Financial statement recasting and credit risk assessment

Abstract

This article examines the importance of adjustments to corporate financial statements for credit risk assessment. Prior research has tended to examine individual adjustments one at a time. As correlations among adjustments and control variables may bias inferences when researchers examine a single adjustment and ignore other adjustments, our results provide important new information about previous research by documenting whether or not such bias exists. We find that financial statement recasting adjustmentswhich aim to better reflect firms' indebtedness, financing costs and recurring earnings than reported financial numbersare reflected in bond yield spreads and have an economically significant impact on credit pricing and loss forecasting. Among individual adjustment categories, we find that those for off-balance-sheet leases, defined benefit pensions and securitized debt have an economically significant impact on credit pricing and loss forecasting. Accounting and Finance 54 (2014) 47-82 2 Of course, Moody's makes these adjustments for their own credit-ratings process, and the adjustment process involves a necessary degree of judgment and assumptionmaking. Further, rating-agency analysts may respond to incentives to bias their adjustments. While this opens the possibility that Moody's adjustments are systematically different in some way from common practice among analysts, this possibility must be weighed against the availability of data sources containing a comprehensive set of adjustments. To our knowledge, no such data sources are available in comparably sufficient scale.

Disclosure-Derived Financial Statement Adjustments in Equity Valuation

“…Batta et al (2012) and Kraft (2011) find that ratios based on recast accounting numbers better explain variation in bond credit spreads than ratios based on reported numbers, in contrast to our results which show that recast numbers are inferior to reported numbers in explaining variation in equity price levels and returns. As a point of comparison to these prior studies, in untabulated tests, we reassess Hypotheses 1 and 2 stock return volatility as an equity-value based risk measure.…”

Credit Rating Agency and Equity Analysts’ Adjustments to GAAP Earnings

“…This prediction is consistent with the literature, which shows that financial ratios adjusted by Moody's analysts explain variation in bond credit spreads better than do ratios based on GAAP financials (Batta et al. ; Kraft ). In contrast, equity analysts’ forecast optimism (Easterwood and Nutt ; Hong and Kubik ) is likely to spill over to their earnings definitions and may not be incrementally effective in predicting bankruptcies.…”

“…Prior studies find that earnings adjustments of rating analysts explain rating levels, bond credit spreads, and stock prices (Batta et al. ; De Franco et al. ; Kraft ).…”

“…Credit rating agency analysts and sell‐side equity analysts adjust company‐reported GAAP earnings to better compare realized performance across companies and to capture the part of realized performance that is more likely to recur in the future. Investors react to the earnings adjustments of credit rating agency analysts (Batta, Ganguly, and Rosett ; De Franco, Wong, and Zhou ; Kraft ) and equity analysts (Bhattacharya, Black, Christensen, and Larson ; Gu and Chen ), which suggests each group of analysts’ ability to capture recurring company performance.…”

The Direct Relevance of Accounting Information for Credit Default Swap Pricing

“…Additionally, accounting information has been found to play a key role in the credit rating assessment process (Kaplan and Urwitz, 1979; and Ahmed et al, 2002). Recent research has also highlighted the rating agencies’ sophisticated use of financial disclosures and press releases to modify (or ‘recast') firms’ financials in order to represent firms’ ongoing earnings power and to impute debt from off‐balance‐sheet financings (Batta et al, 2010; and Kraft, 2011). Models linking accounting information to CDS pricing that fail to account for credit ratings thus miss a crucial channel for interpreting and disseminating credit‐relevant information derived from firms’ financial reports.…”