The Effect of Credit Ratings on Voluntary Disclosure

• In Event: Credit ratings

Abstract

We use the sovereign ceiling rule to show that corporate credit rating changes have a causal effect on firm’s voluntary disclosure. The sovereign ceiling rule allows us to identify the effect of credit ratings on disclosure because it produces firm downgrades that are plausibly unrelated to firm fundamentals. Rather, these downgrades occur primarily because, by rule, the rating of the firm cannot be higher than the rating of the sovereign. We find that firms bound by the sovereign rating increase the likelihood and frequency of management guidance in the year of the sovereign downgrade. In addition, we find that this increase in voluntary disclosure is greater for firms below investment grade, for firms that rely on bank financing, and for firms with low levels of free cash flows. These results suggest that credit rating downgrades independent of firm fundamentals still generate financing frictions, and that firms respond to these frictions by increasing voluntary disclosure. We corroborate these results using an alternative setting comprised of US firms that experienced rating upgrades due to a correction in rating agency adjustments generated by an exogenous change in accounting standards. In this alternative setting, we find that firms experiencing a rating upgrade that is most likely attributable to the change in rating adjustments reduced the likelihood and frequency of management guidance, consistent with our sovereign ceiling results. Overall, our results indicate that credit rating agencies, acting as information intermediaries, have a causal effect on firms’ voluntary disclosure behavior.

Authors

• Riddha Sattam Basu, Northwestern University

• James Patrick Naughton, Northwestern University

• Clare Wang, University of Iowa