Ex Post Settling Up of Financial Misreporting and CEO Compensation

Abstract

In the early years of their terms of service, CEOs tend to face greater concerns about their careers and uncertainties regarding theirabilities, leading them to inflate earnings in an attempt to influence their perceived abilities. We find that financial misreportingdecreases to a greater extent after firms with shorter tenured CEOs adopt clawback provisions, which allows boards to recoupexcess compensation based on misstated earnings. Moreover, following the adoption of clawback provisions by firms with shortertenured CEOs, the sensitivity of CEO annual pay to poor accounting performance diminishes, along with a reduced sensitivity ofCEO equity portfolio to stock returns and an increased sensitivity to stock return volatility. Our evidence suggests that clawbackprovisions are particularly effective in curbing financial misreporting among CEOs who face greater career concerns and abilityuncertainties. In response, boards adjust the compensation contracts of these CEOs to mitigate the incremental compensation riskimposed by the adoption of clawback provisions.