Job Market Paper

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 evidence that, in response to negative economic news, issuers 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 both the year before and the year of the CRA announcement that the firm is “on watch.” 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. However, I find no evidence that the CRA is fooled by these attempts. Rather, it appears more likely that interpretation of other information or firm characteristics that make positive (negative) Watchlist firms poor candidates for credit upgrades (confirmations) guides CRA decisions and the CRA effectively “sees through” earnings manipulation aimed at managing CRA perceptions.