The interplay of real earnings management, internal control and credit ratings in China

Abstract

Purpose This study delves into investigating how corporate real earnings management (REM) activities shape credit ratings (CR). Likewise, it explores how the robustness of internal controls (IC) moderates the relationship between REM and corporate CR. Design/methodology/approach The study examines data from Chinese publicly traded companies between 2010 and 2017. The CR of Chinese companies are assessed by the long-term issuer CR provided by Standard and Poor. The REM activities are measured as an aggregate measure of the abnormal cash flow from operations, abnormal costs of production and abnormal discretionary expenses. Findings The results reveal that Chinese firms with REM practices exhibit low CR scores. Besides, internal control weaknesses increase the negative relationship between real management activities and the CR of companies. This means that companies with high (low) quality IC experience a reduced (increased) inverse impact on their CR when engaging in REM activities. Practical implications The findings offer valuable insights for policymakers, executives and investors. Understanding earnings management’s impact on CR can guide regulators in enhancing financial transparency. Additionally, insights on IC can help managers strengthen governance to curb opportunistic behavior while investors gain foresight into how credit pressures shape financial reporting practices. Originality/value The study provides a distinct perspective by exploring Chinese companies, where market forces, government regulations and cultural aspects play a significant role in shaping business practices. Likewise, it provides the first empirical evidence that strong IC can mitigate the adverse effects of REM on CR, underscoring their significance in financial integrity.