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Annual Bonus Schemes and Earnings Manipulation Case Study

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Updated: Jul 13th, 2020

Introduction

Compensations and benefits that the companies’ executives receive from the various kinds of earnings manipulations are regarded as one of the most significant incentives for corporate income management. Benefits and bonuses play a significant role in defining the accounting procedures and the key influences on managerial decision-making when they manage the accounting accruals. The most common assumption among the researchers of the accounting decision-making and incentives of the earnings management is that the approaches used by the managers involved in the earnings manipulation differ depending on the impression they want to create concerning the company’s performance.

In its turn, the need to make an impression, alongside the aim of misrepresenting the information, has several incentives. The most important of them, in terms of managerial bonuses and manipulation of earnings, is the need to meet the benchmark of the analysts’ forecasts (Dechow 9).

However, the important aspects of improving the understanding of the motivation for the accruals management among the senior-level executives include focusing on the analysis of the discretionary accruals, patterns of accruals behavior, and providing the cross-sectional study of the extent of earnings management.

Annual bonus contracts for senior-level executives

For the senior-level executives, the standard bonus is estimated at the rate of 20% of the overall compensation for the CEO (Holthausen, Larcker and Sloan 32). However, there are some variations in the systems of the bonus calculation. One of the approaches is the budget-based bonus plan when the maximum compensation is contractually defined. Although there are more problematic cases that include ‘shifted’ bonus plans for senior executive combining the short-run benefits with the annual bonuses (Walter 40). For those cases, the significant motivation for the earnings management would be the opportunity for the manager to increase their annual benefits through managing the company’s income.

Fixed-target earnings manipulation

Overall, it is problematic to define the motivations of the CEOs for the earnings manipulation in each particular case, according to the funding formula (Holthausen, Larcker and Sloan 30). Empirical results suggest that it is more likely that the executives are focused on their bonus plans rather than follow some standard patterns within the accounting bonus schemes when it concerns their annual compensations. Such assumption differs from the suggestions made by Healy (1985) concerning the fixed-target earnings manipulation (Healy 90).

The main issue with the fixed-target approach is that the patterns of which discretionary accruals are used for the different types of accrual-based earnings manipulation are hard to define. From a broader perspective, it is also hard to apply to the situation when the managers have the compensation schemes affected and bounded to taxes or other regulations. Therefore, it is more likely that the managed accruals would depend on the manager’s insider bonus plan. Thus, in the situation when the compensation is below or highly above average, the income-decreasing accruals would be a more probable option for them to choose. However, with the average compensation rate, the likelihood that income-increasing accruals are managed is higher.

Estimating earnings manipulation

The alternative accounting methodologies would involve defining the average total assets in the discretionary accruals and trying to adjust them to other material assets of the company (Hand 602). Also, the other approach is the estimation of earnings management based on the company’s expenditures (Dechow and Sloan 65). For example, the assessment of the abnormal production costs alongside high research and development costs is likely to be one of the traces of the earnings management.

Description of the data, empirical results, and data from Healy (1985)

According to Healy (1985), the expectations that the analysts and other outside audiences define the approaches used by the firms’ managers who practice earnings management (Healy 98). The first most common cause of earnings management is the situation when the company’s performance does not reach the threshold of expectations, in which case the managers are likely ‘to borrow’ the profits from the upcoming fiscal periods. The different approach is used in the situation when the performance of the company is expected to be lower than it is in reality. In such a case, the managers can delay the earnings reporting.

The problem with both strategies is that in both cases if the earnings management is practice continuously, the gap between the actual and reported performance becomes quite substantial. In this regard, the study by Holthausen, Larcker, and Sloan (1995) is similar to the study by Healy (1985) since they recognize both the upward and downward manipulation in the earnings manipulation.

Income smoothing

In terms of income smoothing, it is important to concentrate on the upper bound of the executives’ benefits. The investment decisions are not likely to be affected by the annual bonus plans. Moreover, in the cross-sectional perspective of the companies, the income smoothing shows a little consistency with the various expenditures, including advertising, research, and development, etc.

Summary and conclusions

Overall, the extremes (the lower and upper bounds) of the managerial annual bonuses, compensations, and equity offerings can be linked to the income management since they imply that the executives in charge want to gain their benefits from the company’s performance as soon as possible.

Works Cited

Dechow, Patricia. “Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accounting Accruals.” Journal of Accounting and Economics 18.1 (1994): 3-42. Print.

Dechow, Patricia, and Richard Sloan. “Executive Incentives and the Horizon Problem: An Empirical Investigation.” Journal of Accounting and Economics 14.1 (1991): 51-89. Print.

Hand, John. “1988 Competitive Manuscript Award: Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?” Accounting Review 1.1 (1989): 587-623. Print.

Healy, Paul. “The Effect of Bonus Schemes on Accounting Decisions.” Journal of Accounting and Economics 7.1 (1985): 85-107. Print.

Holthausen, Robert, David Larcker, and Richard Sloan. “Annual Bonus Schemes and the Manipulation of Earnings.” Journal of Accounting and Economics 19.1 (1995): 29-74. Print.

Walter, Ira. “Using Incentive Compensation to Create Shareholder Value.” Journal of Compensation and Benefits 7.4 (1992): 40-45. Print.

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1. IvyPanda. "Annual Bonus Schemes and Earnings Manipulation." July 13, 2020. https://ivypanda.com/essays/annual-bonus-schemes-and-earnings-manipulation/.


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IvyPanda. 2020. "Annual Bonus Schemes and Earnings Manipulation." July 13, 2020. https://ivypanda.com/essays/annual-bonus-schemes-and-earnings-manipulation/.

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IvyPanda. (2020) 'Annual Bonus Schemes and Earnings Manipulation'. 13 July.

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