1

3.3 Research Method

3.3.1 Econometric Models

So as to look at the association between the standard of accounting info and credit ratings,

the subsequent models are calculable victimization ordered supplying regression. The primary

main variable of interest in these models is that the Accrual_Quality variable that is measured

with the changed Jones model residual, the Dechow and Dichev model residuals, or the Stubben

model residuals. The second cluster of main variables of interest are the $64000 activities

earnings management variables: Abnorm_CFO, Abnorm_Disexp, Abnorm_Disexp, Real_Em1,

and Real_Em2, that are measured by victimization the of methodology made public by

Roychowdhury (2006) and Cohen and Zarowin (2010). The third cluster of main variables of

interest ar the company governance variables: E_Index, Dual_CEO, Board_Size, Board_IND%,

and Audit_Ind%, that ar measured victimisation the methodology made public by Bebchuk,

Cohen, and Ferrell (2009) and Byard, Li, and Weintrop (2006).

Ratingit = α + β1Accrual_Qualityit + β2Abnorm_CFOit + β3Abnorm_Disexpit (1)

+ β4Abnorm_Prodit + β5 Real_Em1it + β6 Real_Em2it + β7E_Indexit + β8Dual_CEOit +

β9Board_Sizeit + β10Board_IND%it + β11Audit_IND%it + β12 Sizeit + β13Oper_CFit +

β14Interest_Coverageit + β15Debt_Equityit + β16 GDPt + β17Markett + β18Restateit +

β19Industry_Dummyit + β20Year_Dummyt + є

Model 1 is operationalized in a number of different variations. The initial version of the model

excludes the Real_Em1 and Real_Em2 variables as a result of their outline measures of the

abnormal money flows (Abnorm_CFO), abnormal discretionary expenses (Abnorm_Disexp), and

 2

abnormal production (Abnorm_Prod) variables. Ulterior specifications of model one exclude the

abnormal income, abnormal discretionary expenses, and abnormal production variables however

embrace either Real_Em1 or Real_Em2. Similar changes ar created to model one with regard to the

company governance variables. Specifically, as a result of the E-Index may be a outline company

governance live, ulterior runs of model one exclude the E-Index and retain the individual company

governance variables Dual_CEO, Board_Size, Board_IND%, and Audit_IND%.

As specified below in model 2, a reduced version of model 1 is also utilized.

Ratingit = α + β1Accrual_Qualityit + β2 Sizeit + β3Interest_Coverageit + β4Debt_Equityit (2)

+ β5GDPt + β6Markett + β7Industry_Dummyit + β8Year_Dummyit + є

Additionally to the stationary rating variable (rating level) in models 1 and 2, an alternative

specification of the model was estimated with the rating variable being substituted with a change

in rating variable as seen in model

ΔRatingit = α + β1∆Accrual_Qualityit + β2∆Abnorm_CFOit + β3∆Abnorm_Disexpit (3)

+ β4∆Abnorm_Prodit + β5∆E_Indexit + β6∆Dual_CEOit + β7∆Board_Sizeit +

β8∆Board_IND%it + β9∆Audit_IND%it + β10 ∆Sizeit + β11∆Oper_CFit +

β12∆Interest_Coverageit + β13∆Debt_Equityit + β14 ∆GDPt + β15∆Markett

+ β16∆Restateit + β17∆Industry_Dummyit + β18∆Year_Dummyt + є

Where:

Dependent Variables:

Ratingit = the S&P Domestic Long-term issuer credit rating from COMPUSTAT in year t for
firm i. Measures S&P's current opinion of an associate issuer's overall trustworthiness.
 3

ΔRatingit = the change in the S&P Domestic Long-term issuer credit rating, calculated by
taking the difference between the rating variable in time, t, and the rating variable in time,
t -1.

Explanatory Variables:

Accounting Quality Variables:

Accrual_Qualityit = accrual quality measures derived from the modified Jones model,
Dechow and Dichev model, or the Stubben model in year t for firm i.

Real Activities Variables:

Abnorm_CFOit = abnormal income from operations in year t for firm i, derived from the
methodology made public in Roychowdhury (2006), a measure of real activities earnings
management.

Abnorm_Disexpit = abnormal discretionary expenses in year t for firm i, derived from the
methodology outlined in Roychowdhury (2006), a measure of real activities earnings
management.

Abnorm_Prodit = abnormal production costs in year t for firm i, derived from the
methodology outlined in Roychowdhury (2006), a measure of real activities earnings
management.
Real_Em1it = is associate combined measure of real earnings management, as outlined in
Cohen and Zarowin (2010). Calculated by multiplying abnormal discretionary expenditures
by negative one and adding the product to abnormal production costs.

Real_Em2it = is an aggregate measure of real earnings management, as outlined in Cohen

and Zarowin (2010). Calculated by multiplying both abnormal discretionary expenditures
and abnormal cash flows by negative one and adding the merchandise along.

Corporate Governance Variables:

E_Indexit = the E-index score in year t for firm i, derived from Bebchuk, Cohen, and Ferrell
(2009), an outline of company governance measurement starting from zero to six with
higher values indicating higher company governance quality (following Bebchuk, Cohen,
and Ferrell (2009)).

Dual_CEOit = indicator variable, set to 1 if the CEO is also the chair of the board, and 0
otherwise (following Byard, Li, and Weintrop (2006)).

Board_Sizeit = = the whole range of administrators serving on the board of administrators in

year t for firm i (following Byard, Li, and Weintrop (2006)).
 4

Board_IND%it = the proportion of independent directors on the board in year t for firm i
(following Byard, Li, and Weintrop (2006)).

Audit_IND%it = the proportion of independent directors on the audit committee in year t for
firm i (following Byard, Li, and Weintrop (2006)).

Firm Information Environment Variables:

Sizeit = Log of total assets in year t for firm i. Control variable.

Oper_CFit = is the operating cash of both in and out flows in year t for firm i.

Interest_Coverageit = the interest coverage ratio in year t for firm i. Calculated as financial
gain before extraordinary items scaled by interest expense. Provides a sign of the firm’s
monetary health i.e., lower quantitative relation represents a firm with worse monetary
health. Control variable.

Debt_Equityit = the debt to equity ratio in year t for firm i. Firms with higher ratios have a
higher default risk and may correspond to a lower rating. Control variable.

GDPt = the annual gross domestic product in year t. Obtained from the World Bank. Control
variable.
Markett = the overall annual market return in year t. Obtained from the data library on
Kenneth R. French's website. Control variable.

Restateit = is an indicator variable, set to one if within the past year the firm restated their
monetary statements, and zero otherwise.

Control Variables:

Industry_Dummy = indicator variables to control for industry-level effects. Measured

using the two-digit SIC code for each firm. Control variable.

Year_Dummy = indicator variables to control for year effects. Control variable.

Regulation Variables:

CRARA_Dum = an indicator variable, set equal 1 if the observation is after the year
2006, and 0 otherwise.

DoddFran_Dum = an indicator variable, set equal 1 if the observation is after the year
2010, and 0 otherwise.
 5

In order to test the effects of the CRARA and the Dodd-Frank Act, model one is

increased with a dummy variable for the CRARA tests that equals one if the observation is when

the year 2006 and zero otherwise and for the Dodd-Frank Act tests, equals one if the observation

is when the year 2010 and zero otherwise. Following the methodology from Ball and

Shivakumar (2005) model 1 is again augmented by including an interaction variable between the

CRARA or the Dodd-Frank Act dummy variable and the accrual quality variable (Accrual

Quality x CRARA_Dum or Accrual Quality x DoddFran_Dum Implementing these changes

results in the following models (variable descriptions remain the same as in models 1

Ratingit = α + β1Accrual_Qualityit + β2Abnorm_CFOit + β3Abnorm_Disexpit

(4) + β4Abnorm_Prodit + β5E_Indexit + β6Dual_CEOit + β7Board_Sizeit + β8Board_IND%it

+ β9Audit_IND%it + β10 Sizeit + β11Oper_CFit + β12Interest_Coverageit + β13Debt_Equityit +

β14 GDPt + β15Markett + β16Restateit + β17Industry_Dummyit + β18Year_Dummyt + β19

(Accrual Quality x CRARA_Dum) + є

Ratingit = α + β1Accrual_Qualityit + β2Abnorm_CFOit + β3Abnorm_Disexpit (5) +

β4Abnorm_Prodit + β5E_Indexit + β6Dual_CEOit + β7Board_Sizeit + β8Board_IND%it +

β9Audit_IND%it + β10 Sizeit + β11Oper_CFit + β12Interest_Coverageit + β13Debt_Equityit +

β14 GDPt + β15Markett + β16Restateit + β17Industry_Dummyit + β18Year_Dummyt + β19

(Accrual Quality x DoddFran_Dum) + є

Before estimating any of the econometric models described above, it was ensured that

descriptive statistics were examined, it was done to check if there were some to spot the existence

of possible outliers within the information. For this purpose spotting any outliers the data was

Winsorized at the one percent level. The Pearson and Spearman correlations were examined to
 6

identify any highly whether there is any positive or negative relation among various independent

variables.

3.3.2 Dependent Variables

Standard and Poor’s Domestic Long-term issuer credit rating is hypothesized to be

dependent variable and found from COMPUSTAT which is defined as: “Standard & Poor’s

current opinion of a ratee’s overall creditworthiness, apart from its ability to repay individual

liabilities or outsiders claim over assets . In other words the definition tells about the abilities of

borrower to meet its long-term financial commitments (these are non-current commitments, mean

go beyond one year) as they come due. COMPUSTAT arranges this variable from 1 to 22, where

22 is highest rating with AAA, while 1 indicates the lowest rating with D. This writing format is

preserved and employed in the economic science models. Following the Methodology outlined in

Alali et al. (2012), the rating variable is grouped so that the range is reduced from 1-22 to 1-7

based on the following groups:

Group 7: AAA
Group 6: AA+, AA, AA-
Group 5: A+, A, A-
Group 4: BBB+, BBB, BBB-
Group 3: BB+, BB, BB-
Group 2: B+, B, and B-
Group 1: CCC+, CCC, CC, C, D

Furthermore In addition to the above variable (rating level), another variable (dependent)

was used to change in rating behavior over period of time. This variable is calculated by taking

the difference between the rating variable in time, t, and the rating variable in time, t -1. The
 7

variable ranges from -21 to 21, and the 0 indicates that the rating was unchanged, the change in

rating from AAA to D is shown by -21, and change in rating from D to AAA is depicted by 21.

3.3.3 Independent Variables –Accrual Quality

This study considers three discrete measurements of accrual quality, and these are: the modified

Jones model, the Dechow and Dichev model, and the Stubben model. Study uses the modified

Jones model (Dechow, Sloan, and Sweeney 1995) for two evident and main reasons. First, as it

was written by Kothari (2001) that: “the Jones and modified-Jones models are immensely

effective for research and can easily provide greater outcomes as compared the other competing

variables.” The other reason is that it specifically makes the distinction between discretionary

and non-discretionary accruals, which provides a novel approach to activity accounting quality

not found within the models of Dechow and Dichev (2002) and Stubben (2010)

However there is still some low amount of confidence over Jones and modified Jones model

because it is found that the outcomes driven form it might be one-sided or confusing regarding

discrete accumulations (Kang and Sivaramakrishnan 1995; Bernard and Skinner 1996; Guay,

Kothari, and Watts 1996; Thomas and Zhang 2000; Dechow, Ge, and Schrand 2010). Hence, it

decided to use another accrual quality measure for this study, it is the Dechow and Dichev (2002)

cash flow model. In contrast to the modified Jones model, the Dechow and Dichev model use a

methodology to measure whether or not current accruals are related to previous, current, or next

amount money flows. Through this methodology we can avoid the unintentional attempts to

create a difference between intentional or unintentional financial statement manipulation and

errors. This methodology is also potentially fascinating as a result of it focuses specifically on

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money flows, that are arguably the foremost vital issue for a rating agency once developing its

rating credentials.

The third and most up-to-date measure of accrual quality within the literature is that the

discretionary revenue model developed by Stubben (2010). We use this methodology to make

attempts at quantify accrual quality though evidences of premature revenue identification. This is

achieved by examining the relationship between accounts receivable and revenues. However

Stubben argues that this methodology has limitations of its own, as it is an improvement over

existing accrual models, and it only focuses on specific accrual (the receivables accrual) rather than

total accumulated accruals. Furthermore he also argues that, “Dechow and Dichev model (Dechow

and Dichev 2002; McNichols 2002) exhibits greater misspecification than other accrual models

when used to estimate discretionary accruals”

The takes unique approaches offered by all three models to establish mechanism which could

be best for measuring accrual quality, and that too from these models, keeping their limitations in

mind. Therefore, all of three models were used to remove any biasness in computations that might

lead to effects on the study results, these models or further explained below.

Modified Jones Model

The first measure of accrual quality is calculated from the modified Jones model

(Dechow, Sloan, and Sweeney 1995):

(6)
 9

Where:

TAit = total accruals in year t for firm i. Calculated as the change in current assets minus
the change in current liabilities minus the change in cash and cash equivalents plus the
change in debt included in current liabilities minus depreciation and amortization
expense.

∆Revit = revenues in year t less revenues in year t – 1 for firm i

∆Recit = net receivables in year t less net receivables in year t – 1 for firm i

PPEit = gross property, plant, and equipment in year t for firm i

Ait – 1 = total assets in year t – 1 for firm i єit = error term in

year t for firm i

In the modified Jones model, the discretionary portion of the total accruals is proxied by using

the error term. The following equations provide a more detailed explanation of the modified

Jones model. Equation 7 depicts Equation 6 in a simplified format where discretionary accruals

have been moved to the left hand side of the equation.

(7)

Where:

Next, Equation 8 provides the “fitted model” for Equation 6, which is equivalent to the NonDiscrAccr

variable in Equation 7:

(8) Finally,

substituting Equation 8 back into Equation 7 provides the intuition behind the modified Jones

Model, resulting in Equation 9:

(9)
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Dechow & Dichev Model

Dechow and Dichev (2002) is used to find second measure of accrual quality. We find if

current accruals are associated with prior, current, or next period cash flows or not. To cash flows

then we assume that they reduce the quality of accounting information. In order to measure accrual

quality, the following model is estimated:

(10) Where:

= the change in working capital for firm i from year t-1 to year t. Calculated as the
change in accounts receivable plus the change in inventory minus the change in accounts
payable minus the change in taxes payable plus the change in other assets (net)

= firm i’s cash flow from operations in period t-1

= firm i’s cash flow from operations in period t
= firm i’s cash flow from operations in period t+1

= residual for firm i in period t

All variables in the equation are scaled by average total assets.

Following Dechow and Dichev (2002), the residual term in from equation 10 represents

the accruals that are unrelated to cash flow realizations, and the standard deviation of these

residuals is a firm-level measure of accrual quality, where higher standard deviation denotes

lower accrual quality. Additionally, the absolute value of the residual in the current year is

another measure of accrual quality, the larger the error term, the less the change in working

capital is being explained by the cash flows in the three year window and, therefore, the lower the

accrual quality.
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Stubben Model

The third measure of accrual quality is obtained from the developed by we use Stubben (2010)

to find third measure of accrual quality from discretionary revenue models. Stubben, the revenue

model and the conditional revenue model proposed these two models. First we have the revenue

model, which shows the deviations in accounts receivable as a function of discretionary and non-

discretionary revenues. The aim to use this model was that there aren’t any discrete revenues

collected in form of liquid assets or cash. Therefor we say that the discretionary revenues and

uncollected non-discretionary revenues sum up to make the accounts receivables.

The error term in the revenue model captures the discretionary portion of revenues.

Where:
= Annual change in accounts receivable for firm i in year t.
= The change in revenues in the first three quarters for firm i in year t.
= The change in the fourth quarter revenue for firm i in year t.

= Firm i’s discretionary revenues in year t.

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Conditional Revenue Model:

We use the conditional revenue model (Stubben 2010), which is a handle of the revenue

model, tells us that there are specific firms may have specific or firm specific characteristics such as

credit and inventory polices. The original revenue model is increased by dominant for a firm’s

monetary strength, operational performance relative to business competitors, and its stage within the

variation of business cycle. These changes result in the following equation:

Where:
= Annual change in accounts receivable for firm i in year t.
= Annual change in revenue for firm i in year t.

= Natural log of total assets at end of fiscal year for firm i in year t.
= Natural log of the firm i’s age in years at year t.
= Square root of the natural log of the firm i’s age in years at year t.
= Industry-median-adjusted revenue growth (= 0 if negative).
= Industry-median-adjusted revenue growth (= 0 if positive).
= Industry-median-adjusted gross margin at end of fiscal year.
= Square root of the industry-median-adjusted gross margin at end of fiscal
Year.

= Firm i’s discretionary revenues in year t.

We use the measure of a firm’s discretionary revenue as an error term just like the revenue model,

and the error term in the conditional revenue model is composed of discretionary revenues. If we

see higher discretionary revenues, then we say that there is lower accrual quality.
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3.3.4 Independent Variables –Real Activities Earnings Management

We Follow Roychowdhury (2006), by which abnormal cash flows from operations,

abnormal production prices, and abnormal discretionary expenditures are calculated and enclosed

within the models. We assume that Abnormal cash flows from operations explain real activates

earnings management that are directly related to sales manipulation. Hence, we can say that this

variable is used to identify and pick the increase in timing of sales or the generation of

unsustainable sales through the use of price discounts or lenient credit terms. Abnormal cash

flows from operations is calculated by first estimating the following model by industry and year:

Where: CFO is cash flows from operations (CFO), A is the total assets, S is sales. When we used

model estimation, firm revenues, sales and expanses are used to determine normal cash flows with

respect to each year. Abnormal cash flows from operations is calculated by subtracting a firm’s

actual CFO from the “normal” CFO.

It is seen that abnormal production prices is within the model itself, and it reflects enhance

production by management. in an attempt to unfold mounted prices over a lot of units so reducing

this amount price of products oversubscribed (COGS).we use same procedure to find the abnormal

cash flows from operations is used to calculate abnormal production cost using the following

model:

Where: COGS is cost of goods sold, A is the total assets, and S is sales.

Though Abnormal discretionary expenditures we try to reflect real activities earnings

management associated decreased expanses in research and development (R&D), advertising,

and selling, general and administrative (SG&A). the agenda to use this particular variable is that
 14

mangers will be able to decrease these types of expenditures when they won’t immediately result

in revenues. Similarly, the same methodology outlined for the calculation of abnormal cash

flows from operations is used to calculate abnormal discretionary expenditures using the

following model:

Where: DISEXP is discretionary expenses (R&D + Advertising + Selling, General and

Administrative expenses), A is the total assets, S is sales.

We find the summary measures of the abnormal cash flows from operations, abnormal

production costs, and abnormal discretionary expenditures variables are also calculated and

included in the models by following Cohen and Zarowin (2010),. The first summary measure,

Real_Em1, is calculated by multiplying abnormal discretionary expenditures by negative one and

adding the product to abnormal production costs. The second summary measure, Real_Em2, is

calculated by multiplying both abnormal discretionary expenditures and abnormal cash flows by

negative one and adding the products together.

3.3.5 Independent Variables –Corporate Governance

We determine the dual CEO, board size, board independence and audit committee

independence variables by following Byard, Li, and Weintrop (2006). We assume that the dual

CEO variable indicates whether the CEO of the firm is also the chair of the board. The CEO also

serving as chair of the board is an indicator of bad governance. As a result, the duel CEO

variable is expected to be negatively related to credit ratings. We see that the board size variable

finds the total number of directors serving on the board of directors. It were Byard, Li, and

Weintrop (2006), who said that larger boards are less effective and, therefore, represent lower
 15

corporate governance. Similar to the dual CEO variable, board size should be negatively related

to credit ratings. It is also seen that Board independence reflects the percentage of independent

directors on the board. Prior literature suggests that more independent directors on the board

provide better monitoring and, therefore, represent better corporate governance. Similar to board

independence, audit committee independence reflects the percentage of independent directors

serving on the audit committee. Both the board independence and audit committee independence

variables are expected to be positively related to credit ratings. A summary measure of corporate

governance, the E-index, is also included based on the methodology outlined by Bebchuk,

Cohen, and Ferrell (2009). Specifically, the Eindex is calculated by scoring the following six

provisions 1 if it is present in a company and 0 otherwise:

Staggered board: a board in which directors are divided into separate classes (typically three)
with each class being elected to overlapping terms.

Limitation on amending bylaws: a provision limiting shareholders’ ability through

majority vote to amend the corporate bylaws.

Limitation on amending the charter: a provision limiting shareholders’ ability through

majority vote to amend the corporate charter.

Supermajority to approve a merger: a requirement that requires more than a majority of

shareholders to approve a merger.
Golden parachute: a severance agreement that provides benefits to management/board
members in the event of firing, demotion, or resignation following a change in control.

Poison pill: a shareholder right that is triggered in the event of an unauthorized change in
control that typically renders the target company financially unattractive or dilutes the voting
power of the acquirer.

As a result, firms receive a score between 0 and 6, with zero representing low entrenchment and

6 representing high entrenchment. Higher levels of entrenchment represent lower corporate

governance and are expected to be negatively related with credit ratings.

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3.3.6 Independent Variables – Controls

This study strives to specifically examine only the direct association between accrual quality,

real activities earnings management, corporate governance and credit ratings. Clearly, factors other

than accrual quality, real activities earnings management, and corporate governance will have an

effect on ratings that a company will receive. In order to isolate the effects of the accrual quality,

real activities earnings management, and corporate governance on credit ratings, these other

potentially influential factors need to be controlled for.

The first group of control variables are related a firm’s information environment.

Following Cheng and Neamtiu (2009), a size control is included because large firms are expected

to have lower default risk and rating agencies may monitor lower risk firms less closely.

Specifically, the log of the firm’s total assets will be used as the size control. The firm’s cash

flow from operations is included to control for the expected association between higher cash

flows and higher credit ratings. Also, the interest coverage ratio and the debt to equity ratio are

included in the model to control for the expected relationship between a firm’s financial health

and the rating obtained. Consistent with the dependent variable, these ratios consider the overall

financial health of the firm, not the firm’s ability to repay specific obligations. Controlling for

this relationship will enable a more accurate assessment of the unique effects of the quality of

accounting information on credit ratings. A restatement or fraud indicator variable is also

included to reflect whether the firm has restated their financial statements in the past year. Cheng

and Neamtiu (2009) suggest that this variable “is a proxy for the possibility that a borrower may

hide information from the rating agencies which will make default prediction more difficult.”
 17

Factors outside of the firm’s control could also have an effect on the rating that a firm

receives. As Fons, Cantor, and Mahoney (2002) note, “rating agencies may be more sensitive to

any changes in credit quality in periods of heightened credit stress.” Additionally, during strong

economic times, it may be more difficult for firms that are performing poorly to mask their

deteriorating credit quality. Again, following Cheng and Neamtiu (2009), the annual gross domestic

product (GDP) and the annual market return are included in the model to control for general

economic conditions and the condition of the capital markets.

The second group of control variables is included for basic econometric issues related to

panel data. Year dummy variables are included to control for time series effects and cross sectional

autocorrelation is controlled for with industry indicator variables based on the two-digit SIC

industry code.

3.4 Data

This study required the use of company level reported account balances from company

income statements, balance sheets, and statements of cash flows from annual financial

statements, company level corporate governance data, and the Standard & Poor’s credit ratings.

Additionally, the control variables for the gross domestic product, market return, and restatement

needed to be collected. All financial accounting reported balances and credit ratings were

obtained from the most recent COMPUSTAT files available in the Wharton Research Data

Services (WRDS) database. Corporate governance variables were collected from Risk Metrics

and the restatement data was collected from Audit Analytics, both available in WRDS. The

annual gross domestic product information was obtained from the data library on the World
 18

Bank website and the annual market return information was obtained from the data library on

Kenneth R. French’s website.

The sample period is from 1999 to 2016. Observations prior to 1999 are omitted from the

sample because of the change in the definition of the S&P Domestic Long-term issuer credit

rating in 1998. Therefore, this sample period allows for a consistent interpretation of the credit

rating variable. Firms included in the sample had to have at least one observation of the S&P

Domestic Long-term issuer credit rating during the sample period. The comprehensive nature of

the models also required the intersection of multiple databases described above. As a result, in

addition to having credit rating data available, Risk Metrics data and Audit Analytics data need to

be available to be included in the sample. The main sample included only non-financial firms.1

This distinction is made because prior literature suggests that financial firms are subject to

different regulatory environments, and as a result, are not readily comparable to non-financial

firms (e.g., Barniv, Agarwal, and Leach, 2002).

3.4.1 Sub-periods and Subsamples Identified

In order to examine the effect of the CRARA and the Dodd-Frank Act, the overall sample

was partitioned into two sub periods. The CRARA subsample includes the years from 1999 to

2010. Next, this sub period was divided into the pre-CRARA time period which encompasses the

years 1999 to 2005, and the second period runs from 2007 to 2010. This allowed for an

examination of the effects of the Credit Rating Agency Reform Act of 2006 and, as a result,

2006 is excluded to produce clear pre/post periods. The Dodd-Frank sub period, was partitioned
 19

in a similar manner, with the years 2006 to 2010 representing the pre-Dodd-Frank Act period

and the years 2011 to the most recent WRDS file representing the post-period.
 20

3.5 Descriptive Statistics

Table 1 - Descriptive Statistics - Main Sample (1999- 2016)

Variable Mean Standard Deviation Median Minimum Maximum N
Dependent Variables
Rating 13.225 3.541 16 1.5 24 6420
∆Rating 0.0125 1.312 1 -7.7 17.5 6133
Independent Variables
JQ 0.074 0.0301 0.032 0 0.281 6019
DDQ1 1.037 0.131 0.067 0.003 0.631 5721
DDQ2 0.91 0.069 0.072 0.004 0.331 5224
SQ1 0.029 0.06 0.04 0 0.212 6130
SQ2 0.032 0.041 0.018 0.001 0.201 2302
Abnorm_CF 0.129 0.421 0.089 -2.011 2.169 6420
Abnorm_Disexp -0.171 1.898 -1.009 -9.012 9.11 6420
Abnorm_Prod -0.076 0.471 -0.059 -1.786 2.009 6420
Real_Em1 0.311 2.01 0.21 -8.541 8.142 6420
Real_Em2 0.241 1.78 0.071 -8.021 8.123 6420
E_index 2.171 1.81 3 0 8 6420
Dual_Ceo 0.814 0.451 1.5 0.5 3 5670
Board_Size 9.997 3.101 11 4 21 5670
Board_Ind 0.801 0.431 0.961 0.45 1.231 5670
Audit_Ind 1.009 0.174 1.6 0.773 1.7 5621
Size 8.871 1.41 8.441 6.121 12.24 6414
Oper_CF 1296.47 2781.12 381.5 -301.314 19373 6414
Int_Cov 6.768 16.165 3.041 -14.561 147.211 6199
D_E 1.91 4.651 1.525 -21.213 29.134 6410
GDP (Trillions of $) 13.71 2.081 1.991 9.971 17.21 6420
Market (%) 7.717 24.312 8.5 -37.94 33.898 6420
Restate 0.061 0.314 0.002 0 1 6420
CRARA_Dum 0.456 0.527 0 0 1 5799
DoddFran_Dum 0.097 0.301 0.01 0.001 1.3 6029

Rating is the S&P Domestic Long-term issuer credit rating from COMPUSTAT in year t for firm i. ∆Rating is the change in
the S&P Domestic Long-term issuer credit rating in year t for firm i. JQ is the measure of earnings quality from the
modifiedJones model. DDQ1 is the level of earnings quality for the firm in year t from the Dechow & Dichev model. DDQ2
is the standard deviation of the firm's earnings quality over the past five years from the Dechow & Dichev model. SQ1 is the
measure of earnings quality from Stubben's revenue model. SQ2 is the measure of earnings quality from Stubben's
conditional revenue model. Abnorm_CF is the abnormal cash flow from operations in year t for firm i, as outlined in
Roychowdhury (2006). Abnorm_Disexp is the abnormal discretionary expenses in year t for firm i, as outlined in
Roychowdhury (2006). Abnorm_Prod is the abnormal production costs in year t for firm i, as outlined in Roychowdhury
(2006). Real_Em1 is an aggregate measure of real earnings management, as outlined in Cohen and Zarowin (2010).
Calculated by multiplying abnormal discretionary expenditures by -1 and adding the product to abnormal production costs.
Real_Em2 is an aggregate measure of real earnings management, as outlined in Cohen and Zarowin (2010). Calculated by
multiplying both abnormal discretionary expenditures and abnormal cash flows by -1 and adding the products together.
 21

E_Index is the E-index score in year t for firm i, derived from Bebchuk, Cohen, and Ferrell (2009). Dual_CEO is an indicator
variable, set to 1 if the CEO is also the chair of the board, and 0 otherwise (following Byard, Li, and Weintrop (2006)).
Board_Size is the total number of directors serving on the board of directors in year t for firm i (following Byard, Li, and
Weintrop (2006)). Board_Ind is the percentage of independent directors on the board in year t for firm i (following Byard, Li,
and Weintrop (2006)). Audit_Ind is the percentage of independent directors on the audit committee in year t for firm i
(following Byard, Li, and Weintrop (2006)). Size is the log of total assets in year t for firm i. Oper_CF is the operating cash
flows in year t for firm i. Int_Cov is the interest coverage ratio in year t for firm i. D_E is the debt to equity ratio in year t for
firm i. GDP is the annual gross domestic product in year t. Market is the overall annual market return in year t. Restate is an
indicator variable, set to 1 if in the past year the firm restated their financial statements, and 0 otherwise. CRARA_Dum is an
indicator variable, set equal 1 if the observation is after the year 2006, and 0 otherwise. DoddFran_Dum is an indicator
variable, set equal 1 if the observation is after the year 2010, and 0 otherwise.

Table one provides descriptive statistics for the complete sample from 1999 to 2016. The

mean credit rating within the sample is 13.225 that is or so adequate a BBB- rating. The mean

modification within the credit rating variable is -.087. The {little} magnitude of the modification

variable suggests that there's little volatility in credit ratings which if a modification happens, it's a

comparatively little adjustment. This observation is more supported by the comparatively little

variance of .841. Also, the negative sign of the mean modification in rating variable appears to

point that there are a lot of downgrades in ratings than upgrades. As delineated earlier, the

accumulation quality variables (JQ, DDQ1, DDQ2, SQ1, and SQ2) are residuals from completely

different accumulation model estimations and as a result, there isn’t any context within which to

interpret the suggests that the quality deviations and minimum and most values, however, seem to

be comparatively little that helps to alleviate issues of outliers and accumulation model

misspecification. The real activities variables (Abnorm_CF, Abnorm_Disexp, and Abnorm_prod)

are calculated by subtracting a firm’s actual money flows, discretionary expenses or production

from the firm’s foretold level of money flows, discretionary expenses or production. Any

deviation from the expected values is taken into account to be abnormal and proof of real

activities earnings management. Kind of like the accumulation quality variables and because of

the development of the variables, interpretation of the numerical worth of the suggests that on the
 22

$64000 activities variables lacks economic context. However, the very fact that the mean,

minimum, and most values for these variables aren't zero indicates that the sample contains

corporations that will be known as having engaged in real activities earnings management.

Interpretation is analogous for the descriptive statistics of the outline measures of those variables

(Real_Em1 and Real_Em2). The primary company governance variable (E_index) will vary from

zero to six, with zero indicating the simplest company governance and half dozen being the worst.

As a result, the mean of 2.147 indicates moderately sensible company governance within the

sample of corporations collected. Dual_CEO is associate indicator variable adequate one if the

corporate executive is additionally the chairman of the board. A mean of .784 indicates that a

majority of corporations within the sample operated with their corporate executive additionally

acting because the chairman of the board. Also, the minimum and most values of zero and one,

suggests that this variables has been created befittingly. Board_Size represents the whole range of

administrators serving on the board. Over the sample amount, the typical firm’s board of

administrators consisted of roughly ten (9.914) members. The mean of 0.737 on the Board_Ind

variable suggests that 73.7% of {the administrators|the administrators} serving on boards were

freelance directors. Similarly, the mean of 0 .945 for the Audit_Ind variable indicates that ninety

4.5% of the members of the audit committee were freelance administrators. Among the firm info

atmosphere variables, the dimensions variable represents the natural log of the company’s total

assets. The minimum and most values of this variable indicate that the tiniest firm within the

sample had or so $380 million in total assets and therefore the largest firm had or so $156 billion

in total assets. The mean of 1,206 for the Oper_CF variable suggests that the typical firm within

the sample is generating positive money flows from operations. The typical interest coverage

quantitative relation (Int_Cov) within the sample is 6.614 that indicates that the typical firm within

the sample is capable of meeting its finance expenses. whereas ready to meet its finance expenses,
 23

the typical debt to equity quantitative relation (D_E) is one.892 indicating that the typical firm

within the sample is moderately leveraged. Each the GDP and market come back variables

function management variables for general economic conditions. The typical market come back of

five.866% indicates typically favorable economic conditions throughout the sample amount.

Finally, the statement indicator variable mean of .049 indicates that a little range of the

corporations within the sample restated their monetary statements at some purpose throughout the

sample amount.
 52

3.6 Correlations
Table 2 Pearson/Spearman Correlations - Main Sample (1999- 2016)
Rating ∆Rating JQ DDQ1 DDQ2 SQ1 SQ2 Abnorm_CF Abnorm_Disexp Abnorm_Prod Real_Em1 Real_Em2 E_index Dual_Ceo Board_Size Board_Ind Audit_Ind Size Oper_CF Int_Cov D_E Market (%) Restate CRARA_Dum DoddFran_Dum
Rating 1 0.205 -0.011 -0.083 -0.341 0.021 -0.032 0.101 0.023 -0.082 0.041 0.053 -0.002 0.151 0.439 0.139 0.002 0.57 0.501 0.399 -0.002 -0.029 -0.013 -0.001 0.019
∆Rating 0.101 1 -0.043 -0.071 -0.032 -0.029 -0.067 0.071 -0.023 -0.009 0.024 0.0031 0.042 -0.037 -0.002 0.051 0.061 0.021 0.069 0.171 0.005 0.083 -0.011 0.101 0.099
JQ -0.043 -0.029 1 0.303 0.176 0.279 0.331 0.067 0.006 0.016 0.051 0.031 -0.024 0.049 -0.086 -0.021 -0.005 -0.099 -0.081 -0.007 0.0091 -0.014 0.0014 -0.051 -0.011
DDQ1 -0.131 -0.069 0.201 1 0.541 0.421 0.451 0.051 -0.0097 0.061 0.031 0.013 0.033 0.035 -0.019 0.207 0.309 0.215 -0.017 0.009 0.01 0.011 -0.107 0.201 -0.011
DDQ2 -0.159 -0.021 0.143 0.401 1 0.201 0.251 -0.021 0.021 0.071 0.027 0.951 0.024 0.051 0.125 0.067 -0.041 -0.117 -0.129 -0.119 -0.028 0.045 0.331 0.143 0.0021
SQ1 -0.51 -0.039 0.201 0.341 0.231 1 0.955 -0.019 0.023 0.117 0.031 0.007 -0.003 0.045 0.01 -0.013 -0.013 0.017 -0.167 -0.003 0.007 0.011 0.411 0.201 -0.039
SQ2 -0.039 -0.019 0.207 0.329 0.255 0.877 1 -0.012 0.011 0.13 0.041 0.019 -0.005 -0.015 -0.028 0.014 0.014 0.031 -0.019 -0.019 -0.017 -0.032 -0.029 0.207 -0.053
Abnorm_CF 0.121 0.125 0.067 -0.01 -0.017 -0.013 0.011 1 -0.359 -0.232 0.359 0.017 0.007 -0.032 0.028 -0.011 -0.015 0.031 0.125 0.005 0.0301 0.376 -0.017 0.067 -0.041
Abnorm_Disexp 0.009 0.01 -0.013 -0.013 0.007 0.006 0.012 -0.401 1 0.21 -0.937 0.181 0.031 0.032 0.019 -0.021 -0.014 0.035 0.01 0.105 -0.0106 0.149 -0.017 -0.013 0.097
Abnorm_Prod -0.119 -0.028 0.014 0.084 0.101 0.03 -0.017 0.111 -0.0391 1 0.071 -0.943 0.054 0.041 0.122 -0.131 -0.007 -0.025 -0.028 0.037 -0.017 -0.007 0.038 0.014 0.033
Real_Em1 -0.003 0.007 0.036 0.051 0.037 -0.024 0.014 -0.052 -0.881 0.401 1 -0.124 0.0011 0.032 0.031 0.015 0.011 -0.083 0.007 0.159 0.038 0.479 0.017 0.036 -0.029
Real_Em2 -0.009 -0.017 0.029 0.043 0.021 0.017 -0.099 0.221 -0.849 -0.019 0.862 1 0.007 0.041 0.046 -0.071 -0.051 -0.071 -0.017 -0.027 0.017 0.091 0.112 0.054 -0.029
E_index 0.005 0.031 -0.011 0.046 0.043 0.035 0.031 0.139 0.019 0.125 -0.011 -0.051 1 -0.019 0.016 -0.051 0.034 0.303 0.031 -0.051 -0.013 0.021 -0.047 0.031 0.018
Dual_Ceo 0.165 -0.056 0.039 0.015 0.011 0.021 0.412 0.121 -0.004 0.01 0.141 0.023 -0.011 1 0.0171 0.009 0.652 0.021 -0.056 -0.081 0.031 0.029 -0.032 0.002 -0.0181
Board_Size 0.376 -0.017 -0.074 -0.059 -0.049 -0.011 0.0153 -0.004 0.011 -0.028 0.12 0.023 0.079 0.101 1 -0.003 0.133 0.0051 -0.017 -0.0011 0.024 -0.029 -0.061 0.061 0.0031
Board_Ind 0.149 0.038 -0.019 -0.02 0.007 -0.017 0.0011 0.043 0.019 0.007 0.271 0.001 0.041 0.115 1 0.0201 -0.041 0.038 0.016 0.051 0.218 0.031 -0.005 0.032
Audit_Ind -0.007 0.017 -0.014 -0.014 0.031 -0.127 0.031 -0.021 0.031 -0.017 0.061 0.004 -0.081 -0.007 0.011 -0.014 1 -0.026 0.017 -0.013 -0.013 0.411 0.045 -0.007 0.041
Size 0.479 0.112 -0.101 -0.017 -0.035 -0.151 0.013 0.032 -0.009 0.031 0.151 0.41 -0.017 0.061 0.01 0.011 0.057 1 0.112 -0.043 -0.071 -0.032 -0.029 -0.067 0.071
Oper_CF 0.612 0.303 -0.005 -0.129 -0.131 -0.076 0.951 0.0124 0.057 -0.056 -0.007 0.101 -0.129 -0.019 -0.048 0.031 -0.027 0.412 1 -0.013 -0.51 -0.039 0.201 0.341 0.031
Int_Cov 0.579 -0.97 -0.011 -0.167 -0.149 0.059 -0.007 -0.013 0.018 -0.017 0.221 0.037 -0.003 0.007 -0.026 0.041 0.032 0.0153 -0.97 1 0.125 0.067 -0.046 0.203 -0.015
D_E -0.069 0.139 -0.051 0.069 0.067 -0.101 0.014 -0.015 0.153 0.038 0.149 0.021 -0.067 0.021 0.901 0.027 0.052 0.013 0.139 0.033 1 -0.042 0.101 -0.47 -0.012
Market (%) -0.031 0.071 -0.015 -0.029 -0.008 -0.008 0.127 -0.113 -0.031 0.017 0.201 0.043 0.331 0.033 0.107 -0.013 0.041 0.951 -0.017 0.017 0.016 1 0.036 0.129 -0.041
Restate -0.051 -0.012 0.021 -0.047 0.031 0.018 0.014 -0.015 0.021 0.112 0.217 0.011 0.451 0.141 0.014 -0.005 -0.015 0.007 0.074 0.151 0.013 -0.072 1 0.0171 0.015
CRARA_Dum -0.011 0.098 -0.039 0.009 0.046 -0.071 -0.051 0.018 0.154 0.032 -0.021 -0.049 0.251 0.0125 -0.051 -0.012 0.021 -0.047 0.031 0.018 0.084 0.101 0.013 1 -0.007
DoddFran_Dum 0.0011 0.101 -0.007 -0.029 0.006 -0.059 0.034 0.0611 0.094 0.017 0.031 0.007 0.135 -0.017 0.091 -0.017 0.034 0.017 -0.849 -0.019 0.862 0.019 0.024 0.018 1
 Table 2 provides the Pearson (Spearman) correlations above the (below) the diagonal,

with each measures exhibiting significantly similar results. Most of the correlations between the

independent variables exhibit solely comparatively little correlations. The most variables of

interest, the accumulation quality variables (JQ, DDQ1, DDQ2, SQ1, and SQ2), the $64000

activities earnings management variables (Abnorm_CF, Abnorm_Disexp, Abnorm_Prod), and

therefore the company governance variables (Dual_CEO, Board_size, Board_Ind, Audit_Ind) are

largely considerably correlative with the credit rating variable (Rating). The measures of accrual

quality are considerably negatively correlative with the rating variable. This can be according to

corporations with poorer accrual quality receiving lower credit ratings. This provides association

of early indication that the rating agency could contemplate the amount of accrual quality once

creating rating selections. The correlations between the credit rating variable and therefore the

real activities earnings management variables and corporate governance variables are mixed in

significances and sign. According to previous literature, the dimensions of the firm (Size),

operational income (Oper_CF), and its ability to fulfill its finance expenditures (Int_Cov) are

completely correlative with a firm’s rating. Apparently, the overall market conditions (Market)

don't seem to be notably correlative with the rating variable. This might result to the long run

nature of the rating variable.