Earnings Management upon a Sovereign Downgrade

We examine the effect of sovereign credit rating downgrades on firms’ earnings management. Using the exogenous variation in credit ratings caused by sovereign rating downgrades from 61 countries, we show that firms reduce discretionary accruals after sovereign downgrades and are likely to experience a reversal of earnings subsequent to the accrual reduction. The reduction in discretionary accruals is more significant in countries with a better institutional environment and when the sovereign rating falls into a lower bin. Our study provides new evidence that managers strategically employ downward earnings management in response to the negative shock on sovereign credit ratings.