CEO Inside Debt and Earnings Management

Abstract

This study examines the impact of CEO inside debt on earnings management. Theory predicts 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 expectations, 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. Further, 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 investors understand the deterrence effect of inside debt on earnings management.

Keywords: CEO inside debt; earnings smoothing; earnings management; agency theory; executive compensation

JEL Classification: G30, G32, M40, M42