Abstract
Boards sometimes cut a CEO’s pay following poor performance. This study examines whether such CEO paycuts really work. We identify 1,496 instances of large CEO paycuts during the period 1994–2013. We then create a propensity-score-matched control group of firms that did not cut their CEOs’ pay and employ a difference-in-differences approach to examine the consequences of paycuts. Our results show that, following a paycut, CEOs are likely to engage in earnings management in an attempt to accelerate improvement in the reported performance and to achieve a speedier restoration of their pay to pre-cut levels. Further, we find that improvement in long-term performance after a paycut occurs only for those firms with lower levels of earnings management after the paycut. Finally, we show that paycuts are more likely to lead to unintended value-destroying consequences in the absence of high institutional ownership or when the CEO is sufficiently entrenched, thereby impairing the effectiveness of internal monitoring by boards.
1. Introduction
Boards of directors (board) often cut CEO pay following poor performance1 and these paycuts often go beyond the general payfor-performance relation (Matsunaga and Park, 2001; Gao et al., 2012; Mergenthaler et al., 2012). Fama (1980) suggests that such paycuts can act as a mechanism for ex-post settling up by the CEO for his past performance, and therefore, can lead to decreased managerial agency costs and better performance in subsequent periods. Consistent with this line of reasoning, Gao et al. (2012) find that firm performance improves following a CEO paycut and conclude that a paycut is therefore an effective mechanism to motivate a poorly performing CEO.
5. Conclusion
In this study, we examine whether a paycut is an effective strategy to stimulate CEO effort in the wake of poor performance. We find that while performance as measured by reported ROA certainly improves after a paycut, such improvement is primarily driven by accruals and real activities management. We argue that in the year following a paycut, CEOs are more likely to engage in earnings management because it will lead to a faster improvement in the reported performance and a speedier restoration of CEO pay to earlier levels. We also show that, in the absence of more effective monitoring in the form of greater institutional holding, CEOs tend to engage more in such earnings management activities. We find improvement in long-term performance measures after a paycut only in those firms with lower levels of earnings management.
