Question

A significant part of the compensation received by the leaders of large business entities comes from company-sponsored bonus plans. Determination of the amount of compensation to be awarded under many of these bonus plans is based on net income or some variant of net income. Bonus plans typically provide for a target earnings number that must be achieved in order for bonuses to be paid. This target amount of earnings usually is a percentage either of shareholders’ equity or total assets. If earnings fall below the target, then no bonuses are awarded. A bonus plan may also provide for a maximum amount of earnings above which no bonus will be paid. Accounting research suggests that managers of firms with bonus plans are more likely to choose accounting procedures that shift reported earnings from future periods to the current period. In light of this finding, consider how managers might behave given the following situations:

1. Earnings are far below the target level for the bonus.

2. Earnings are just slightly below the target level for the bonus.

3. Earnings are above the upper limit provided by the bonus plan; no bonus would be paid beyond this upper limit.

Required: Describe what you believe would be the likely behavior of managers under each of the three situations described above.

Answer 1

Case 1:

They will be checking all the probable future losses. These identified losses could be recognized to avoid future amounts of depreciation and also amortization along with other reductions in future earnings. When the managers identify those losses, they could likely avoid the situation of losses in future. And likely to shift reported earnings from future periods to the current period in order to use it for bonus.

Case 2:

Earnings are just below the target level for the bonus. Judgmental accruals will be checked by the Managers or the team of accountants reporting to managers. By that they will be able to find expenses or losses, that could be avoided in CY and revenues or gains which can be continued to the current period. This process will help to gain the earnings to the target level for payment of the bonus.

Case 3:

Earnings are above the upper limit provided by the bonus plan; no bonus would be paid beyond this upper limit. Management is likely to use the accounting policies to defer the reported earnings from current periods to future periods in order to avoid regulations and more taxes.