Impact of credit rating downgrades and tightness of accounting standards on earnings management in listed SMES

Abstract

Due to its nature, funding remains the main problem for listed small and medium-sized enterprises (SMEs) globally. To overcome such a problem, there is a trend of using credit rating as the benchmark to appraise funding opportunities and applications in listed SMEs. As credit rating levels vary across time, subject to the performance of the listed SMEs, changes in the credit rating levels might trigger attention from listed SMEs, and actions might then be taken by the management to ensure that the credit rating is at the desired level. Since the literature in this strand of study is limited, this study aimed to examine the effect of credit rating downgrade and tightness of accounting standards on earnings management in listed SMEs. Employing a 2x3 between-subjects experiment manipulating credit rating downgrades (category or notch) and tightness of accounting standards (less tight, moderately tight, tight), it is evidenced that credit rating downgrades, especially notch downgrades, lead to more earnings management behaviors in the presence of a tight and less tight set of accounting standards. Different classifications of credit rating downgrades – notches and categories – will have different implications for earnings management based on the extent to which they are subject to external monitoring. As a practical matter, it is recommended that regulators exercise equal monitoring regardless of whether credit rating downgrades occur by category or notch.