Changes Over Time in the Relevance of Accounting Information in Credit Ratings

We examine the time-series change in the explanatory power of accounting information for credit ratings, denoted as ‘credit rating relevance’. The legal and reputational risks against credit rating agency (CRAs) in the U.S. have continuously risen. CRAs have an incentive to evaluate a firm’s overall creditworthiness to minimize their legal and reputational risk. Therefore, the changes in the external environment are expected to cause changes in the behavior of CRAs. We find an increasing trend in credit rating relevance, indicating that CRAs have relied more on publicly available and defendable accounting information than on privately collected information in assessing credit ratings over time. We also find that capital information primarily drives this trend compared to performance information. This is consistent with our prediction that capital information better measures the firm’s cash-generating ability in the event of default (i.e., liquidating value), while performance information tends to be declining in its quality and becomes more arguable in legal conflicts. Additional tests show that the trend is more pronounced in firms with high litigation risk and after the passage of the Dodd-Frank Act which significantly increases the legal and reputational risk of CRAs. We also show that credit rating relevance is higher for firms with high default risks. These results suggest that increases in credit rating relevance over time are related to the legal and reputational risk against CRAs.