We investigate whether issuers on negative credit watch manage earnings upward and whether such earnings management favorably influences the watch resolution. We find that rating, industry, and performance matched discretionary accruals reported during negative watch are significantly higher than their respective pre- and post-watch levels, after controlling for accrual reversal. Consistent with its opportunistic nature, we find that accrual management increases with issuers' incentives to avoid downgrade, and decreases with their earnings management constraints and the strength of the external monitoring. Surprisingly, such accrual management significantly increases the likelihood of a favorable resolution—issuers in the top half of the discretionary accruals distribution are 24 percent less likely to be downgraded than those in the propensity score matched bottom half. We find that issuers that avoid downgrades through income-increasing accrual management significantly underperform those that do not over the ensuing year, mitigating the signaling or measurement error explanations for our results. Finally, we find that accrual management does not reflect attempts to improve short-term credit quality.
JEL Classifications: M41; G29; G38.
SYNOPSIS
This study examines whether financial analysts and institutional investors play a disciplinary role in monitoring corporate financial reporting and disclosure. Using a sample of firms that meet or marginally beat analysts' forecasts, likely through upward earnings management and downward expectations management, this study shows that managers' use of the two tactics is associated with monitoring measures, including analyst following, analyst experience and independence, institutional ownership, and institutional investors' experience and investment style. Managers under more effective monitoring by analysts and institutional investors are more likely to manage expectations downward than to manage earnings upward. Overall, the findings are consistent with financial analysts and institutional investors playing a monitoring role in constraining distortions in reported earnings and inducing timely disclosure of bad news.
Data Availability: All data are from public sources.
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