About 25 years ago, an important innovation emerged in bank lending to companies. In contrast to the traditional practice of charging fixed interest rates based on centrally adopted benchmarks, like LIBOR or the prime rate, banks increasingly adopted a more flexible process called “performance pricing.”

The new method simplified the resetting of interest as the creditworthiness of a borrower improved or declined over time, so that, instead of having to be formally renegotiated, the rate would rise or fall automatically as specified in a grid included in the lending contract.

In the early period of performance pricing, creditworthiness (and, therefore, rates) were determined principally by accounting metrics, most commonly the ratio of company debt to earnings, with grids specifying higher rates as a firm’s ratio increased and lower rates as it fell.

In addition, in a sizable minority of cases — about 25% in the late 1990s — interest rose or fell based on companies’ credit ratings.

Now, drawing on more recent data, a study in Accounting Horizons suggests that the role of credit agencies in performance pricing has increased considerably — and that their expanded role leaves much to be desired.

The new study finds interest rates to be based on credit ratings (PPrating, as the practice is called) in about 56% of the cases of performance pricing. And, most pertinently, the research finds PPrating significantly linked to financial manipulation by corporate borrowers, who thereby succeed in substantially lowering their interest costs.

In the words of the study, by Xia (Eliza) Zhang of the University of Washington, Tacoma, “The potential for large interest rate changes and significant debt cost savings associated with credit-rating movement … gives borrowers strong incentives to influence their firm ratings…. Credit-rating agencies do not fully adjust to these managerial opportunistic behaviors.”

Zhang finds that firms carry out this manipulation by artful management of two major aspects of corporate accounting: cash flow from operations (CFFO), a measure of cash generated from company revenues; and accruals, non-cash accounting items that can affect earnings, such as revenues from credit sales or estimated value of inventory.

The gains in such manipulations can be considerable. As an example, wily cash-flow management may keep a decline in a company’s performance from prompting a drop in its credit rating. The company might resort to such late-year maneuvers as greatly accelerating bill collections from customers and delaying payments to suppliers, or it might misreport major operating costs as capital investments.

In contrast to the maneuverings associated with PPrating, no significant evidence emerged of CFFO or accrual manipulation being associated with performance pricing that was based on accounting metrics.

Coming a decade after credit agencies were widely condemned for issuing deeply flawed ratings of mortgage-backed securities, with dire economic consequences, do the study’s findings represent a further blot on the industry?

Zhang demurs, observing that credit agencies readily acknowledge their limitations as auditing agents. Still, the new findings, she says, should certainly be of concern to the credit industry as well as to the banking industry and regulators.

All of them, the professor says, should take particular note of the success companies enjoy through manipulation of cash flow, a feat that seems to defy conventional wisdom.

“Numerous accounting textbooks and investment advisers,” she writes, “recommend using [CFFO] as a benchmark to evaluate earnings quality.” Further, “credit-rating agencies emphasize cash flow analysis as one of the most critical aspects of rating decision-making, because they believe debt is serviced out of cash [as distinct from earnings] and cash flows cannot be easily managed.”

In at least one respect, though, the agencies show themselves equal to PPrating firms’ financial manipulations — namely, when the grid incorporated in the lending contract indicates the company can lower its interest rate markedly through an improved credit score.

“When a larger benefit is associated with inflated ratings,” Zhang writes, “credit agencies could well understand such incentives…. Therefore, [they] could impose more scrutiny in this scenario, which could lead to a less pronounced association between CFFO and accruals management and ratings. The results are consistent with this conjecture.”

In other words, munificent grids become red flags, leading credit agencies to intensify their monitoring of borrowers’ finances and rendering the debtors’ manipulations less effective than they would otherwise be. “In view of this evidence that credit agencies are capable of stringent monitoring in PPrating, it would be nice to see more of it,” says Zhang.

The study’s findings derive largely from an analysis of the relationship among PPrating, financial reporting, and credit scores of 581 companies during the 17-year period from 1994 (when comprehensive information about performance pricing first became available) through 2011.

Financial manipulation was determined by the amount firms exceeded norms for CFFO and accruals as estimated in prior accounting research.

The increased propensity of PPrating borrowers to engage in financial manipulation compared to companies with accounting-based performance pricing emerged from analysis that included firms in both groups.

The paper, “Do Firms Manage their Credit Ratings? Evidence from Rating-Based Contracts,” is in the December issue of Accounting Horizons, published quarterly by the American Accounting Association.

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