Study suggests credit ratings encourage companies to manipulate accounting

A new study suggests companies are manipulating their cash flow and accruals to boost their ratings with credit agencies and lower their interest rates on borrowing.

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The study, by Xia (Eliza) Zhang of the University of Washington, Tacoma, looks at performance pricing, under which banks reset interest rates based on the creditworthiness of a borrower, lowering the interest as a company’s financial performance improves.

In the early days of performance pricing, creditworthiness and interest rates were mainly determined by accounting measures such as the ratio of debt to earnings. In the late 1990s, only about a quarter of the cases of performance pricing were based on credit ratings, but lenders are increasingly relying on them. The study, which appears in the December issue of the American Accounting Association’s journal Accounting Horizons, found that interest rates and performance pricing based on credit ratings (or PPrating) now occurs in approximately 56 percent of the cases of performance pricing. The study also suggests that PPrating is often tied to financial manipulation by corporate borrowers, enabling them to lower their interest costs significantly.

“The potential for large interest rate changes and significant debt cost savings associated with credit-rating movement ... gives borrowers strong incentives to influence their firm ratings,” said the study. “Credit-rating agencies do not fully adjust to these managerial opportunistic behaviors."

Zhang found evidence of companies manipulating both their cash flow from operations as well as their accruals, the non-cash accounting items that can affect earnings, including revenues from credit sales or estimated value of inventory. The manipulation can prevent a decline in corporate performance from leading to a drop in credit ratings. Companies may accelerate bill collections from customers late in the year and delay payments to suppliers, or misreport their operating costs as capital investments.

In contrast to the tactics associated with PPrating, no major evidence showed up of CFO or accrual manipulation being associated with performance pricing based on accounting measures. “I examine whether PPrating firms are more likely to undertake CFO and accruals management than firms with accounting-based performance pricing provisions,” said Zhang. “Although [the latter] could also have the incentive to manage CFO and accruals, they should overall have a weaker incentive to do so…[Results] are consistent with my prediction…that PPrating firms are more likely to achieve better ratings through CFO and accruals management.”

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