Do Rating Agencies Fully Understand Information in Earnings and its Components?

This paper examines whether credit rating agencies fully understand the implications of earnings and its components for future performance. After establishing that earnings are more relevant to the rating process than cash flows, we find that future rating changes can be predicted using current earnings information. This finding suggests that rating agencies underreact to earnings information. When earnings are decomposed into accruals and cash flows, credit rating agencies do not distinguish the differential persistence of these two components of earnings. This inefficiency in ratings with respect to earnings information increases with information uncertainty, the contractual use of ratings, and potential conflicts of interest. Interestingly, the predictability of future rating changes by current earnings has disappeared in the post-crisis period as regulation of the rating industry has been tightened