CEO Pay Cuts and Investors’ Perceptions of Earnings Quality

SYNOPSIS The pay of a CEO is often cut in poorly performing firms to prod the CEO to work harder and restore profitability. Using earnings response coefficients (ERCs) as a proxy for investor perceptions of earnings quality, we find that ERCs decline following CEO pay cuts. Furthermore, firms with weaker oversight mechanisms and those subject to higher credibility concerns have a greater decline in ERCs following CEO pay cuts. We also offer weak evidence that credit rating agencies might perceive CEO pay cuts as impairing earnings quality. Our results suggest that pay cuts incentivize CEOs to boost earnings in the short run, and investors might perceive reported earnings as more likely to be opportunistic and of lower quality. A key implication of our study is that it provides evidence to support that the market views a CEO’s pay-cut status as vital information in appraising the earnings quality of a firm. Data Availability: The data that support the findings of this study are available from author Ting-Kai Chou upon request. JEL Classifications: G34; M41; M52.