Do Firms Use Classification Shifting to Manage Credit Rating? Evidence from the Investment-Speculative Grade Borderline

Credit ratings are important determinants of access to the debt market. We examine whether firms near the investment–speculative borderline use classification shifting to manage their credit ratings. Using the S&P long-term credit ratings, we find that firms in the broad categories of BBB and BB misclassify core expenses as special items to inflate core earnings. We also find that firms facing financial constraints and those with high leverage are more likely to engage in classification shifting. Further, we show that managers rely on classification shifting when they perceive the costs of accrual-based and real activities earnings management to be significant. Governance mechanisms in the form of analyst following, institutional ownership, and audit quality have deterrent effects on the use of classification shifting by rated firms. Finally, firms near the investment–speculative borderline successfully receive a rating upgrade in the near future through classification shifting