Effects of Executive Compensation Components...1 Effects of Executive Compensation on Earnings Management and Cost of Equity Capital Abstract This study examines how executive compensation

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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

[email protected]

Leon Wong

UNSW Australia

UNSW Sydney NSW 2052, Australia

+61 2 93855810

[email protected]

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)


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.


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)


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.


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.


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.


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.


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.


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.


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


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 =



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


COE = β0 + β1LEV + β2BP + β3BETA + β4GROWTH + β5SIZE + β6VAR + β7ROA + β8EQ + Variables of interest

+ ε

CEO CFO


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



37



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


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


executives

Variable

Exp.

sign

Coef.

t-

value

VIF Coef.

t-

value

VIF Coef.

t-

value

VIF


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


executives

Variable

Exp.

sign

Coef.

t-

value

VIF Coef.

t-

value

VIF Coef.

t-

value

VIF


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





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 =



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


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


executives

Variable

Exp.

sign

Coef.

t-

value

VIF Coef.

t-

value

VIF Coef.

t-

value

VIF


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


executives

Variable

Exp.

sign

Coef.

t-

value

VIF Coef.

t-

value

VIF Coef.

t-

value

VIF


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





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.

Documents

Effects of Executive Compensation Components...1 Effects of Executive Compensation on Earnings Management and Cost of Equity Capital Abstract This study examines how executive compensation