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.”

Previously published in Kellogg Insight. Reprinted with permission of the Kellogg School of Management.