Does the Permanently Reinvested Earnings Assertion Influence Perceptions of Credit Risk?

Abstract

In recent years, the impact of the permanently reinvested earnings (PRE) assertion on the financial reporting environment has grown tremendously. Under Accounting Standards Codification (ASC) 740, a firm making the PRE assertion is able to avoid recognizing residual U.S. taxes on earnings of its foreign subsidiaries so long as it reinvests those earnings outside of the U.S. Suboptimal reinvestment is a potential consequence for PRE-asserting firms due to limited reinvestment opportunities abroad. Suboptimal foreign reinvestment, typically high amounts of reinvestment in financial assets, may be viewed negatively by financial statement users, particularly those users concerned with the default risk of a firm.

The disclosure of PRE-related information varies substantially and the actual degree of compliance with this accounting standard has been questioned by the Securities and Exchange Commission (SEC). While firms may believe it is advantageous to obscure their PRE-related activity due to media or political concerns, recent academic literature has highlighted a negative relation between disclosure quality in financial statements and credit risk.

The purpose of this study is to examine the relations among foreign reinvestment strategy, PRE disclosure, and long-term credit ratings. First, I examine the direct effect of a firm's reinvestment strategy on its long-term credit rating. Second, I investigate the relation between a firm's reinvestment strategy and its choice to disclose PRE-related information. Third, I study the relation between a firm's choice to disclose PRE-related information and its long-term credit rating. Finally, I examine the potential attenuating effect of the PRE disclosure on the negative relation between financial reinvestment and credit ratings. Using hand collected PRE data for Fortune 500 firms from 1997-2010, I find a negative relation between the intensity of a firm's reinvestment in financial assets and its (1) long-term credit rating and (2) choice to disclose PRE-related information. Furthermore, I find a positive relation between a firm's choice to disclose PRE and its credit rating.