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The effect of bonus schemes on accounting decision, Problems in past test,…
The effect of bonus schemes on accounting decision
Introduction & description of accounting bonus schemes
Idea of the articles is to examining managerial accounting decision postulate - the executives rewarded
Analysis the format of typical bonus contract - because the Earnings based bonus schemes are very popular means of rewarding corporate executives in 1980s
Test the association between manager's accrual and accounting procedure decision and their income reporting incentives under these plan
Tested using actual parameters & definitions of bonus contract for sample of 94 companies
Accrual test
Define as the difference between reported earnings and cash flows from operations
Test of changes in accounting procedures
Suggest that managers' decision to change procedures are not associated with bonus plan incentives
Also tested whether accruals differ for companies with different bonus plans
However additional test find that changes in accounting procedures are related to adoption or modification of bonus plan.
Executives rewarded by bonus scheme always select income increasing accounting procedures to maximize their bonus
Ignore the earning's definitions of the plan
Earning are often define so that certain accounting decision do not effect bonuses
For example the test that collected for this study define bonus awards as function of income before taxes
Previous test assume compensation schemes always induce managers to select income increasing accounting procedure by any means
If current income are so low that nothing can done to achieve the targeted company earnings-managers have incentives to further reduce by deferring revenue or accelerating write offs so the future earning target will achieve although not effecting current bonus awards
Accounting bonus schemes
Deferred salary payment, insurance plans, non-qualified stock option, restricted stock, stock appreciation rights, performance plans & bonus plans are the popular forms of compensation
Bonus schemes & performance plans are the 2 that explicitly depends on accounting earnings
Bonus scheme is similar to performance plan except it specify annual rather than long term earnings goals
Performance plan awards manager value of performance units or shares in cash or stock if long term earning target achieve
Bonus scheme and performance plan can operate simultaneous
Studies done on firms whose only remuneration explicitly related to earnings in bunuses
Formulae and variable definitions use in bonus schemes vary considerably between firms - even withing single firm across time
Definition incentive income
earning after interest
Capital is a function of book value of equity
earning before interest
Capital is a function of the sum of long term debt and equity
Administrative of the bonus pool and awards are made by a committee of director who are not ineligible to participate in those scheme
Bonus plan & accounting choice decision
The manager receives in bonus if earnings exceed the lower bound and are less than the bonus plan limit in earnings
Discretionary accruals
adjustment to cash flows selected by the manager from an opportunity set generally accepted procedure define by accounting standard setting bodies
Non-discretionary accruals
are adjustment to the firms' cash flows mandated by the accounting standard setting bodies - SEC, FASB
Accruals modify the timing of reported earning
Discretionary accruals therefore enable the manager to transfer earnings between periods
The manager observe cash flows from operations and non-discretionary accruals at the end of each year and select discretionary accounting procedure and accruals to maximize his expected utility from bonus awards
These cash effect are financed by stock issues or repurchases therefore do not effect the firm production decision
Discretionary accruals are constrained to sum to zero over 2 period
depicts discretionary accruals in the first period as a function of earnings before discretionary accruals
Summary the sign and magnitude of discretionary accruals are function of expected earning before discretionary accruals, the parameter of the bonus plan, the limit on discretionary accruals, the manager's risk preferences and the discount rate - where 3 implications of this theory tested
If the earnings before discretionary accruals are > the threshold represented by the L'( lower bound) manager has incentive to select income decreasing discretionary accruals
If the earnings before discretionary accruals exceed the lower threshold, denoted by L' but not the upper limit, the manager has an incentive to select discretionary accruals to increase income
If the bonus plan specifies an upper bound and earnings before discretionary accruals exceed that limit the manager has an incentive to select discretionary accruals to decrease income
Earlier studies about smoothing hypothesis -
implies that manager chooses income increasing accruals when earning before accruals decision are less than the threshold L'
While compensation theory predicts that the manager select income decreasing discretionary accruals
Sample design & collection of financial data
Sample design
Population selected for this study is companies listed on the 1980 Fortune Directory of the 250 largest U.S. industrial corporation
First available copy of the bonus plan that included in proxy statement to rectified the subsequent plan renewal is collected for each company - from 3 sources
Peat Marwick, the Citicorp Library and the Baker Library at Harvard Business School
From total sample that collected 156 sample excluded comprise 123 firms detail that never publicly available, 6 firms never award bonus and 27 firms that have limit the transfer to bonus pool.
Some of sample companies operate earnings-based bonus and performance plan simultaneously
to control the effect of performance plans on managers' accounting decision companies are deleted from the sample in years both plan are used - subsequently reduce 239 companies
The usable sample is only 94 and from that 30 is bonus plan which specify both upper and lower bounds on earning
Earnings are defined as earnings before taxes for 52.7% of the company years
As earning before interest for 33.5%
42% observed define Bonus contract typically as the lower bound as function of net worth
As a function of net worth plus long term liabilities (37.2%)
Some contract define the lower bound as function of more that one variable
The upper bound is commonly written as a function of cash dividend
Collection of financial data
The data to compute these variables(earnings & upper & lower bound for each company year) is collected from COMPUSTAT for the years 1964-80 & Moody's Industrial Manual for earlier years
2 proxies for discretionary accruals & accounting procedures are used - total accruals & the effect of voluntary changes in accounting procedures on earnings
Total accruals included both discretionary & non discretionary components and are estimated by different between reported accounting earnings and cash flows from operation
2nd proxy for discretionary accruals and accounting procedures is the effect of voluntary changes in accounting procedure on reporting earnings
Accounting changes are collected for sample companies from 1968 to 1980 using 2 sources
The sample of depreciation changes used by Holthausen (1981)
Changes documented by Accounting Trends and Techniques
The effect of each changes on current and retained earnings is collected from companies annual reports
Accrual test & results
Contingency tests & results
Contingency table are constructed to test the implications of the theory
Each company year is assigned to one of three portfolios - UPP, LOW & MID
Comprise observation for which the bonus the bonus contract upper limit is binding
Theory implies that observation should assigned to portfolio UPP when cash flows from operation plus non discretionary accruals exceed the upper bound
This method of identifying company years when the upper bound is binding leads to mis-classifications which increase the probability of incorrectly rejecting the null hypothesis
Comprises observations fro which the bonus plan lower bound is binding
Company years are assigned to this portfolio if earnings are less than the lower bound specified in the bonus plan
Theory implies that observations should be assigned to portfolio LOW when cash flows from operation plus non discretionary accruals are less than the lower threshold.
Contains observation where neither the upper nor lower bounds are binding
Company years that not assigned to the other 2 portfolio included in portfolio MID and expected to have a higher proportion of positive accruals than the other 2 portfolio
Table 2
Sample A
Suggests that managers are more likely to take a bath that is select income decreasing accruals when the lower bound of their bonus plan is binding than when it is not
Sample B
Managers are more likely to select income decreasing accruals when the lower and upper bounds of their bonus plans are binding
Sample C
Aggregates sample A & sample B and confirm the result
One explanation is that bonus plan administration enforce an informal upper bound when one is not specified in contract.
Portfolio MID are stronger for plans with upper bounds
Table 3
There are more negative inventory accruals when the upper and lower constraints are binding than for the MID portfolio - aggregate sample result
The result for receivable accruals confirm the theory for portfolio LOW and MID there is no different in the proportion of negative accruals for portfolio MID & UPP
In summary the evidence in table 2 & 3 is generally inconsistent with the null hypothesis that there is no association between discretionary accruals and manager's income reporting incentives under the bonus plan
Limitations
Method of assigning observation to portfolio LOW induces a selection bias - the selection bias increase the probability of incorrectly rejecting the null hypothesis
Errors in measuring discretionary accruals - total accruals are used as a proxy for discretionary accruals
Errors in measuring earnings before discretionary accruals
Additional test & results
Compare accruals for firms whose bonus plans include an upper bound with accruals for firms whose plans contain no upper limit
This implies that holding earnings before discretionary accruals constant, discretionary accruals are lower for company plan with a binding upper bound than for firm whose bonus plan exclude an upper bound
Additional prediction of theory are tested using all company years for which earning exceed the lower bound and it divided into 2 observation sample
company years when the bonus plan specified an upper bound
company years when no such limit is define
Test design implemented
Company years with a bonus plan upper bound are assigned to one of two portfolio
Observation whose cash flows exceed the upper bound
Company years when the upper bound is not binding
Company years with a binding upper bound are arrayed on the basis of cash flows and deciles are constructed
Company years with no bonus plan upper bound are assigned to one of ten groups
is replicated to compare company years whose upper bound is not binding with company years whose bonus plan contain no upper bound
Changes in accounting procedure test & results
Contingency test is to compare the incidence of income increasing and income decreasing accounting procedure changes for each portfolio - the result not support the theory
Casual evidence suggested that is is more costly for managers to transfer earnings between periods by changing accounting procedures than by changing accruals
Changes in accounting procedures effect earnings and the bonus plan lower bound in the current and future years
Test of the association between bonus plan changes & changes in accounting procedures
Companies more likely to voluntarily changes accounting procedure during years following the adoption or modification of bonus plan, than when there is no such contracting change - to test this hypothesis usable sample divide into 2 portfolio
Comprises companies that adopt or modify their bonus plan
Contain companies that have no such contracting change
The sign and Wilcoxon Ranked sign test use to evaluate the mean number of changes per firm differ for firms with and without a bonus plan
Limitation
The proxy for managers'accounting decision in those test, the effect of an accounting procedure change on bonus earning in the year on change - ignores the effect on future years bonus earnings
Test of the association between bonus plan modifications/adoptions and the incidence of changes in accounting procedures avoid estimating this effect
The effect of voluntary changes in accounting procedures on earning is also used to test the implication of the theory
Voluntary changes in accounting procedures reflect purely discretionary accounting procedure
Reported changes in accounting procedure are available from 2 sources - sample of depreciation switches used by Holthausen (1981) and changes reported by Accounting Trends and technique
In 100 cases the effect of the changes is described as immaterial or not disclose
Conclusion & suggestion
The test results suggest that
Accrual policies of managers are related to income reporting incentives of their bonus contracts
Changes in accounting procedures by managers are associated with adoption or modification of their bonus plan
Bonus scheme create incentives for managers to select accounting procedures and accruals to maximize the value of their bonus awards
Managers are more likely to choose income-decreasing accruals when their bonus plan upper or lower bounds are binding and income increasing accruals when these bounds are not binding
Result of tests comparing accruals for firms whose bonus plans include and exclude an upper bound further support the theory
Questions for future investigation
Why do bonus contracts reward managers on the basis of earning, rather than stock price
What are the other incentive effects of bonus contracts
What are the joint incentive effect of bonus schemes and other forms of compensation
Test of theory also use voluntary changes in accounting procedures as a proxy for discretionary accounting decisions
Problems in past test
Problems in past test
Two classes of test are presented
Accounting earnings are decomposed into Cash flows from operations
Figure 1
Case 1
Case 2
Case 3
Table 1
Portfolio UPP
Portfolio LOW
Portfolio MID
Potential explanation of finding
SETUPATHY RATHA KRISHNAN
ARTICLE 5 : THE EFFECT OF BONUS SCHEMES ON ACCOUNTING DECISION