (1986). Why split ratings occur. Financial Management, 15(1), 37–47.CrossRefGoogle Scholar
  39. Elton, E. J., Gruber, M. J. Agrawal, D., & Mann, C. (2001). Explaining the rate spread on corporate bonds. Journal of Finance, 56(1), 247–278.CrossRefGoogle Scholar
  40. Fang, V. W., M. Maffett, & B. Zhang (2012). The effect of foreign institutional investment on financial reporting comparability. Working Paper.Google Scholar
  41. FASB. (2010). Statement of financial accounting concepts no. 8. Conceptual framework for finanical reporting.Google Scholar
  42. Glosten, L. R., & Milgrom, P. R. (1985). Bid, ask and transaction prices in a specialist market with heterogeneously informed traders. Journal of Financial Economics, 14(1), 71–100.CrossRefGoogle Scholar
  43. Gow, I. D., Taylor, D., & Verrecchia, R. (2011). Disclosure and the cost of capital: Evidence of information complementarities. Working Paper.Google Scholar
  44. Gu, Z., & Chen, T. (2004). Analysts’ treatment of nonrecurring items in street earnings. Journal of Accounting and Economics, 38(1), 129–170.CrossRefGoogle Scholar
  45. Hand, J. R. M., Holthausen, R. W., & Leftwich, R. W. (1992). The effect of bond rating agency announcements on bond and stock prices. Journal of Finance, 47(2), 733–752.CrossRefGoogle Scholar
  46. Healy, P. M., Hutton, A. P., & Palepu, K. G. (1999). Stock performance and intermediation changes surrounding sustained increases in disclosure. Contemporary Accounting Research, 16(3), 485–520.CrossRefGoogle Scholar
  47. Hillegeist, S. A., Keating, E. K., Cram, D. P., & Lundstedt, K. G. (2004). Assessing the probability of bankruptcy. Review of Accounting Studies, 9(1), 5–34.CrossRefGoogle Scholar
  48. Holthausen, R. W., & Leftwich, R. W. (1986). The effect of bond rating changes on common stock prices. Journal of Financial Economics, 17(1), 57–89.CrossRefGoogle Scholar
  49. Huang, J., & Huang, M. (2012). How much of the corporate-treasury yield spread is due to credit risk?. Review of Asset Pricing Studies, 2(2), 153–202.CrossRefGoogle Scholar
  50. Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193–228.CrossRefGoogle Scholar
  51. Joos, P., & Lang, M. (1994). The effects of accounting diversity: Evidence from the European Union. Journal of Accounting Research, 32, 141–168.CrossRefGoogle Scholar
  52. Jorion, P., Liu, Z., & Shi, C. (2005). Informational effects of Regulation FD: Evidence from rating agencies. Journal of Financial Economics, 76(2), 309–330.CrossRefGoogle Scholar
  53. Jorion, P., & Zhang, G. (2007). Good and bad credit contagion: Evidence from credit default swaps. Journal of Financial Economics, 84(3), 860–883.CrossRefGoogle Scholar
  54. Kaplan, R. S., & Urwitz, G. (1979). Statistical models of bond ratings: A methodological inquiry. Journal of Business, 52(2), 231–61.CrossRefGoogle Scholar
  55. Khanna, T., Palepu, K. G., & Srinivasan, S. (2004). Disclosure practices of foreign companies interacting with US markets. Journal of Accounting Research, 42(2), 475–508.CrossRefGoogle Scholar
  56. Kim, O., & Verrecchia, R. E. (1994). Market liquidity and volume around earnings announcements. Journal of Accounting and Economics, 17(12), 41–67.CrossRefGoogle Scholar
  57. Kothari, S., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting & Economics, 39(1), 163–197.CrossRefGoogle Scholar
  58. Kraft, P. (2010). Rating agency adjustments to GAAP financial statements and their effect on ratings and bond yields. Working Paper.Google Scholar
  59. Kyle, A. S. (1985). Continuous auctions and insider trading. Econometrica, 53(6), 1315–1335.CrossRefGoogle Scholar
  60. Lambert, R., Leuz, C., & Verrecchia, R. E. (2007). Accounting information, disclosure, and the cost of capital. Journal of Accounting Research, 45(2), 385–420.CrossRefGoogle Scholar
  61. Lambert, R. A., Leuz, C., & Verrecchia, R. E. (2012). Information asymmetry, information precision, and the cost of capital. Review of Finance, 16(1), 1–29.CrossRefGoogle Scholar
  62. Land, J., & Lang, M. H. (2002). Empirical evidence on the evolution of international earnings. The Accounting Review, 77, 115–133.CrossRefGoogle Scholar
  63. Leftwich, R. (1983). Accounting information in private markets: Evidence from private lending agreements. The Accounting Review, 58(1), 23–42.Google Scholar
  64. Leuz, C. (2003). IAS versus US GAAP: Information asymmetry-based evidence from Germany’s New Market. Journal of Accounting Research, 41(3), 445–472.Google Scholar
  65. Leuz, C., & Verrecchia, R. E. (2000). The economic consequences of increased disclosure. Journal of Accounting Research, 38(Supplement), 91–124.CrossRefGoogle Scholar
  66. Li, N. (2010). Negotiated measurement rules in debt contracts. Journal of Accounting Research, 48(5), 1103–1144.CrossRefGoogle Scholar
  67. Livingston, M., Naranjo, A., & Zhou, L. (2007). Asset opaqueness and split bond ratings. Financial Management, 36(3), 49–62.CrossRefGoogle Scholar
  68. Longstaff, F. A., Mithal, S., & Neis, E. (2005). Corporate yield spreads: Default risk or liquidity? new evidence from the credit default swap market. Journal of Finance, 60(5), 2213–2253.CrossRefGoogle Scholar
  69. Mansi, S. A., Maxwell, W. F., & Miller, D. P. (2004). Does auditor quality and tenure matter to investors? Evidence from the bond market. Journal of Accounting Research, 42(4), 755–793.CrossRefGoogle Scholar
  70. Moody’s. (2006). Moody’s approach to global standard adjustments in the analysis of financial statements for non-financial corporations—part I.Google Scholar
  71. Morgan, D. P. (2002). Rating banks: Risk and uncertainty in an opaque industry. The American Economic Review, 92(4), 874–888.CrossRefGoogle Scholar
  72. Patell, J. M. (1979). The API and the design of experiments. Journal of Accounting Research, 17(2), 528–549.CrossRefGoogle Scholar
  73. Roll, R. (1984). A simple implicit measure of the effective bid-ask spread in an efficient market. The Journal of Finance, 39(4), 1127–1139.CrossRefGoogle Scholar
  74. Standard & Poor’s. (2008). Corporate ratings criteria.Google Scholar
  75. Welker, M. (1995). Disclosure policy, information asymmetry, and liquidity in equity markets. Contemporary Accounting Research, 11(2), 801–827.CrossRefGoogle Scholar
  76. Yu, F. (2005). Accounting transparency and the term structure of credit spreads. Journal of Financial Economics, 75(1), 53–84.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.Stern School of BusinessNew York UniversityNew YorkUSA

Personalised recommendations