When a company is underperforming, many boards take a seemingly sensible action: cut the CEO’s pay. Such a move, the thinking goes, will encourage the CEO to improve the company’s performance in order to restore his or her full pay.
But pay cuts can backfire, says Swaminathan (Sri) Sridharan, professor of accounting information and management at the Kellogg School, who has researched the question. In fact, Sridharan found that CEOs whose pay was docked at least 25 percent were likely to use a combination of both accounting techniques and opportunistic economic decisions that produce overly positive financial reports to accelerate the company’s reported performance in the short term.
These techniques, known as earnings management, can provide the appearance of a financial turnaround. But, Sridharan and coauthors find, earnings management can actually damage the company’s long-term profits.
“CEOs are under a lot of pressure to meet market expectations,” Sridharan says. “Sometimes these market pressures may compel some CEOs to try to manage reported earnings, but such efforts can hurt the firm in the long run.” The markets, he explains, are generally not fooled by these earnings-management attempts, and firms’ profits will soon start to suffer.
Nevertheless, Sridharan says that CEO pay cuts can work well to help a company’s performance—if they are combined with other corporate-governance measures.
“Is there a way the CEO and board can work together and enhance value for everybody?” he says. “The answer is often yes.”
Studying CEO Pay Cuts as a Disciplinary Measure
The issue of CEO pay has made headlines over the past several years as the ratio of executive-to-worker pay has increased while the median pay for CEOs of the 100 largest companies reached a record $15.7 million in 2017.
“The board should not just reduce the pay and then sit back and enjoy.”
CEO compensation contracts are generally tied to stock-price performance and accounting earnings numbers, but tying compensation to these measures could potentially lead to distorted incentives. Sridharan and his coauthors, Gerald J. Lobo of the University of Houston and Hariom Manchiraju of the Indian School of Business, wanted to investigate this idea by researching the effectiveness of pay cuts as a disciplinary mechanism.
“There has been limited research on this,” he says. Though previous work found some evidence that firm performance improved after a CEO pay cut, Sridharan hypothesized that this was because those CEOs engaged in earnings management.
Earnings-management techniques generally fall into two categories: accruals manipulation, which involves manipulating the timing of reported income, and real-activities management, which includes cutting discretionary expenditures such as research and development and advertising budgets. Both boost reported earnings in the short term.
“It is well known among researchers that occasionally CEOs postpone some expenditures or cherry-pick the timing of a sale of an asset in order to meet market expectations,” Sridharan says. “We were curious if a pay cut caused CEOs to behave in this opportunistic manner.”
In the first-of-its-kind study to look at the effect of pay cuts on both types of earnings management, Sridharan and his colleagues examined 1,496 instances of CEOs of publicly traded companies who had their pay docked by at least 25 percent between 1994 and 2013. The researchers measured those companies’ performance against the performance of similar firms that did not cut CEOs’ pay.
The researchers then measured the level of earnings management among firms in the three years prior to and following a CEO pay cut.
Markets Are Not Fooled
As the researchers suspected, CEOs who had their pay cut began engaging in a greater level of earnings management than they had been pre pay cut.
“Both real earnings management and accruals manipulation strengthened after a pay cut,” Sridharan says. “There are reports of wide prevalence of this activity, and this study shows that this is the case.”
But when the researchers looked at both the short-term and long-term effects on profits and stock price, what they found is that “the markets are not fooled,” Sridharan says. Instead, it seems that the market prefers CEOs who do not engage in earnings management.
The researchers find that one year after the pay cut, firms whose CEOs engaged in lower levels of earnings management reported a return on assets (the ratio of how profitable a company is compared to its assets) that was more than five times higher than that of firms whose CEOs engaged in higher levels of earnings management.
The study also found that there were circumstances that affected the likelihood that a CEO would engage in earnings management.
One factor was the level of the firm’s institutional ownership, meaning the amount of stock owned by funds and investment firms. When institutional ownership was high, it seemed to provide a check on the CEO, which meant lower levels of earnings management. This is in keeping with the larger belief that greater institutional ownership generally leads to a more effective monitoring of a firm’s managers.
Conversely, if a CEO had greater power over the board, the CEO was more likely to engage in earnings management.
“You often find power struggles between CEOs and their boards,” Sridharan says. “If a CEO has too much power, the board often is unable to monitor the firm as effectively.”
Because this is apparent to markets, the researchers hypothesize it must be apparent to boards, too. They tolerate the practice because boards, too, must appear to be responsive to less than stellar performance of their managers. Pay cuts are thus often used as a strong signal by the board to let markets know that they are in control of their firm’s performance—meaning that in some circumstances pay cuts perform these dual roles of being both a disciplinary measure and a way to shore up public confidence in the firm during times of poor performance.
“Boards also want to be seen as being responsive,” Sridharan says. “The market, in its myopia, wants everything to be corrected today. But the larger the ship, the longer it takes to steer it back on course.”
Monitoring Is a Key for Effective Governance
That is not to say boards should not cut CEO pay when a company is struggling, Sridharan says. In fact, pay cuts can be an effective form of discipline if they are combined with other forms of monitoring.
“The board should not just reduce the pay and then sit back and enjoy,” he says. When a pay cut takes place, the board should engage in effective monitoring to ensure that the CEO does not engage in short-term earnings management.
“When boards take a greater interest in monitoring managers, and when the firm has a high level of institutional ownership, pay cuts can be an effective tool,” he says. “It’s a team effort.”
Likewise, CEOs should understand that while earnings management might appear to help the firm in the near future, it will hurt the firm in the long run, ultimately harming their reputation as a leader.
“If they engage in earnings management, they are going to get stigmatized in the process,” Sridharan says. “They need to take their time and be mature enough to carefully chart the waters.”
About the Writer
Emily Ayshford is a freelance writer in Chicago.
About the Research
Lobo, Gerald J., Hariom Manchiraju, and Sri S. Sridharan. 2018. “Accounting and Economic Consequences of CEO Paycuts.” Journal of Accounting and Public Policy. (37): 1–20.
Most Popular This Week
How Are Black–White Biracial People Perceived in Terms of Race?Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
Don’t Wait to Be Asked: LeadA roadmap for increasing your influence at work.
How (Not) to Change Someone’s MindPsychologists have found two persuasion tactics that work. But put them together and the magic is lost.
Which Form of Government Is Best?Democracies may not outlast dictatorships, but they adapt better.
How Autocracies UnravelOver time, leaders grow more repressive and cling to yes-men—a cycle that’s playing out today in Putin’s Russia.
Knowing Your Boss’s Salary Can Make You Work Harder—or Slack OffYour level of motivation depends on whether you have a fair shot at getting promoted yourself.
Sitting Near a High-Performer Can Make You Better at Your Job“Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
It’s Performance Review Time. Which Ranking System Is Best for Your Team?A look at the benefits and downsides of two different approaches.
Will AI Eventually Replace Doctors?Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
Why Do Some People Succeed after Failing, While Others Continue to Flounder?A new study dispels some of the mystery behind success after failure.
Four Strategies for Cultivating Strong Leaders InternallyA retired brigadier general explains how companies can prioritize talent development.
Take 5: Not So Fast!A little patience can lead to better ideas, stronger organizations, and more-ethical conduct at work.
Too Much Cross Talk. Too Little Creativity. How to Fix the Worst Parts of a Virtual Meeting.Six tools from an unlikely place—improv comedy—to use on your next Zoom call.
Take 5: How to Be Prepared for Important Career MomentsExpert advice on getting ready to network, negotiate, or make your case to the CEO.
Entrepreneurship Through Acquisition Is Still EntrepreneurshipETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
Why Do Long Wars Happen?War is a highly inefficient way of dividing contested resources—yet conflicts endure when there are powerful incentives to feign strength.
5 Tips for Growing as a Leader without Burning Yourself OutA leadership coach and former CEO on how to take a holistic approach to your career.
2 Factors Will Determine How Much AI Transforms Our EconomyThey’ll also dictate how workers stand to fare.
What Went Wrong at AIG?Unpacking the insurance giant's collapse during the 2008 financial crisis.
Add Insight to your inbox.