Accruals, Income Smoothing and Bond Ratings

We examine the role of accounting accruals in bond ratings in this paper. Accruals affect not only the levels but also the volatility of reported earnings. We show that bond ratings are significantly related to accruals and their income-smoothing effect. Relative to cash flows, accrual-based earnings either in levels or in volatility dominate cash flows in explaining bond ratings. Incremental to cash flows, accruals that are higher or make income smoother are associated with more favorable bond ratings. Accruals also receive larger weight in bond ratings when they serve the income-smoothing function. These results from the debt market complement the consistent results from the stock market on the usefulness of accruals as a performance measure. Finally, we show that accruals may not be responsible for the over-time downward trend in bond ratings.