Credit rating agencies and accounting fraud detection

This study examines whether and when credit rating agencies take negative rating actions against issuers committing accounting fraud before the fraud is publicly revealed as well as the economic impacts of such rating actions. We find that Standard & Poor's (S&P), an issuer-paid rating agency, downgrades fraud firms and puts them on negative credit watch as early as four quarters prior to public fraud revelation, controlling for firms' economic fundamentals and performance. Furthermore, Egan-Jones, an investor-paid rating agency without access to management and private information, is much less timely than S&P in downgrading fraud firms, especially when information uncertainty is high. In addition, S&P distinguishes fraud firms from similar-looking non-fraud firms even when the former appears financially healthy, whereas Egan-Jones does not. This further supports that S&P's private information advantage facilitates fraud detection. Finally, S&P's negative rating actions against fraud firms inform the market and are associated with management turnover and shorter fraud duration