The impact of bonus schemes on accounting choices

Abstract

Bonus contracts are a popular means of rewarding corporate executives. Awards under these contracts are conditioned on accounting earnings. If it is costly for administrators of bonus schemes to adjust earnings numbers for changes in accounting techniques, managers have an Incentive to select procedures that increase the value of their awards. Available evidence on the relationship between the accounting procedures used to report earnings and the existence of an accounting-based compensation scheme is conflicting. However, this literature has largely ignored the structure of the compensation agreements; it has assumed that profit-sharing schemes induce the manager always to select income-inflating accounting procedures. This paper identifies the common features of bonus plans. The relationship between accounting choice decisions and bonus plan parameters is examined assuming costly monitoring of accounting decisions. Conditional on the cash flows of the firm, managers are predicted to have an incentive to select income-increasing or income-decreasing accounting procedures. From these implications tests of the association between accounting choice decisions and the incentives created by accounting-based compensation schemes are constructed. The results, using accruals as a proxy for the managers' accounting choice variable, are generally consistent with the theory. Managers appear to select accruals to Increase the value of their bonus awards. Changes in inventory and receivables are identified as the accrual elements most strongly associated with managerial compensation incentives. Additional tests reinforce these results: managers are more likely to change accounting methods when a bonus plan is adopted or modified, than when there is no such contractual change. 1 . INTRODUCTION Recent research in accounting has sought to explain why managers select particular accounting procedures to report corporate financial performance. Compensation contracts, which condition awards on reported accounting earnings, have been widely-cited as one factor influencing managers' accounting choice decisions. If it is costly for the administrators of these schemes to isolate the impact of accounting choices on earnings, managers have an incentive to select procedures that increase their bonus remuneration. Of course, if plan administrators have rational expectations, they anticipate this behavior, and ex ante fix managerial remuneration such that, after taking advantage of their control over the accounting system, the managers expect to earn only tlielr opportunity wage. The results of extant empirical tests of the association between the accounting procedures used to report earnings and the existence of an accounting-based compensation scheme are conflicting. However, these tests have largely ignored the structure of the compensation agreements; they have assumed that profit-sharing schemes induce the manager always 2 to select income-inflating accounting procedures. This paper examines the structure of the most common form of explicit accounting-based remuneration the bonus plan. The relationship between accounting choice decisions and the parameters of these bonus plans is examined and conditions under which managers have an incentive to select income-increasing or income-decreasing accounting procedures are