Credit Rating Agencies and Accounting Frauds

This study examines whether credit rating agencies detect accounting frauds and convey private information about these frauds before they are publicly revealed. First, using securities class-action lawsuits that involve accounting misstatements as the fraud sample, we find that compared to matched non-fraud firms, fraud firms experience more negative rating actions, such as lower abnormal ratings, a greater likelihood of rating downgrades, and a greater likelihood of negative credit watches during the four quarters prior to the fraud revelation. Next, we find that negative rating actions against fraud firms are associated with shorter fraud durations, suggesting credit rating agencies help to expose frauds in a timelier manner. Lastly, we find that as early as four quarters before the fraud revelation, rating agencies put more weight on cash flow based measures than on accounting based measures in determining the ratings of fraud firms, suggesting that rating agencies adjust their reliance on the reported financial information of fraud firms before the revelation. Overall, we conclude that rating agencies possess private information about accounting frauds prior to their public revelations and impound the information in ratings actions, which accelerate fraud detection.