Suk, 2016 PDF

Article
Journal of Accounting,
Auditing & Finance
CEO Inside Debt and Earnings 2016, Vol. 31(4) 515550
The Author(s) 2015
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DOI: 10.1177/0148558X15596907
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Sandip Dhole1, Hariom Manchiraju2, and Inho Suk3
Abstract
This study examines the impact of CEO inside debt on earnings management. Theory pre-
dicts that CEOs with higher inside debt holdings adopt less risky corporate policies and
choose investment policies that result in less volatile earnings. Under such circumstances,
CEOs would face weaker demand for income smoothing. Consistent with these expecta-
tions, our results reveal that CEO inside debt is negatively associated with both accrual-
and real activities-based earnings management. We also find that firms with higher levels of
CEO inside debt are less likely to meet or slightly beat analysts earnings forecasts.
Furthermore, the capital market response to positive earnings surprises is greater when
CEOs hold higher positions of inside debt. Overall, our findings suggest that inside debt
counteracts CEOs incentives to smooth earnings through earnings management and inves-
tors understand the deterrence effect of inside debt on earnings management.
Keywords
CEO inside debt, earnings smoothing, earnings management, agency theory, executive
compensation
Introduction
A large body of literature documents that firms accounting choices are affected by com-
pensation contracts. For example, numerous prior studies have intensively examined the
effect of cash and equity-based incentives of the CEO on earnings management.1 However,
this literature has paid little attention to how earnings management is related to the pres-
ence and amount of inside debt in the CEO compensation. Our study extends the literature
on the link between components of executive compensation and earnings management by
investigating how CEO inside debt affects earnings management. Considering the recently
increasing attention to debt-like compensation in the total executive compensation and its
underdeveloped stage in the literature, our investigation is timely and adds useful insights
into the executive compensation schemes and their accounting choices.
1
University of Melbourne, Victoria, Australia
2
Indian School of Business, Hyderabad, India
3
University at Buffalo, NY, USA
Corresponding Author:
Inho Suk, University of Buffalo School of Management, University at Buffalo, NY 14260, USA.
Email: inhosuk@buffalo.edu
516 Journal of Accounting, Auditing & Finance
In agency theory (Edmans & Liu, 2011; Jensen & Meckling, 1976), the notion of paying
the manager with a fraction of firms debt (or any security with payoffs similar to debt) is
termed as inside debt. Inside debt is considered as one way to mitigate stockholder
debtholder conflicts. When the manager is compensated by equity only, he has incentives
to increase firm risk beyond a level that debtholders prefer and take actions that expropriate
wealth from debtholders to shareholders. In contrast, when the manager holds inside debt,
his incentives vary with the relative importance of debt- versus equity-based compensation
in his pay. The higher a managers inside leverage (inside debt/inside equity) relative to
firm leverage, the more closely his incentives are likely to be aligned with those of debt-
holders vis-a-vis shareholders. Thus, the presence of inside debt in CEO compensation can
have significant influence on managerial incentives, and in turn on various investing and
financing choices (Sundaram & Yermack, 2007). Consistent with this argument, Cassell,
Huang, Sanchez, and Stuart (2012) find a negative association between CEO inside debt
holdings and the volatility of future stock returns, research and development (R&D) expen-
ditures, and financial leverage (more risky investing and financing choices), and a positive
association between CEO inside debt holdings and the extent of diversification and asset
liquidity (less risky investment policies).
In this article, we extend the extant literature by focusing on the impact of inside debt
on a firms accounting choices. Prior research (e.g., Graham, Harvey, & Rajgopal, 2005)
documents that managers have preference for a smooth pattern of reported earnings because
investors perceive firms with smooth earnings as less risky. Consequently, managers often
resort to earnings management techniques to achieve a smooth pattern of earnings. We
argue that in the presence of inside debt, a CEOs incentives to manage earnings are
altered. CEOs with large inside debt holdings are more likely to protect the value of their
inside debt holdings by undertaking less risky financing and investing activities (Cassell
et al., 2012). Because less risky corporate policies lead to more stable earnings patterns,
CEOs with higher inside debt holdings have weaker incentives to further manage earnings
for the purpose of smoothing income. Thus, we hypothesize that compensating CEOs with
inside debt results in an equilibrium with lower levels of income smoothing.
Although the theoretical implications of CEO inside debt on accounting choices seem
unambiguous, empirical limitations and other practical considerations can affect the
observed relation between CEO inside debt on earnings management. First, firms rarely
pay CEOs with a portion of their debt in practice. Instead certain components of CEO com-
pensation can be seen as a reasonable approximation to a compensation component with
debt-like payoffs. Sundaram and Yermack (2007) find that defined benefit pensions (pen-
sions, hereafter) and other deferred compensation (ODC, hereafter) are the two most
common components of CEO compensation that have payoffs resembling the payoffs of
inside debt. These incentives are structured such that a firm promises to pay its CEO fixed
amounts at or after retirement, as long as it is solvent. In case of insolvency, the CEO risks
losing these benefits because they are often unfunded and unsecured. However, some stud-
ies (e.g., Bebchuk & Fried, 2004) argue that CEO pension plans and deferred compensation
plans contain many special arrangements to ensure the security of these benefits in case of
bankruptcy, thereby potentially mitigating the inside debt-like nature of these compensation
components. Thus the hypothesized relation between the inside debt and earnings manage-
ment would hinge on how truly the CEO pensions and ODC capture the theoretical notion
of inside debt.2
Furthermore, certain features of pension plans can also affect earnings management
choices. For example, Kalyta (2009a, 2009b) reports that some pension plans have a clause
Dhole et al. 517
under which the pension benefits accruing to managers after the retirement are a function
of firms performance in the final preretirement years. In such a situation, pension plans
can create incentives for CEOs to actively engage in income-increasing earnings manipula-
tion as they approach retirement. Finally, CEOs with differing inside debt holdings might
also be indifferent about the properties of short-term earnings and levels of earnings man-
agement, especially when the payoffs occur far into the future. In other words, when the
payoffs from inside debt are far into the future, it may not influence the CEOs decision to
influence short-term earnings. Based on the reasoning above, the link between CEO inside
debt holdings and earnings management is not clear ex ante. Considering all these possibili-
ties, our study empirically investigates the impact of CEO inside debt on earnings
management.
Using a broad sample of S&P 1500 nonfinancial firms over a 5-year period from 2006
to 2010, we test our prediction.3 Following extant research (Anantharaman, Fang, & Gong,
2013; Cassell et al., 2012; Edmans & Liu, 2011; Jensen & Meckling, 1976; Sundaram &
Yermack, 2007; Wei & Yermack, 2011), we employ the following two alternative proxies
to measure CEO inside debt. First, we use CEO relative leverage ratio, defined as CEO
debt-to-equity ratio divided by firm debt-to-equity ratio, where CEO inside debt is approxi-
mated to the sum of defined benefit pensions and deferred compensation, and CEO inside
equity includes the value of both stock and options of the firm held by the CEO. Our
second measure for CEO inside debt is CEO relative incentive ratio, which focuses on the
marginal change in CEO wealth (including CEO inside debt and equity holdings) associ-
ated with a unit change in firm value. In our analysis, we investigate not only accounting-
or accrual-based earnings management (AEM) but also real earnings management (REM),
which has become an increasingly popular tool to manage earnings after the Sarbanes
Oxley Act of 2002 (SOX; Cohen, Dey, & Lys, 2008). We use absolute values of these
earnings management proxies in our analysis because our hypotheses do not predict any
specific direction (i.e., upward or downward) for earnings management. We also consider
an outcome-based proxy for earnings management: meeting or slightly beating analysts
earnings expectations (Cheng & Warfield, 2005).
We report several key findings. First, we find a negative association between CEO
inside debt and accruals-based earnings management for income smoothing as proxied by
(a) the correlation between change in discretionary accruals (DA) and change in pre-DA
income and (b) the absolute value of discretionary accruals (|DA|). We also document that
higher levels of inside debt holdings are associated with lower levels of absolute values of
REM proxies, as defined in Roychowdhury (2006)specifically the absolute values of
abnormal cash flow from operations (|RCFO|), abnormal production costs (|RPROD|), and
abnormal discretionary expenditure (|RDISX|). The economic significance of these results
translates as follows: increasing CEO relative leverage ratio from 25th to 75th percentile
reduces |DA| by 0.0094, which is 10.90% lower than the sample mean of |DA|. Similarly,
increasing CEO relative leverage ratio from 25th to 75th percentile reduces the |RCFO| by
0.0105, which is an 11.44% decrease relative to the sample mean of |RCFO|. Together,
these results suggest that higher proportions of inside debt leads managers to choose strate-
gies that reduce the extent of both AEM and REM.
To formally document the mechanism through which inside debt affects earnings man-
agement, we conduct a path analysis and report the direct effect of inside debt on the earn-
ings management, as well as the mediated effect of inside debt on earnings management
that flows through earnings volatility. We find that between 10% and 45% of the total cor-
relation between inside debt and the earnings management is attributable to the mediated
path (i.e., path that flows through earnings volatility), suggesting that inside debt counter-
acts the need for income smoothing more strongly in firms that have more volatile
earnings.
Our results are also robust to alternate measures of earnings management and estimation
techniques. First, we find that firms are less likely to meet or just marginally beat analysts
earnings estimates and avoid large positive earnings surprises when CEOs have higher
ratios of inside debt holdings. These proxies of earnings management are outcome-based
proxies and are thus likely to be free from measurement error (Cheng & Warfield, 2005;
Leuz, Nanda, & Wysocki, 2003). Second, although our primary model specifications
assume that the level of CEO inside debt holdings is exogenously determined, it is possible
that the CEO inside debt holdings and the various dependent variables we consider are
jointly determined. To test the robustness of our results to such endogeneity, we employ
two-stage least squares (2SLS) and find results consistent with our main findings. Third,
our results are robust to (a) alternate measures of inside debt and (b) use of signed mea-
sures of earnings management, rather than absolute values.
Finally, we broaden the scope of our study by examining the stock market response to
earnings surprises conditioned on firms CEO inside debt holdings. In efficient capital mar-
kets, investors can adjust for expected earnings management (Fields, Lys, & Vincent,
2001). If investors understand the positive role of inside debt in enhancing the quality of
reported earnings, the market reaction to the earnings surprise should be stronger. We find
results consistent with our predictions.
Our study contributes to the literature in several ways. First, we extend the extant litera-
ture that examines the impact of CEO compensation, such as cash (Gaver, Gaver, &
Austin, 1995; Healy, 1985; Holthausen, Larcker, & Sloan, 1995; Watts & Zimmerman,
1986) and equity incentives (Aboody & Kasznik, 2000; Armstrong, Jagolinzer, & Larcker,
2010; Bartov & Mohanram, 2004; Bergstresser & Philippon, 2006; Cheng & Warfield,
2005; Jiang, Petroni, & Wang, 2010), on earnings management. Unlike most of the extant
literature, we focus on the effect of the debt component of CEO wealth on earnings man-
agement and find that inside debt holdings changes the equilibrium level of DA. Our results
suggest that one possible mechanism by which inside debt (and hence compensation)
affects the firms reported outcomes is through its effect on the operating risk of the firm,
which in turn reduces the volatility of the underlying earnings and dampens incentives for
earnings management.
Our findings also have implications for the design of executive compensation schemes.
Bebchuk and Fried (2004) argue that executive pension plans and deferred compensation
are examples of stealth compensation because they disguise or downplay the amount and
performance sensitivity of CEO compensation. Thus, including inside debt on CEO com-
pensation can be detrimental to shareholder value. In contrast, agency theory (Edmans &
Liu, 2011; Jensen & Meckling, 1976) suggests that inside debt in CEO compensation could
serve as a mechanism to better align the interests of shareholders and debtholders, thereby
increasing the value of the firm. Our study contributes to this debate by providing evidence
of the channels through which inside debt can enhance the efficiency of compensation con-
tracts. More specifically, we show that when inside debt increases as a component of the
CEOs compensation contract, the CEOs respond by choosing less risky investments and
report them with lower levels of income smoothing. As a consequence, the capital market
response to positive earnings surprises is stronger for firms with higher positions of inside
debt. This suggests that inside debt can play a valuable role in helping to align the interests
of management with those of capital providers to the firm.
Dhole et al. 519
Although we highlight the role of inside debt in optimal compensation contracts, we do

not imply that redesigning compensation contracts to include higher inside debt compo-
nents is necessary condition in an optimal contracting solution. The mere fact that not all
firms have inside debt and several firm still rely predominantly on equity-based incentives
suggest that high inside debt is not always optimal in certain settings. First, Demski, Patell,
and Wolfson (1984) point out that giving managers the flexibility to select accounting
methods can improve the efficiency of compensation contracts. Therefore, to the extent
that high levels of inside debt reduce the flexibility of choosing accounting methods, they
could reduce the efficiency of compensation contracts. Second, high level of inside debt
(relative to firms leverage) can lead to situations where managers behave in a risk-averse
way to the detriment of shareholders (Jensen & Meckling, 1976). Finally, certain level of
income smoothing is also beneficial because it can reveal managers private information
and thereby improve the informativeness of past and current earnings about future earnings
and cash flows (Tucker & Zarowin, 2006). Thus, the board of directors of a firm might be
willing to encourage certain level of risk taking and tolerate earnings management and
therefore have no or low levels of inside debt in the compensation contracts. Overall, we
note that maximizing the value of the firm requires giving managers the optimal level of
flexibility and therefore, the correct level of insider debtnot too much and not too little.4
Related Research and Hypothesis Development

Literature on the Role of Inside Debt
Jensen and Meckling (1976), show that there is a conflict of interest between shareholders
and debtholders. This conflict arises because shareholders (or managers, acting on behalf of
shareholders) can expropriate wealth from debtholders in several ways such as claim dilu-
tion, underinvestment, and asset substitution or risk shifting. Agency theory (Edmans &
Liu, 2011; Jensen & Meckling, 1976) posits that including inside debt in CEO compensa-
tion contracts can align interests of shareholders and debtholders. The argument is that the
presence of inside debt potentially acts as a check on managers incentives to take actions
that transfer wealth from debtholders to shareholders, thereby lowering the cost of debt
capital to the firm
In theory, inside debt would mean paying CEOs with a portion of firms debt. However,
this usually does not happen in practice. Sundaram and Yermack (2007) argue that CEO
pension plans and ODC plans are the two most common components of CEO compensation
that have debt-like payoffs and could function as inside debt. Anantharaman, Fang, and
Wong (2013) report that the accumulated pension and deferred compensation benefits of
S&P 1500 firms in the United States amounted to around 25% of their equity-based com-
pensation in 2007 and 43% in 2008.
The information on CEO pensions and ODC is broadly available from 2006 onwards
because the U.S. Securities Exchange Commission (SEC) expanded its disclosure require-
ments on executive compensation to include CEO pensions and ODC plans, giving rise to
an emerging literature examining the implications of inside debt for investment, financing,
and reporting policies. Sundaram and Yermack (2007) find that the CEO compensation has
a greater component of inside debt as the CEO gets older. They document that the firms
default risk decreases with the level of inside debt, consistent with higher inside debt lead-
ing managers to take on lower risk.
Several studies reason that debtholders require a lower risk premium for firms with
higher inside debt and present evidence consistent with this prediction. For example, Wei
and Yermack (2011) show that the disclosure of their inside debt positions by firms, fol-
lowing the SEC regulation in 2007, led to bond prices rising significantly and stock prices
falling. This evidence is consistent with debtholders regarding higher positions of inside
debt as a mark of confidence in the security of their interest in the firm. Similarly,
Anantharaman, Fang, and Gong (2013) find that firms whose CEOs have higher inside debt
holdings have lower borrowing rates and fewer debt covenants. A recent study by Cassell
et al. (2012) documents that CEO inside debt is negatively associated with future stock
returns, R&D expenditures, and financial leverage, which are widely used as proxies for
risk-taking activities. Inside debt, however, is positively associated with risk reduction mea-
sures such as diversification and asset liquidity. In this study, we extend this emerging liter-
ature by investigating the implications of inside debt on CEOs propensity to manage
earnings.
Hypothesis
As the discussion above shows, firms with high levels of CEO inside debt typically take on
less risky projects. Consequently, the payoffs from the projects undertaken are relatively
less volatile, potentially giving rise to a smoother income stream, a desirable characteristic
of reported earnings. Income smoothing is common in the industry. Indeed, as Graham
et al. (2005) report in their influential survey, managers express strong desires to report
smooth earnings paths, holding cash flow volatility low. Earnings smoothing generally indi-
cates that, rather than having years of exceptionally good or bad earnings, firms attempt to
keep the figures relatively stable by adding and removing earnings components across mul-
tiple years. A primary motivation offered for such behavior is that managers believe that
investors perceive firms with smoother earnings to be less risky, and thus demand a lower
expected return, or cost of equity capital. Their survey results also show that managers indi-
cate a willingness to engage in both accruals and real activities-based earnings management
to achieve smoother earnings. Managers tendency to smooth income via earnings manage-
ment has been widely documented.5
We argue that the presence of inside debt in CEO compensation affects the CEOs moti-
vation to engage in earnings manipulation to smooth earnings. It is possible that firms with
high CEO inside debt will adopt less risky policies and avoid overinvestment in risky proj-
ects. As a result, their earnings will be less volatile. Our conjecture is consistent with
Cassell et al. (2012), who find that CEOs with large inside debt holdings reduce the riski-
ness of firm operations to preserve firm value and reduce the probability of bankruptcy.
They also find that the volatility of stock returns is smaller for those firms with higher
CEO debt. Because in an efficient market, the volatility of stock returns is mirrored by the
idiosyncratic volatility of future earnings, a lower volatility of stock returns could be attrib-
uted to a lower volatility of future earnings. This will lead the firms to face weaker
demand for earnings smoothing, reducing incentives for CEOs for earnings smoothing
through the medium of earnings management. Therefore, based on this line of reasoning, it
can be hypothesized that firms with higher proportions of inside debt would be less likely
to engage in the earnings management for the purpose of earnings smoothing.
Because income smoothing can be achieved through accounting earnings management
(AEM) and/or through the choice of firm strategies (REM), we predict that CEO inside
debt is negatively associated with lower levels of both accounting- or accrual-based
Dhole et al. 521
earnings management (AEM) and REM. Furthermore, we also predict a negative associa-
tion between CEO inside debt and outcome-based proxies for earnings management, such
as the likelihood to just meet or slightly beat analysts forecasts across years and the ten-
dency to avoid large positive earnings surprise (Cheng & Warfield, 2005).
However, our hypothesized relation between inside debt and earnings management
relies on the extent to which the empirical measures of inside debt (i.e., pensions and
ODC) capture the theoretical notion of inside debt. Although these components of CEO
compensation could be a reasonable approximation to compensation with debt-like payoffs,
they also have certain characteristics that could potentially make them deviate from the the-
oretical definition of inside debt. Defined benefit pension plans typically include two com-
ponents: (a) tax qualified plans that cover all employees (regular pension plans, hereafter)
and (b) supplemental executive retirement plans (SERPs, hereafter) that are restricted to
top executives. The Employee Retirement Income Security Act of 1974 (ERISA) requires a
firm to fund and secure its regular pension plans. In case of bankruptcy, the Pension
Benefit Guaranty Corporation (PBGC) shores up the underfunded regular pension plan up
to a maximum limit reset by law annually (US$60,136, per beneficiary in 2015). Hence,
regular pension plan balances are partially secured, making them less debt-like and limiting
their potential to align managerial interests with outside debtholders.
SERPs are often included in CEO compensation packages to increase CEOs postretire-
ment income beyond the regular pension limit on regular plans. SERPs do not have to be
funded or secured and thus expose executives to risk of loss in insolvency. Therefore, they
resemble unsecured corporate debt in payoffs more closely than regular pension plans.
However, there are considerable differences in the way SERP contracts are designed that
may affect their incentive-alignment potential (e.g., Bebchuk & Fried, 2004; Bebchuk &
Jackson, 2005). For instance, CEOs are sometimes allowed to take a lump-sum pension
payout at retirement and/or withdraw pension benefits prior to normal retirement age.
Allowing such flexibility to the CEOs probably makes CEO claims senior to those of out-
side debtholders. Typically, SERP benefits are calculated as a certain percentage of pen-
sionable earnings times number of years of pensionable service minus capped regular
pension benefits. Pensionable earnings used in the formula can be defined differently by
each firm. Kalyta (2009a) argues that if pensionable earnings also consist of bonus, and
other performance-based compensation components (in addition to base salary), then CEOs
have incentives to engage in income-increasing earnings management during the preretire-
ment years because it will amplify the value of their pensions.
Under ODC plans, CEOs voluntarily defer a part of their current compensation and
agree to withdraw it later. These ODC plans do not have to be secured or funded, leading
their characterization as being debt-like compensation. However, certain features of the
ODC plans might make them less debt-like. ODC plans often allow withdrawal on a
prespecified schedule that can start before retirement, leaving the CEO with flexibility over
the maturity of his claims (Wei & Yermack, 2011). This flexible withdrawal schedule
increases the seniority of ODC claims by allowing withdrawal ahead of outside debt-
holders. Furthermore, ODC plans often allow the CEOs to invest in the firms equity,
thereby making them less debt-like to begin with.
To the extent that the components of CEO compensation deviate from the theoretical
inside debt, it is not obvious that inside debt will always reduce earnings management.
Indeed, some counter arguments can also be proposed. For example, inside debt could
encourage inter-temporal smoothing through upward or downward earnings management
over a longer period of time. Furthermore, having a performance-contingent SERP that,
say, is based on the final 3 years salary plus incentives could encourage the CEO to front-
load discretionary expenses in the earlier years of his tenure leading up to the last 3 years,
so that earnings, stock price, and so on in the last 3 years are higher. Based on the argu-
ments above, it is not obvious ex ante that the presence of inside debt in the CEOs com-
pensation contract will reduce or increase the level of earnings management. Our article
examines this link.
Variable Measurement, Empirical Design, and Sample Selection

Variable Measurement
CEO incentives arising from inside debt holdings. We measure CEO incentives arising
from inside debt in two ways. First, following the theoretical predictions of Jensen and
Meckling (1976) and Edmans and Liu (2011), and recent empirical applications (e.g.,
Cassell et al., 2012; Sundaram & Yermack, 2007; Wei & Yermack, 2011), we calculate the
CEOs relative (to the firm) debt-to-equity ratio as
CEO IDH=CEO EH
CEO relative leverage ratio = : 1
FD=FE
CEO inside debt holdings (CEO IDH) are calculated as the sum of the present value of
accumulated pension benefits and deferred compensation as reported in Execucomp. The
value of CEO equity holdings (CEO EH) is the fair value of stock holdings, including
restricted stock (number of shares held times stock price at the end of the firms fiscal
year) holdings, and option holdings. The fair value of option holdings is calculated follow-
ing the Black and Scholes (1973) option valuation model.6 The CEOs debt-to-equity ratio
is then scaled by the firms debt-to-equity ratio, measured as the ratio of total debt (FD) to
the market value of equity (FE). FD equals current plus long-term debt.
A potential limitation of the CEO relative leverage ratio measure is that it is based on
levels rather than changes in the value of debt and equity. Hence, we also adopt the CEO
relative incentive ratio measure developed by Wei and Yermack (2011), which estimates
how a one-dollar increase in the value of the firm affects the value of the CEOs inside
debt versus inside equity claims, scaled by an estimate of how the value of the companys
external debt versus external equity is affected by the same one-dollar change in firm
value.
DCEO IDH=DCEO EH
CEO relative incentive ratio = : 2
DFD=DFE
DCEO EH can be thought of as the CEOs total delta and is constructed as the sum
of the CEOs total share delta (equal to the number of shares held times an assumed
delta of 1.0) and the CEOs total option delta. The option delta, calculated using the
Black and Scholes (1973) model, is the change in the value of option for a one-dollar
change in the underlying stock price. To calculate the firm-level delta, DFE, we follow
Cassell et al. (2012). The approach is similar to that used for DCEO EH except that there
are not complete data on all of the outstanding option tranches issued by the firm. Hence,
the inputs used into the Black-Scholes formula are the total number of employee stock
options outstanding, the average exercise price of outstanding options, and an assumed
Dhole et al. 523
remaining life of 4 years for all options. Finally, as in Wei and Yermack (2011), we adopt
a simplifying assumption, where DCEO IDH and DFD are set as CEO IDH and FD,
respectively.7
Measures of accruals management. We use two accounting earnings management mea-

sures based on DA. We estimate DA using the cross-sectional version of the Jones (1991)
model, with the adjustment for earnings performance (Kothari, Leone, & Wasley, 2005).
We estimate the following performance-controlled regression for all firms in the same
industry (two-digit Standard Industrial Classification [SIC] for fiscal year t:
TACCi, t 1 DREVi, t PPEi, t

= k1 + k2 + k3 + k4 ROAi, t + eit : 3
Ai, t1 Ai, t1 Ai, t1 Ai, t1
TACC is income before extraordinary items less cash flow from operations; DREV is
change in sales revenue from the preceding year; PPE is gross value of property plant and
equipment. These variables are scaled by total assets (A) at the beginning of the year. ROA
is income before extraordinary items, scaled by total assets at the beginning of the year.
All these variables are obtained from COMPUSTAT. The nondiscretionary accruals (NDA)
are the fitted values of Equation 3 and the DA are the deviations of actual accruals from
NDA for fiscal year t and firm i.8
We use two earnings management measures based on the estimated DA above. First, fol-
lowing prior studies (e.g., Leuz et al., 2003; Myers, Myers, & Skinner, 2007; Tucker &
Zarowin, 2006), we measure income smoothing via DA by the negative (i.e., multiplying by
1) correlation between the change in DA and change in prediscretionary income (PDI =
ROA DA), using current year and the previous 4 years observations. This measure assumes
that there is an underlying premanaged income series and that managers use DA to make the
reported income series smooth. More income smoothing is evident in a more negative corre-
lation between DDA and DPDI. Because the correlation between DDA and DPDI (CORR)
has a highly skewed distribution, we transform it as a percentile-ranked measure and divide it
by 100 to create a variable CORRK, whose value, therefore, is in the range [0, 1].
Second, we use the |DA| as an alternate measure of earnings management. This is
because DA can be used to increase or decrease reported earnings to smooth earnings. For
example, the incentives to manipulate earnings upward can include managers attempts to
boost their equity-based compensation (Cheng & Warfield, 2005) and to make new equity
issues more attractive to outside investors (Teoh, Welch, & Wong, 1998a, 1998b).
Managers also have incentives to manage earnings downward before options are awarded
(McAnally, Srivastava, & Weaver, 2008). Negative accruals could also reflect strategic
time-shifting of income to allow the firm to show stable growth over time. By taking the
absolute value of abnormal accruals, we capture managers attempts to manipulate earnings
in both directions (i.e., temporarily to inflate or deflate earnings).
Measures of REM. Similar to the DA measure, we use absolute values of REM proxies in
our analysis. Following Roychowdhury (2006), we consider abnormal levels of cash flow
from operations, production costs, and discretionary expenditures as measures of real activ-
ities management. The three manipulation methods and their impacts on earnings are as fol-
lows: (a) Acceleration of the timing of sales through increased price discounts or more
lenient credit termssuch discounts and lenient credit terms temporarily increase sales
volume and boost the current period earnings, assuming the margins are positive. (b)
Reporting lower cost of goods sold (COGS) through increased productionWhen manag-
ers produce more units, they can spread the fixed overhead costs over a larger number of
units, thus lowering fixed costs per unit. As long as the reduction in fixed costs per unit is
not offset by any increase in marginal cost per unit, total cost per unit decreases. This
decreases reported COGS and the firm can report higher operating margins. (c) Decreases
in discretionary expenditures that include advertising, R&D, and sales, general, and admin-
istrative expenses (SG&A)Reducing such expenses boosts the current period earnings.
All variables used to calculate these three REM metrics are obtained from COMPUSTAT.
We first generate the normal levels of cash from operations (CFO), discretionary
expenses, and production costs following the model used in Roychowdhury (2006). We
express normal CFO as the linear function of sales and change in sales. To estimate this
model, we run the following cross-sectional regression for each industry year:
CFOi, t 1 SALEi, t DSALEi, t

= k1 + k2 + k3 + eit , 4
where CFO is cash flow from operations. RCFOthe abnormal CFO is actual CFO minus
normal level of CFO calculated using the estimated coefficients from Equation 4.
Production costs are defined as the sum of COGS and change in inventory (DINVT)
during the year. We model COGS as a linear function of contemporaneous sales:
COGSi, t 1 SALEi, t
= k1 + k2 + eit : 5
Ai, t1 Ai, t1 Ai, t1
Next, we model inventory growth by the following:
DINVi, t 1 DSALEi, t DSALEi, t1

= k1 + k2 + k3 + eit : 6
Using Equations 5 and 6, we estimate the normal level of production costs as
PRODi, t 1 SALEi, t DSALEi, t DSALEi, t1

= k1 + k2 + k3 + k4 + eit , 7
Ai, t1 Ai, t1 Ai, t1 Ai, t1 Ai, t1
where PROD represents production costs in period t, defined as the sum of COGS and
change in inventory (DINVT). RPRODthe abnormal production costs are actual produc-
tion costs minus normal level of production costs calculated using the estimated coeffi-
cients from Equation 7.
We model the normal level of discretionary expenses as
DISXi, t 1 SALEi, t1

= k1 + k2 + eit , 8
Ai, t1 Ai, t1 Ai, t1
where DISX represents the discretionary expenditures in period t, defined as the sum of
advertising expenses, R&D expenses, and SG&A expenses. RDISXthe abnormal discre-
tionary expenses are actual discretionary expenses minus normal level of discretionary
expenses calculated using the estimated coefficients from Equation 8.
Dhole et al. 525
Given sales levels, firms that manage earnings are likely to have engaged in one or all
of the three real activities management techniques. Thus, following Cohen et al. (2008), we
develop a comprehensive measure combining the three individual REM variables.
Specifically, we compute RMPROXY as the sum of three standardized variables RCFO,
RPROD, and RDISX. Finally, we obtain absolute values of these four REM proxies in our
analysis.
Outcome-based measures of earnings management. Although firms can use both accruals-
and REM-based techniques to smooth earnings, it is unclear whether they use these two
methods simultaneously or sequentially. Barton (2001) documents a simultaneous process
in which firms use DA and hedging with derivative instruments (a REM technique in their
setting) to smooth earnings. In contrast, Pincus and Rajgopal (2002) show a sequential pro-
cess in which firms first smooth earnings using hedging and then manage the residual earn-
ings volatility using DA. Rather than making assumptions about the underlying process in
which firm use accruals and REM to smooth earnings, we rely on outcome-based measures
of earnings management because prior studies (e.g., Cheng & Warfield, 2005) find that
both earnings management techniques to smooth earnings are positively related to the out-
come of meeting/beating analysts earnings forecasts (MBE).
Prior research suggests that MBE is important for firms and that managers are likely to
manipulate earnings to achieve this (e.g., Degeorge, Patel, & Zeckhauser, 1999; Graham
et al., 2005). Compared with DA and real activities management, a firms tendency to beat
earnings benchmarks is an outcome-based proxy for earnings management (Degeorge
et al., 1999) and is likely to be free from measurement error (Leuz et al., 2003). Cheng and
Warfield (2005) suggest that by engaging in income-decreasing earnings management in
years with good performance, managers can reserve for the future and reduce the likelihood
of missing analysts forecasts in the future. That is why firms that meet or slightly beat ana-
lysts forecasts are treated as suspect firms for earnings management in the literature (e.g.,
Roychowdhury, 2006).
We use three outcome-based measures of earnings management. First, we create an indi-
cator variable JustMBE that equals one if the current years (i.e., year t) earnings surprise
equals to zero or one cent. Such firms are more likely to have engaged in earnings manage-
ment (either accruals and/or real activities) to meet or beat earnings benchmarks. Second, we
create an indicator variable LargeMBE that equals one if the current years (i.e., year t) earn-
ings surprise equals or greater than four cents.9 Such firms with large positive earnings sur-
prises are less likely to have engaged in earnings management to save for the future. Finally,
if reserving for future is successful, firms should be able to meet or just beat analysts fore-
casts in the future, resulting in smooth earnings patterns. Hence, we create another indicator
variable JustMBEt + 1 that equals one if the earnings surprise in the year t + 1 is zero or just
one cent. Such firms are likely to have smoothed earnings in the year t.
Empirical Model
To test our hypothesis on the impact of CEO inside debt on earnings management, we esti-
mate the following model:
Earnings management proxy = f CEO inside debt proxy, Controls: 9

The dependent variables in the above model are the proxies for earnings manage-
ment(a) accruals-based measure, (b) real activities-based measure, and (c) MBE-based
measure, as defined in the Variable Measurement section. We estimate ordinary least
squares (OLS) models when the dependent variables are accruals-based (CORRK and |DA|)
and real activities-based (|RCFO|, |RPROD|, |RDISX|, and| RMPROXY|) measures and logit
models when dependent variables are MBE-based binary choice variables (JustMBE,
LargeMBE, and JustMBEt + 1).
Our variables of interest are the CEO relative leverage ratio and CEO relative incentive
ratio. To the extent CEOs with large inside debt holdings face less demand for policies that
lower future earnings volatility, they are less likely to attempt to smooth earnings with the
help of accruals management, REM, and meeting or slightly beating earnings expectations.
Hence, we expect a negative coefficient on CEO relative leverage ratio and CEO relative
incentive ratio in Equation 9 when dependent variables are CORRK, |DA|, |RCFO|,
|RPROD|, |RDISX|, | RMPROXY|, JustMBE, and JustMBEt + 1 whereas we predict a posi-
tive coefficient on the CEO inside debt measures when the dependent variable is
LargeMBE.
In estimating the regression specified in Equation 9, we control for several variables that
are expected to be associated with firms incentives to manage earnings. These variables
are taken from prior literature on earnings management (Dechow, Ge, & Schrand, 2010;
Fields et al., 2001; Healy & Wahlen, 1999). We explain the construction of these variables
in the appendix.
Our first set of control variables relates to cash and equity compensation-related incen-
tives to manage earnings. We also control for the Cash pay (salary plus bonus) because
prior literature (e.g., Healy, 1985) finds that CEOs manage earnings to increase their cash
compensation. To control for incentives arising from equity-based compensation, we
include Deltathe sensitivity of the value of the CEOs accumulated equity-based com-
pensation to a 1% change in the stock price, and Vegathe sensitivity of the value of the
CEOs accumulated equity-based compensation to a 0.01 change in the volatility of stock
prices. Several studies examining the relationship between earnings management and exec-
utives equity incentives generally find that equity-based compensation and holdings pro-
vide incentives for managers to manipulate accounting numbers, perhaps to increase gains
from pending insider sales (e.g., Bergstresser & Philippon, 2006; Cheng & Warfield,
2005). However, using post-SOX data (2002-2006), Jiang et al. (2010) find no effect of
CEO and CFO equity incentives on |DA| and the likelihood of meeting or beating analysts
forecasts. Recent evidence shows that CEO equity incentives can even deter earnings resta-
tement (e.g., Armstrong et al., 2010; OConnor, Priem, Coombs, & Gilley, 2006) or reduce
signed DA (H. Kim, Kwak, & Suk, 2013), suggesting that equity-based compensation alle-
viates managers opportunistic behaviors by aligning managers interests with sharehold-
ers. Hence, we make no predictions on the expected signs of the coefficients for these
variables.
Following Hribar and Nichols (2007), we include earnings volatility in the model
because our dependent variable is the absolute value of earnings management proxy. We
measure earnings volatility using the standard deviation (or coefficient of variation) of the
previous 5 years earnings, with the additional requirement that at least 4 years are required
for each calculation. Computed standard deviations of earnings for each firm-year are used
as proxies for firm-specific earnings volatility (Evol).
Our next set of control variables relate to firm characteristics such as firm size (Total
assets), growth opportunities (Market-to-book ratio and Firm age), and leverage
Dhole et al. 527
(Leverage). Prior studies on the relation between firm size and earnings management pro-
vide mixed evidence. On one hand, it can be argued that larger firms are less likely to
manage earnings upward in response to greater regulatory/political scrutiny (Watts &
Zimmerman, 1986). However, recent studies suggest that firm size is positively associated
with earnings quality because of greater proclivity to maintain adequate internal controls
over financial reporting (Doyle, Ge, & McVay, 2007). Hence, we make no prediction on
the sign of the coefficient for firm size. High growth firms are more likely to manage earn-
ings to meet or beat analysts forecasts to avoid negative consequences associated with
missing analysts forecasts (Skinner & Sloan, 2002). Hence, we expect a positive coeffi-
cient on Market-to-book ratio. If high leverage is indicative of a firm that is closer to a
debt covenant restriction, then managers in more levered firms are more likely to take
actions to boost reported income to avoid possible covenant violations (Watts &
Zimmerman, 1986). Hence, we expect a positive coefficient for Leverage.
Our third set of control variables relates to constraints on earnings management beha-
vior. Beginning-of-period Net operating assets is included because Barton and Simko
(2002) find that firms with high net operating assets in the previous year are less likely to
meet or just beat analysts forecasts, arguably due to a lack of flexibility in managing earn-
ings upward. Firms with greater litigation risk and implicit claims face greater scrutiny
and, hence, are less likely to manage earnings. However, it can also be argued that incen-
tives to avoid negative earnings surprises increase with greater scrutiny (Ali & Kallapur,
2001; Bowen, DuCharme, & Shores, 1995; Francis, Philbrick, & Schipper, 1994). We
therefore include an industry-based Litigation dummy variable and an Implicit Claim vari-
able (proxied by labor intensity), but make no predictions on the expected signs of their
coefficients. We include the number of outstanding shares because firms with more out-
standing shares have smaller earnings per share (EPS) and are thus, more likely to meet or
just beat analysts forecasts of EPS (Barton & Simko, 2002). Following Zang (2012), we
predict lower earnings management in firms audited by the Big 4 auditors (Big4).
Our final set of controls captures capital market pressures to manage earnings. Teoh
et al. (1998a, 1998b) and Rangan (1998) find that managers manage earnings at the time of
seasoned equity offerings (SEOs), suggesting stronger incentives to boost their stock prices
just before they issue equity. We measure this incentive using an indicator variable Issue
that equals one if the firm issues equity in the next year and zero otherwise. Bartov,
Givoly, and Hayn (2002) and Kasznik and McNichols (2002) find that the market places a
greater premium on beating earnings forecasts for firms that have repeatedly beaten earn-
ings targets. Such firms have stronger incentives to keep meeting or beating analyst esti-
mates. We thus control for the number of times a firm meets or beats analysts earnings
forecast in the past four quarters (String of MBE). Because analyst coverage might create
pressure for managers to beat forecast targets, we include the number of analysts following
the firm (Analyst following) as a control.
Finally, we include industry and year fixed effects to control for industry characteristics
and unspecified macroeconomic factors. Because the models based on Equation 9 are esti-
mated using pooled cross-sectional data, statistical inferences are based on heteroscedasti-
city-consistent standard errors that are clustered at firm and year levels (Petersen, 2009).10
Sample Selection
Our sample covers the period from 2006 to 2010. We start in 2006 because the SECs
expanded executive compensation disclosure requirements became effective in the 2006
Table 1. Sample Selection and Distribution.
Panel A: Sample Selection.

Total number of observations relating to nonfinancial firms in Execucomp (2006-2010) 6,244
Less: Observations with insufficient data on COMPUSTAT to calculate (609)
earnings management proxies
Less: Observations without data to calculate equity incentives and other control variables (790)
Final sample 4,845
Panel B: Sample Distribution by Year.

Year Frequency %
2006 860 17.75
2007 943 19.46
2008 993 20.50
2009 1,023 21.11
2010 1,026 21.18
Total 4,845 100.00
Panel C: Sample Distribution by Industry.

Two-digit SIC code Frequency %
13: Oil and gas extraction 191 3.94
20: Food and kindred products 160 3.30
28: Chemicals and allied products 382 7.88
35: Industrial machinery and equipment 308 6.36
36: Electronic & other electric equipment 431 8.90
37: Transportation equipment 115 2.37
38: Instruments and related products 351 7.24
48: Communication 131 2.70
50: Wholesale tradeDurable goods 111 2.29
56: Apparel and accessory stores 113 2.33
58: Eating and drinking places 120 2.48
73: Business services 511 10.55
80: Health services 119 2.46
Industries with \ 2% representation 1,802 37.19
Total 4,845 100.00
Note. SIC = Standard Industrial Classification
fiscal year-end. We obtain CEO compensation, firm financial information, analysts earn-
ings forecasts, and stock returns data from Execucomp, COMPUSTAT, Institutional
Brokers Estimate System (I/B/E/S), and Center for Research in Security Prices (CRSP)
databases, respectively. We collect observations from 2006 to 2010 and identify all firms
with complete compensation data available to calculate the relative CEO debt-to-equity
ratio measures and with the dependent and control variables to estimate our empirical
models. With the above procedures, our final sample consists of 4,845 firm-year observa-
tions, representing 1,348 unique firms. Panel A of Table 1 outlines the sample reconcilia-
tion. Panel B of Table 1 provides the temporal distribution of the sample firms across
years. In general, our sample firms are evenly distributed from 2006 to 2010. Panel C of
Table 1 presents the industry classification (by two-digit SIC codes) across our sample and
indicates that the sample firms are from a broad spectrum of industries.
Dhole et al. 529
Table 2. Descriptive Statistics.
M SD Q1 Median Q3
CEO compensation variables
Inside debt holdings (US$ millions) 3.1834 6.7425 0.0000 0.3666 2.9854
Deferred compensation (US$ millions) 1.2717 3.1815 0.0000 0.0212 0.9697
Pension (US$ millions) 1.7866 4.4207 0.0000 0.0000 0.9672
CEO relative leverage ratio 1.2539 2.4448 0.0000 0.0764 1.1643
CEO relative incentive ratio 0.6462 1.2021 0.0000 0.0447 0.6555
Total compensation (US$ millions) 4.6831 4.9406 1.5094 2.9702 5.9636
Cash pay (US$ millions) 0.8718 0.6348 0.5040 0.7250 1.0000
Equity holdings (US$ millions) 47.9053 156.0779 2.8999 8.8084 28.0802
Delta (US$ millions) 0.4241 0.9207 0.0407 0.1347 0.3803
Vega (US$ millions) 0.1133 0.1870 0.0108 0.0443 0.1271
Income smoothing (management) proxies
CORRK 0.6373 0.4635 0.4931 0.8437 0.9597
|DA| 0.0865 0.0652 0.0370 0.0765 0.1199
|RCFO| 0.0916 0.0593 0.0578 0.0807 0.1052
|RPROD| 0.1438 0.1393 0.0600 0.0932 0.1829
|RDISX| 0.1492 0.1337 0.0718 0.1111 0.1853
|REM PROXY| 0.0000 2.3569 21.5767 20.7226 0.9467
JustMBE 0.1193 0.3242 0.0000 0.0000 0.0000
LargeMBE 0.2834 0.4507 0.0000 0.0000 1.0000
JustMBEt + 1 0.1038 0.3051 0.0000 0.0000 0.0000
Control variables
Total assets (US$ billions) 9.2796 33.6126 0.7260 2.0356 6.3879
Evol 0.0523 0.0608 0.0113 0.0313 0.0702
Firm age 24.3320 1.8503 15.0000 23.0000 45.0000
Market-to-book ratio 2.9150 2.7716 1.4317 2.1763 3.4042
Leverage 0.4603 1.3215 0.0332 0.1867 0.4750
Net operating assets 0.5365 0.1918 0.4243 0.5740 0.6753
Implicit claims 0.4904 0.3250 0.1847 0.5504 0.7826
Litigation dummy 0.3286 0.4697 0.0000 0.0000 1.0000
Log(Shares) 4.5133 1.2271 3.6113 4.3340 5.2045
Big4 0.9373 0.2425 1.0000 1.0000 1.0000
Issue 0.1071 0.3093 0.0000 0.0000 0.0000
Habitual beater 2.9327 1.0905 2.0000 3.0000 4.0000
Analyst following 5.5041 2.0661 3.0000 5.0000 9.0000
Note. This table presents the descriptive statistics of the key variables used in the empirical analysis. The sample
comprises of 4,845 firm-year observations from 2006 to 2010. The definitions of variables used in the model are in
the appendix. All continuous variables are winsorized at top and bottom 1% to mitigate the effect of outliers.
Empirical Results
Descriptive Statistics
Table 2 provides descriptive statistics for the variables used in our analyses. All continuous
variables are winsorized at the top and bottom 1% to mitigate the effect of potential out-
liers. The summary statistics indicate that sample firms are diverse in terms of firm size
(mean and median Total assets are US$9.27 and US$2.03 billion, respectively). The mean
and median values of earnings volatility are 0.0523 and 0.0313, respectively. With respect
to CEO compensation variables, the average CEO holds about US$3.18 million in inside
debt, suggesting that inside debt holdings are substantial for our sample CEOs.11 The mean
CEO relative leverage ratio and CEO relative incentive ratio is 1.254 and 0.646, respec-
tively. The mean CEO holds on average US$47.91 million in equity (consisting of stock
and option holdings). With respect to the earnings management proxies measured by
accruals and real activities, the mean |DA|, |RCFO|, |RPROD|, and |RDISX| are 0.0865,
0.0916, 0.1438, and 0.1492, respectively. At first, this may appear to be a large value as a
percentage of total assets. However the signed values of DA, RCFO, RPROD, and RDISX
have a mean 20.01, 0.06, 20.06, and 0.005, respectively. The mean values are shifted to
the right by taking absolute values. These statistics are comparable with the numbers
reported in Cohen et al. (2008). The likelihood of just meeting or slightly beating in the
current (next) year is about 12% (10%) but that of beating by a large margin is 28%.
The Pearson correlations among measures of CEO IDH and earnings management
proxies are reported in Table 3. The table indicates significant and negative correlations
between proxies of CEO inside debt and earnings volatility, validating our assumption that
firms with high CEO inside debt have lower earnings volatility. We find significant and
negative relations between CEO IDH and various proxies of earnings management based
on accruals and real activities management, suggesting that managers are less likely to
engage in earnings management to smooth income when their compensation includes more
of debt components. Results also show that firms are less likely to meet or slightly beat the
three earnings benchmarks when CEO debt holdings are higher. These univariate results
provide initial evidence of a negative association of CEO IDH with earnings management.
An interesting finding is that the various AEM and REM proxies for income smoothing are
positively correlated with each other, suggesting that they capture the same underlying
phenomenon.12
Main Results
CEO inside debt and accruals management. The results from the regression analysis on
the association between CEO IDH and accruals management are presented in Table 4. Our
dependent variables are CORRK in columns 1 and 2, and the |DA| in columns 3 and 4. In
all the columns, the estimated coefficients on both inside debt proxies are negative and sta-
tistically significant at the 1% level. This suggests that higher inside debt compensation is
associated with lower income smoothing, through accruals management. These results are
also economically significant. In column 1, for example, increasing CEO relative leverage
ratio from the 25th to the 75th percentile reduces the CORRK by 0.0611 (= 20.0525 3
1.1643, where 20.0525 is the coefficient estimate on CEO relative leverage ratio reported
in column 1 of Table 4, and 1.1643 is the interquartile range of CEO relative leverage
ratio calculated from descriptive statistics reported in Table 2). This is a 9.59% (=
20.0611/0.6373, where 0.6373 is the sample mean of CORRK reported in Table 2)
decrease relative to the sample mean of CORRK. Similarly, in column 3 the coefficient on
CEO relative leverage ratio is 20.0081, indicating that increasing CEO relative leverage
ratio from the 25th to the 75th percentile reduces |DA| by 0.0094 (= 20.0081 3 1.1643,
and 1.1643 is the interquartile range of CEO relative leverage ratio calculated from
descriptive statistics reported in Table 2), which is 10.90% lower than the sample mean of
|DA|.
The results on other compensation components such as cash compensation and equity-
based incentive, which potentially compete with inside debt, indicate that cash and equity-
Dhole et al. 531
Table 3. Correlations.
1 2 3 4 5 6 7 8 9 10 11
1 CEO relative 1.0000

leverage ratio
2 CEO relative .9196* 1.0000
incentive ratio
3 Evol 2.2275* 2.2392* 1.0000
4 CORRK 2.1375* 2.1326* 2.2592* 1.0000
5 |DA| 2.2174* 2.2301* .4825* .1252* 1.0000
6 |RCFO| 2.1752* 2.1898* .3978* .1056* .4718* 1.0000
7 |RPROD| 2.1178* 2.1012* .2258* .1662* .3152* .3617* 1.0000
8 |RDISX| 2.1473* 2.1559* .3515* .1005* .3996* .3630* .5528* 1.0000
9 JustMBE 2.1652* 2.1676* .0275* .0717* .0860* .0967* .0826* .0849* 1.0000
10 LargeMBE 2.2766* 2.2755* .1184* .0063 .1242* .1106* .0625* .1038* 2.2314* 1.0000
11 JustMBEt + 1 2.1508* 2.1518* .0248* .0653* .0684* .0744* .0461* .0546* .1106* .0202 1.0000
Note. This table presents the Pearson correlations among main variables utilized in our tests. The definitions of
variables used in the model are in the appendix. All continuous variables are winsorized at top and bottom 1% to
mitigate the effect of outliers.
*corresponds to at least 10% significance level.
based compensation creates incentives for CEOs to manage accruals. Similar to the correla-
tion analysis in Table 3, the results show that the coefficient on |RMPROXY| is positive and
significant in all the four specifications. This implies that REM and AEM can be used as
complements when they are used to manage earnings.13 The coefficients on the other con-
trol variables in the models are consistent with those in theory and prior research.
Specifically, the results also show that larger firms are less likely to manipulate accruals,
although they are statistically significant only in columns 1 and 2. We also find positive
and statistically significant coefficients on firm age, market-to-book ratio, leverage, and
analyst following, consistent with our predictions. Overall, the results in Table 4 suggest
that higher ratios of inside debt reduce the extent of earnings management through
accruals.
CEO inside debt and REM. Table 5 presents results of the association between inside debt
holdings and the proxies of REM|RCFO|, |RPROD|, |RDISX|, and |RMPROXY|. We
expect negative and statistically significant coefficients on the two inside debt measures
mentioned above for all the four REM metrics. Consistent with the results in Table 4, the
results in Table 5 show significantly negative coefficients on both CEO relative leverage
ratio and CEO relative incentive ratio for all four models. Specifically, the estimated coef-
ficients on CEO relative leverage ratio are 20.0090, 20.0185, 20.0155, and 20.1166 for
absolute values of abnormal CFO, production costs, discretionary expenditure, and the
composite REM proxy, respectively, all of which are significant at the 1% significance
level. Similarly, the estimated coefficients on CEO relative incentive ratio are 20.0162,
20.0319, 20.0298, and 20.2350, respectively, all of which are significant at the 1% sig-
nificance level.
These results indicate that higher ratios of inside debt are likely to lead to lower levels
of absolute values of REM. The coefficients on the variables of interest are economically
significant as well. For example, increasing CEO relative leverage ratio from the 25th to
the 75th percentile reduces the |RCFO| by 0.0105, which is an 11.44% decrease relative to
the sample mean for |RCFO|. In column 8, increasing CEO relative incentive ratio from
Table 4. CEO Inside Debt and Income Smoothing Via Accruals.
(1) (2) (3) (4)

CORRK CORRK |DA| |DA|
CEO relative leverage ratio 20.0525*** 20.0081***
(24.66) (25.41)
CEO relative incentive ratio 20.0925*** 20.0121***
(25.14) (25.70)
Ln(Cash pay) 0.0606*** 0.0585*** 0.0080* 0.0072
(3.42) (3.31) (1.76) (1.63)
Ln(Delta) 0.0042 0.0057 0.0041*** 0.0045***
(0.44) (0.59) (5.49) (5.87)
Ln(Vega) 20.0088 20.0105 20.0025*** 20.0030***
(21.21) (21.44) (23.17) (23.54)
|RMPROXY| 0.0230*** 0.0230*** 0.0092*** 0.0091***
(12.91) (12.57) (17.40) (17.26)
Evol 1.5518*** 1.5511*** 0.2951*** 0.2931***
(216.53) (216.38) (4.37) (4.31)
Ln(Total assets) 0.0052 0.0053 20.0035** 20.0036**
(0.84) (0.85) (22.49) (22.52)
Ln(Firm age) 20.0097 20.0092 20.0069*** 20.0066***
(20.75) (20.72) (23.83) (23.65)
Market-to-book ratio 0.0020* 0.0021* 0.0007** 0.0007**
(1.91) (1.93) (22.06) (22.05)
Leverage 20.0126*** 20.0124*** 0.0007 0.0006
(22.67) (22.68) (1.56) (1.50)
Net operating assets 20.0396 20.0376 0.0054 0.0052
(21.38) (21.28) (0.52) (0.50)
Implicit claims 0.0601** 0.0594** 0.0059** 0.0056**
(2.57) (2.54) (2.31) (2.20)
Litigation dummy 20.0470 20.0461 0.0066 0.0066
(21.23) (21.21) (1.61) (1.61)
Ln(Shares) 20.0145** 20.0148** 0.0024 0.0024
(22.37) (22.39) (1.38) (1.40)
Big4 20.0491** 20.0488** 20.0002 20.0000
(22.11) (22.10) (20.07) (20.00)
Issue 0.0048 0.0055 0.0050* 0.0052*
(0.39) (0.44) (1.76) (1.82)
String of MBE 0.0004 0.0001 0.0020*** 0.0020***
(20.09) (20.03) (23.65) (23.63)
Ln(Analyst following) 0.0003 20.0014* 20.0015* 0.0007
(0.05) (21.80) (21.92) (0.09)
Industry and Year dummies Included Included Included Included
N 4,845 4,845 4,845 4,845
Adjusted R2 .2361 .2357 .4011 .4039
Note. This table presents results from the estimation of Equation 9. Dependent variable is the measure of earnings
smoothing calculated following Tucker and Zarowin (2006) in columns 1 and 2, and absolute value of discretionary
accruals calculated following Kothari, Leone, and Wasley (2005) in columns 3 and 4, respectively. Key variable of
interest is the inside debt proxy. Definitions of variables used in the model are in the appendix. The t statistics
(reported in parentheses) are based on heteroscedasticity-consistent standard errors clustered at firm and year
levels. The coefficient estimates for the intercept, year dummies, and industry dummies are not reported for
brevity.
***, **, and * correspond to 1%, 5%, and 10% significance levels, respectively.
Dhole et al. 533
Table 5. CEO Inside Debt and Income Smoothing via Real Earnings Management.
(1) (2) (3) (4) (5) (6) (7) (8)
|RCFO| |RCFO| |RPROD| |RPROD| |RDISX| |RDISX| |RMPROXY| |RMPROXY|
CEO relative 20.0090*** 20.0185*** 20.0155*** 20.1166***

leverage ratio (23.80) (24.11) (24.10) (25.05)
CEO relative 20.0162*** 20.0319*** 20.0298*** 20.2350***
incentive ratio (24.87) (25.16) (25.55) (25.14)
Ln(Cash pay) 0.0056 0.0051 0.0292*** 0.0287*** 0.0261*** 0.0253*** 0.5033*** 0.4853***
(1.03) (0.96) (3.32) (3.25) (4.87) (4.79) (3.77) (3.64)
Ln(Delta) 20.0018* 20.0015 20.0024 20.0020 20.0016 20.0009 20.0601* 20.0458
(21.78) (21.27) (21.14) (20.90) (21.13) (20.67) (21.87) (21.28)
Ln(Vega) 0.0004 20.0000 0.0035 0.0030 0.0017 0.0009 0.0416 0.0247
(0.42) (20.01) (1.56) (1.30) (1.11) (0.58) (1.12) (0.62)
|DA| 0.3812*** 0.3797*** 0.2547*** 0.2521*** 0.2732*** 0.2714*** 0.1726** 0.1629**
(3.58) (3.58) (2.72) (2.70) (2.82) (2.81) (2.29) (2.27)
Evol 0.1264*** 0.1269*** 0.1648*** 0.1661*** 0.2874*** 0.2894*** 5.0466*** 5.0794***
(5.20) (5.25) (3.06) (3.09) (4.31) (4.43) (5.92) (6.02)
Ln(Total assets) 20.0047*** 20.0046*** 20.0014 20.0013 20.0085** 20.0085** 20.1513** 20.1507**
(22.66) (22.66) (20.29) (20.28) (22.15) (22.13) (22.32) (22.31)
Ln(Firm age) 20.0022 20.0021 20.0110** 20.0110** 20.0069 20.0068 20.1783** 20.1750*
(21.26) (21.18) (22.21) (22.19) (21.11) (21.08) (22.01) (21.95)
Market-to-book ratio 0.0011** 0.0011** 0.0026*** 0.0026*** 0.0022 0.0022 0.0447** 0.0449**
(2.52) (2.46) (2.66) (2.67) (1.45) (1.47) (2.32) (2.33)
Leverage 20.0014*** 20.0014*** 20.0031** 20.0030** 20.0030*** 20.0029** 20.0663*** 20.0650***
(23.74) (23.70) (21.97) (21.96) (22.62) (22.56) (22.86) (22.83)
Net operating assets 20.0286*** 20.0282*** 20.0867*** 20.0860*** 20.0746*** 20.0736*** 21.5478*** 21.5294***
(24.42) (24.37) (25.32) (25.26) (24.82) (24.79) (26.41) (26.33)
Implicit claims 0.0032 0.0030 0.0225* 0.0224* 20.0179 20.0182 0.1272 0.1214
(0.82) (0.79) (1.91) (1.90) (21.46) (21.49) (0.79) (0.76)
Litigation dummy 0.0134** 0.0135** 20.0052 20.0048 0.0182* 0.0187* 0.3371* 0.3463*
(2.04) (2.08) (20.40) (20.38) (1.73) (1.77) (1.76) (1.81)
Ln(Shares) 0.0031 0.0031 20.0068 20.0068 20.0022 20.0023 20.0050 20.0068
(1.38) (1.37) (21.46) (21.48) (20.61) (20.64) (20.08) (20.11)
Big4 20.0104** 20.0103** 20.0154 20.0153 20.0118 20.0117 20.3570* 20.3541*
(22.32) (22.28) (21.03) (21.02) (20.99) (20.98) (21.73) (21.69)
Issue 20.0011 20.0009 20.0024 20.0022 0.0100*** 0.0104*** 0.0322 0.0392
(20.25) (20.21) (20.48) (20.43) (3.08) (3.13) (0.32) (0.40)
String of MBE 0.0011 0.0012 0.0023 0.0024 0.0023 0.0024 0.0489 0.0513*
(1.27) (1.30) (0.99) (1.04) (0.77) (0.82) (1.56) (1.67)
Ln(Analyst following) 0.0057*** 0.0056*** 20.0009 20.0010 0.0015 0.0013 0.1058** 0.1026**
(4.50) (4.44) (20.21) (20.24) (0.43) (0.38) (2.22) (2.17)
Industry and year Included Included Included Included Included Included Included Included
dummies
N 4,845 4,845 4,845 4,845 4,845 4,845 4,845 4,845
Adjusted R2 .3300 .3303 .2920 .2918 .3159 .3154 .4411 .4407
Note. This table presents results from the estimation of Equation 9. Dependent variable is the real earnings
management proxy calculated following Roychowdhury (2006). Key variable of interest is the inside debt proxy.
Definitions of variables used in the model are in the appendix. The t statistics (reported in parentheses) are based
on heteroscedasticity-consistent standard errors clustered at firm and year levels. The coefficient estimates for the
intercept, year dummies, and industry dummies are not reported for brevity.
the 25th to the 75th percentile reduces the |RMPROXY| by 0.1540, which is a 12.73%
decrease relative to the sample mean for |RMPROXY|. The coefficients on the control vari-
ables have similar signs as reported for Table 4 and are generally consistent with our pre-
dictions. In sum, the results in Table 5 suggest that higher ratios of inside debt reduce the
extent of earnings management by means of managing real activities.
CEO Inside debt Earnings management
Earnings volatility
Figure 1. Basic path diagram showing the relation between CEO inside debt, earnings volatility, and
Direct and mediated effects of CEO inside debt on earnings management. Although the
results of previous two subsections show a negative relation between CEO inside debt and
earnings management, they do not articulate the mechanism through which inside debt
influences earnings management. Our hypothesis is that inside debt leads to less risky
investing and financing policies, which in turn lower earnings volatility, thereby reducing
the need to manage earnings. We use a path analysis to formally document this mechanism
through which inside debt affects earnings management.
Path analysis belongs to a class of causal models used to explain the correlation struc-
ture among several related variables. The correlation between two variables is decomposed
into a direct path and an indirect path that includes a mediating variable. In our setting,
earning volatility mediates the relation between inside debt and earnings management.14
We illustrate this relation in Figure 1.
In the path analysis, the following system of equations is estimated simultaneously:
Earnings management = f CEO inside debt proxy, earnings volatility, Controls, 10
Earnings volatility = f CEO inside debt proxy, Controls: 11
All variables in the model outlined above are previously defined in Equation 9. The key
output of a path analysis is a path coefficient that links two variables in a path. A direct
path has one coefficient whereas the mediated path contains a coefficient linking the source
variable to the mediating variable and a coefficient linking the mediating variable to the
outcome variable. The path coefficient for the mediated path is the product of the individ-
ual path coefficients for each segment of that path. In our setting, the direct effect is cap-
tured by the path coefficient between inside debt and earnings management. The mediated
effect is measured by the product of the path coefficients between inside debt and earnings
volatility and the path coefficients between earnings volatility and earnings management.
The relative importance of each path is measured as the ratio of the path coefficient to the
total correlation between the source variable and the outcome variable. Table 6 presents the
results of our path analysis.15 We find that between 10% and 45% of the total correlation
between inside debt and the earnings management is attributable to the mediated path (i.e.,
path that flows through earnings volatility), suggesting that the deterrence role of inside
debt on earnings management is higher in firms that have more volatile earnings.
Robustness Checks
CEO inside debt and meeting or just beating analysts expectations. If a higher level of
inside debt reduces the instances and extent of earnings management, it would be less
Table 6. Direct and Mediated Effects of CEO Inside Debt and Earnings Management.
(1) (2) (3) (4) (5) (6)

CORRK |DA| |RCFO| |RPROD| |RDISX| |RMPROXY|
r[Inside debt, earnings management] (1) 2.1375*** 2.2174*** 2.1752*** 2.1178*** 2.1473*** 2.2055***
Direct path
p[Inside debt, earnings management] (2) 2.0718*** 2.1183*** 2.1319*** 2.0748*** 2.1001*** 2.1393***
t statistics (212.96) (214.22) (214.07) (27.76) (211.11) (215.45)
Percentage (3) = (2) / (1) 52.22 54.42 75.29 63.50 67.96 67.79
Indirect path
p[Inside debt, earnings volatility] (4) 2.1489*** 2.1493*** 2.1493*** 2.1493*** 2.1493*** 2.1493***
t statistics (211.91) (211.94) (211.94) (211.94) (211.94) (211.94)
p[Earnings volatility, earnings management] (5) .4224*** .3603*** .2067*** .0861*** .1819*** .1707***
t statistics (23.27) (23.98) (16.25) (5.00) (11.87) (14.69)
Total mediated path (6) = (4) 3 (5) 2.0629 2.0538 2.0309 2.0129 2.0272 2.0255
Percentage (7) = (6) / (1) 45.74 24.74 17.61 10.91 18.44 12.40
Note. This table reports path analyses of the links between CEO inside debt and earnings management, a direct link, and a link mediated by earnings volatility. r indicates Pearson
correlation coefficients and p indicates standardized path coefficients. In the path analysis the following system of equations is estimated simultaneously
Earnings management = f CEO inside debt proxy, earnings volatility, Controls, 10
Earnings volatility = f CEO inside debt proxy, Controls: 11
where Controls refer to all the control variables included in Equation 9. The t statistics are reported in parentheses.
535
Table 7. CEO Inside Debt and Meeting or Slightly Beating Analyst Forecasts.
(1) (2) (3) (4) (5) (6)
JustMBE JustMBE LargeMBE LargeMBE JustMBEt + 1 JustMBEt + 1
CEO relative leverage ratio 20.1162*** 20.3991*** 20.0703***

(.00) (.00) (.00)
CEO relative incentive ratio 20.7420*** 20.9731*** 20.6190***
(.00) (.00) (.00)
Ln(Cash pay) 0.4890** 0.5107** 20.2849* 20.2570 0.1240 0.1530
(.02) (.01) (.10) (.14) (.58) (.50)
Ln(Delta) 0.0203 0.0433 20.0226 0.0150 0.0019 0.0245
(.45) (.11) (.34) (.54) (.95) (.41)
Ln(Vega) 0.0086 20.0182 0.0234 20.0260 20.0147 20.0417
(.81) (.61) (.42) (.38) (.69) (.26)
Evol 26.1667*** 25.7462*** 2.6165*** 3.1618*** 25.1860*** 24.7361***
(.00) (.00) (.00) (.00) (.00) (.00)
Ln(Total assets) 20.5889*** 20.5802*** 0.5710*** 0.5529*** 20.5408*** 20.5337***
(.00) (.00) (.00) (.00) (.00) (.00)
Ln(Firm age) 20.0333 20.0552 0.2070*** 0.1611** 0.1445 0.1183
(.74) (.58) (.01) (.04) (.16) (.24)
Market-to-book ratio 20.0159 20.0172 20.0368** 20.0370** 20.0005 20.0024
(.36) (.32) (.02) (.02) (.98) (.89)
Leverage 20.0317 20.0262 20.0320 20.0249 0.0113 0.0156
(.57) (.62) (.34) (.42) (.76) (.65)
Net operating assets 0.4302 0.4453* 21.2035*** 21.1477*** 0.5926** 0.6051**
(.11) (.09) (.00) (.00) (.04) (.04)
Implicit claims 20.1035 20.1306 0.0807 0.0283 20.1489 20.1746
(.52) (.42) (.56) (.84) (.39) (.31)
Litigation dummy 20.1075 20.0985 20.0400 20.0262 20.0318 20.0221
(.34) (.38) (.66) (.77) (.80) (.86)
Ln(Shares) 0.8077*** 0.7938*** 20.7997*** 20.7796*** 0.7152*** 0.7035***
(.00) (.00) (.00) (.00) (.00) (.00)
Big4 20.3019* 20.3022* 0.2904* 0.2899* 20.2537 20.2530
(.08) (.08) (.06) (.06) (.18) (.18)
Issue 20.1267 20.1089 0.0420 0.0521 20.2252 20.2053
(.40) (.47) (.72) (.65) (.19) (.24)
String of MBE 0.2133*** 0.2115*** 0.4654*** 0.4605*** 0.2669*** 0.2650***
(.00) (.00) (.00) (.00) (.00) (.00)
Ln(Analyst following) 20.0562 20.0570 0.1744*** 0.1642*** 0.0308 0.0297
(.48) (.47) (.01) (.01) (.73) (.73)
Industry and year Included Included Included Included Included Included

dummies
N 4,845 4,845 4,845 4,845 4,845 4,845
Pseudo R2 .1299 .1225 .1947 .1760 .1163 .1078
Note. This table presents results from the logit model estimation of Equation 9. The dependent variable is an
outcome-based measure of earnings management calculated following Cheng and Warfield (2005). Specifically,
JustMBE equals one if the earnings surprise in the year is zero or just one cent; LargeMBE equals one if the current
years (i.e., year t) earnings surprise equals to or greater than four cents; and JustMBEt + 1 equals one if the
earnings surprise in the year t + 1 is zero or just one cent. Key variable of interest is the inside debt proxy.
Definitions of variables used in the model are in the appendix. The p values (reported in parentheses) are based
on heteroscedasticity-consistent standard errors clustered at firm and year levels.
likely that firms would meet or just marginally beat analysts earnings estimates and that
they would avoid large positive earnings surprise when CEOs have higher ratios of inside
debt holdings. The results of this conjecture are reported in Table 7. The dependent vari-
ables are JustMBE (columns 1 and 2), LargeMBE (columns 3 and 4), and JustMBEt + 1
(columns 5 and 6).
Dhole et al. 537
The coefficients on CEO relative leverage ratio and CEO relative incentive ratio are
negative and significant in columns 1 and 2, respectively, suggesting that firms with higher
CEO IDH are less likely to meet or slightly beat analyst earnings expectations. The eco-
nomic significance of this result can be interpreted as follows: Increasing CEO relative
leverage ratio from the 25th to the 75th percentile reduces the odds of a firm just meeting
or beating the consensus analysts EPS expectation by 12.65%.16 The signs and signifi-
cance levels of the control variables are as expected. Columns 3 and 4 of Table 7 report
logit regression results of the probability of a large positive earnings surprise (i.e., an earn-
ings surprise equal to or greater than four cents) on proxies for CEO IDH and other covari-
ates as in Equation 9. The positive coefficient on CEO relative leverage ratio suggests that
CEOs who have higher ratios of inside debt are less likely to manage earnings downward
to save for the future. Similarly, columns 5 and 6 of Table 7 report the results from logit
regression of meeting or slightly beating analysts forecasts in year t + 1 on inside debt in
year t. The negative coefficient on CEO relative leverage ratio suggests that CEOs with
higher ratios of inside debt holdings are less likely to meet or just beat analysts forecasts
in the next year, consistent with the notion that these CEOs less rely on earnings manage-
ment. Overall, the results from Table 7 indicate that firms with higher CEO IDH are less
likely to meet or slightly beat analysts forecasts through earnings management.
Endogeneity. Parameter estimates from OLS will be biased when the regressors are endo-
genously determined along with the dependent variable. In our setting, endogeneity can
arise from reverse causality or omitted correlated variables. If earnings management is pre-
valent, then the compensation committee can design compensation structures, which pro-
vide executives with more inside debt compensation. Alternately, certain omitted variables
such as high growth expectations may be correlated with both earnings management and
inside debt compensation. For example, firms with high growth expectations are likely to
have low inside debt incentives (e.g., Gerakos, 2010; Sundaram & Yermack, 2007); and,
these firms are also likely to have strong incentives to engage in earnings management to
avoid missing earnings benchmarks (Skinner & Sloan, 2002).
To address this potential endogeneity issue, we first use future (lagged) values of earn-
ings management (inside debt) and obtain similar results to those in Tables 4 and 5. To fur-
ther mitigate the likelihood that our results are spurious and to isolate the effects of inside
debt on earnings management, we estimate our models under a 2SLS framework as
follows:
First stage: CEO inside debt proxy = f IV, Controls, 12
Secondstage: Earnings management proxy = f Predicted CEO inside debt proxy, Controls,
13
where CEO inside debt proxy, Earnings management proxy, and Controls are as defined in
Equation 9. Following Cassell et al. (2012) and Anantharaman et al. (2013), we use the
maximum personal tax rate for wages, maximum personal tax rate for long-term capital
gains, and the mortgage subsidy rate of the state in which the firm is headquartered as the
instrument variable (IV).
Table 8 reports the results from this 2SLS analysis. First, we establish the validity of
our IV. To qualify as a valid IV, state personal tax rates must (a) be relevant in explaining
substantial variation in CEO inside debt proxies and (b) satisfy exclusion restrictions. The
538
Table 8. CEO Inside Debt and Income Smoothing2SLS.
(1.1) (2.1) (3.1) (4.1)
First-stage (1.2) First-stage (2.2) First-stage (3.2) First-stage (4.2)
CEO relative Second stage CEO relative Second stage CEO relative Second stage CEO relative Second stage
Dependent variable leverage ratio CORRK leverage ratio |RMPROXY| incentive ratio CORRK incentive ratio |RMPROXY|
State tax rateWage 0.0261** 0.0287** 0.0239** 0.0238**

(2.06) (2.15) (2.01) (2.00)
State tax rateGains 0.0074 0.0081 0.0065 0.0067
(0.83) (0.86) (0.79) (0.80)
State tax rateMortgage 20.0018** 20.0023** 20.0018** 20.0018**
(2.17) (2.21) (2.14) (2.15)
CEO relative leverage ratioPredicted 20.0475*** 20.0343**
(25.03) (22.26)
CEO relative incentive ratioPredicted 20.0532*** 20.0414**
(25.51) (22.33)
Control variables Included Included Included Included Included Included Included Included
Industry and year dummies Included Included Included Included Included Included Included Included
N 4,845 4,845 4,845 4,845 4,845 4,845 4,845 4,845
Adjusted R2 .196 .128 .197 .129 .175 .278 .177 .281
Under-identification test .00 .00 .00 .00
KleibergenPaap LM statistic: p value of x2(3)
Over-identification test: .36 .43 .28 .32
Hansen J statistic: p value of x2(2)
Note. This table presents the results of our 2SLS analysis. First-stage regression results for CEO relative leverage ratio and CEO relative incentive ratio are presented in columns 1.1
to 4.1. Second-stage results are presented in columns 1.2 to 4.2, where various earnings management proxies are used as dependent variables and predicted values of CEO
relative leverage ratio and CEO relative incentive ratio obtained from first-stage results are used as the independent variables. The definitions of other variables used in the model
are in the appendix. The t statistics (reported in parentheses) are based on heteroscedasticity-consistent standard errors clustered at firm and year levels.
***, **, and * correspond to 1%, 5%, and 10% significance levels, respectively. 2SLS = two-stage least squares.
Dhole et al. 539
economic rationale for the validity of our IV is as follows. Inside debt allows CEOs to
defer income and the associated tax burden to a later period. The benefit from deferring tax
payments increases with the CEOs marginal tax rate (E. H. Kim & Lu, 2011; Scholes,
Wolfson, Erickson, Maydew, & Shevlin, 2002). Hence, the personal tax rate of the state in
which the firm is headquartered is expected to affect a CEOs willingness to accept inside
debt-based compensation. At the same time, we do not expect any plausible direct link
between state personal tax rates and firm-level earnings management proxies. We also per-
form statistical tests to establish the validity of our IV. The under-identification test rejects
the null hypothesis of no correlation between the IV and the inside debt proxies (p values
\ .01). Furthermore, the Cragg and Donald (1993) F statistics for IV range between 9.39
and 9.81 in columns 1.1 to 4.1, which are higher than the Stock and Yogo (2005) critical
value of 9.08 for a maximal relative bias. Based on these test statistics, we conclude that
the IV is relevant. We also perform overidentifying restrictions test. The Hansens (1982)
J statistic for the test is insignificant at conventional levels in each of the four columns 1.2
to 4.2 (p value ranges between .28 and .43). This suggests that we cannot reject the null
hypothesis that the IV is uncorrelated with the error term.
Columns 1.1 to 4.1 present the results from first-stage regressions. Consistent with our
expectations, we find CEO inside debt proxies to be positively associated with tax rates for
wages and capital gains and negatively associated with the mortgage subsidy rate because
the mortgage subsidy reduces the CEOs overall tax burden. In the second stage, we repli-
cate Tables 4 and 5 after replacing the CEO IDH measures with their predicted values
from the first-stage estimation. Consistent with the results in Tables 4 and 5, the results
from the second-stage models demonstrate the negative association between various proxies
of earnings management, and the instrumented (i.e., predicted values of) CEO relative
leverage ratio and CEO relative incentive ratio. For brevity we report the results only for
CORRK and |RMPROXY| from the second-stage models. The estimated coefficients on the
predicted CEO relative leverage ratio are 20.0475 and 20.0343 for CORRK (column 1.2)
and |RMPROXY| (column 2.2), respectively, all of which are significant at the 5% signifi-
cance level. Similarly, the estimated coefficients on the predicted CEO relative incentive
ratio are 20.0532 and 20.0414 for CORRK (column 3.2) and |RMPROXY| (column 4.2),
respectively, all of which are significant at the 5% significance level. These results thus
confirm that CEO inside debt deters earnings management, even after controlling for the
potential endogeneity.
Inside debt measurement. Thus far, following Wei and Yermack (2011) and Cassell et al.
(2012), we have used the ratio of inside debt over inside equity (i.e., CEO relative leverage
ratio and CEO relative incentive ratio) as our main measure of inside debt. Although we
control for Delta and Vega in the regression, it can be argued that the results based on this
ratio can be driven by (a) the positive impact of inside debt and/or (b) the negative impact
of inside equity on earnings management. To address this issue, we further separate the
effects of inside debt and equity effects to ensure that the results are driven by CEO inside
debt, irrespective of CEO EH. Specifically, we first break the relative leverage ratio into
two sets of ratios: inside debt-to-firm debt ratio and inside equity-to-firm equity ratio and
re-estimate Equation 9 with the inside debt-to-firm debt ratio (CEO IDH/FD) and the
change in inside debt-to-firm debt ratio (D (CEO IDH/FD)) in place of CEO relative lever-
age ratio and CEO relative incentive ratio, respectively. (Untabulated) results show that
the coefficients on both inside debt-to-firm debt ratio and change in the ratio are negative
and significant at the 5% level. This result confirms that CEO inside debt by itself reduces
Inside debt components. As discussed in the Related Research and Hypothesis

Development section, the empirical relation between the inside debt and earnings manage-
ment relies on the extent to which the defined benefit plans and deferred compensation cap-
ture the theoretical notion of inside debt. To evaluate this relation further, we re-estimate
Equation 9 by disaggregating inside debt as regular pension plan balance, SERP balance,
and ODC.17 In untabulated results we find that the coefficients on CEO relative leverage
ratio and CEO relative incentive ratio for regular plan and SERP-based inside debt compo-
nents are negative and significant across all specifications. However, the coefficients for
ODC-based inside debt component are marginally significant or insignificant (though nega-
tive in sign). These results suggest that the observed relation between inside debt and
income smoothing is more attributable to the pension component of inside debt than the
deferred compensation component. Furthermore, the deterrence effect of CEO inside debt
on earnings management arises from both the traditional regular pension plans and SERPs.
Global financial crisis. Our sample period covers the period 2006 -2010, which overlaps
with the Global Financial Crisis (GFC) period. It is generally accepted that the GFC started
in late 2007 (e.g., Ryan, 2008). Both income smoothing and earnings management incen-
tives could have been affected by the GFC. For example, income-increasing (decreasing)
earnings management could have decreased (increased) during the GFC, which could have
affected the relation between CEO inside debt and our earnings smoothing metrics. We
thus conduct our empirical analyses only for a subperiod spanning the financial crisis (i.e.,
the eight quarters from the first quarter of 2008 to the fourth quarter of 2009). When we
replicate all our previous tests only for firm years spanning the financial crisis, the results
still hold, suggesting that the prevention effect of CEO inside debt on income smoothing
by means of earnings management is not significantly affected by the financial crisis.
Signed accruals and REM measures and upward earnings management. Thus far, we
used the absolute (i.e., unsigned) values of DA and real activities management in our analy-
sis because our hypotheses do not focus on the direction of earnings management. We now
use the signed values of DA and REM (RCFO, RPROD, RDISX, and RMPROXY), to exam-
ine whether CEO inside debt reduces income-increasing (i.e., upward) earnings manage-
ment. Specifically, using these measures of signed values, we re-estimate the models in
columns 3 and 4 of Table 4 and all models in Table 5. The results (untabulated) indicate
that CEO inside debt still deters income-increasing DA and real activities management,
although the effects are much weaker in most cases than those with absolute values. For
example, the coefficients of CEO relative leverage ratio and CEO relative incentive ratio
are only 20.0247 (t stat = 21.98) and 20.0288 (t stat = 21.86), respectively.
These results may be explained by the relative prevalence of income-increasing earnings
management over income-decreasing earnings management in the process of income
smoothing and that the deterrence effect of CEO inside debt on income-increasing earnings
management is more apparent than that on income-decreasing earnings management over
the earnings smoothing process. We can also interpret this as indicating that financial mis-
reporting exposes a firm to high risks of subsequent detection along with litigation and reg-
ulatory actions (e.g., Ball & Shivakumar, 2008), as well as forced CEO turnover (Hazarika,
Karpoff, & Nahata, 2012), thereby having a negative impact on the value CEO IDH. This
Dhole et al. 541
effect is expected to be more pronounced for income-increasing manipulation than for

income-decreasing manipulation. Thus, inside debt can have a moderating effect on CEOs
tendency to manage earnings.
Extension
Thus far, our evidence suggests that CEOs with higher inside debt holdings would have
weaker incentives to manage earnings because they face weaker demand for income
smoothing. Given the above evidence, it is interesting to ask whether investors understand
the role of inside debts in dampening managers incentives to smooth earnings, which
broadens the scope of the study. We thus examine the stock market response to earnings
surprises conditioned on firms CEO IDH. The efficient capital market assumption posits
that investors can adjust for expected earnings management (Fields et al., 2001). Hence, we
test whether the market reaction to positive earnings surprise will be higher for firms with
higher CEO insider debt holdings. Specifically, we estimate the following event-study
regression model:
CAR1, + 1 = f Earnings Surprise, MBE, JustMBE, CEO inside debt proxy, Controls,
14
The dependent variable is the 3-day cumulative market adjusted stock returns around
earnings announcement date. We hypothesize that the market recognizes that CEOs are less
likely to manage earnings for the purpose of earnings smoothing or MBE when CEO IDH
are higher. To examine this, we include the interaction terms inside debt proxy 3 MBE and
inside debt proxy 3 JustMBE. Hence the premium for MBE, even in the case of meeting
or just beatings the analysts forecasts (JustMBE), is greater as CEO inside debt is higher.
Thus we expect positive coefficients on interaction terms inside debt proxy 3 MBE and
inside debt proxy 3 JustMBE. To ensure that CEO IDH information is available to inves-
tors at the earnings announcement, we use lagged values of inside debt proxies in Equation
10). We also include Size and Book-to-market ratio as control variables in the equation.
Table 9 reports the results from estimating Equation 14. Column 1 presents the bench-
mark model on the market reaction to earnings surprise whereas columns 2 and 3 present
the market reaction to earnings surprise conditioned on the level of CEO relative leverage
ratio and CEO relative incentive ratio, respectively. Consistent with a large body of
accounting research, the coefficient on Earnings surprise is positive and significant (5%
level) in all three columns. The coefficient on MBE is also positive and significant (1%
level) in columns 1 to 3, suggesting a premium associated with meeting or beating consen-
sus analysts earnings forecast. The coefficient on JustMBE is significantly negative, indi-
cating that the premium associated with meeting or beating consensus analysts earnings
forecast is lower if the firm meets or just beats the analysts earnings expectations by one
cent than when the firm beats the expectations by more than one cent. This is consistent
with the notion that the market suspects earnings management (or expectations manage-
ment) when a firm meets or slightly beats the markets earnings expectations and thus dis-
counts the firms earnings positive earnings performance.18
Column 2 shows that the coefficient on the interaction term CEO relative leverage
ratiot21 3 MBE is positive and significant. This suggests that the reward for positive earn-
ings surprise is greater in firms with higher inside debt, because such firms are less likely
to have engaged in earnings management. Furthermore, the markets discount for meeting
Table 9. CEO Inside Debt and Stock Market Reaction Around Earnings Announcements.
(1) (2) (3)

CAR(21, + 1) CAR(21, + 1) CAR(21, + 1)
Earnings surprise 0.5667*** 0.4425** 0.4701***
(7.13) (4.66) (4.23)
MBE 0.0488*** 0.0478*** 0.0422***
(16.08) (12.02) (14.45)
JustMBE 20.0302*** 20.0337*** 20.0330***
(27.85) (26.12) (26.07)
CEO relative leverage ratiot21 0.0020***
(3.49)
CEO relative incentive ratiot21 0.0043***
(3.73)
CEO relative leverage ratiot21 3 Earnings surprise 0.2581***
(3.72)
CEO relative leverage ratiot21 3 MBE 0.0162**
(2.76)
CEO relative leverage ratiot21 3 JustMBE 0.0147**
(2.51)
CEO relative incentive ratiot21 3 Earnings surprise 0.2243***
(3.19)
CEO relative incentive ratiot21 3 MBE 0.0171**
(2.78)
CEO relative incentive ratiot21 3 JustMBE 0.0153**
(2.54)
Size 20.0013* 20.0014* 20.0011*
(21.69) (21.66) (21.67)
Book-to-market ratio 0.0007 0.0007 0.0006
(1.16) (1.19) (1.03)
Industry and year dummies Included Included Included
n 4,536 4,536 4,536
Adjusted R2 .0549 .0576 .0579
Note. This table presents results from the estimation of Equation 14. The dependent variable is the 3-day
cumulative abnormal return around earnings announcement date. The variable of interest is the interaction term
between earnings surprise and inside debt proxy. The definitions of variables used in the model are in the
appendix. The t statistics (reported in parentheses) are based on heteroscedasticity-consistent standard errors
clustered at firm and year levels.
or slightly beating is much lower for firms with high inside debt as indicated by a positive
coefficient on interaction CEO relative leverage ratiot21 3 JustMBE. This suggests that
the market views the small positive earnings surprise of such firms with less suspicion of
earnings management. Column 3 presents similar results. The coefficients on CEO relative
incentive ratiot21 3 MBE and CEO relative leverage ratiot21 3 JustMBE are both signifi-
cantly positive. Again this indicates that the markets reward for MBE is much higher and
the discount for just meeting or beating is much lower for firms with higher inside debt,
suggesting that the market understands that firms with high inside debt are less likely to
attempt to manage earnings.19
Dhole et al. 543
Conclusion
This study examines how the level of CEO IDH is associated with firms earnings manage-
ment behavior. Inside debt refers to the debt-like component of executive compensation
and includes items like deferred compensation and pensions. Our findings indicate that
both investment strategies and reporting strategies change as the proportion of inside debt
rises. We further find that firms with higher inside debt positions are less likely to report
earnings that meet or slightly beat analysts earnings expectations. Overall our findings
suggest that the extent of earnings management, as traditionally measured, decreases with
an increasing ratio of inside debt. Additional evidence indicates that the capital market
response to small positive earnings surprises is stronger for firms with higher positions of
inside debt, suggesting that investors understand the role of inside debt in reducing earnings
management.
The implications of our results are twofold. First, on the academic side, the examination
of agency theory to rationalize a congruence of interests between the manager, sharehold-
ers, and debtholders should consider the effect of inside debt on management behavior.
Second, from a policy perspective, because CEO inside debt reduces managerial incentives
for earnings management, firms should take this factor into account when designing opti-
mal compensation packages.
We are however careful to recognize that too much of insider debt in the compensation
contract is also not optimal. An excessive level of inside debt might (a) curtail managerial
flexibility in choosing between alternate accounting methods, (b) make managers extremely
risk averse, and (c) eliminate benefits of income smoothing. Overall, our study points to
the importance of inside debt as a component of an efficient compensation contract and
suggests caution in determining its appropriate level in the optimal contract.
Appendix. Variable Definitions.

Compensation variables
CEO relative leverage ratio The ratio of the CEOs debt-to-equity ratio to the firms debt-to-equity
ratio, defined as (CEO IDH/CEO EH) / (FD/FE). CEO IDH is calculated
as sum of the present value of accumulated pension benefits and
deferred compensation and CEO EH includes the value of both stock
and stock options. We calculate the value of stock held by the CEO
by multiplying the number of shares held (including restricted shares)
by the stock price at the firms fiscal year-end and the value of both
stock and stock options by applying the Black and Scholes (1973)
option valuation formula. FD is total debt (DLC + DLTT), where DLC
is debt in current liabilities and DLTT is long-term debt and FE is the
market value of equity (CSHO 3 PRCC_F), where CSHO is common
shares outstanding and PRCC_F is the share price at the end of the
fiscal year.
CEO relative incentive ratio This ratio is defined as (DCEO IDH/DCEO EH)/(DFD/DFE) following Wei
and Yermack (2011). DCEO EH equals the number of shares held by
the CEO times 1 (assuming a share delta of 1) plus the number of
options held by the CEO times the option delta calculated using the
Black-Scholes option valuation formula. DFE is constructed using an
approach similar to that used for DCEO EH except that there are no
complete data on all the outstanding option tranches issued by the
firm (inputs to the valuation formula are the total number of
employee stock options outstanding [OPTOSEY], the average
exercise price of outstanding options [OPTPRCBY], and an assumed
remaining life of 4 years for all options). Following Wei and Yermack
(2011), DCEO IDH and DFD are set as CEO IDH and FD, respectively.
Cash Pay Sum of CEO salary and cash incentive payment.
Delta Sensitivity of the value of CEO accumulated equity-based compensation
to a one-dollar change in stock price.
Vega Sensitivity of the value of CEO accumulated equity-based compensation
to a 0.01 change in the volatility of stock price.
Proxies for earnings smoothing via earnings management
CORR Negative correlation between the change in discretionary accruals and
change in prediscretionary accruals income, calculated using current
year and previous 4 years observations.
CORRK Percentile-rank of CORR.
|DA| The absolute value of discretionary accruals computed using Jones
(1991) model, modified by Kothari, Leone, and Wasley (2005).
|RCFO| The absolute value of abnormal cash flows from operations calculated
following Roychowdhury (2006).
|RPROD| The absolute value of abnormal production costs calculated following
Roychowdhury (2006), where production costs are defined as the
sum of cost of goods sold and the change in inventory.
|RDISX| The absolute value of abnormal discretionary expenditure calculated
following Roychowdhury (2006), where the discretionary expenditure
is the sum of research and development (R&D), advertising, and
selling, general, and administrative expenses.
|RMPROXY| The absolute value of the sum of the three standardized real earnings
management proxies, that is, RCFO, RPROD, and RDISX.
JustMBE An indicator variable that equals one if the difference between actual
earnings per share (EPS) and analyst consensus forecast EPS in the
year t is zero or just one cent, and zero otherwise.
(continued)
Dhole et al. 545
Appendix. (continued)
LargeMBE An indicator variable that equals one if the difference between actual
EPS and analyst consensus forecast EPS in the year t is greater than
four cents, and zero otherwise.
JustMBEt + 1 An indicator variable that equals one if the difference between actual
EPS and analyst consensus forecast EPS in the year t + 1 is zero or
just one cent, and zero otherwise.
Evol The standard deviation of previous 5 years ROA (IBY/AT), and at least 4
years are required for each calculation.
Total assets Total assets at the end of fiscal year (AT).
Firm age Age of the firm measured from data on COMPUSTAT.
Market-to-book ratio The ratio of the market value of equity (PRCC_F 3 CSHO) to the book
value of equity (CEQ) of the firm at the end of fiscal year.
Leverage The ratio of total debt (DLC + DLTT) to the market value of equity
(PRCC_F 3 CSHO) of the firm at the end of fiscal year.
Net operating assets Net operating assets (CEQ CHE + DLC + DLTT) at the end of fiscal
year t 2 1, divided by total assets (AT) at the end of fiscal year t ? 1.
Implicit claims Proxied by labor intensity, calculated as 1 minus the ratio of gross
property, plant, and equipment (PPEGT) divided by total assets (AT)
at the end of fiscal year.
Litigation dummy An indicator variable that equals one if the firm is in the following
industries: Pharmaceutical/biotechnology (SIC codes 2833-2836,
8731-8734), computer (3570-3577, 7370-7374), electronics (3600-
3674), or retail (5200-5961), and zero otherwise.
Log(Shares) The natural of number of shares outstanding (CSHO).
Big4 An indicator variable that equals one if the firm is audited by a Big 4
auditor.
Issue An indicator variable that equals one if the number of shares
outstanding of a firm increase by more than 10% during the year.
Habitual beater The frequency of meeting or beating analysts earnings forecasts in the
past four quarters (ranges from 0 to 4).
Analyst following The number of analysts whose forecasts are included in the I/B/E/S
consensus annual earnings forecast.
CEO age The age of the CEO at fiscal year t.
New CEO An indicator variable set equal to one if the firm has a new CEO, and
zero otherwise.
Liquidity constraint An indicator variable set equal to one if the firm generates negative
operating cash flow (OANCF), and zero otherwise.
Tax status An indicator variable set equal to one if the firm has a loss carry-
forward (TLCF), and zero otherwise.
State tax rate Maximum tax rate for the wage faced by a CEO in the state where his
firm is headquartered (available at http://www.nber.org/~taxsim/
state-rates/).
Variables used in market reaction tests
CAR(21, + 1) Three-day cumulative market adjusted return centered around earnings
announcement date at the end of fiscal year, where return on CRPS
value weighted index is the taken as the market return.
Earnings surprise Actual EPS minus the most recent analyst consensus forecast EPS for
the year t, scaled by the stock price at the beginning of year.
MBE An indicator variable that equals one if the actual EPS is greater than or
equal to the analyst consensus forecast EPS in the year t.
Size Log(market value of equity).
Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/
or publication of this article.
Funding
The author(s) received no financial support for the research, authorship, and/or publication of this
article.
Notes
1. For example, studies examining the relationship between cash compensation contracts and finan-
cial reporting quality include Watts and Zimmerman (1986), Healy (1985), Gaver et al. (1995),
and Holthausen, Larcker, and Sloan (1995). Studies examining the effect of equity incentives on
accounting choices include Aboody and Kasznik (2000), Bartov and Mohanram (2004), Cheng
and Warfield (2005), Bergstresser and Philippon (2006), Jiang, Petroni, and Wang. (2010), and
Armstrong, Jagolinzer, and Larcker (2010).
2. In the Hypothesis section, we discuss in detail the features of defined benefit pensions and
deferred compensation that make (or do not make) these compensation components close to the
theoretical construct of inside debt.
3. The sample for analysis begins in 2006 because the Securities and Exchange Commission (SEC)
issued a requirement that firms disclose the CEO pension benefits and deferred compensation
from that year onwards.
4. We thank Bharat Sarath (Editor-in-Chief) for providing these insights.
5. See, for example, Beidleman (1973), Subramanyam (1996), Healy and Wahlen (1999), and
Tucker and Zarowin (2006).
6. Before 2006, all the inputs necessary to calculate the value of option and its delta were not avail-
able on Execucomp. Thus a 1-year approximation (OA) method proposed by Core and Guay
(2002) was commonly used to calculate equity incentives. Post-2006, the SEC requires firms to
report data on executives outstanding option holdings under the new reporting format in their
DEF14A filings. Accordingly, Execucomp provides tranche-level data on the number of vested,
unvested, and unearned options and their corresponding exercise price and expiration date, which
allows us to directly calculate equity incentives. However, 16% of the observations in our
sample do not have complete tranche-level option data for the year 2006. Therefore, we calculate
equity incentives using OA method for these observations. Our results remain unchanged when
we (a) drop those observations that do not have necessary data to calculate option delta or (b)
apply OA method for all observations.
7. Wei and Yermack (2011) offer two arguments to support this simplifying assumption. First, if
sample firms are not financially distressed, DCEO IDH and DFD are likely to be small and diffi-
cult to estimate. Second, because the information in the firms debt maturity structure disclosures
is not sufficient (U.S. public firms are not required to disclose the maturity details of debt with a
remaining life exceeding five years), estimating DCEO IDH and DFD is problematic.
8. Alternatively, we obtain performance-matched discretionary accruals (DA) by subtracting DA of
a performance-matched firm. In this approach, DA are initially obtained by estimating Equation
3 without ROAi,. Performance-matched firms are obtained by matching each firm-year observa-
tion with its counterpart that has the closest return on assets (i.e., ROAi,t), in the same year and
industry (2-digit SIC [Standard Industrial Classification]). Results from this alternative approach
yield similar results.
9. Results are qualitatively similar when we use different cutoff points (such as 3 cents, 5 cents, or
6 cents).
10. Alternatively, we use a Fama and MacBeth (1973) procedure with the Newey and West (1987)
adjustment, which detects cross-sectional differences in income smoothing behaviors after
Dhole et al. 547
controlling for serial correlations across years. Furthermore, we take into account the unobserved
heterogeneity across firms by allowing for randomness in the intercept and slope parameters of
covariates CEO relative leverage ratio and CEO relative incentive ratio, respectively. This
addresses the possible correlation between errors of these parameter estimates within a firm and
across-firm variations in the parameter, thereby reducing a potential bias in the slope parameter
estimation of the covariates. Our results are not sensitive to these alternative specifications.
11. About 39% CEO-year observations have zero inside debt. For observations with nonzero inside
debt, the average CEO inside debt holding is US$6.34 million.
12. Cohen, Dey, and Lys (2008) document that RMPROXY (i.e., signed value) is negatively corre-
lated with |DA| (i.e., absolute value). They interpret this as indicative that real earnings manage-
ment (REM) and AEM can be viewed as substitutes for manipulating earnings. Our sample also
show negative correlation coefficients between |DA| and REM proxy (i.e., signed value), consis-
tent with Cohen et al. (2008). This indicates that their relation depends upon whether signed or
unsigned values are used, suggesting that directional earnings management and nondirectional
earnings management, particularly earnings smoothing, have different implications with respect
to their interactions.
13. Similar to the findings from the correlation analysis, when we replace |RMPROXY| (i.e., absolute
value) with REM proxy (i.e., signed value), the coefficient on RMPROXY is negative and signifi-
cant in all the four specifications, which is consistent with Cohen et al. (2008).
14. Path analysis has been used in several accounting studies. For example, Bushee and Noe (2000)
document that voluntary disclosures by a firm increase its stock return volatility by attracting
transient institutional investors using a path analysis. Similarly, Bhattacharya, Ecker, Olsson, and
Schipper (2011) use path analysis to examine the effect of earnings quality on cost of equity cap-
ital. They decompose this effect into a direct effect and a mediated effect that arise because earn-
ings quality affects information asymmetry, which in turn affects cost of equity.
15. We used pathreg command of STATA to estimate this model. The program is available at
www.ats.ucla.edu/stat/stata/faq/pathreg.htm
16. Odds ratio is the likelihood of meeting or beating earnings benchmark divided by the likelihood
of not meeting or beating earnings benchmark. The change in odds ratio of meeting or beating
the consensus analysts earnings expectations associated with one standard deviation increase in
CEO relative leverage ratio is calculated as (exp [20.1162 3 1.1643] 1), where 20.1162 is
the coefficient estimate on CEO relative leverage ratio reported in Table 7, column 1, and
1.1643 is the interquartile range of CEO relative leverage ratio reported in Table 2.
17. Execucomp does not explicitly label each pension plan balance into SERP or otherwise.
Hence we look at the pension plan name provided by the Execucomp (PENSION_NAME) and
classify a pension plan as SERP or regular pension plan. In several instances, this classification
is straightforward because the pension plan name contains the words such as Supplemental
Executive Retirement Plan, Supplemental Key Executive Retirement Plan, Defined Benefit
Supplemental Executive Plan, ERISA Excess Benefits Plan, ERISA Supplemental
Program, Excess Benefit Plan, and so on. In instances where it is difficult to infer anything
from the name of the pension plan (e.g., Plan 1 and Plan 2), if the company has more than
one pension plan, we classify the plan with the larger pension value as the regular pension plan,
and the pension plan(s) with the smaller balance to be the SERP. If the company has just one
pension plan we classify it as the regular pension plan.
18. However, the market reward is still greater when a firm meets or slightly beats the markets earn-
ings expectations than when the firm misses the expectations because the sum of coefficients on
MBE and JustMBEt is significantly positive. This is consistent with Bartov, Givoly, and Hayn
(2002).
19. It is interesting that the coefficient on Earnings surprise 3 CEO inside debt proxy is positive
and marginally significant. It could be counterintuitive to the notion that firms with higher inside
debt could have a lower market response because more of the future cash flows associated with
the earnings surprise accrue to bondholders rather than equity holders due to more conservative
investment policies. However, the result suggests that the deterrence effect of inside debt on
earnings management may be stronger than its effect driven by the stockholderbondholder inter-
est conflict.
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Article

Sandip Dhole1, Hariom Manchiraju2, and Inho Suk3

Although we highlight the role of inside debt in optimal compensation contracts, we do

Related Research and Hypothesis Development

Variable Measurement, Empirical Design, and Sample Selection

Measures of accruals management. We use two accounting earnings management mea-

TACCi, t 1 DREVi, t PPEi, t

CFOi, t 1 SALEi, t DSALEi, t

Next, we model inventory growth by the following:

DINVi, t 1 DSALEi, t DSALEi, t1

Using Equations 5 and 6, we estimate the normal level of production costs as

PRODi, t 1 SALEi, t DSALEi, t DSALEi, t1

DISXi, t 1 SALEi, t1

Earnings management proxy = f CEO inside debt proxy, Controls: 9

Table 1. Sample Selection and Distribution.

Panel A: Sample Selection.

Panel B: Sample Distribution by Year.

Panel C: Sample Distribution by Industry.

Note. SIC = Standard Industrial Classification

Table 2. Descriptive Statistics.

1 CEO relative 1.0000

Table 4. CEO Inside Debt and Income Smoothing Via Accruals.

(1) (2) (3) (4)

CEO relative 20.0090*** 20.0185*** 20.0155*** 20.1166***

CEO Inside debt Earnings management

Earnings management = f CEO inside debt proxy, earnings volatility, Controls, 10

Earnings volatility = f CEO inside debt proxy, Controls: 11

(1) (2) (3) (4) (5) (6)

Earnings management = f CEO inside debt proxy, earnings volatility, Controls, 10

Earnings volatility = f CEO inside debt proxy, Controls: 11

CEO relative leverage ratio 20.1162*** 20.3991*** 20.0703***

Industry and year Included Included Included Included Included Included

First stage: CEO inside debt proxy = f IV, Controls, 12

State tax rateWage 0.0261** 0.0287** 0.0239** 0.0238**

Inside debt components. As discussed in the Related Research and Hypothesis

effect is expected to be more pronounced for income-increasing manipulation than for

(1) (2) (3)

Appendix. Variable Definitions.

Declaration of Conflicting Interests

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CEO relative 20.0090* 20.0185* 20.0155* 20.1166*

CEO relative leverage ratio 20.1162* 20.3991* 20.0703***

State tax rateWage 0.0261 0.0287 0.0239 0.0238