Voluntary Disclosure during Credit Watches: Do Credit Rating Agencies Concern about Disclosure Quality?

Transcription

1 Voluntary Disclosure during Credit Watches: Do Credit Rating Agencies Concern about Disclosure Quality? Presented by Dr Kai Wai Hui Associate Professor Hong Kong University of Science and Technology #2012/13-13 The views and opinions expressed in this working paper are those of the author(s) and not necessarily those of the School of Accountancy, Singapore Management University.

2 Voluntary Disclosure during Credit Watches: Do Credit Rating Agencies Concern about Disclosure Quality? Kai Wai Hui* Department of Accounting Hong Kong University of Science and Technology Zhu Lui Department of Accounting and Law University at Albany, SUNY October 2012 Preliminary

3 Voluntary Disclosure during Credit Watches: Do Credit Rating Agencies Concern about Disclosure Quality? Abstract: This paper investigates managers voluntary disclosure during credit watch periods. A credit watch warns investors of a possible rating revision and the uncertainty in a firm s future creditworthiness and, therefore, is accompanied by intense demand for information. We investigate 1) whether managers disclose more information during credit watches; 2) whether managers strategically disclose biased information in response to credit watches, and 3) whether and how effectively credit rating agencies monitor managers voluntary disclosure in such a setting. Using credit watch data from Moody s, we report that 1) management earnings forecast frequency is higher during credit watches, 2) compared with non-watch periods, management earnings forecasts disclosed during credit watches are more optimistically biased and less accurate in case of downward watches, but less optimistically biased and more accurate in the case of upward watches, and 3) optimistically biased and less accurate forecasts issued during credit watches are not associated with resolutions of downgrade watches, but are associated with less favorable resolutions of upgrade watches. Our findings suggest that managers voluntary disclosure increases during credit watches, but the credibility of forecasts depends on the direction of credit watch. Rating agencies play an important but limited role in monitoring the credibility of voluntary disclosures.

4 Voluntary Disclosure during Credit Watches: Do Credit Rating Agencies Concern about Disclosure Quality? I. INTRODUCTION The accounting literature suggests that management forecasts are an important channel used by the management to adjust market expectations (Ajinkia and Gift 1986) which accounts for 66% of accounting-based information provided to the market (Beyer et al. 2010). However, managers may issue biased information, especially when there is significant uncertainty about future performance (Roger and Stocken 2005). This paper examines management forecasts during credit watches. Given that credit rating agencies engage in private information production to discover managers superior information (e.g. Healy and Palepu 2001), we also examine whether credit rating agencies monitor the disclosure quality during credit watches. A credit watch is a rating procedure publicly announced by credit rating agencies. When credit rating agencies expect a firm s creditworthiness to undergo a significant change but cannot make an immediate rating decision, they place the firm on a credit watch for a possible rating revision. Literature shows that credit watches account for a significant portion of rating revisions (Chung et al. 2012). Since a rating revision has significant impact on a company s stock/bond price and future financing costs (Hand et al. 1992; Dhaliwal and Reynolds 1994; Dichev and Piotroski 2001), being put on credit watch triggers significant demand for additional information from outsiders. Yet little is known on whether and how managers respond to this information demand via voluntary disclosure amid such a critical event. Nor is there any evidence about whether credit rating agencies, important information intermediaries in the financial market with information advantages compared to many market participants (Healy and Palepu 2001; Jorion et 1

5 al. 2005), monitor the quality of managers voluntary disclosure. 1 Therefore, we study managers voluntary disclosure during credit watch periods, including disclosure frequency, content and bias, for better understanding of managers behaviors of voluntary disclosure and the monitoring role potentially played by the rating agencies. To assess management disclosure during credit watch and rating agencies monitoring of disclosure quality, we investigate three related research questions. First, we study whether managers of on-watch firms disclose more information in response to increased information demand by issuing management earnings forecasts during credit watch periods. Since credit watch may soon lead to rating changes, credit watch placements draw investors attention regarding firms future performance and creditworthiness. Therefore, we predict that firms are more likely to issue management earnings forecasts in response to the increased information demand after being put on credit watches. We further examine whether managers are more likely to issue earnings forecasts when the credit watch is for downgrade than in cases of upgrade. Extant literature suggests that bond investors have limited upside payoffs and are more sensitive to negative news than to positive news (Plummer and Tse 1999). Equity investors also react to downgrades more than to upgrades. For example, Hand et al. (1992) report that stock/bond price reactions to downgrades are much stronger than to upgrades. Given the significant impacts of rating downgrades on firms future financing costs and investment constraints, failing to warn investors about the deterioration of creditworthiness in advance before rating downgrades may significantly increase on-watch firms litigation risk (e.g. Skinner 1994). We, therefore, predict that firms are more likely to issue management earnings forecasts in response to credit watches for rating downgrades. 1 Ajinkia et al. (2005) establish the critical role of corporate governance in maintaining credibility of voluntary disclosures. 2

6 Second, we investigate the quality of management earnings forecasts issued during credit watch periods by examining forecast bias and accuracy. The uncertainty accompanying credit watches makes it difficult for outsiders to assess the truthfulness of managers voluntary disclosures (Roger and Stocken 2005). This difficulty in assessing the credibility of managers disclosures along with managers incentives to avoid the significant negative impact of rating downgrades (or to benefit more from rating upgrades) on firm value may induce bias in voluntary disclosures. In addition, given the substantial cost of downgrades (e.g., the large negative market reaction to downgrades, higher future financing costs and more stringent debt/loan covenants, etc.) and investors asymmetric reactions to bad/good news in the bond market, managers may have stronger incentives to issue earnings forecasts biased upwards during credit watches for downgrades than during upgrades. Overall, we predict that management earnings forecasts issued in credit watch periods are less accurate/more biased (relative to actual earnings) than management earnings forecasts issued in other periods, especially when credit watches are for possible downgrades. However, as an alternative hypothesis, rating agencies may deter managers from issuing biased forecasts. Credit rating agencies are considered to be sophisticated users of financial information and engage in private information production to uncover managers private information, thereby helping mitigate agency problems between managers and outsiders (Healy and Palepu 2001). More importantly, credit rating agencies have private communications with managers and, after the passage of Regulation FD, have the privilege to access private information that may be unavailable to other outsiders (Jorion et al., 2005). Credit rating agencies thus are better equipped to detect management misbehavior. Therefore, credit rating 3

7 agencies may be able to undo biases in management disclosures when formulating watch resolutions. Credit watch resolutions released after credit reviews can serve as an effective verification of adequacy and reliability of management disclosures. Rating agencies may even consider the accuracy of management forecasts as signals of managers talent (e.g. Truemen 1986; Kasznik 1999; Healy and Palepu 2001) when assessing future credit risks. Therefore, credit rating agencies can play a monitoring role in improving the transparency and quality of management disclosure. We expect that management forecasts issued during watch periods are less optimistically biased and more accurate compared with those issued in non-watch periods. Lastly, we investigate whether rating agencies consider disclosure quality when reaching credit watch resolutions. To this end, we examine two properties of credit watches, the watch duration and watch resolution. Timely credit rating revisions are important to investors and regulators (Cheng and Neamtiu 2008). While rating agencies claim to maintain, on average, a 90-day review period for credit watches, actual descriptive statistics reported by prior research show considerable variation in watch durations (Keenan et al. 1998; Bannier and Hirsch 2010; Chung et al. 2012). Since information provided by managers during credit watch periods is an important input for watch resolutions (Keenan et al. 1998; S&P Corporate Rating Criteria 2006), we expect that management forecasts of higher quality (i.e., less biased and more accurate) should facilitate rating agencies credit analysis and therefore lead to shorter watch durations. We further study the relationship between rating resolution and forecast quality. Prior studies (e.g., Truemen 1986; Kasznik 1999; Healy and Palepu 2001) suggest a reputation effect of disclosure. That is, accurate management forecasts indicate managers ability to accurately forecast future performance and to manage business in a challenging environment. Similarly, credit rating agencies may consider whether managers deliver the promises made in management 4

8 forecasts as an indicator of the ability to uphold their promises to debt holders. As a result, we expect that firms issuing more accurate and less biased forecasts are more likely to receive favorable watch resolutions. Moreover, prior research shows that downgrade watches are, on average, resolved in shorter periods than upgrade watches (Keenan et al. 1998; Chung et al. 2012), which suggests that rating agencies provide more timely resolutions for downgrade watches than for upgrade watches. The trade-off between the accuracy and timeliness of rating revisions has always been a concern for agencies (Cheng and Neamtiu 2008). A shorter watch duration constrains the efforts put in to resolve the uncertainty of a firm s future credit risk and results in greater difficulty to detect bias in management disclosures. To the extent the relatively longer duration of upgrade watches enables rating agencies to better monitor quality of disclosure, we expect the relationship between forecast bias/accuracy and favorable rating resolutions to be stronger during upgrade watches than during downgrade watches. In sum, we predict that there is a positive association between the accuracy of management earnings forecasts and favorable watch resolutions, especially during upgrade credit watches. We identify a sample of 519 forecasts issued during Moody s credit watch reviews (named Watchlist by Moody s) from 1996 to 2009 for 251 firms. We first document that firms are more likely to release management earnings forecasts in credit watch periods than in non-watch periods. This is consistent with the notion that firms use management earnings forecasts to meet investors information demand and to reduce the information asymmetry between managers and outsiders. We also find that firms are more likely to issue management earnings forecasts during credit watches for downgrades than during credit watches for upgrades, consistent with the notion that firms face stronger information demand during downgrade watch periods. 5

9 We next examine the quality of management earnings forecasts issued during Moody s Watchlist review periods. First, we find that management earnings forecasts are on average more optimistically biased during credit watch periods than in non-watch periods (i.e. managers forecast earnings are higher than the realized earnings when firms are on watch for possible rating changes). This is consistent with managers incentive to optimistically bias their public disclosure during credit watches to manage public expectations. Second, we find that the quality of managers earnings forecasts is associated with the direction of the intended rating changes announced upon watch placements. Compared with non-watch periods, managers issue more optimistically biased and less accurate earnings forecasts during downgrade watches but less optimistically biased and more accurate earnings forecasts during upgrade watches. Together, our findings suggest that managers strategically determine the quality of their disclosure during the watch periods. However, we also provide evidence that rating agencies seem to monitor the disclosure quality and their monitoring is more effective in cases of upgrade watches than for downgrades. This suggests that the emphasis on timeliness in downgrade decisions may have impaired rating agencies monitoring of the quality of forecast earnings information issued by on-watch firms. We further investigate rating agencies monitoring role by examining the association between the quality of management earnings forecasts and two properties of credit watches the duration and the resolution. We find that lower quality earnings forecasts issued during credit watch periods prolong the duration of the watches, especially for upgrades. This negative association is observed only for upgrade watches, and not for downgrade watches. These findings suggest that accurate forecasts facilitate timely watch resolution and have a positive impact on obtaining favorable resolution of upgrade watches. Combined with our observation 6

10 that management earnings forecasts issued during upgrade watches are less optimistically biased and are more accurate, credit rating agencies apparently do consider the quality of managers voluntary disclosure during watch periods and their monitoring is effective in cases of upgrades. Our findings support the notion that credit rating agencies play a governance role and help improve disclosure quality. Our paper contributes to the literature in the following ways. First, our paper addresses an important question of whether managers disclose credible information in response to the market s demand for additional information during credit watches, an important event that reveals critical information to both creditors and equity investors. We provide for the first time the evidence that managers do respond to such demand by disclosing additional information but also take the opportunity to influence outsiders perspectives of their firms. By examining firms voluntary disclosures in an event-like setting, our paper provides additional evidence for understanding managers incentives for voluntary disclosures, as well as insights to investors on how to interpret the publicly disclosed information during credit watches. Second, our paper is the first to explore credit rating agencies role in monitoring the quality of voluntary financial disclosures. Prior studies have mainly focused on the role of rating agencies as information intermediaries in financial markets. We investigate the frequency and quality of voluntary disclosures probably triggered by credit watches and its consequences for rating actions. We find increased amount of voluntary disclosure following rating agencies watch placements. We also find that rating agencies consider disclosure quality. Specifically, optimistically biased and low accuracy forecasts lead to longer credit watch durations whereas firms on upgrade watches are less likely to be upgraded when their earnings forecasts released during watches are upwardly biased and less accurate. Accordingly, we find improved disclosure 7

11 quality during upgrade watches. Nevertheless, while credit rating resolutions are apparently not affected by disclosures, the overall magnitude of bias in management earnings forecasts during watch periods, especially during downgrade watches, suggests that rating agencies play a limited role in monitoring disclosure quality. The rest of the paper is organized as follows. Section 2 reviews the related literature and develops our main hypotheses. Section 3 presents the research methodology. Section 4 reports descriptive statistics of the sample and results of the empirical analysis. Section 5 concludes. II. CREDIT WATCH AND PROPERTIES OF MANAGEMENT FORECAST 2.1. Likelihood of Issuing Management Earnings Forecasts during Credit Watches We first examine the likelihood of managements issuing earnings forecasts during credit watches. Firms are more likely to issue management earnings forecasts during credit watches for two reasons. First, credit watch placements cause intense demand for information from both credit rating agencies and investors. The rating agencies claim that putting firms on credit watches instead of direct change in rating is mainly driven by the uncertainty in firms future creditworthiness. Rating agencies collect additional information, including inputs from managers of the firms under review, for analysis during credit watch reviews. 2 Therefore, a credit watch placement itself represents rating agencies demand for additional information. In addition, a credit watch is a public warning from credit rating agencies that signals to investors a significant likelihood of a change in an on-watch firm s credit rating. In credit watch announcements, rating agencies express their concerns about the changes in the on-watch firm s 2 For example, Moody s states that during the course of a rating review, Moody s solicits information from the issuer in order to understand plans either for addressing the problem, or for taking advantage of the opportunities that have inspired the review (Keenan et al. 1998, 3). 8

12 financial and risk profile, which may draw investors attention and induce them to demand additional information. Empirical evidence shows that rating agencies are more likely to put a firm on watch before rating change if there is greater demand for information by investors (Chung et al., 2012). Moreover, a negative rating change may significantly increase a firm s financing cost and prior studies show significant negative reactions in both equity and bond markets (Hand et al., 1992). As such, a credit watch accompanies strong demand for additional information during the watch period by credit rating agencies to decide whether a rating change is warranted, as well as by general investors to investigate whether a firm s creditworthiness has significantly changed and to predict a possible rating change. Managers acting on behalf of shareholders, therefore, have incentives to disclose additional information regarding potential changes in firms creditworthiness in response to demand from either rating agencies or investors in general. Second, credit watch may increase the tendency to make voluntary disclosure by affecting managers costs/benefits assessments. A credit watch reveals rating agencies private information of a firm s future performance. Its impact is two-fold: 1) it reduces the potential benefits that managers may earn by withholding information which can be inferred, at least to some extent, from rating agencies announcement of watch placement; and 2) it alleviates managers concerns about the proprietary cost of disclosure because credit watch at least partly publicizes managers private information. 3 Therefore, credit watch induces managers to issue 3 Managers might be reluctant to issue management forecasts to correct market expectations if they worry that management forecasts may disclose sensitive information to competitors (Bamber and Cheon 1998). 9

13 management forecasts by reducing the benefit of non-disclosure as well as the cost of disclosure. 4 In summary, credit watch placements trigger demand for information from market participants and lower the hurdles of voluntary disclosures and, therefore, may encourage managers to provide to the market their own assessments of firms future performance. We present our first hypothesis as follows. H1A. Firms are more likely to issue management earnings forecasts after being placed on credit watch. Prior research has shown that managers are more likely to issue voluntary disclosures in anticipation of negative performance shock (Kasznik and Lev 1995; Skinner 1994). Litigation risk is a major concern of managers when considering timely disclosure to pre-empt the bad news (Skinner 1997). Managers are more likely to issue management forecasts conveying bad news than good news, especially when facing greater litigation risk (Roger and Stocken 2005). To this end, credit watches for possible downgrades may imply additional litigation risk. Empirical studies show that downgrades, but not upgrades, have significant impacts on firms stock returns at the time of and during periods after the rating changes (Hauthousan and Leftwich 1984; Hand et al. 1992; Dichev and Piotroski 2001). Rating downgrades also increase firms future financing costs and constrain firms future investment activities. Failing to warn investors about the downside risk in advance may, therefore, significantly increase firms litigation risk. As such, downgrade credit watches may further increase the propensity of disclosure of additional information by managers during watch periods. We present our second hypothesis as follows. 4 The greater information demand during credit watches may increase disclosure cost by increasing the litigation risk of presenting misleading information, although prior studies suggests that litigation cost of non-disclosure dominants (e.g. Field et al 2005). 10

14 H1B. Firms are more likely to issue management earnings forecasts after being placed on credit watches for downgrades than upgrades Biases in Management Earnings Forecasts during Credit Watches Extant literature suggests that although in general, management earnings forecasts are credible (Pownall and Waymire 1989), managers can make biased forecasts, especially when the market s ability to detect bias is limited (Bamber et al., 2009). The literature also suggests that managers may strategically use voluntary disclosure to influence stock prices amid certain important corporate events, for instance, before seasonal equity offerings (Lang and Lundholm 2000; Jo and Kim 2007). During credit watch periods, managers are more likely to provide biased forecasts because of two reasons. First, the cost of issuing optimistically biased forecasts is lower. Compared to non-watch periods, there is greater uncertainty during credit watch periods, which increases the difficulty that rating agencies and investors face in detecting and filtering the bias in the issued forecasts. Second, the benefit of issuing biased forecast is higher. In the debt market, management earnings forecasts have a greater impact on investors expectations of future performance when there is greater uncertainty about future performance (Shivakumar et al. 2011). Optimistic forecasts issued during credit watch periods may help shape investors perspectives on the issue at stake, clarify rating agencies concern over future performance and control the damage caused by unfavorable comments released by rating agencies. Therefore, we present our hypothesis regarding the potential bias in management earnings forecasts issued in credit watch periods as follows. H2A. Compared to actual earnings, management earnings forecasts issued during credit watch periods are more optimistically biased and less accurate than forecasts issued in other periods. In addition, managers may have stronger tendency to issue optimistically biased earnings forecasts during downgrade watches than during upgrade watches. Rating downgrades result in 11

15 significant costs to the firm, including higher future financing costs, more stringent debt/loan covenants and a smaller pool of institutional investors. This leads to significant negative stock/bond price reactions. On the contrary, market reactions to upgrades are usually of much smaller magnitude. The asymmetric stock/bond valuation consequences of rating downgrades and upgrades offer greater incentives for managers to issue optimistically biased earnings forecasts to nudge market expectations upwards (or prevent them from further sliding). We therefore predict a higher optimistic bias and lower forecast accuracy of management earnings forecasts issued during downgrade watch periods. 5 H2B. Compared to actual earnings, management earnings forecasts issued during downgrade credit watch periods are more optimistically biased and less accurate than forecasts issued in other periods Rating Agencies Monitoring Role during Credit Watches A notable factor in examining management earnings forecasts during credit watches is the potential monitoring role played by the involved credit rating agencies. According to the rating methodology published by rating agencies, rating change decisions are based on public information, private information from managers and rating agencies own research. Credit rating agencies are arguably sophisticated users of financial information having the capability to interpret the obtained information effectively. Credit rating agencies carry the risk of losing reputation if they make incorrect rating revisions based on biased information provided by managers of on-watch firms. The passage of Regulation FD has further enhanced credit rating agencies role as important information intermediaries by granting them the privilege to access managers private 5 Prior literature suggests that firms may face litigation risk if the forecasts are misleading. However, Field et al. (2005) finds that the litigation risk of not warning the investors dominate the disclosure decision and the implications of litigation from misleading the market is not significant in the derterminates of forecast issuance. 12

16 information unavailable to other market participants. The rating agencies privileged access to private information and sophisticated information processing capabilities, therefore, enable them to detect bias in management forecasts when formulating rating resolutions. The potential inconsistency between optimistically biased forecasts and unfavorable watch resolutions thus helps deter managers from issuing biased forecasts by increasing the costs of misleading forecasts. As such, rating decisions at watch resolutions can serve as a mechanism for verification of the credibility of managers earnings forecasts. In addition, prior literature suggests that disclosure accuracy is an important indicator of managers ability to manage the business (e.g. Truemen 1986; Healy and Palepu 2001). If rating agencies use this valuable information when formulating their resolutions, failing to provide accurate forecasts results in significant reputation costs to the management and may lead to less favorable rating resolutions. Overall, we expect that effective monitoring by rating agencies during credit watches induces more accurate and less biased management earnings forecasts during credit watch periods. We present an alternative hypothesis to H2A, on disclosure quality, as follows: H3A. Compared to actual earnings, management earnings forecasts issued during credit watch periods are less optimistically biased and more accurate than forecasts issued in other periods. Given bond holders asymmetry payoffs between upgrades and downgrades and the regulation requirement to maintain a minimum rating for the firms, rating agencies are under substantial pressure to provide timely revisions of downgrade watches. Consistent with this, prior research shows that it takes a significantly longer period for rating agencies to resolve upgrade watches than downgrade watches (Keenan et al. 1998; Chung et al. 2012). The demand for timely rating revisions raises the concerns on the trade-offs between timely rating revisions and the accuracy of ratings by the rating agencies and regulators (Cheng and Neamtiu 2008). Longer 13

17 review periods in cases of upgrade watches enable rating agencies to exert more effort and caution when evaluating on-watch firms creditworthiness. We expect that rating agencies monitoring of disclosure quality, if any, is more effective during upgrade watches than during downgrades. Therefore, optimistically biased management earnings forecasts may be less effective in influencing rating agencies decisions during upgrade watches, which consequently reduces on-watch firms incentive to issue upward biased management forecasts. We present Hypothesis H3B as follows. H3B. Compared to actual earnings, management earnings forecasts issued during upgrade credit watch periods are less optimistically biased and more accurate than forecasts issued in other periods. If rating agencies monitor disclosures, quality of management forecasts may affect how rating agencies proceed with credit analysis during credit watches. We therefore further examine two properties of credit watches the watch duration and whether the watch resolution is favorable to an on-watch firm. The duration of a credit watch is the length of time that credit rating agencies take for information collection, analysis and resolution of the uncertainty in on-watch firms creditworthiness. Watch duration may be related to availability and quality of information required for credit analysis (Keenan et al. 1998; Bannier and Hirsch 2010; Chung et al. 2012). Other things being equal, the lower the quality of information provided by managers to rating agencies during credit watches, the more are the time and effort rating agencies need to spend on resolving credit watches, and hence a longer watch duration. We expect that management forecasts that are less biased and more accurate facilitate better analysis and, therefore, lead to shorter watch duration. We present our hypothesis on watch duration as follows. H4A. The credit watch duration is shorter if management earnings forecasts are more accurate and less optimistically biased. 14

18 In addition, following our expectation in H3B that rating agencies monitoring may be more effective during upgrade watches, we expect the relationship between forecast bias/accuracy and watch duration to be stronger during upgrade watches. H4B. The credit watch duration is shorter if management earnings forecasts are more accurate and less optimistically biased during upgrade watches. The second credit watch property we examine is the watch resolution. We focus on whether the likelihood of receiving a favorable watch resolution is related to the quality of management earnings forecasts issued during credit watches. 6 Prior studies (e.g. Truemen, 1986;, Kasznik 1999, Healy and Palepu 2001) suggest a reputation effect of disclosure. That is, accurate management forecasts indicate managers ability to accurately forecast future performances and to manage business in a challenging environment. If rating agencies are sophisticated and do discount overly optimistic information from managers, following the reputation hypothesis, we would expect rating agencies to incorporate the perceived quality of management forecasts in their credit resolutions. In other words, if credit agencies consider disclosure quality as an indicator of the ability of the management team to deliver their promises to the debt holders, a firm issuing more accurate forecasts is more likely to have a favorable resolution. Therefore, we develop our Hypothesis H5A as follows. H5A. The credit watch resolution is more favorable if management forecast is more accurate and less optimistically biased. 6 One argument is that biased forecasts may be effective in influencing rating decisions only if the realized earnings are announced after watch resolutions. We therefore conduct a robustness check for this test by excluding forecastwatches with earnings announced in the watch periods. Our result is robust if we limit forecasts to those with actual earnings announcements after the watch resolutions. 15

19 In addition, following our expectation in H3B that rating agencies play a stronger monitoring role when concluding upgrade credit watches, we expect the relationship between forecast bias/accuracy and rating resolution to be stronger. H5B. The credit watch resolution is more favorable if management earnings forecast is more accurate and less optimistically biased during upgrade watches. III. RESEARCH DESIGN 3.1 Sample selection We collect credit watch data over the period from 1996 to 2009 from Moody s Default Risk Service. This database includes Moody s credit rating actions on bond issuers and issues, including Moody s credit watch actions Watchlist reviews. Each Watchlist review is uniquely identified with the firm under review, the starting and resolution dates of the review, the intended rating action announced at the Watchlist placement date, and the actual rating action at the Watchlist resolution date. Therefore, we are able to identify the unique credit watch period for each sample firm. There are two types of Watchlist reviews, one for bond issuers (i.e. possible rating changes at the firm level for bond issuers as business entities) and the other for bond issues (i.e. possible rating changes at the security level for individual bonds). In this paper we focus only on Watchlist reviews for bond issuers at the firm level because such reviews indicate significant changes in the overall creditworthiness of firms and, therefore, provide stronger incentives for firms to disclose management earnings forecasts. We collect management earnings forecasts along with analyst earnings forecasts and actual earnings from Thomson Financial s First Call database. We only include management earnings forecasts of earnings per share (EPS) issued by US firms. Given that whether to provide 16

20 management earnings forecasts can be affected by corporate disclosure policy, we only focus on firms that issued at least one management earnings forecast between 1996 and If a management earnings forecast is issued during credit watch (i.e. after the starting date and before the resolution date of a Watchlist review), we classify the management earnings forecast as a watch-period forecast; otherwise we classify it as a non-watch-period forecast. To control for the policy of credit rating agencies in following and selecting watch firms, we also restrict our analysis to firms that had ever received credit watches. Since we are comparing characteristics of management forecasts for the same group of firms between watch and non-watch periods, this helps control for time-invariant firm effects that may affect corporate disclosure and focus on the possible impact of credit watch on management earnings forecast. 3.2 Propensity of management earnings forecast To examine the association between credit watches and management earnings forecasts, we first investigate the probability of issuance of management earnings forecasts, defined by a dummy variable, ISSUE. ISSUE = 1 if a firm issues a management earnings forecast during the credit watch period, and 0 otherwise. If credit watches represent rating agencies and investors demand for information and firms on watch respond to such demand by issuing management earnings forecasts, we should find a positive association between credit watch placements and the issuance of management earnings forecasts. In addition, we examine the propensity of issuing management earnings forecasts in upgrade and downgrade watch periods to test if firms are more likely to issue forecasts in downgrade watch periods than in upgrade watch periods.. We conduct both univariate and multivariate tests to examine these associations. We first compare the likelihood of issuing management earnings forecasts in fiscal quarters that overlap with credit watch periods, with the likelihood of issuing management earnings forecasts in fiscal 17

21 quarters that do not overlap with credit watch periods. We then follow Ajinkya et al. (2005) and use the following regression specifications to control for other determinants of voluntary disclosure. ISSUE = α 0 + α 1 WATCH + α 2 SIZE + α 3 MB + α 4 RD + α 5 ROASTD + α 6 IO +α 7 AF + α 8 FESTD + α 9 LEV + α 10 REGFD + α 11 LITI + α 12 New+ α 13 Loss + α 14 QCAR + Year Dummies + ε, (1) ISSUE = α 0 + α 1 DWATCH + α 2 UWATCH + α 3 SIZE + α 4 MB + α 5 RD + α 6 ROASTD + α 7 IO +α 8 AF + α 9 FESTD + α 10 LEV + α 11 REGFD + α 12 LITI + α 13 New+ α 14 Loss + α 15 QCAR + Year Dummies + ε, (2) where: WATCH = 1 if a fiscal quarter overlaps with a credit watch period, and 0 otherwise; DWATCH = 1 if a fiscal quarter overlaps with a credit watch period for downgrade, and 0 otherwise; UWATCH = 1 if a fiscal quarter overlaps with a credit watch period for upgrade, and 0 otherwise; SIZE = log of market value of common equity; MB = market-to-book ratio; RD = R&D expense scaled by total assets; ROASTD = Standard deviation of ROA in the past 6 years; IO = total institutional ownership; AF = number of analysts following a firm in the previous quarter; FESTD = standard deviation of analyst forecasts, scaled by the median forecast; LEV = financial leverage; REGFD = 1 if a management earnings forecast is issued in a post-reg FD period. LITI = 1 if a firm is in one of the following industries defined by SIC4 (biotechnology and , computers and , electronics and retail ), and 0 otherwise (Francis, Philbrick and Schipper, 1994). New = 1 if earnings growth from last year and 0 otherwise. Loss = 1 if the firm has loss and 0 otherwise. QCAR = Abnormal stock returns during the quarter. We control relevant firm characteristics including size (SIZE), market-to-book ratio (MB), R&D intensity (RD), and control for the predictability of future earnings using earnings volatility (ROASTD). To control for the information environment and governance role played by sophisticated investors and analysts, institutional ownership (IO), analyst following (AF), analyst forecast dispersion (FESTD) and financial leverage (LEV) are also added as controls. We also 18

22 control for litigation risk (LITI). Since Reg. FD affects firms voluntary disclosure, we also include a dummy variable, REGFD, to identify management earnings forecasts issued in the post-reg. FD periods. In the end, we also add the control for the total amount of information revealed in the quarter to control for any special information events that might drive our findings, which may also related to the watch. 3.3 Accuracy and bias of watch-period management earnings forecasts We assess the quality of management earnings forecasts issued in credit watch periods based on forecast accuracy and bias. We define accuracy, AFE, as the absolute value of the difference between actual earnings per share and management forecast of earnings per share, scaled by stock price at the beginning of the fiscal quarter. We define bias, FE, as management forecast of earnings per share minus actual earnings per share, scaled by stock price at the beginning of the fiscal quarter. A management earnings forecast is optimistically biased if FE>0. We run the following regressions to examine the accuracy and bias of management earnings forecasts to see if firms issue opportunistic management earnings forecasts to influence rating agencies decisions and investors perception of future performance: FE = η 0 + η 1 WATCH + η 2 SIZE + η 3 MB + η 4 RD + η 5 ROASTD + η 6 IO + η 7 AF + η 8 FESTD + η 9 LEV + η 10 REGFD + η 11 Liti + η 12 New + η 13 Loss + η 14 ANNUAL + Year Dummies + ε, (3) AFE = δ 0 + η 1 WATCH + η 2 SIZE + η 3 MB + η 4 RD + η 5 ROASTD + η 6 IO + η 7 AF + η 8 FESTD + η 9 LEV + η 10 REGFD + η 11 Liti + η 12 New + η 13 Loss + η 14 ANNUAL + Year Dummies + ε, (4) where the explanatory variables are defined in Equations (1) and (2). ANNUAL = 1 if a forecast is on annual earnings, and 0 otherwise; 3.4 Watch resolution and management earnings forecasts 19

23 Finally, we investigate whether there is an association between watch duration/resolution and quality of management earnings forecasts. If credit rating agencies are sophisticated to assess the quality of management earnings forecasts, we expect that firms issuing high-quality management earnings forecasts are more likely to have short watch durations and receive favorable watch resolutions than firms issuing low-quality management earnings forecasts, all else being equal. We run the following regressions to examine the effect of management earnings forecasts on the durations and resolutions of credit watches. The dependent variable, WDUR, is the number of calendar days between a credit watch addition and its resolution; WRSLT, is a dummy variable equal to 1 if the resolution of a credit watch is favorable to onwatch firms (i.e. no downgrade after a negative credit watch and upgrade after a positive credit watch) and 0 otherwise. The explanatory variables of our interest are forecast bias (FE) and forecast accuracy (AFE). 7 WDUR = θ 0 + θ 1 FE or AFE + θ 2 SIZE + θ 3 MB + θ 4 RD + θ 5 ROASTD + θ 6 IO + θ 7 AF + θ 8 LEV + θ 9 LITI + θ 10 NEW + θ 12 LOSS + θ 13 ANNUAL + Year Dummies + ε, (5) WRSLT = θ 0 + θ 1 FE or AFE + θ 2 SIZE + θ 3 MB + θ 4 RD + θ 5 ROASTD + θ 6 IO + θ 7 AF + θ 8 LEV + θ 9 LITI + θ 10 NEW + θ 12 LOSS + θ 13 ANNUAL + Year Dummies + ε, (6) where the explanatory variables are defined in Equations (1) to (4). IV. EMPIRICAL RESULTS Table 1 summarizes the sample selection procedures and provides descriptive statistics of the sample of 7,277 management earnings forecasts. We use Moody s Watchlist data. Panel A shows that we start with 10,502 management earnings forecasts issued by US firms that issued at 7 The actual earnings that management forecasts are forecasting may be realized during the watch period, or they may be realized after the watch period. For forecasts that are realized during the watch period, the observed forecast errors are used by the rating agencies to access the reputation of the managements. For forecasts that are unrealized during the watch period, the rating agencies use the expected forecast errors in their decisions. In the second case, we use the ex-pose forecast errors as an empirical proxy. Our results are robust if we measure forecast errors using the difference between analyst consensus at watch period ends and management forecasts. 20

24 least one forecast over the period from 1996 to 2009, and had at least one credit watch. After merging the data with IBES, CRSP and Compustat, we are able to identify 519 watch-period and 6,766 non-watch-period management earnings forecasts. 8 We also examine the distribution of the sample and the type of management earnings forecasts issued during credit watch periods and in other periods, and report the descriptive statistics in Panel B of Table 1. In general, we observe similar patterns in the format and horizon of management earnings forecasts issued in watch periods and non-watch periods. This suggests that firms do not issue more precise or longer horizon forecasts during watch periods. We also observe similar industry distributions of management earnings forecasts. Table 2 provides summary statistics of the variables for the sample management earnings forecasts used in our analysis. We also provide descriptive statistics of characteristics of sample firms that are related to management earnings forecasts as identified in the literature. 4.1 Likelihood of issuing management earnings forecasts We first examine the association between credit watch and the likelihood of on-watch firms issuing management earnings forecasts. Table 3 reports the frequency of management earnings forecasts in credit watch periods and in other periods. Panel A shows that overall, regardless of whether a watch is for a downgrade or an upgrade, firms are more likely to issue management earnings forecasts in credit watch periods than in other periods. For firms that issued at least one management earnings forecast from 1996 to 2009, they issued management earnings forecasts in about 46% of credit-watch-related fiscal quarters while in only 35% of nonwatch fiscal quarters. The difference in the frequency of issuing management earnings forecasts is economically and statistically significant (11.3% with p-value less than 0.01). 8 We only focus on point and range forecasts in order to calculate the forecast errors. 21

25 We further break down the watch periods into upgrade watches and downgrade watches. 48% firms issue management forecasts during downgrade watches and 43% firms issue forecasts during upgrade watches. Both results are significantly higher than the non-watch firm quarters at 1% level. In addition, consistent with concerns about litigation risk, firms are more likely to voluntarily make disclosures when they are put on watch for downgrades than upgrades. The difference is 5.5% significant at two-tail 1% level. The results reported in Panel A of Table 3 are in support of Hypothesis 1 that firms are more likely to voluntarily disclose information when put on watch by credit rating agencies for possible rating changes, especially for downgrades. Since prior literature suggests that whether to issue management earnings forecasts might be related to other firm characteristics, we further perform multivariate analyses to examine the association between credit watch and the issuance of management earnings forecasts. Table 3 Panel B reports the results of regressing the issuance of management earnings forecasts on credit watch placement, controlling for relevant firm characteristics including size (SIZE), firm growth using market-to-book ratio (MB) and R&D intensity (RD), and uncertainty to predict future earnings using earnings volatility (ROASTD). RD is significantly positive and ROASTD is significantly negative, suggesting R&D intensive firms issue more forecasts to reveal information on developments, and volatile earnings indicates less predictable future earnings. We also control for governance using institutional ownership (IO), other information intermediaries analyst following (AF). Consistent with Ajinkia et al. (2005), institution holders improve management forecast quality. Uncertainty in analysts earnings forecasts analyst forecast dispersion (FESTD) is negative, which indicates the high uncertainty in predicting future earnings reduces forecast frequency. Firms issue management forecasts to mitigate the litigation risks and LITI is significantly positive. Since Reg. FD affects firms voluntary 22

26 disclosure, we also include a dummy variable, REGFD, to identify management earnings a forecast issued in the post-reg FD periods and is significantly positive. Loss firms issue fewer forecasts due to high uncertainty associated with future earnings and LOSS is significantly negative. QCAR is significantly positive suggesting firms with more positive news in the quarter issues more forecasts. Columns A and B of Panel B reports the regression results for all credit watch placements regardless of the direction of possible rating changes. The coefficient on WATCH is and significant at 1% level. This is consistent with the univariate comparison result in Panel A and supports our first hypothesis that firms are more likely to issue management earnings forecasts after being put on credit watch. We further exam whether firms are more likely to issue management earnings forecasts during downgrade watches. Specifically, we run multivariate regressions by separating downgrade watches (DWATCH) and upgrade watches (UWATCH), and report the results in Columns C and D of Panel B Table 3. Two observations emerge. First, both coefficients on DWATCH and UWATCH are significantly positive, further supporting Hypothesis 1 that firms are more likely to issue management earnings forecasts during watch periods regardless of the direction of watch. Second, the coefficient on DWATCH is significantly more positive (0.306 with t-statistics 6.65) than that on UWATCH (0.153 with t-statistics 2.52). The difference is reported at the bottom of the table with F-statistics of 4.21, significant at 5% level. This is consistent with firms being more likely to issue management earnings forecasts during downgrade watches. The results in Table 3 suggest that firms on credit watch, especially those on downgrade watch, are more likely to use voluntary disclosure to reveal additional information to the market. 4.2 Bias and accuracy of watch-period management earnings forecasts 23

27 As we previously suggested, we expect firms on credit watch to have conflicting incentives when providing management earnings forecasts. On the one hand, managers want to provide credible information to the market to satisfy investors demand for information and to mitigate the risk of litigation against withholding material information. On the other hand, managers have incentives to strategically disclose optimistically biased information to influence investors and rating agencies perceptions about their firms. To test how management earnings forecasts are affected by the two conflicting incentives, we first compare the accuracy (AFE) and the bias (FE) of management earnings forecasts issued in watch and non-watch periods. Panel A of Table 4 shows that compared with management earnings forecasts issued in non-watch periods, forecasts issued in watch periods are more optimistic and less accurate. The average forecast error (FE) of management earnings forecasts issued in watch periods is about twice of the error of forecasts issued in non-watch periods ( vs and the difference is statistically significant at 1% level with t-statistics of 2.42). Management earnings forecasts issued in watch periods are also less accurate than those issued in non-watch periods ( vs with t-statistics of 3.26). Panel B of Table 4 reports the results of multivariate regression of forecast bias and forecast accuracy on watch placement and other control variables. The coefficient on WATCH is positive and marginally significant in the forecast bias regression (0.001 with t-statistics 1.74) and significantly positive in the forecast accuracy regression (0.001 with t-statistics 2.15). Table 4 thus shows result consistent with Hypothesis 3 that firms on credit watch seem to be overly optimistic and less accurate in their voluntary disclosures. We also examine if firms voluntary disclosures in watch periods are related to the direction of suggested rating changes and report the findings in Table 5. Panel A of Table 5 24