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The report in question is based on Healy's article, effect of bonus schemes on accounting decisions.It shows how executives aim at deriving the highest possible reward based on an earnings- based bonus scheme. He based his conclusion on actual parameters and definitions of bonus contracts of 94 of the largest US industrial companies over the period 1930-1980.Past studies show that these executives will use income increasing accounting procedures to obtain the best possible compensation but Healy's study provides a different approach on the accounting incentive effects of bonus contracts showing conflicting thoughts on this topic.
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.
This study tests the association between managers' accrual and accounting procedure decisions and their income reporting incentives under these plans. Past studies claim that executives rewarded using the bonus schemes method select income increasing accounting methods to maximise their compensation. What Healy claims is that there are different situations that arise in regard to the financial statement and these will then provide a basis as to which the executives will use an accounting method based on accruals. He explains that when the period earnings before discretionary accruals exceed the lower bound, income increasing accruals are used. If the earnings exceeded the upper bound, income decreasing accruals would be used as this would make no difference to the bonuses. These claims comply with other research like that of Holthausen et al. (1995) but they disagreed with his third claim which was when the earnings were below the lower bound managers would use income decreasing methods. This is to postpone the bonus to the next year as accruals would be charged to the current year. Healy's assumption that bonus parameters in his bonus formula are fixed is also noted as a drawback in a study by Leone et al. (1998). Leone states that managers act differently towards ratcheting targets compared to fixed ones.
Many firms operate both bonus and performance plans simulatenously hence a wise decision by Healy, when collecting data for his research, was to limit his study to firms which only earned bonuses and not any other reward. Previous studies have shown that there are limitations of using aggregated financial data from a large number of firms that have varying forms of incentive compensation. Guidry et al. (1999) and Gaver et al. (1995) agree that tests should be done in an environment where, relative to prior studies, the potential effects of competing incentives (such as stock ownership and stock-based compensation) to manage earnings are reduced. Healy picked 94 firms out of a possible 250, the rest excluded as their contract details were not available or suitable. 94 companies is a small sample size and a larger number would increase accuracy. He uses the aggregate firm in its analysis and does not take in to account the fact that different business unit managers, within the same firm, may perform contradicting actions to each other, for their own benefit.
The financial data was obtained from Compustat which is a very reliable source hence a wise decision. Contingency tests caused the assignment of the company years in to three different portfolios. When cash flows from operations exceed the binding upper bound defined in the bonus plan they are assigned to portfolio UPP. This has been criticised as categorisation based on earnings would have given a less biased result towards his findings. When they are less than the binding lower bound they are assgined to portfolio LOW. Portflio MID inlcudes those company years where neither bounds are binding.
Two statistical tests were used to obtain the results. A parametrical t-test and a non parametrical, chi square test. An observed problem with the chi square test is that it yields only and approximate value for p hence not showing a precise significant level. This in turn is corrected by performing the yates continuity correction.The fishers test could have been used instead as it gives a more accurate value. This contingency test has several limitations. The contingency test presented many problems which could possibly lead to the unfair rejection of the null hypothesis. Firstly the method of assigning observations to portfolio LOW induced selection bias both reported earnings and total assets included non discretionary accruals so the company years with negative non discretionary accruals are therefore likely to be assigned to this portfolio resulting in negative total accruals.
This introduces biases that support his bonus maximization hypothesis. Secondly there were errors in measuring discretionary accruals.The use of total accruals as a proxy for discretionary accruals is the subject of some criticism by Kaplan (1985). Lastly errors in measuring earnings before discretionary accruals. Further tests were performed to overcome these limitations yet some of the results were not consistent. Healy does give his assumptions as to why this is the case but one cannot be entirely sure as to the reliability of these.
In conclusion bonus schemes result in managers selecting accounting procedures to maximise their compensation showing a strong link between accruals and managers income reporting incentives under their bonus contracts. Income decreasing accruals are more likely to be chosen when their bonus plan upper or lower bounds are binding and income decreasing when its not. Healy has tried to prove that unlike previous tests, managers also have an incentive to use decreasing accounting procedures. His research seems good and there seems to be a significant number of people who believe in his work, yet as always there is bound to be criticism and inconsistency in beliefs on the topic. He made far too many assumptions, perhaps as justification for claims and these could be used as future areas of research. This paper provides a good insight to areas not touched upon before and hence enables one to look at bonus scheme procedures under a new perspective.
Gaver, J., Gaver, K., Austin, J. (1995). Additional evidence on bonus plans and income management. Journal of Accounting and Economics .19, p3-28.
Guidry, F., Leone, A., Rock, S. (1999).Earnings based bonus plans and earnings management by business-unit managers. Journal of Accounting and Economics.26, p113-142.
Holthausen, R., Larcker, D., Sloan, R. (1995). Annual bonus schemes and the manipulation of earnings. Journal of Accounting and Economics. 19, p29-74
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Leone, A., Rock, S., Guidry, F. (1998). Empirical tests of the ratchet effect and implications for studies of earnings management. Working paper, University of Rochester.