The Effect of Bonus Scheme on Accounting Decision

In: Business and Management

Submitted By Hansy
Words 10639
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Journal of Accounting and Economics 7 (1985) 85-107. North-Holland

THE EFFECT OF BONUS SCHEMES ON ACCOUNTING DECISIONS* Paul M. HEALY
Massachusetts Institute of Technology, Cambridge, MA .02139, USA
Received October 1983, final version received September 1984 Studies examining managerial accounting decisions postulate that executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation. The empirical results of these studies are conflicting. This paper analyzes the format of typical bonus contracts, providing a more complete characterization of their accounting incentive effects than earlier studies. The test results suggest that (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan.

1. Introduction Earnings-based bonus schemes are a popular means of rewarding corporate executives. Fox (1980) reports that in 1980 ninety percent of the one thousand largest U.S. manufacturing corporations used a bonus plan based on accounting earnings to remunerate managers. This paper tests the association between managers' accrual and accounting procedure decisions and their incomereporting incentives under these plans. Earlier studies testing this relation postulate that executives rewarded by bonus schemes select income-increasing accounting procedures to maximize their bonus compensation. 1 Their empirical results are conflicting. These tests, however, have several problems. First, they ignore the earnings' definitions of the plans; earnings are often defined so that certain accounting decisions do not affect bonuses. For exam* I am indebted to Ross Watts for many valuable discussions and for his insightful remarks on this paper. I also wish to thank the remaining…...

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