Credit rating agency efficiency: Credit watch, monitoring role, and effects of earnings management

This study empirically tests whether the credit Watchlist creates an implicit contract between debt issuing firms and credit rating agencies (CRAs), whereby the CRA effectively motivates the issuer to take necessary actions that alleviate conditions that might otherwise lower the credit rating and then effectively monitors those actions. Based on Boot, Milbourn, and Schmeits (2006), I hypothesize and provide some evidence that, in response to negative economic news, issuers, who are most likely to effectively respond to the terms of the implicit contract, appear on the Watchlist. In addition, I find that firms placed on Watchlists generally manage earnings upward in the year of the CRA announcement that the firm is "on watch," and in the quarter prior to Watchlist resolutions. I investigate various forms of earnings management, including accruals and real operating activities manipulation. Some evidence suggests that firms manage earnings in attempts to gain favorable Watchlist treatment. CRA appear to be misled by these attempts in light of the results from a logit model. Last, I develop a measure, Spread Monitor Coefficient (SMC), for bondholders' reliance on monitors. Further, I provide systematic evidence that the Sarbanes-Oxley Act of 2002 (SOX) affects market participants' reliance on the five types of monitors: auditors, corporate governance, equity analysts, CRAs, and banks. Results suggest that bondholders have relied more (less) on the monitoring of equity analysts (auditors and CRAs) since SOX.