Effects of Executive Compensation Components
Transcript of Effects of Executive Compensation Components
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Effects of Executive Compensation on Earnings Management
and Cost of Equity Capital
Kanyarat Sanoran
Corresponding author:
Chulalongkorn Business School, Chulalongkorn University
254 Phayathai Road, Pathumwan, Bangkok 10330, Thailand
+66 990955355
Leon Wong
UNSW Australia
UNSW Sydney NSW 2052, Australia
+61 2 93855810
We thank Ferdinand Gul and Gary Monroe for their helpful comments.
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Effects of Executive Compensation on Earnings Management
and Cost of Equity Capital
Abstract
This study examines how executive compensation in the form of stock option, shareholdings,
bonus, and long-term performance plan affect the discretionary accruals and cost of equity
capital. We find that executive bonus and long-term performance plan are negatively
associated with both discretionary accruals and cost of equity capital. In addition, CEO
shareholdings, but not other executives’ shareholdings, are negatively associated with both
discretionary accruals and cost of equity capital. Our additional analyses demonstrate that
executive bonus and long-term performance plan affect only income-increasing earnings
management, but not income-decreasing earnings management. In sum, our results suggest
that executives and shareholders are responsive to different types of executive compensation.
Keywords: Executive compensation, Discretionary accruals, Earnings management, Cost of
equity capital
JEL Classification: G31, M41, M52
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1. Introduction
To the extent that executive compensation can influence earnings management, investors
may be expected to respond with increased or decreased information risk by demanding higher
or lower returns. In this paper, we examine the effects of executive compensation on earnings
management and cost of equity capital for four components of executive compensation. Each
component of executive compensation differ in its nature, which lead to differences in the
executive incentives and investors’ pricing of information risk. We hypothesize and provide
evidence that the effects of executive compensation on earnings management and cost of
equity capital are different for each component of executive compensation.
Our analyses are based on a sample of 3,436 firm-year observations on the U.S.
companies from 2004 to 2010. Consistent with prior research, we use discretionary accruals as
a measurement for earnings management. We measure the cost of equity capital by using
average value of nine alternative methods introduced by prior literature (Easton 2004; Ohlson
and Juettner-Nauroth 2005; Gode and Mohanram 2003; Botosan and Plumlee 2002; Gordon
and Gordon 1997; Claus and Thomas 2001; Gebhardt, Lee, and Swaminathan 2001; Hail and
Leuz 2006; Dhaliwal, Krull, and Li 2007). We find a significantly lower discretionary accruals for
bonus and long-term performance plan. Interestingly, we find that CEO shareholdings, but not
other executives’ shareholdings, is negatively associated with the discretionary accruals. By
contrast, we do not observe a significant difference in the discretionary accruals for executive
stock option. Additionally, we find a significant reduction in cost of equity capital for bonus
plans and long-term performance plans, but not for stock options. Remarkably, CEO
shareholdings, but not other executives’ shareholdings, are negatively related to the cost of
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equity capital. Therefore, our analyses indicate that the effect of executive compensation on
discretionary accruals and cost of equity capital is not uniform across different types of
executive compensation.
Our study complement and extend previous studies (i.e., Shaw 2012; Prevost, Devos, and
Rao 2013; Boone, Khurana, and Raman 2011; Kabir, Li, and Veld-Merkoulova 2013) by providing
evidence on whether each type of executive compensation impact executives’ accruals
reporting behavior and investors’ benefit in the form of cost of equity capital. This paper may
be of interest to regulators, managers, and investors faced with questions about the possible
consequences of executive compensation on information risk and shareholder wealth.
The rest of this paper is organized as follows. We describe the effects of information risk
on cost of equity capital in section 2. We develop the hypotheses in section 3, describe our
sample and data in section 4, and present the research design in section 5. We discuss the
results of the main and additional tests in sections 6 and 7. We present our conclusions in
section 8.
2. Literature review and hypothesis development
2.1. Effects of stock option on earnings management and cost of equity capital
Information risk is a non-diversifiable risk factor that is priced by the market (Gray et al.,
2009). The higher quality of accruals, the better earnings map into cash flows and hence, the
lower the information risk (Francis et al., 2005; Gray et al., 2009). Quality of information,
including earnings quality, can mitigate the information risk and thus reduce the cost of equity
capital (Aboody et al., 2005; Easley and O'Hara, 2004). Many previous studies (e.g., Aboody et
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al., 2005; Easley and O'Hara, 2004; Francis et al., 2005; Gray et al., 2009) report that higher
information risk leads to higher cost of equity capital. Francis et al. (2005) use accrual quality as
a proxy for the information risk and find that firms with poorer accruals quality have higher cost
of equity capital, compared to firms with better accrual quality.
Compensation can influence the executives’ incentives and earnings management, which
affect the firm’s cost of equity capital. The effect of each compensation element on the cost of
equity capital can be different due to the unique information risk features of each element.
Therefore, the hypotheses on the impact of each executive compensation component are
separately developed in this study. We expect to detect a positive association between the cost
of equity capital and executive compensation components that cause higher information risks.
A negative association between the cost of equity capital and executive compensation
components that lead to lower information risks is expected.
Some incentives for earnings management are the result of executive compensation
(Brown, Beekes, and Verhoeven 2011; Pourciau 1993). The opportunistic behavior of executives
is primarily associated with increases in executive compensation in the form of stock options
and creates the opportunity for executives to manipulate accrual-based earnings (Cohen, Dey,
and Lys 2008). Stock option awards may induce compensation incentives that motivate
executives to manipulate earnings with the intention of meeting favorable factors of the option
grants (Vafeas and Waegelein 2007). Despite this, Laux and Laux (2009) argue that earnings
management may not increase even if CEO equity incentives are increased because directors
alter their monitoring efforts in response to changes in CEO incentives. In addition, Armstrong,
Jagolinzer, and Larcker (2010) find that relatively higher levels of CEO equity incentives lead to a
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decreased incidence of accounting irregularities. In contrast, there is considerable evidence
pointing to incentive-based pay, particularly the use of stock option compensation, motivating
earnings management in order to meet performance targets or thresholds (Shrieves and Gao
2002; Cheng and Warfield 2005; Bergstresser and Philippon 2006; Grant, Markarian, and
Parbonetti 2009; Houmes and Skantz 2010) and earnings restatements (Burns and Kedia 2006;
Efendi, Srivastava, and Swanson 2007). For example, Bergstresser and Philippon (2006) report a
positive association between CEOs’ equity compensation and accruals management. McAnally,
Srivastava, and Weaver (2008) find that, for companies that manage earnings downward, stock
option grants are positively associated with the probability of missing earnings targets. Meek,
Rao, and Skousen (2007) find a positive relationship between annual CEO stock option
compensation and the absolute value of discretionary accruals, implying the likelihood that
earnings management increases when CEO compensation in the form of stock options is higher.
Cohen, Dey, and Lys (2008) corroborate that an increase in accrual-based earnings
management is concurrent with increases in the proportion of equity-based executive
compensation.
The arguments presented earlier suggest earnings management is positively related with
the cost of equity capital. Therefore, there may be either a positive or a negative relation
between executive stock option and the cost of equity capital. Hence, the first set of
hypotheses is developed as follows:
H1a: The proportion of executive stock option compensation is associated with the discretionary
accruals.
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H1b: The proportion of executive stock option compensation is associated with the cost of equity
capital.
2.2. Effects of executive shareholdings on earnings management and cost of equity capital
Another source of incentives for executives is the percentage of managerial
shareholdings. Similar to stock option compensation, stock ownership can also impact
incentives for earnings management (Cheng and Warfield 2005). Cheng and Warfield (2005)
indicate that executives with high stock ownership are more likely to report earnings that meet
or just beat analysts’ forecasts. Another perspective is that managerial shareholdings provide
managers with shareholder-like interests so executives’ tendency to manage earnings may be
decreased (Vafeas and Waegelein 2007). Agency theory indicates that management ownership
might reduce the conflict of interest between managers and stockholders (Wright et al. 2002).
Executives might not be able to diversify away the risk attached with his or her wealth due to
stock ownership because his or her human capital is enormously invested in a single place of
employment (Smith and Watts 1992). Therefore, executives’ tolerance for risk is affected by
their limited ability to reduce personal risk (Bryan, Hwang, and Lilien 2000). Warfield, Wild, and
Wild (1995) report that the level of managerial shareholdings is negatively associated with the
level of earnings management. The arguments presented earlier suggest earnings management
is positively related with the cost of equity capital. Therefore, there may be either a positive or
a negative relation between executive shareholdings and the cost of equity capital. Therefore,
the second set of hypotheses is stated as follows:
H2a: The proportion of executive shareholdings is associated with the discretionary accruals.
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H2b: The proportion of executive shareholdings is associated with the cost of equity capital.
2.3. Effects of bonus on earnings management and cost of equity capital
Previous research provides evidence to strongly support the argument that executives
use incentive compensation to their advantage, even though it might disadvantage the
shareholders (Devers et al. 2007). CEOs with higher accounting-based compensation are more
likely to be involved in opportunistic behavior in order to maximize the value of such
compensation (Jiang, Petroni, and Yanyan Wang 2010). Executives can directly manipulate
accounting-based measures in many ways such as via changes in debt structure, inventory
management, and accounting policies (Murphy 2000). However, it is more difficult for
executives to directly manipulate market-based measures (Wiseman and Gomez-Mejia 1998).
Cornett, McNutt, and Tehranian (2009) find that there is greater earnings management when
an executive’s compensation is attached to the firm’s performance. Bonus pay creates
incentives for executives to choose accounting policies and accruals that make the most of the
value of their bonus compensation (Healy 1985; Shrieves and Gao 2002). There is a significant
relation between accruals and executives’ income-reporting incentives under the bonus
contracts (Healy 1985; Shrieves and Gao 2002). Gaver, Gaver, and Austin (1995) and
Holthausen, Larcker, and Sloan (1995) argue that, with the intention of maximizing their bonus
in subsequent periods, executives may manipulate earnings downward when they perceive that
their bonuses are at the highest level. Guidry, J. Leone, and Rock (1999) extend the literature by
looking at managers within a single firm, which minimizes aggregation effects and removes
confounding effects of stock-based pay plans. They provide evidence that managers manipulate
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earnings to maximize their short-term bonus compensation. The arguments presented earlier
suggest earnings management is positively related with the cost of equity capital. Therefore,
there may be a positive relation between executive bonus and the cost of equity capital. Thus,
the third set of hypotheses is:
H3a: The proportion of executive bonus compensation is positively associated with the
discretionary accruals.
H3b: The proportion of executive bonus compensation is positively associated with the cost of
equity capital.
2.4. Effects of long-term performance plan on earnings management and cost of equity capital
A long-term performance plan is implemented to encourage executives to concentrate on
enhancing firm performance over several years instead of focusing on short-term performance
only (Richardson and Waegelein 2002). Long-term performance plans encourage executives to
increase their decision-making perspectives and make decisions that align with shareholders’
interests (Larcker 1983; Tehranian, Travlos, and Waegelein 1987b, 1987a). Also, performance
plans can decrease the manager’s exposure to risk by reducing the extraneous variability in the
manager’s performance measures (Richardson and Waegelein 2002). Prior literature
(e.g.,(Richardson and Waegelein 2002; Vafeas and Waegelein 2007) indicates that companies
with long-term performance plans undertake less earnings management than do companies
that have only short-term bonus plans. Long-term performance plans encourage executives to
increase their decision-making perspective because there is less incentive to manage annual
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accounting earnings (Vafeas and Waegelein 2007), because executives pay more attention on
long-term earnings growth rather than managing the accounting earnings of each period to
take advantage of their annual benefit (Richardson and Waegelein 2002). The arguments
presented earlier suggest earnings management is positively related with the cost of equity
capital. Therefore, there may be a negative relation between long-term performance plan and
the cost of equity capital. This leads to the last set of hypotheses as follows:
H4a: The proportion of executive long-term performance compensation is negatively associated
with the discretionary accruals.
H4b: The proportion of executive long-term performance compensation is negatively associated
with the cost of equity capital.
3. Sample selection and data
The sample is comprised of U.S. companies during the period from 2004 to 2010. The
data about executive compensation is collected from the Compustat ExecuComp database. We
collect the compensation data and run the tests separately for CEOs, CFOs, and top five highly-
paid executives because the CFOs manage financial system of the company, while CEOs have
the power to replace CFOs who do not follow the CEOs’ preferences (Mian 2001; Fee and
Hadlock 2004). CEOs were identified based on executives’ titles that include any of the
following phrases: CEO, chief executive, and managing director. CFOs were identified based on
executives’ titles that include any of the following phrases: CFO, chief financial, finance,
controller, and treasurer. Auditor data was obtained from AuditAnalytics. The market-based
data was obtained from CRSP. The analysts’ earnings forecasts were obtained from I/B/E/S.
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Stock price and financial data was collected from CRSP Daily Prices and CRSP Compustat
Merged Annual data. A firm-year observation is only included if all data items are available for
the firm-year observation. Consistent with prior research and to eliminate confounding industry
effects, observations in the banking and financial sector (SIC code 6000–6999) are excluded
from this study. Furthermore, all continuous variables are winsorized at the 1st
and 99th
percentile of their values. The final sample for the tests consists of 3,436 observations.
[insert Table 1 here]
Panel A of Table 1 details the distribution of samples in each year. The number of sample
observations is highest in 2010, with 576 firm-year observations, and lowest in 2008, with 452
firm-year observations. Panel B of Table 1 details the distribution of samples across industries.
Manufacturing is the largest represented industry, making up 50.55 percent of the sample. This
is followed by services, which represented 19.35 percent of the sample.
4. Variable measurement and research design
4.1. Variables of interest
The variables of interest involve four measures of executive compensations.
Stock option
STOPCEO = Percentage of compensation in the form of grants of stock options to the CEO
during the current financial year;
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STOPCFO = Percentage of compensation in the form of grants of stock options to the CFO
during the current financial year; and
STOPALL = Percentage of compensation in the form of grants of stock options to the top highly
paid executives during the current financial year.
Managerial shareholdings
SHARECEO = Percentage of total shares outstanding held by the CEO at the balance sheet date,
excluding options;
SHARECFO = Percentage of total shares outstanding held by the CFO at the balance sheet date,
excluding options; and
SHAREALL = Percentage of total shares outstanding held by the top highly paid executives at the
balance sheet date, excluding options.
Bonus
BONCEO = Percentage of compensation in the form of a bonus earned by the CEO during the
current financial year;
BONCFO = Percentage of compensation in the form of a bonus earned by the CFO during the
current financial year; and
BONALL = Percentage of compensation in the form of a bonus earned by the top highly paid
executives during the current financial year.
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Long-term performance plans
LTPPCEO = Percentage of compensation in the form of the amount paid to the CEO during the
current financial year under the company's long-term incentive plan;
LTPPCFO = Percentage of compensation in the form of the amount paid to the CFO during the
current financial year under the company's long-term incentive plan; and
LTPPALL = Percentage of compensation in the form of the amount paid to the top highly paid
executives during the current financial year under the company's long-term incentive plan.
4.2. Model specification
4.2.1. Earnings management
Following previous studies (e.g., Ball and Shivakumar 2008; Ball and Shivakumar 2006;
Dechow and Dichev 2002; Dechow, Sloan, and Sweeney 1995; Gul, Fung, and Jaggi 2009;
Kothari, Leone, and Wasley 2005), we use discretionary accruals as a measurement for earnings
management. We measure discretionary accruals as the residual from the model by following
Ball and Shivakumar (2006) and Ball and Shivakumar (2008). The model is as follows:
TACC = β0 + β1∆SALES + β2PPE + β3OCF + β4NOCF + β5OCF*NOCF + ε (1)
The variables are defined as follows:
TACC = total accruals, calculated as net income before extraordinary items less cash flow from
operations;
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∆SALES = change in sales;
PPE = gross property, plant, and equipment;
OCF = cash flow from operations;
NOCF = 1 when OCF < 0, 0 otherwise; and
OCF*NOCF = an interaction term of OCF and NOCF.
The above variables are standardized by average total assets. We estimate this model for
each firm in cross-sectional regressions by 2-digit SIC industry code. We require each industry
to have at least 20 observations in any given year. Then, we use the following model to test our
hypotheses regarding the discretionary accruals:
DACC = β0 + β1SIZE + β2LEV + β3ROA + β4LOSS + β5OCF + β6INVREC + β7GROWTH + β8BP + β9BETA
+ Variables of interest + ε (2)
The variables are defined as follows:
DACC = residual from TACC model;
SIZE = size measured by the natural logarithm of the market value of common equity at the
end of the fiscal year;
LEV = financial leverage measured by the ratio of total debt to total assets at the end of the
fiscal year;
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ROA = return on assets calculated as the ratio of earnings before interest and tax divided by
total assets;
LOSS = 1 for firms with negative net income, 0 otherwise;
OCF = cash flow from operations;
INVREC = total inventories plus total receivables divided by total assets;
GROWTH = earnings growth measured as the difference between the mean analysts’ earnings
forecasts for four and three years ahead divided by the mean of three year ahead
earnings forecasts;
BP = ratio of book value of equity to market value of equity at the end of the fiscal year;
and
BETA = share beta (systematic risk) calculated over 36 months to the fiscal year-end.
We include several control variables in order to control for factors affecting discretionary
accruals. SIZE is included in the model because the accrual behavior of executives of large and
small firms is different. Specifically, executives of larger firms report more stable discretionary
accruals (Dechow and Dichev 2002). Dechow, Sloan, and Sweeney (1995) document that
overestimated accruals may resulted from poorly performing firms. As a result, LEV, ROA, and
LOSS are included in the model to capture the financial condition of the firm. We include OCF in
the model because Dechow (1994) report the negative association between cash flows and
accruals. We include INVREC in the model because firms may report higher proportions of
inventory and receivables due to greater opportunities for earnings management (Ittonen,
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Vähämaa, and Vähämaa 2013). Growth firms may report systematically high levels of
discretionary accruals (Gul, Fung, and Jaggi 2009; Ittonen, Vähämaa, and Vähämaa 2013).
Therefore, GROWTH and BP are included to capture the difference in the accruals behavior
between high growth firms and low growth firms. We include BETA in the model because
previous studies find that the level of earnings management decreases with BETA.
4.2.2. Cost of equity capital
Following previous research (i.e., Boone, Khurana, and Raman 2011; Hail and Leuz 2006;
Dhaliwal, Heitzman, and Zhen Li 2006), to mitigate the effects of specific assumptions that
underlie each method on the results, the dependent variable is a measure of the average
expected cost of equity capital from different alternative approaches. Boone, Khurana, and
Raman (2011) use the average of the four alternative approaches as rGLS, rCT, rOJN, and rMPEG.
Nevertheless, in this paper, we measure the average value of the expected cost of equity
capital by using nine estimates used in prior literature (Easton 2004; Ohlson and Juettner-
Nauroth 2005; Gode and Mohanram 2003; Botosan and Plumlee 2002; Gordon and Gordon
1997; Claus and Thomas 2001; Gebhardt, Lee, and Swaminathan 2001; Hail and Leuz 2006;
Dhaliwal, Krull, and Li 2007). These are rPEG, rPEGST, rMPEG, rOJN, rGM, rBP, rGG, rCT, and rGLS, as
defined in Table 2.
[insert Table 2 here]
We use the following model to test our hypotheses regarding the cost of equity capital:
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COE = β0 + β1LEV + β2BP + β3BETA + β4GROWTH + β5SIZE + β6VAR + β7ROA + β8EQ + Variables of
interest + ε (3)
The variables are defined as follows:
COE = cost of equity capital estimated by nine models as listed in Table 1;
LEV = financial leverage measured by the ratio of total debt to total assets at the end of the
fiscal year;
BP = ratio of book value of equity to market value of equity at the end of the fiscal year;
BETA = share beta (systematic risk) calculated over 36 months to the fiscal year-end;
GROWTH = earnings growth measured as the difference between the mean analysts’ earnings
forecasts for four and three years ahead divided by the mean of three year ahead
earnings forecasts;
SIZE = size measured by the natural logarithm of the market value of common equity at the
end of the fiscal year;
VAR = earnings variability measured by the standard deviation of analysts’ earnings forecasts
available on I/B/E/S International during the fiscal year-end month;
ROA = return on assets calculated as the ratio of earnings before interest and tax divided by
total assets; and
EQ = earnings quality measured as the absolute value of residuals using the Dechow and
Dichev (2002) approach.
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Consistent with prior research, we include commonly used control variables to capture
the effects of other factors that impact cost of equity capital. Prior research (e.g., Fama and
French 1992; Gebhardt, Lee, and Swaminathan 2001) find a positive relation between the
perceived risk associated with leverage (LEV) and the cost of equity capital. Previous studies
(e.g., Fama and French 1997, 1992; Khurana and Raman 2004; Boone, Khurana, and Raman
2008) indicate that book-to-price ratios (BP) is positively associated with the cost of equity
capital. A firm’s systematic risk (BETA) is positively related to its cost of equity capital (Botosan
and Plumlee 2005). Beaver, Kettler, and Scholes (1970) and La Porta (1996) document a positive
association between growth (GROWTH) and the cost of equity capital because earnings from
growth opportunities are riskier than normal earnings. As in prior research (e.g., Khurana and
Raman 2004; Botosan and Plumlee 2005; Boone, Khurana, and Raman 2008; Brennan and
Subrahmanyam 1996; Fama and French 1997; Gebhardt, Lee, and Swaminathan 2001), firm size
(SIZE), as measured by market capitalization, is included in the model. Earnings variability (VAR)
is controlled for in the model because Gebhardt, Lee, and Swaminathan (2001) present that
stable and increasing earnings lead to lower risk premiums. Return on assets (ROA) has
implications for the financial health of the firm and reported earnings directly affect the cost of
capital through investors’ expectations of returns (Gebhardt, Lee, and Swaminathan 2001;
Gode and Mohanram 2003). Francis et al. (2005) report that firms with good earnings quality
(EQ) have a lower cost of capital than firms with poor earnings quality.
5. Results
5.1. Descriptive statistics
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We report descriptive statistics for the full sample in Table 3. The mean (median)
discretionary accruals is 0.02 (0.02) with a standard deviation of 0.04. The mean (median) cost
of equity capital for the average value of nine estimates is 0.10 (0.09) with a standard deviation
of 0.04. Boone, Khurana, and Raman (2011) report lower mean and median cost of equity
capital of 0.050 and 0.046 respectively, which may be attributable to the different number of
estimates used to calculate average value and their larger sample.
[insert Table 3 here]
5.2. Univariate correlations
We report Pearson (below the diagonal) and Spearman (above the diagonal) pairwise
correlations among the variables for the full sample in Table 4. As expected, discretionary
accruals and cost of equity capital are strongly correlated with many executive compensation
variables. For Pearson correlation, we find a significantly positive correlation between
discretionary accruals and STOPCEO, STOPCFO, and STOPALL. We find a significantly negative
correlation between discretionary accruals and BONCEO, BONCFO, and BONALL. However, the
Pearson correlation between discretionary accruals and SHARECEO, SHARECFO, SHAREALL,
LTPPCEO, LTPPCFO, LTPPALL is not reliably different from zero. In addition, we find a
significantly negative Pearson correlation between cost of equity capital and SHARECEO,
BONCEO, LTPPCEO, BONCFO, LTPPCFO, BONALL, and LTPPALL. However, the Pearson
correlation between cost of equity capital and STOPCEO, STOPCFO, SHARECFO, STOPALL, and
SHAREALL is not reliably different from zero.
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For Spearman correlation, we find a significantly positive correlation between
discretionary accruals and STOPCEO, STOPCFO, and STOPALL. We find a significantly negative
correlation between discretionary accruals and SHARECEO, BONCEO, SHARECFO, BONCFO,
SHAREALL, and BONALL. However, the Spearman correlation between discretionary accruals
and LTPPCEO, LTPPCFO, LTPPALL is not reliably different from zero. In addition, we find a
significantly negative Spearman correlation between cost of equity capital and BONCEO,
LTPPCEO, BONCFO, LTPPCFO, BONALL, and LTPPALL. However, the Spearman correlation
between cost of equity capital and STOPCEO, SHARECEO, STOPCFO, SHARECFO, STOPALL, and
SHAREALL is not reliably different from zero. We diagnose multicollinearity in the regressions
using variable inflation factors (VIFs) as discussed in the section of regression results.
[insert Table 4 here]
5.3. Regression results
5.3.1. Discretionary accruals
Table 5 presents regression results of the effect of executive compensation on the
discretionary accruals, testing H1a, H2a, H3a and H4a with respect to earnings management.
We perform separate analyses for CEO, CFO, and top five highest-paid executives. Each model
shows the R-squared value of 0.0935, 0.0925 and 0.0933, respectively. The low VIFs suggest
that collinearity is not likely to be a problem in interpreting the regression results. The
coefficient estimates of BONCEO, LTPPCEO, BONCFO, LTPPCFO, BONALL, and LTPPALL are
significant with a negative sign, showing that bonus and long-term performance plan of CEO,
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CFO, and top-five highly paid executives are associated with a lower discretionary accruals.
Remarkably, the coefficient of SHARECEO is also significant with a negative sign, indicating that
CEO shareholdings is also related to a lower discretionary accruals. The coefficient estimates of
STOPCEO, STOPCFO, SHARECFO, STOPALL, SHAREALL are not statistically significant, suggesting
that CEO stock option, CFO stock option, top-highly paid executives stock option, CFO
shareholdings, and top-highly paid executives shareholdings are not related to the change of
discretionary accruals. Overall, the results support H3a and H4a.
[insert Table 5 here]
5.3.2. Cost of equity capital
Table 6 reports regression results of the effect of executive compensation on the cost of
equity capital, testing H1b, H2b, H3b and H4b. We perform separate analyses for CEO, CFO, and
top five highest-paid executives. Each model shows the R-squared value of 0.2118, 0.2145 and
0.2194, respectively. The low VIFs suggest that collinearity is not likely to be a problem in
interpreting the regression results. The coefficient estimates of BONCEO, LTPPCEO, BONCFO,
LTPPCFO, BONALL, and LTPPALL are negative and significant, showing that bonus and long-term
performance plan of CEO, CFO, and top-five highly paid executives are associated with a lower
cost of equity capital. Remarkably, the coefficient of SHARECEO is also significant with a
negative sign, indicating that CEO shareholding is also related to a lower cost of equity capital.
The coefficient estimates of STOPCEO, STOPCFO, SHARECFO, STOPALL, SHAREALL are not
statistically significant, suggesting that CEO stock option, CFO stock option, top-highly paid
executives stock option, CFO shareholdings, and top-highly paid executives shareholdings are
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not related to the change of cost of equity capital. Taken together, the results support H3b and
H4b.
[insert Table 6 here]
6. Additional analyses
We partition the sample into two groups based on the sign of DACC to examine whether
there is a differential relation between executive compensation components and earnings
management behavior, which result in cost of equity capital, conditional on whether firms
engage in income-increasing or income-decreasing accruals. Table 7 reports regression results
for discretionary accruals that estimated separately for the subsamples of income-increasing
(Panel A) and income-decreasing accruals (Panel B). We find that executive compensation
components affect only income-increasing earnings management, but not income-decreasing
earnings management. Focusing on the variables of interest tested in discretionary accruals
model, the results for income-increasing accruals subsample are in line with the results for full
sample, except for CEO shareholdings that becomes statistically insignificant.
[insert Table 7 here]
The results of cost of equity capital are consistent with the results of discretionary
accruals. Table 8 reports regression results for cost of equity that estimated separately for the
subsamples of income-increasing (Panel A) and income-decreasing accruals (Panel B). We find
that executive compensation components of firms with income-increasing earnings
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management and income-decreasing earnings management affect cost of equity capital.
Focusing on the variables of interest tested in cost of equity model, the results for both income-
increasing accruals and income-decreasing accruals subsamples are in line with the results for
full sample, except for CEO shareholdings of firms with income-increasing accruals that
becomes statistically insignificant and CFO shareholdings of firms with income-decreasing
accruals that becomes statistically significant.
[insert Table 8 here]
7. Conclusion
This study examines how executive compensation components affect earnings
management and cost of equity capital. We hypothesize that the different types of executive
compensation lead to different effects on earnings management and cost of equity capital. We
test our hypotheses by using 3,436 firm-year observations of U.S. firms over the years 2004 to
2010. The results of discretionary accruals are consistent with the results of cost of equity
capital. We find that executive bonus and long-term performance plan lead to the reduction in
both earnings management and cost of equity capital. We also find that only executive bonus
and long-term performance plan of firms that engage in income-increasing accruals exhibit
significantly reduction in earnings management. Our findings reveal that shareholders realize
the information risks resulted from the type of executive compensation and value these risks
into the cost of equity capital. These findings would be of interest to regulators, standard
setters, managers and investors who are interested in executive compensation design, earnings
management, and cost of equity capital.
23
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Table 1
Descriptive information on year and industry distribution
Panel A: Distribution of sample firms by year
Year N Percent
2004 495 14.41
2005 464 13.50
2006 511 14.87
2007 472 13.74
2008 452 13.15
2009 466 13.56
2010 576 16.77
Total 3,436 100.00
Panel B: Distribution of sample firms by industry
SIC Industry N Percent
20–39 Manufacturing 1,737 50.55
70–89 Services 665 19.35
40–49 Transportation and Public Utilities 398 11.58
52–59 Retail Trade 342 9.95
50–51 Wholesale Trade 156 4.54
10–14 Mining 107 3.11
15–17 Construction 17 0.49
01–09 Agriculture, Forestry, and Fishing 8 0.23
91–99 Public Administration 6 0.20
Total 3,436 100.00
29
Table 2
Cost of equity capital equations
COE proxies Equation ����
(Easton 2004) ���� � ��� � ��� �
������
(Easton 2004) ������ � ���� � ��� �
�����
(Easton 2004) ����� � � � ��� � ��� � ��� �
� � ���2 � ����
(Ohlson and Juettner-
Nauroth 2005)
���� � � � ��� � ��� � ���� � ������ � �� � 1�
� � 12 ��� � 1� � ��� � ���
(Gode and Mohanram
2003) ��� � � � !�� � ��� � "��# � ������ � �� � ������2 $ � �� � 1�
� � 12 ��� � 1� � ��� � �%�
(Botosan and Plumlee
2002)
� � & ��'�1 � �%��'
'(� � �1 � �%��
���
(Gordon and Gordon
1997)
� � & ��'�1 � ����'�'(� � ������1 � �����
�)�
(Claus and Thomas
2001)
� � *�� � &*�'+�. �-�' � �)��1 � �)��'
'(� � *��. ��-� � �)���1 � ����)� � ���1 � �)��
��.�
(Gebhardt, Lee, and
Swaminathan 2001)
� � *�� � &*�'+�. �-�' � ��.��1 � ��.��'��'(� � *���. ��-��� � ��.����.��1 � ��.����
����, ������, ����� = cost of equity capital estimated approaches introduced by Easton (2004); ���� = cost of equity capital estimated approach
introduced by Ohlson and Juettner-Nauroth (2005); ��� = cost of equity capital estimated approach introduced by Gode and Mohanram (2003); �%� = cost of equity capital estimated approach introduced by Botosan and Plumlee (2002); ��� = cost of equity capital estimated approach
introduced by Gordon and Gordon (1997); �)� = cost of equity capital estimated approach introduced by Claus and Thomas (2001); ��.� = cost
of equity capital estimated approach introduced by Gebhardt, Lee, and Swaminathan (2001); eps = earnings per share; P = stock price at fiscal
year end; dps = dividend per share; bps = book value per share; and roe = return on equity.
30
Table 3
Descriptive statistics for sample companies
Total Sample (n = 3,436)
Mean
Std.
Deviation
Min 25% Median 75% Max
Dependent Variables
DACC 0.02 0.04 −0.08 0.00 0.02 0.04 0.17
COE 0.10 0.04 0.02 0.07 0.09 0.11 0.24
Control Variables
LOSS 0.00 0.06 0.00 0.00 0.00 0.00 1.00
OCF 828.15 1846.20 −16.42 80.19 223.04 652.30 12625.00
INVREC 0.23 0.15 0.02 0.11 0.21 0.31 0.69
LEV 0.48 0.20 0.08 0.34 0.49 0.63 0.95
BP 0.43 0.24 0.03 0.26 0.38 0.57 1.25
BETA 1.09 0.41 0.37 0.78 1.04 1.36 2.24
GROWTH −0.34 0.56 −1.00 −1.00 0.01 0.13 0.54
SIZE 7.99 1.39 5.44 6.95 7.84 8.85 11.87
VAR 3.90 3.65 0.00 1.69 2.95 4.88 21.13
ROA 0.12 0.07 0.01 0.07 0.11 0.15 0.36
EQ 0.01 0.00 0.01 0.01 0.02 0.02 0.03
Variables of interest
STOPCEO 0.25 0.24 0.00 0.00 0.21 0.40 0.87
SHARECEO 1.20 3.42 0.00 0.00 0.09 0.68 22.12
BONCEO 0.09 0.15 0.00 0.00 0.00 0.14 0.67
LTPPCEO 0.15 0.16 0.00 0.00 0.12 0.25 0.64
STOPCFO 0.22 0.21 0.00 0.00 0.18 0.35 0.82
SHARECFO 0.04 0.13 0.00 0.00 0.00 0.01 0.95
BONCFO 0.09 0.13 0.00 0.00 0.00 0.15 0.58
LTPPCFO 0.14 0.14 0.00 0.00 0.11 0.23 0.58
STOPALL 0.22 0.19 0.00 0.04 0.19 0.34 0.76
SHAREALL 0.44 1.11 0.00 0.00 0.06 0.27 7.28
BONALL 0.09 0.13 0.00 0.00 0.02 0.15 0.54
LTPPALL 0.14 0.14 0.00 0.00 0.13 0.23 0.54
DACC = residual from TACC model; COE = cost of equity capital estimated by nine models as listed in Table 1; LOSS
= 1 for firms with negative net income, 0 otherwise; OCF = cash flow from operations; INVREC = total inventories
plus total receivables divided by total assets; LEV = financial leverage measured by the ratio of total debt to total
assets at the end of the fiscal year; BP = ratio of book value of equity to market value of equity at the end of the
31
fiscal year; BETA = share beta (systematic risk) calculated over 36 months to the fiscal year-end; GROWTH =
earnings growth measured as the difference between the mean analysts’ earnings forecasts for four and three
years ahead divided by the mean of three year ahead earnings forecasts; SIZE = size measured by the natural
logarithm of the market value of common equity at the end of the fiscal year; VAR = earnings variability measured
by the standard deviation of analysts’ earnings forecasts available on I/B/E/S International during the fiscal year-
end month; ROA = return on assets calculated as the ratio of earnings before interest and tax divided by total
assets; EQ = earnings quality measured as the absolute value of residuals using the Dechow and Dichev (2002)
approach; STOPCEO = Percentage of compensation in the form of grants of stock options to the CEO during the
current financial year; SHARECEO = Percentage of total shares outstanding held by the CEO at the balance sheet
date, excluding options; BONCEO = Percentage of compensation in the form of a bonus earned by the CEO during
the current financial year; LTPPCEO = Percentage of compensation in the form of the amount paid to the CEO
during the current financial year under the company's long-term incentive plan; STOPCFO = Percentage of
compensation in the form of grants of stock options to the CFO during the current financial year; SHARECFO =
Percentage of total shares outstanding held by the CFO at the balance sheet date, excluding options; BONCFO =
Percentage of compensation in the form of a bonus earned by the CFO during the current financial year; LTPPCFO =
Percentage of compensation in the form of the amount paid to the CFO during the current financial year under the
company's long-term incentive plan; STOPALL = Percentage of compensation in the form of grants of stock options
to the top highly paid executives during the current financial year; SHAREALL = Percentage of total shares
outstanding held by the top highly paid executives at the balance sheet date, excluding options; BONALL =
Percentage of compensation in the form of a bonus earned by the top highly paid executives during the current
financial year; and LTPPALL = Percentage of compensation in the form of the amount paid to the top highly paid
executives during the current financial year under the company's long-term incentive plan.
32
Table 4 Pearson and Spearman correlation matrix (n = 3,436)
DACC COE LOSS OCF INVREC LEV BP BETA GROWTH SIZE VAR ROA EQ STOPCEO SHARECEO BONCEO LTTPPCEO STOPCFO SHARECFO BONCFO LTPPCFO STOPALL SHAREALL BONALL LTPPALL
DACC 1 −0.02 −0.01 −0.01 0.08 −0.11 −0.15 −0.06 0.03 0.10 −0.04 0.27 0.11 0.06 −0.06 −0.06 −0.01 0.06 −0.04 −0.04 −0.01 0.07 −0.06 −0.07 −0.01
COE −0.01 1 0.03 −0.11 0.00 −0.05 0.31 0.19 −0.01 −0.20 0.16 −0.20 0.15 −0.01 0.01 −0.14 −0.07 −0.01 −0.03 −0.11 −0.08 −0.01 0.02 −0.11 −0.07
LOSS 0.00 0.04 1 −0.01 0.00 0.03 0.02 0.01 0.00 −0.02 0.00 −0.04 0.01 −0.02 0.01 0.03 −0.03 −0.01 −0.01 0.06 −0.03 0.00 0.01 0.05 −0.03
OCF 0.06 −0.00 −0.02 1 −0.27 0.36 -0.11 −0.19 0.28 0.89 −0.05 0.12 −0.09 0.08 −0.33 −0.05 0.17 0.09 −0.06 −0.08 0.20 0.10 −0.33 −0.08 0.19
INVREC 0.05 0.01 −0.00 −0.17 1 −0.06 −0.02 0.14 −0.16 −0.19 −0.08 0.17 0.14 −0.03 0.04 0.03 0.00 −0.03 −0.02 0.04 0.01 −0.04 0.08 0.03 0.00
LEV −0.09 −0.02 0.03 0.13 −0.01 1 −0.04 −0.14 0.07 0.26 −0.19 −0.21 −0.26 −0.13 −0.15 −0.01 0.17 −0.12 −0.03 −0.02 0.17 −0.14 −0.20 −0.02 0.18
BP −0.10 0.33 0.04 −0.06 0.03 −0.05 1 0.11 −0.10 −0.29 −0.03 −0.61 −0.05 −0.18 0.02 −0.05 0.05 −0.21 0.10 −0.05 0.04 −0.23 0.02 −0.03 0.05
BETA −0.05 0.22 0.00 −0.17 0.14 −0.13 0.11 1 −0.08 −0.19 0.25 −0.15 0.26 −0.02 0.05 0.08 −0.02 −0.02 −0.06 0.08 −0.03 −0.02 0.05 0.09 −0.02
GROWTH 0.04 −0.03 −0.01 0.21 −0.20 0.13 −0.08 −0.13 1 0.29 0.09 0.03 −0.12 0.09 −0.04 −0.06 0.04 0.09 0.06 −0.07 0.05 0.10 −0.07 −0.07 0.05
SIZE 0.09 −0.18 −0.02 0.70 −0.20 0.23 −0.28 −0.20 0.34 1 −0.02 0.16 −0.07 0.15 −0.37 0.00 0.12 0.15 −0.11 −0.03 0.14 0.17 −0.36 −0.02 0.14
VAR −0.03 0.15 −0.00 −0.01 −0.07 −0.14 0.00 0.24 0.06 −0.03 1 −0.04 0.14 0.08 0.06 0.01 −0.07 0.08 0.01 0.01 −0.06 0.09 0.07 0.02 −0.07
ROA 0.27 −0.17 −0.03 0.05 0.11 −0.18 −0.53 −0.14 0.02 0.13 −0.03 1 0.08 0.12 0.03 −0.03 0.03 0.15 −0.03 −0.03 0.03 0.16 0.05 −0.05 0.03
EQ 0.09 0.15 0.02 −0.03 0.14 −0.24 −0.04 0.23 −0.14 −0.07 0.08 0.08 1 0.06 0.05 −0.02 −0.04 0.08 −0.04 −0.02 −0.04 0.08 0.08 −0.02 −0.05
STOPCEO 0.05 −0.02 −0.02 0.01 −0.06 −0.16 −0.19 −0.02 0.07 0.13 0.05 0.10 0.06 1 −0.12 0.00 −0.21 0.79 −0.18 0.02 −0.19 0.91 −0.12 0.01 −0.20
SHARECEO −0.02 −0.04 −0.01 −0.02 0.02 −0.11 −0.05 0.02 −0.07 −0.12 0.02 0.07 0.10 −0.08 1 −0.05 0.01 −0.07 0.38 −0.04 −0.02 −0.10 0.81 −0.04 0.00
BONCEO −0.04 −0.11 0.01 0.02 0.07 −0.00 −0.05 0.10 −0.07 0.02 −0.01 −0.00 −0.02 −0.13 0.04 1 −0.56 0.00 −0.25 0.85 −0.55 0.02 −0.03 0.88 −0.57
LTPPCEO −0.02 −0.07 −0.03 0.06 0.02 0.16 0.02 −0.00 0.06 0.10 −0.03 0.04 −0.04 −0.28 0.01 −0.43 1 −0.17 0.24 −0.55 0.89 −0.20 −0.02 −0.56 0.95
STOPCFO 0.04 −0.02 −0.01 0.02 −0.07 −0.13 −0.22 −0.03 0.07 0.14 0.05 0.13 0.07 0.78 −0.04 −0.08 −0.23 1 −0.17 −0.02 −0.19 0.91 −0.08 0.00 −0.19
SHARECFO −0.02 0.01 −0.00 −0.11 0.05 −0.07 0.06 0.02 −0.05 −0.22 0.03 0.01 −0.01 −0.11 0.12 −0.05 0.04 −0.10 1 −0.26 0.25 −0.21 0.38 −0.26 0.24
BONCFO −0.04 −0.10 0.05 −0.01 0.06 −0.01 −0.05 0.10 −0.09 −0.00 −0.02 −0.01 −0.02 −0.05 0.04 0.81 −0.41 −0.11 −0.07 1 −0.60 0.02 −0.04 0.90 −0.58
LTPPCFO −0.02 −0.08 −0.03 0.08 0.02 0.17 0.02 −0.00 0.07 0.13 −0.02 0.02 −0.04 −0.24 −0.06 −0.42 0.85 −0.26 0.05 −0.48 1 −0.21 −0.03 −0.58 0.95
STOPALL 0.06 −0.02 −0.01 0.03 −0.07 −0.15 −0.23 −0.03 0.08 0.16 0.05 0.15 0.08 0.91 −0.06 −0.10 −0.25 0.91 −0.13 −0.07 −0.26 1 −0.10 0.01 −0.22
SHAREALL −0.00 −0.01 0.01 −0.06 0.05 −0.16 −0.01 0.03 −0.10 −0.18 0.02 0.06 0.09 −0.11 0.75 0.04 −0.03 −0.07 0.17 0.04 −0.07 −0.09 1 −0.04 −0.02
BONALL −0.05 −0.11 0.04 −0.01 0.06 −0.01 −0.04 0.11 −0.09 0.00 −0.00 −0.02 −0.03 −0.06 0.05 0.91 −0.45 −0.07 −0.06 0.92 −0.48 −0.08 0.05 1 −0.59
LTPPALL −0.01 −0.08 −0.03 0.08 0.02 0.18 0.02 −0.00 0.08 0.12 −0.03 0.03 −0.04 −0.26 −0.03 −0.44 0.93 −0.25 0.05 −0.46 0.94 −0.27 −0.05 −0.50 1
33
The table reports the correlation matrix for the full sample (3,436 firm-year observations). Pearson (Spearman) correlation are presented below (above) the
diagonal.
Bold and Italics indicate significance at the 1 percent and 5 percent levels, respectively (two-tailed test).
DACC = residual from TACC model; COE = cost of equity capital estimated by nine models as listed in Table 1; LOSS = 1 for firms with negative net income, 0
otherwise; OCF = cash flow from operations; INVREC = total inventories plus total receivables divided by total assets; LEV = financial leverage measured by the
ratio of total debt to total assets at the end of the fiscal year; BP = ratio of book value of equity to market value of equity at the end of the fiscal year; BETA =
share beta (systematic risk) calculated over 36 months to the fiscal year-end; GROWTH = earnings growth measured as the difference between the mean
analysts’ earnings forecasts for four and three years ahead divided by the mean of three year ahead earnings forecasts; SIZE = size measured by the natural
logarithm of the market value of common equity at the end of the fiscal year; VAR = earnings variability measured by the standard deviation of analysts’
earnings forecasts available on I/B/E/S International during the fiscal year-end month; ROA = return on assets calculated as the ratio of earnings before interest
and tax divided by total assets; EQ = earnings quality measured as the absolute value of residuals using the Dechow and Dichev (2002) approach; STOPCEO =
Percentage of compensation in the form of grants of stock options to the CEO during the current financial year; SHARECEO = Percentage of total shares
outstanding held by the CEO at the balance sheet date, excluding options; BONCEO = Percentage of compensation in the form of a bonus earned by the CEO
during the current financial year; LTPPCEO = Percentage of compensation in the form of the amount paid to the CEO during the current financial year under the
company's long-term incentive plan; STOPCFO = Percentage of compensation in the form of grants of stock options to the CFO during the current financial
year; SHARECFO = Percentage of total shares outstanding held by the CFO at the balance sheet date, excluding options; BONCFO = Percentage of compensation
in the form of a bonus earned by the CFO during the current financial year; LTPPCFO = Percentage of compensation in the form of the amount paid to the CFO
during the current financial year under the company's long-term incentive plan; STOPALL = Percentage of compensation in the form of grants of stock options
to the top highly paid executives during the current financial year; SHAREALL = Percentage of total shares outstanding held by the top highly paid executives at
the balance sheet date, excluding options; BONALL = Percentage of compensation in the form of a bonus earned by the top highly paid executives during the
current financial year; and LTPPALL = Percentage of compensation in the form of the amount paid to the top highly paid executives during the current financial
year under the company's long-term incentive plan.
34
Table 5
Multivariate test results for discretionary accruals
Total Sample (n = 3,436)
DACC = β0 + β1SIZE + β2LEV + β3ROA + β4LOSS + β5OCF + β6INVREC + β7GROWTH + β8BP + β9BETA +
Variables of interest + ε
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest
STOPCEO ? −0.004 −0.69 1.32
SHARECEO ? −0.001** −2.29 1.06
BONCEO + −0.020** −1.76 1.40
LTPPCEO − −0.019*** −2.93 1.51
STOPCFO ? −0.006 −0.99 1.30
SHARECFO ? −0.004 −0.51 1.08
BONCFO + −0.024** −1.76 1.49
LTPPCFO − −0.022*** −3.03 1.62
STOPALL ? −0.004 −0.56 1.33
SHAREALL ? −0.001 −0.58 1.08
BONALL + −0.029** −1.93 1.51
LTPPALL − −0.024*** −2.74 1.66
Control variables
Intercept ? −0.020 −1.51 −0.022* −1.94 −0.022* −1.68
SIZE − 0.003*** 2.70 2.63 0.003*** 3.07 2.69 0.003*** 2.96 2.68
LEV + −0.012** −2.09 1.23 −0.011** −2.06 1.21 −0.011** −1.86 1.24
ROA − 0.187*** 7.34 1.57 0.186*** 7.29 1.57 0.185*** 7.47 1.57
LOSS + 0.007 0.32 1.00 0.009 0.41 1.01 0.009 0.39 1.01
OCF − 0.000 0.18 2.12 −0.000 −0.06 2.10 −0.000 −0.01 2.11
INVREC + 0.013** 2.23 1.12 0.013** 2.22 1.12 0.013** 2.25 1.12
GROWTH + 0.001 0.80 1.17 0.001 0.77 1.17 0.001 0.71 1.17
BP + 0.012 1.00 1.62 0.012 1.03 1.62 0.013 1.01 1.63
BETA − −0.001 −0.10 1.11 −0.001 −0.11 1.11 −0.001 −0.01 1.12
R-squared 0.0935 0.0925 0.0933
35
The regression clustered by firm and by year was run. For each variable, the regression coefficient is reported,
followed by the t-statistic. *,**, and *** denote significance at 10 percent, 5 percent, and 1 percent levels,
respectively (one-tailed test where directional predictions are made, two-tailed test otherwise). VIF denotes the
variance inflation factor.
DACC = residual from TACC model; STOPCEO = Percentage of compensation in the form of grants of stock options
to the CEO during the current financial year; SHARECEO = Percentage of total shares outstanding held by the CEO
at the balance sheet date, excluding options; BONCEO = Percentage of compensation in the form of a bonus
earned by the CEO during the current financial year; LTPPCEO = Percentage of compensation in the form of the
amount paid to the CEO during the current financial year under the company's long-term incentive plan; STOPCFO
= Percentage of compensation in the form of grants of stock options to the CFO during the current financial year;
SHARECFO = Percentage of total shares outstanding held by the CFO at the balance sheet date, excluding options;
BONCFO = Percentage of compensation in the form of a bonus earned by the CFO during the current financial year;
LTPPCFO = Percentage of compensation in the form of the amount paid to the CFO during the current financial
year under the company's long-term incentive plan; STOPALL = Percentage of compensation in the form of grants
of stock options to the top highly paid executives during the current financial year; SHAREALL = Percentage of total
shares outstanding held by the top highly paid executives at the balance sheet date, excluding options; BONALL =
Percentage of compensation in the form of a bonus earned by the top highly paid executives during the current
financial year; and LTPPALL = Percentage of compensation in the form of the amount paid to the top highly paid
executives during the current financial year under the company's long-term incentive plan; SIZE = size measured by
the natural logarithm of the market value of common equity at the end of the fiscal year; LEV = financial leverage
measured by the ratio of total debt to total assets at the end of the fiscal year; ROA = return on assets calculated
as the ratio of earnings before interest and tax divided by total assets; LOSS = 1 for firms with negative net income,
0 otherwise; OCF = cash flow from operations; INVREC = total inventories plus total receivables divided by total
assets; GROWTH = earnings growth measured as the difference between the mean analysts’ earnings forecasts for
four and three years ahead divided by the mean of three year ahead earnings forecasts; BP = ratio of book value of
equity to market value of equity at the end of the fiscal year; BETA = share beta (systematic risk) calculated over 36
months to the fiscal year-end.
36
Table 6
Multivariate test results for cost of equity capital
Total Sample (n = 3,436)
COE = β0 + β1LEV + β2BP + β3BETA + β4GROWTH + β5SIZE + β6VAR + β7ROA + β8EQ + Variables of interest
+ ε
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest:
STOPCEO ? −0.003 −0.72 1.30
SHARECEO ? −0.001** −2.34 1.05
BONCEO + −0.046*** −4.61 1.40
LTPPCEO − −0.041*** −5.94 1.51
STOPCFO ? −0.003 −0.61 1.29
SHARECFO ? −0.007 −1.36 1.07
BONCFO + −0.055*** −5.85 1.49
LTPPCFO − −0.051*** −5.31 1.61
STOPALL ? −0.002 −0.28 1.32
SHAREALL ? −0.001 −1.18 1.07
BONALL + −0.063*** −5.72 1.51
LTPPALL − −0.058*** −6.24 1.66
Control variables:
Intercept ? 0.050*** 3.44 0.050*** 3.81 0.050*** 3.46
LEV + 0.021** 1.97 1.28 0.022** 2.16 1.26 0.023** 2.18 1.29
BP + 0.053*** 5.26 1.56 0.053*** 5.53 1.56 0.053*** 5.29 1.57
BETA + 0.014*** 5.98 1.21 0.015*** 6.37 1.21 0.015*** 6.32 1.21
GROWTH + 0.002** 1.99 1.17 0.002** 1.78 1.18 0.002** 1.62 1.18
SIZE − −0.002*** −2.34 1.35 −0.002** −2.14 1.40 −0.002** −2.02 1.38
VAR + 0.001*** 2.61 1.09 0.001*** 2.58 1.09 0.001*** 2.60 1.09
ROA + 0.035 1.07 1.53 0.034 1.03 1.52 0.034 1.07 1.52
EQ + 1.136*** 3.08 1.14 1.098*** 3.06 1.14 1.090*** 2.87 1.14
R-squared 0.2118 0.2145 0.2194
The regression clustered by firm and by year was run. For each variable, the regression coefficient is reported,
followed by the t-statistic. *,**, and *** denote significance at 10 percent, 5 percent, and 1 percent levels,
37
respectively (one-tailed test where directional predictions are made, two-tailed test otherwise). VIF denotes the
variance inflation factor.
COE = cost of equity capital estimated by nine models as listed in Table 1; STOPCEO = Percentage of compensation
in the form of grants of stock options to the CEO during the current financial year; SHARECEO = Percentage of total
shares outstanding held by the CEO at the balance sheet date, excluding options; BONCEO = Percentage of
compensation in the form of a bonus earned by the CEO during the current financial year; LTPPCEO = Percentage
of compensation in the form of the amount paid to the CEO during the current financial year under the company's
long-term incentive plan; STOPCFO = Percentage of compensation in the form of grants of stock options to the CFO
during the current financial year; SHARECFO = Percentage of total shares outstanding held by the CFO at the
balance sheet date, excluding options; BONCFO = Percentage of compensation in the form of a bonus earned by
the CFO during the current financial year; LTPPCFO = Percentage of compensation in the form of the amount paid
to the CFO during the current financial year under the company's long-term incentive plan; STOPALL = Percentage
of compensation in the form of grants of stock options to the top highly paid executives during the current
financial year; SHAREALL = Percentage of total shares outstanding held by the top highly paid executives at the
balance sheet date, excluding options; BONALL = Percentage of compensation in the form of a bonus earned by
the top highly paid executives during the current financial year; and LTPPALL = Percentage of compensation in the
form of the amount paid to the top highly paid executives during the current financial year under the company's
long-term incentive plan; LEV = financial leverage measured by the ratio of total debt to total assets at the end of
the fiscal year; BP = ratio of book value of equity to market value of equity at the end of the fiscal year; BETA =
share beta (systematic risk) calculated over 36 months to the fiscal year-end; GROWTH = earnings growth
measured as the difference between the mean analysts’ earnings forecasts for four and three years ahead divided
by the mean of three year ahead earnings forecasts; SIZE = size measured by the natural logarithm of the market
value of common equity at the end of the fiscal year; LEV = financial leverage measured by the ratio of total debt
to total assets at the end of the fiscal year; VAR = earnings variability measured by the standard deviation of
analysts’ earnings forecasts available on I/B/E/S International during the fiscal year-end month; ROA = return on
assets calculated as the ratio of earnings before interest and tax divided by total assets; EQ = earnings quality
measured as the absolute value of residuals using the Dechow and Dichev (2002) approach.
38
Table 7
Multivariate test results for income-increasing and income-decreasing accruals subsamples
Total Sample (n = 3,436)
DACC = β0 + β1SIZE + β2LEV + β3ROA + β4LOSS + β5OCF + β6INVREC + β7GROWTH + β8BP + β9BETA +
Variables of interest + ε
Panel A: Income-increasing discretionary accruals subsample (n = 2,414)
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest:
STOPCEO ? −0.002 −0.53 1.30
SHARECEO ? −0.001 −1.48 1.06
BONCEO + −0.017** −1.87 1.39
LTPPCEO − −0.017*** −4.21 1.48
STOPCFO ? −0.006 −1.14 1.31
SHARECFO ? −0.007 −1.35 1.09
BONCFO + −0.018** −1.68 1.48
LTPPCFO − −0.021*** −4.49 1.60
STOPALL ? −0.004 −0.61 1.33
SHAREALL ? −0.001 −1.12 1.08
BONALL + −0.023** −1.99 1.49
LTPPALL − −0.024*** −4.94 1.64
Control variables:
Intercept ? 0.027*** 2.60 0.027*** 2.96 0.026*** 2.53
SIZE − −0.001* −1.51 2.81 −0.001 −1.27 2.92 −0.001 −1.17 2.86
LEV + −0.010** −1.77 1.26 −0.010** −1.85 1.25 −0.009** −1.65 1.28
ROA − 0.160*** 5.50 1.63 0.159*** 5.59 1.63 0.159*** 5.59 1.63
LOSS + 0.019 1.22 1.01 0.020 1.22 1.01 0.021 1.23 1.01
OCF − 0.000* 1.37 2.21 0.000 1.06 2.20 0.000 1.18 2.20
INVREC + 0.007 0.99 1.14 0.007 1.02 1.14 0.007 1.03 1.14
GROWTH + 0.002** 2.18 1.18 0.002*** 2.27 1.18 0.002** 2.12 1.18
BP + 0.005 0.36 1.70 0.005 0.36 1.71 0.005 0.36 1.71
BETA − 0.006*** 2.88 1.14 0.006*** 2.79 1.13 0.006*** 2.96 1.14
R-squared 0.1046 0.1041 0.1054
39
Panel B: Income-decreasing discretionary accruals subsample (n = 1,022)
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest:
STOPCEO ? −0.003 −0.82 1.36
SHARECEO ? −0.001 −0.76 1.06
BONCEO + 0.002 0.37 1.48
LTPPCEO − 0.003 0.67 1.65
STOPCFO ? −0.003 −0.68 1.30
SHARECFO ? 0.005 1.42 1.05
BONCFO + 0.002 0.21 1.56
LTPPCFO − 0.006 0.96 1.71
STOPALL ? −0.005 −1.41 1.34
SHAREALL ? −0.001 −0.49 1.07
BONALL + 0.004 0.43 1.62
LTPPALL − 0.008 1.36 1.80
Control variables:
Intercept ? −0.047*** −11.00 −0.049*** −11.51 −0.047*** −10.46
SIZE − 0.003*** 3.50 2.43 0.003*** 3.86 2.40 0.003*** 3.76 2.46
LEV + 0.009*** 2.48 1.21 0.009*** 2.19 1.19 0.008** 2.17 1.23
ROA − −0.004 −0.52 1.44 −0.006 −0.73 1.43 −0.006 −0.89 1.44
LOSS + −0.001 −0.12 1.01 −0.001 −0.06 1.01 0.001 0.05 1.01
OCF − −0.000* −1.46 2.09 −0.000* −1.58 2.05 −0.000* −1.56 2.08
INVREC + −0.007* −1.45 1.14 −0.007* −1.51 1.13 −0.007* −1.44 1.14
GROWTH + −0.001 −0.52 1.18 −0.001 −0.63 1.18 −0.001 −0.58 1.18
BP + 0.012*** 2.58 1.54 0.012*** 2.59 1.51 0.011*** 2.47 1.53
BETA − −0.006*** −3.58 1.08 −0.006*** −3.39 1.09 −0.006*** −3.58 1.09
R-squared 0.0616 0.0630 0.0637
The regression clustered by firm and by year was run. For each variable, the regression coefficient is reported,
followed by the t-statistic. *,**, and *** denote significance at 10 percent, 5 percent, and 1 percent levels,
respectively (one-tailed test where directional predictions are made, two-tailed test otherwise). VIF denotes the
variance inflation factor.
DACC = residual from TACC model; STOPCEO = Percentage of compensation in the form of grants of stock options
to the CEO during the current financial year; SHARECEO = Percentage of total shares outstanding held by the CEO
at the balance sheet date, excluding options; BONCEO = Percentage of compensation in the form of a bonus
earned by the CEO during the current financial year; LTPPCEO = Percentage of compensation in the form of the
40
amount paid to the CEO during the current financial year under the company's long-term incentive plan; STOPCFO
= Percentage of compensation in the form of grants of stock options to the CFO during the current financial year;
SHARECFO = Percentage of total shares outstanding held by the CFO at the balance sheet date, excluding options;
BONCFO = Percentage of compensation in the form of a bonus earned by the CFO during the current financial year;
LTPPCFO = Percentage of compensation in the form of the amount paid to the CFO during the current financial
year under the company's long-term incentive plan; STOPALL = Percentage of compensation in the form of grants
of stock options to the top highly paid executives during the current financial year; SHAREALL = Percentage of total
shares outstanding held by the top highly paid executives at the balance sheet date, excluding options; BONALL =
Percentage of compensation in the form of a bonus earned by the top highly paid executives during the current
financial year; and LTPPALL = Percentage of compensation in the form of the amount paid to the top highly paid
executives during the current financial year under the company's long-term incentive plan; SIZE = size measured by
the natural logarithm of the market value of common equity at the end of the fiscal year; LEV = financial leverage
measured by the ratio of total debt to total assets at the end of the fiscal year; ROA = return on assets calculated
as the ratio of earnings before interest and tax divided by total assets; LOSS = 1 for firms with negative net income,
0 otherwise; OCF = cash flow from operations; INVREC = total inventories plus total receivables divided by total
assets; GROWTH = earnings growth measured as the difference between the mean analysts’ earnings forecasts for
four and three years ahead divided by the mean of three year ahead earnings forecasts; BP = ratio of book value of
equity to market value of equity at the end of the fiscal year; BETA = share beta (systematic risk) calculated over 36
months to the fiscal year-end.
41
Table 8
Multivariate test results for cost of equity capital of income-increasing and income-decreasing
accruals subsamples
Total Sample (n = 3,436)
COE = β0 + β1LEV + β2BP + β3BETA + β4GROWTH + β5SIZE + β6VAR + β7ROA + β8EQ + Variables of interest
+ ε
Panel A: Income-increasing discretionary accruals subsample (n = 2,414)
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest:
STOPCEO ? −0.001 −0.35 1.29
SHARECEO ? −0.001 −1.26 1.04
BONCEO + −0.038*** −3.63 1.40
LTPPCEO − −0.035*** −6.24 1.48
STOPCFO ? 0.001 0.11 1.30
SHARECFO ? −0.005 −0.68 1.08
BONCFO + −0.045*** −3.99 1.49
LTPPCFO − −0.044*** −5.14 1.60
STOPALL ? 0.002 0.37 1.31
SHAREALL ? −0.001 −0.83 1.07
BONALL + −0.053*** −4.32 1.50
LTPPALL − −0.049*** −6.01 1.63
Control variables:
Intercept ? 0.031** 2.12 0.032*** 2.41 0.031** 2.15
LEV + 0.026** 2.14 1.31 0.027*** 2.30 1.30 0.028*** 2.27 1.33
BP + 0.060*** 6.31 1.64 0.061*** 6.57 1.65 0.061*** 6.20 1.65
BETA + 0.016*** 5.34 1.23 0.016*** 5.71 1.23 0.016*** 5.56 1.24
GROWTH + 0.002* 1.35 1.17 0.002 1.19 1.18 0.002 1.11 1.18
SIZE − −0.001* −1.52 1.38 −0.001* −1.41 1.44 −0.001* −1.38 1.41
VAR + 0.001** 1.85 1.09 0.001** 1.89 1.09 0.001** 1.87 1.09
ROA + 0.066*** 2.37 1.59 0.064*** 2.30 1.59 0.064*** 2.34 1.59
EQ + 1.230*** 3.45 1.13 1.183*** 3.41 1.13 1.175*** 3.20 1.13
R-squared 0.2312 0.2340 0.2387
42
Panel B: Income-decreasing discretionary accruals subsample (n = 1,022)
CEO CFO
Top five highly-paid
executives
Variable
Exp.
sign
Coef.
t-
value
VIF Coef.
t-
value
VIF Coef.
t-
value
VIF
Variables of interest:
STOPCEO ? −0.007 −1.08 1.34
SHARECEO ? −0.001* −1.65 1.07
BONCEO + −0.063*** −5.79 1.43
LTPPCEO − −0.049*** −2.99 1.63
STOPCFO ? −0.010 −1.31 1.29
SHARECFO ? −0.011* −1.82 1.05
BONCFO + −0.072*** −9.10 1.54
LTPPCFO − −0.063*** −3.27 1.70
STOPALL ? −0.010 −1.05 1.33
SHAREALL ? −0.001 −0.80 1.07
BONALL + −0.082*** −9.04 1.58
LTPPALL − −0.074*** −3.85 1.79
Control variables:
Intercept ? 0.092*** 6.23 0.087*** 6.06 0.088*** 5.96
LEV + 0.014 1.20 1.25 0.016* 1.34 1.24 0.017* 1.49 1.26
BP + 0.039*** 3.80 1.45 0.040*** 4.17 1.44 0.040*** 4.05 1.45
BETA + 0.011*** 2.65 1.17 0.012*** 2.80 1.17 0.012*** 2.85 1.18
GROWTH + 0.003 1.00 1.19 0.002 0.75 1.20 0.003 0.83 1.20
SIZE − −0.004*** −4.78 1.31 −0.003*** −4.38 1.33 −0.003*** −4.00 1.34
VAR + 0.001*** 3.52 1.10 0.001*** 3.55 1.10 0.001*** 3.68 1.10
ROA + −0.039 −0.84 1.43 −0.036 −0.77 1.41 −0.034 −0.75 1.42
EQ + 0.960*** 2.35 1.19 0.975*** 2.35 1.18 0.964*** 2.25 1.19
R-squared 0.1916 0.1905 0.1966
The regression clustered by firm and by year was run. For each variable, the regression coefficient is reported,
followed by the t-statistic. *,**, and *** denote significance at 10 percent, 5 percent, and 1 percent levels,
respectively (one-tailed test where directional predictions are made, two-tailed test otherwise). VIF denotes the
variance inflation factor.
COE = cost of equity capital estimated by nine models as listed in Table 1; STOPCEO = Percentage of compensation
in the form of grants of stock options to the CEO during the current financial year; SHARECEO = Percentage of total
shares outstanding held by the CEO at the balance sheet date, excluding options; BONCEO = Percentage of
compensation in the form of a bonus earned by the CEO during the current financial year; LTPPCEO = Percentage
of compensation in the form of the amount paid to the CEO during the current financial year under the company's
43
long-term incentive plan; STOPCFO = Percentage of compensation in the form of grants of stock options to the CFO
during the current financial year; SHARECFO = Percentage of total shares outstanding held by the CFO at the
balance sheet date, excluding options; BONCFO = Percentage of compensation in the form of a bonus earned by
the CFO during the current financial year; LTPPCFO = Percentage of compensation in the form of the amount paid
to the CFO during the current financial year under the company's long-term incentive plan; STOPALL = Percentage
of compensation in the form of grants of stock options to the top highly paid executives during the current
financial year; SHAREALL = Percentage of total shares outstanding held by the top highly paid executives at the
balance sheet date, excluding options; BONALL = Percentage of compensation in the form of a bonus earned by
the top highly paid executives during the current financial year; and LTPPALL = Percentage of compensation in the
form of the amount paid to the top highly paid executives during the current financial year under the company's
long-term incentive plan; LEV = financial leverage measured by the ratio of total debt to total assets at the end of
the fiscal year; BP = ratio of book value of equity to market value of equity at the end of the fiscal year; BETA =
share beta (systematic risk) calculated over 36 months to the fiscal year-end; GROWTH = earnings growth
measured as the difference between the mean analysts’ earnings forecasts for four and three years ahead divided
by the mean of three year ahead earnings forecasts; SIZE = size measured by the natural logarithm of the market
value of common equity at the end of the fiscal year; LEV = financial leverage measured by the ratio of total debt
to total assets at the end of the fiscal year; VAR = earnings variability measured by the standard deviation of
analysts’ earnings forecasts available on I/B/E/S International during the fiscal year-end month; ROA = return on
assets calculated as the ratio of earnings before interest and tax divided by total assets; EQ = earnings quality
measured as the absolute value of residuals using the Dechow and Dichev (2002) approach.