Comments on Bonus Scheme Hypothesis

Essay by jackson2090 April 2007

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Comments on Bonus Scheme Hypothesis

Positive accounting theory (PAT) has made a significant contribution to our understanding of corporate financial reporting practices. Particularly, it provided an explanation of managers' choice among accounting methods and established the existence of incentives for earning management. Managers' choice of accounting methods is explained in terms of the underlying trade-off between these various incentives (Beattie et al. 1994).

This essay is related to the 'strong association between accruals and managers' which interpreted by Healy (and other). In this essay, two major hypotheses under PAT, competing hypothesis (so-called bonus plan hypothesis) and income-smoothing hypothesis, and related empirical research, will be mentioned to support the discussion.

Healy (1985, p.106) discussed that 'bonus schemes create incentives for managers to select accounting procedures and accruals to maximize the value of their bonus. Specifically, 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'.

In Healy's research, he defined accruals as the difference between reported earning and cash flow from operations. Put another way, net earning can be thought of as cash from operations, plus accruals. If managers are focus on the reported earnings, then the role of accruals as an earning management tool because: for a given amount of cash flow from operations, reported income is increased by positive accruals, and decreases by negative accruals (Gao & Shrieves 2002). This implies the possibility for managers to adopt accruals if there are intensives for them to adjust reported income.

In addition, accounting earnings are often used to calculate the managers' payoff (Smith & Watts 1982) because it is a more efficient measure of the manager's performance than other measures such as stock prices and realised cash flow. Using the accounting earning as the...