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THE EFFECT OF BONUS SCHEMES ON ACCOUNTING DECISIONS By Paul M.…

- - - - Bonus contracts have a similar format to performance contracts except that they specify annual rather than long-term earnings goals.
    - - Performance plans award managers the value of performance units or shares in cash or stock if certain long-term (three or five years) earnings' targets are attained.
- - - - Non-discretionary accruals are accounting adjustments to the firm's cash flows mandated by accounting standard-setting bodies (e.g., the Securities Exchange Commission and the Financial Accounting Standards Board). These bodies require, for example, that companies depreciate long-lived assets in some systematic manner, value inventories using the lower of cost or market rule, and value obligations on financing leases at the present value of the lease payments.
    - - Discretionary accruals are adjustments to cash flows selected by the manager. The manager chooses discretionary accruals from an opportunity set of generally accepted procedures defined by accounting standard-setting bodies.
  - - - If earnings before discretionary accruals exceed the lower threshold, denoted by L' in fig. 1, 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.
      - If earnings before discretionary accruals are less than the threshold represented by L', the manager has an incentive to select income-decreasing discretionary accruals.
- - - - Total accruals include both discretionary and non-discretion (A CC,) ary components and are estimated by the difference (ACC t = NA t + DAt), between reported accounting earnings and cash flows from operations.
    - - Accounting changes are collected for sample companies from 1968 to 1980 using two sources: the sample of depreciation changes used by Holthausen (1981) and changes documented by Accounting Trends and Techniques.
- - - - Portfolio UPP
        
        Portfolio UPP comprises observations for which the bonus contract upper limit is binding.
      - Portfolio LOW
        
        Portfolio LOW comprises observations for which the bonus plan lower bound is binding.
      - Portfolio MID
        
        Portfolio MID contains observations where neither the upper nor lower bounds are binding.
    - - The evidence in tables 2 and 3 is generally inconsistent with the null hypothesis that there is no association between discretionary accruals and managers' income-reporting incentives under the bonus plan. There is a greater incidence of negative accruals when the upper and lower bounds in the bonus contracts are binding.
    - - Second limitation of the contingency tests arises from errors in measuring discretionary accruals.
      - Third limitation of the contingency tests arises from errors in measuring earnings before discretionary accruals.
      - First, the method of assigning observations to portfolio LOW induces a selection bias.
  - - - Company-years with a binding upper bound are arrayed on the basis of cash flows (deflated by the book value of total assets) and deciles are constructed. Mean accruals and cash flows (both deflated by total assets) are estimated by decile.
      - Company-years with no bonus plan upper bound are assigned to one of ten groups. The groups are constructed to have mean deflated cash flows approximately equal to the means of the deciles formed in Step 2. The high and low deflated cash flows for each decile are used as cut offs to form the ten groups; a company-year with no upper bound is assigned to a group if deflated cash flows are within its cut offs. Mean deflated accruals and cash flows are estimated for each group.
      - Company-years with a bonus plan upper bound are assigned to one of two portfolios. The first comprises observations whose cash flows exceed the upper bound. The second contains company-years when the upper bound is not binding.
- - - - Statistically significant at the 0.0730 and 0.0212 levels respectively, consistent with the hypothesis those changes in bonus schemes are associated with changes in accounting procedures.