Extra Credit

Based on research by Brian Akins

• When Credit Rating Agencies have access to better financial reporting, there’s greater agreement among agencies and less credit risk uncertainty.
• After the 1997 implementation of Statement of Financial Accounting Standards, firms that were most affected by the standards had less credit risk uncertainty.
• While higher quality financial reporting lowers risk uncertainty for all credit reporting agencies, it’s especially important for agencies that rely heavily on publicly available reports.

Credit Rating Agencies (CRAs) help make the economy go ‘round. That’s why investors rely so heavily on CRAs such as Moody’s Investor Service (Moody’s) and Standard and Poor’s (S&P) to let them know how likely their “bet” is to pay them back in a timely fashion — or ever.

So imagine that you’re thinking of investing in a company with a strong credit rating from a top CRA. As you conduct your due diligence, you discover that yet another top CRA has assigned the very same firm a significantly lower credit rating, indicating that it’s more likely to default on its loans.

Not surprisingly, this disagreement between the CRAs introduces a greater uncertainty of risk, which could influence your investment decision. You might decide you need a higher yield, or request any number of other measures to protect yourself from the perceived risk.

Fortunately for would-be investors, Rice Business professor Brian Akins set out to find out what can be done to increase the harmony between CRA ratings. In particular, he wanted to know if improving the financial reporting that CRAs use would lower the risk uncertainty that ensues when they disagree.

To find out, Akins studied data from three major CRAs: Moody’s and S&P — both of which have access to not just public reports but also corporations’ private information — and Egan-Jones Rating Company (EJR), which relies mainly on public reports.

Akins began by trying to see if reporting quality affected disagreement between Moody’s and S&P, since they have access to similar data. As an indicator of reporting quality, Akins used a measure called “debt contracting value of accounting” (DCV), which shows how well a firm’s earnings information predicts a possible rating change. He calculated the DCV for 1,959 bonds representing 875 firms that were rated by both S&P and Moody’s between 1985 and 2008.

Next, Akins looked at the default risk that S&P and Moody’s assigned to each of these 1,959 bonds. He found that on average, the higher the DCV — that is, the higher the reporting quality — the more likely the agencies were to agree in their ratings. In other words, better reporting quality was indeed linked to less risk uncertainty.

But what about firms such as EJR, which doesn’t have the luxury of accessing a corporation’s privately available information?

Akins found that for EJR, better reporting quality was even more important. That’s because nearly all of the data the firm uses come from the “publicly available” bucket, so the better the quality of this data, the more aligned its ratings will be with other agencies.

Akins wanted to be sure that reporting quality, and nothing else, was indeed the key variable at play, so he analyzed the level of disagreement among credit ratings before and after a mandatory change was made to accounting standards in 1997. This change, Statement of Financial Accounting Standards (SFAS) 131, is recognized as having improved reporting quality.

What Akins found is that after SFAS 131 was put into effect, the firms most impacted by the standards had far less disagreement on their credit ratings than similar firms less affected by SFAS 131. Consistent with Akins’ earlier findings, better reporting quality meant more consistent ratings.

In short, when CRAs analyze firms that have higher quality reporting to determine their ratings, they’re more likely to agree on those ratings. This, in turn, means less risk uncertainty for investors, who can be more decisive. Because when it comes to investing money, no one likes surprises.

Brian Akins is an Assistant Professor of Accounting at Jones Graduate School of Business at Rice University.

To learn more, please see: Akins, B. (2018). Financial reporting quality and uncertainty about credit risk among the credit ratings agencies. The Accounting Review, 93(4), 1-22.