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Dewey

WORKING PAPERALFRED P. SLOAN SCHOOL OF MANAGEMENT

THE EFFECT OF BONUS SCHEMESON ACCOUNTING DECISIONS

byPaul M. Healy

September 1984

MIT Sloan School of Management Working Paper #1589-84

MASSACHUSETTSINSTITUTE OF TECHNOLOGY

50 MEMORIAL DRIVECAMBRIDGE, MASSACHUSETTS 02139

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THE EFFECT OF BONUS SCHEMESON ACCOUNTING DECISIONS

byPaul M. Healy

September 1984

MIT Sloan School of Management Working Paper //1589-84

I am indebted to Ross Watts for many valuable discussions and forhis insightful remarks on this paper. I also wish to thank theremaining members of my Ph.D. committee, Andrew Christie, CliffSmith and Jerry Zimmerman, for their helpful comments. The paperhas benefited from the comments of Bob Kaplan, Rick Antle, GeorgeBenston, Tom Dyckman, Bob Holthausen, Michael Jensen, Rick Lambert,David Larcker, Richard Leftwich, Tom Lys, Terry Marsh, RamRamakrishnan, and Rick Ruback. I am grateful to George Goddu andPeat Marwick for allowing me to use their library and financingmy preliminary data collection, and to Bob Holthausen and RichardRikert for letting me use their data bases of changes in accountingprocedures. Financial support for this paper was provided by theErnst and Whinney Foundation and the American Accounting Association.

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M.I.T. LIBRARIESFEB 2 2 1985RECEIVED

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ABSTRACT

Studies examining managerial accounting decisions postulate thatexecutives rewarded by earnings-based bonuses select accountingprocedures that Increase their compensation. The empirical results ofthese studies are conflicting. This paper analyzes the format of typicalbonus contracts, providing a more complete characterization of theiraccounting incentive effects than earlier studies. The test resultssuggest that (1) accrual policies of managers are related toincome-reporting Incentives of their bonus contracts; and, (2) changes inaccounting procedures by managers are associated with adoption ormodification of their bonus plan.

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1. INTRODUCTIONEarnings-based bonus schemes are a popular means of rewarding corporate

executives. Fox (1980) reports that In 1980 ninety percent of the onethousand largest U.S. manufacturing corporations used a bonus plan based onaccounting earnings to remunerate managers. This paper tests theassociation between managers' accrual and accounting procedure decisions andtheir Income-reporting Incentives under these plans. Earlier studiestesting this relation postulate that executives rewarded by bonus schemesselect Income-Increasing accounting procedures to maximize their bonuscompensation. Their empirical results are conflicting. These tests,however, have several problems. First, they Ignore the earnings'definitions of the plans; earnings are often defined so that certainaccounting decisions do not affect bonuses. For example, more than half ofthe sample plans collected for my study define bonus awards as a function ofIncome before taxes. It Is not surprising, therefore, that Hagerman andZmljewskl (1979) find no significant association between the existence ofaccounting-based compensation schemes and companies' methods of recordingthe Investment tax credit.

Second, previous tests assume compensation schemes always Inducemanagers to select Income Increasing accounting procedures. The schemesexamined In my study also give managers an Incentive to selectincome-decreasing procedures. For example, they typically permit funds tobe set aside for compensation awards when earnings exceed a specifiedtarget. If earnings are so low that no matter which accounting proceduresare selected target earnings will not be met, managers have Incentives to

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-2-further reduce current earnings by deferring revenues or acceleratingwrite-offs, a strategy known as "taking a bath." This strategy does notaffect current bonus awards and Increases the probability of meeting future

2earnings' targets. Past studies do not control for such situations and,therefore, understate the association between compensation Incentives andaccounting procedure decisions.

This study examines typical bonus contracts, providing a more completeanalysis of their accounting incentive effects than earlier studies. Thetheory is tested using actual parameters and definitions of bonus contractsfor a sample of 94 companies. Two classes of tests are presented: accrualtests and tests of changes in accounting procedures. I define accruals asthe difference between reported earnings and cash flows from operations.The accrual tests compare the actual sign of accruals for a particularcompany and year with the predicted sign given the managers' bonusincentives. The results are consistent with the theory. I also testwhether accruals differ for companies with different bonus plan formats.The accrual differences provide further evidence of a relation betweenmanagers' accrual decisions and their income-reporting incentives under thebonus plan. Tests using changes in accounting procedures suggest thatmanagers' decisions to change procedures are not associated with bonus planIncentives. However, additional tests find that changes in accountingprocedures are related to the adoption or modification of a bonus plan.

Section 2 outlines the provisions of bonus agreements. The accountingincentive effects generated by bonus plans are discussed In Section 3.

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-3-Sectlon 4 describes the sample design and data collection, and Section 5reports the results of accrual tests. Tests of changes in accountingprocedures are described In Section 6. The conclusions are presented InSection 7.

2. DESCRIPTION OF ACCODNTING BONUS SCHEMESDeferred salary payment, Insurance plans, nonqualified stock options,

restricted stock, stock appreciation rights, performance plans and bonus3plans are popular forms of compensation. Two of these explicitly depend

on accounting earnings: bonus schemes and performance plans. Performanceplans award managers the value of performance units or shares in cash orstock if certain long-term (three or five year) earnings' targets areattained. The earnings' targets are typically written in terms of earningsper share, return on total assets, or return on equity. Bonus contracts

have a similar format to performance contracts except that they specifyannual rather than long-term earnings goals.

A number of companies operate bonus and performance planssimultaneously. Differences in earnings definitions and target horizons ofthese two plans make it difficult to identify their combined effect onmanagers' accounting decisions. I therefore limit the study to firms whoseonly remuneration explicitly related to earnings is bonuses. Fox (1980)finds that in 1980 90 percent of the one thousand largest U.S. manufacturingcorporations used a bonus plan to remunerate managers, whereas only 25percent used a performance plan. Bonus awards also tend to constitute ahigher proportion of top executives ' compensation than performancepayments. In 1978, for example. Fox reports that for his sample the median

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-4-ratio of accounting bonus to base salary was 52 percent. The median ratiofor performance awards was 34 percent

The formulae and variable definitions used In bonus schemes varyconsiderably between firms, and even within a single firm across time.Nonetheless, there are common features of these contracts. They typicallydefine a variant of reported earnings (E. ) and an earnings target or lowerbound (L ) for use In bonus computations. If reported earnings exceedtheir target, the contract defines the maximum percentage (p,.) of thedifference that can be allocated to a bonus pool. If earnings are less thantheir target, no funds are allocated to the pool. The formula for themaximum transfer to the bonus pool (B ) Is:

Bt = pt Max{(Et - L^), 0}

Standard Oil Company of California, for example, defines Its 1980 bonusformula as follows:

...the annual fund from which awards may be made Is two percent ofthe amount by which the company's annual Income for the award yearexceeds six percent of Its annual capital Investment for such year.Standard Oil defines "annual Income" as audited net Income before thebonus expense and Interest, and "capital Investment" as the average ofopening and closing book values of long-term liabilities plus equity.Variations on these definitions are found in other companies' plans.Earnings are defined before or after a number of factors Includinginterest, the bonus expense, taxes, extraordinary and nonrecurring items,and/or preferred dividends. Capital is a function of the book value ofequity when Incentive income Is earnings after interest and a function ofthe sum of long-term debt and equity when Incentive Income is earnings

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-5-before Interest. Bonus plans for 94 companies are examined In this studyand only seven do not use these definitions of earnings and capital.

Some schemes specify an upper limit (U^^) on the excess of earningsover target earnings. When the difference between actual and targetearnings Is greater than the upper limit, the transfer to the bonus poolIs limited. Implying the formula for allocation to the bonus pool (B' )is:

B\ = Pt{Mln {Ut , Max { (E,. - L^) , } }The upper limit Is commonly related to cash dividend payments on common

4stock. The 1980 bonus contract for Gulf Oil Corporation, for example,limits the transfer to the bonus reserve to six percent of the excess ofearnings over six percent of capital "provided that the amount creditedto the Incentive Compensation Account shall not exceed ten percent of thetotal amount of the dividends paid on the corporation's stock."

Administration of the bonus pool and awards to executives are made bya committee of directors who are Ineligible to participate In thescheme. Awards are made In cash, stock, stock options or dividendequivalents. The bonus contract usually permits unallocated funds tobe available for future bonus awards. Plans also provide for awarddeferrals over as many as five years, either at the discretion of thecompensation committee or the manager.

3. BONUS PLANS AND ACCOUNTING CHOICE DECISIONSWatts (1977) and Watts and Zimmerman (1978) postulate that bonus

schemes create an Incentive for managers to select accounting proceduresand accruals to Increase the present value of their awards. This paperproposes a more complete theory of the accounting Incentive effects of

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-6-bonus schemes. The firm Is assumed to comprise a single risk-aversemanager and one or more ovraers. The manager Is rewarded by the followingbonus formula:

B' = p {mln {U', Max { (E,. - L),0 }}}

where L Is the lower bound on earnings (E ), U' Is the limit on theexcess of earnings over the lower bound (E -L), and p Is the payoutpercentage defined In the bonus contract. The manager receives p(E - L)In bonus If earnings exceed the lower bound and are less than the bonusplan limit (the upper bound) on earnings, U, given by the sum (U' + L).

The bonus Is fixed at pU' when earnings exceed this upper bound.Accounting earnings are decomposed Into cash flows from operations

(C ), non-dlscretlonary accruals (NA ) and discretionary accruals(DA ) . Nondlscretlonary accruals are accounting adjustments to thefirm's cash flows mandated by accounting standard-setting bodies (e.g.,the Securities Exchange Commission and the Financial Accounting StandardsBoard). These bodies require, for example, that companies depreciatelong-lived assets in some systematic manner, value inventories using thelower of cost or market rule, and value obligations on financing leasesat the present value of the lease payments. Discretionary accruals areadjustments to cash flows selected by the manager. The manager choosesdiscretionary accruals from an opportunity set of generally acceptedprocedures defined by accounting standard-setting bodies. For example,the manager can choose the method of depreciating long-lived assets; hecan accelerate or delay delivery of inventory at the end of the fiscalyear; and he can allocate fixed factory overheads between cost of goodssold and inventories.

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-7-Accruals modify the timing of reported earnings. Discretionary

accruals therefore enable the manager to transfer earnings betweenperiods. I assume that discretionary accruals sum to zero over themanager's employment horizon with the firm. The magnitude ofdiscretionary accruals each year Is limited by the available accountingtechnology to a maximum of K and a minimum of -K.

The manager observes cash flows from operations and nondlscretlonaryaccruals at the end of each year and selects discretionary accountingprocedures and accruals to maximize his expected utility from bonusawards. The choice of discretionary accruals affects his bonus awardand the cash flows of the firm. I assume that these cash effects arefinanced by stock Issues or repurchases and, therefore, do not affect thefirm's production/investment decisions.

Healy (1983) derives the manager's decision rule for choosingdiscretionary accruals when his employment horizon Is two periods. Thechoice of discretionary accruals In period one fixes his decision In thesecond period because discretionary accruals are constrained to sum tozero over these two periods. Figure 1 depicts discretionary accruals Inthe first period as a function of earnings before discretionaryaccruals. These results are discussed in three cases.

INSERT FIGURE 1

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-8-Case 1

In Case 1, the manager has an Incentive to choose Income-decreasingdiscretionary accruals, that Is to take a bath. This case has tworegions. In the first, earnings before discretionary accruals are morethan K below the lower bound (I.e., C^^ + NA^^ < L - K) . Themanager selects the minimum discretionary accrual (DA. = -K) becauseeven if he chooses the maximum, reported income will not exceed the lowerbound and no bonus will be awarded. By deferring earnings to period two,he maximizes his expected future award.

In the second region of Case 1 earnings before discretionary accrualsin period one (C, + NA,) are within + K of the lower bound (L). Themanager either selects the minimum (DA, = -K) or maximum (DA^^ = K)discretionary accrual. If he chooses the maximum accrual, he receives abonus in period one but foregoes some expected bonus in period twobecause he is now constrained to report the minimum accrual in that

period (DA_ = -K) . If he selects the minimum discretionary accrual inperiod one the manager maximizes his expected bonus in period two, butreceives no bonus in the first period. He trades off present value andcertainty advantages of receiving a bonus in period one against theforegone expected bonus in period two. Conditional on the bonus planparameters, expected earnings before discretionary accruals in periodtwo, the discount rate, and his risk aversion, the manager estimates athreshold (denoted by L' in Figure 1) where he is indifferent betweenreporting the minimum and maximum accrual in period one. In Figure 1,the threshold (L') exceeds the lower bound in the bonus plan (L).However, the threshold can also be less than the lower bound, dependingon expected earnings in period two. The manager selects the minimum

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-9-dlscretlonary accrual (DA, = - K) when earnings before discretionaryaccruals are less than the threshold. I.e., C- + NA^ < L'.

Case 2In Case 2, the manager has an Incentive to choose Income-Increasing

discretionary accruals. If first period earnings before discretionaryaccruals exceed the threshold L', the present value and certaintyadvantages of accelerating Income and receiving a bonus In period oneoutweigh foregone expected awards In period two. The manager, therefore,selects positive discretionary accruals. When earnings before accountingchoices are less than (U - K), he chooses the maximum accrual(DA^ = K) . When earnings before accounting choices are within K of theupper bound, the manager selects less than the maximum discretionaryaccrual because income beyond the upper bound is lost for bonuscalculations. He chooses DA. = (U - C^ - NA.), thereby reportingearnings equal to the upper bound. If the bonus plan does not specify anupper bound, the manager selects the maxlmun discretionary accrual(DA. = K) when earnings before accounting choices exceed the threshold

Case 3In Case 3, the manager has an incentive to select income-decreasing

discretionary accruals. When the bonus plan upper bound is binding,earnings before discretionary accruals exceeding that bound are lost forbonus purposes. By deferring Income that exceeds the upper bound, themanager does not reduce his current bonus and increases his expectedfuture award. When earnings before discretionary accruals are less than

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-10-U + K, he selects DA, = (C, + NA, - U) , reporting earnings equal tothe upper bound. When earnings before discretionary accruals exceed(U + K) , he chooses the minimum accrual (DA = -K)

In summary, the sign and magnitude of discretionary accruals are afunction of expected earnings before discretionary accruals, theparameters of the bonus plan, the limit on discretionary accruals, themanager's risk preferences and the discount rate. Three Implications ofthis theory are tested:

(1) If earnings before discretionary accruals are less than the thresholdrepresented by L', the manager has an Incentive to selectIncome-decreasing discretionary accruals.

(2) If earnings before discretionary accruals exceed the lower threshold,denoted by L' In Figure 1, but not the upper limit, the manager has

an Incentive to select discretionary accruals to Increase Income.

(3) If the bonus plan specifies an upper bound and earnings beforediscretionary accruals exceed that limit, the manager has anIncentive to select discretionary accruals to decrease Income.

Earlier studies on the smoothing hypothesis postulate that discretionaryQaccruals are a function of earnings before accruals. However, the

predictions of the compensation theory outlined here differ from those ofthe smoothing hypothesis: when earnings before accrual decisions are lessthan the threshold L', the compensation theory predicts that the managerselects Income-decreasing discretionary accruals; the smoothing hypothesisImplies that he chooses Income-Increasing accruals.

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-11-4. SAMPLE DESIGN AND COLLECTION OF FMANCIAL DATA

4 .1 Sample DesignThe population selected for this study Is companies listed on the

1980 Fortune Directory of the 250 largest U.S. Industrial9corporations. It Is common for stockholders of these companies to

endorse the Implementation of a bonus plan at the annual meeting.Subsequent plan renewals are ratified, usually every three, five or tenyears and a summary of the plan Is included in the proxy statement oneach of these occasions. The first available copy of the bonus plan iscollected for each company from proxy statements at one of threesources: Peat Marwick, the Citicorp Library and the Baker Library atHarvard Business School. Plan Information is updated whenever changes inthe plan are ratified.

One hundred and fifty-six companies are excluded from the finalsample. The managers of 123 of these firms receive bonus awards but thedetails of the bonus contracts are not publicly available. Six companiesdo not appear to reward top management by bonus during any of the yearsproxy statements are available. A further twenty-seven companies havecontracts which limit the transfer to the bonus pool to a percentage ofthe participating employees' salaries. Since this Information is notpublicly disclosed, no upper limit can be estimated for these companies.

Some of the sample companies operate earnings-based bonus andperformance plans simultaneously. To control for the effect ofperformance plans on managers' accounting decisions, companies aredeleted from the sample in years when both plans are used. Thisrestriction reduces the number of company years by 239.

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-12-The useable sample comprises 94 companies. Thirty of these have

bonus plans which specify both upper and lower bounds on earnings. Thecontract definitions of earnings, the net upper bound and the lower boundfor the sample are summarized In Table 1. Earnings are defined asearnings before taxes for 52.7 percent of the company-years and earningsbefore interest for 33.5 percent of the observations. Bonus contractstypically define the lower bound as a function of net worth (42.0 percentof the observations) or as a function of net worth plus long-termliabilities (37.2 percent). Some contracts define the lower bound as afunction of more than one variable. For example, the 1975 bonus contractof American Home Products Corporation defines the lower bound as "thegreater of (a) an amount equal to 12 percent of Average Net Capital or(b) an amount equal to $1.00 multiplied by the average number of sharesof the Corporation's common stock outstanding at the close of business oneach day of the year." The upper bound is commonly written as a functionof cash dividends.

INSERT TABLE 14.2 Collection of Financial Data

Earnings and upper and lower bounds for each company-year areestimated using actual bonus plan definitions. The definitions areupdated whenever the plan is amended. The data to compute thesevariables is collected from COMPUSTAT for the years 1946-80 and fromMoody's Industrial Manual for earlier years.

Two proxies for discretionary accruals and accounting procedures areused: total accruals and the effect of voluntary changes in accountingprocedures on earnings. Total accruals (ACC.) include both

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-13-dlscretlonary and nondiscretlonary components (ACC^^ = NA^ + DA.),and are estimated by the difference between reported accounting earningsand cash flows from operations. Cash flows are working capital fromoperations (reported In the funds statement) less changes In Inventoryand receivables, plus changes In payables and Income taxes payable:

ACC^= - DEP^

where, DEPj-XltAARt

AINVAAPtATPt

DEF.

D2

XI^.D^ + AARj. + AINV^ - AAP^ - {ATP^+ DEFJ.D2depreciation In year textraordinary Items In year taccounts receivable In year t less accounts receivableIn year t-1Inventory In year t less Inventory In year t-1accounts payable In year t less accounts payable In year t-1Income taxes payable In year t less Income taxespayable In year t-1deferred Income tax expense (credit) for year t

( 1 if bonus plan earnings are defined after extraordinary Items( If bonus plan earnings are defined before extraordinary Items

!1 If bonus plan earnings are defined after Income taxesIf bonus plan earnings are defined before Income taxes

The only accrual omitted Is the earnings effect of the equity method ofaccounting for Investments In associated companies.

The second proxy for discretionary accruals and accounting proceduresis the effect of voluntary changes in accounting procedures on reportedearnings. Accounting changes are collected for sample companies from1968 to 1980 using two sources: the sample of depreciation changes usedby Holthausen (1981) and changes documented by Accounting Trends and

Techniques. The effect of each change on current and retained earnings

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-14-is collected from the companies' annual reports. This data Is furtherdescribed In Section 6.

5. ACCSnAL TESTS AND RESULTS

5.1 Contingency Tests and ResultsContingency tables are constructed to test the Implications of the

theory. Managers have an Incentive to select Income-decreasingdiscretionary accruals when their bonus plan's upper and lower bounds arebinding. When these bounds are not binding the manager has an Incentiveto choose income-increasing discretionary accruals. Total accruals proxyfor discretionary accruals.

Each company-year is assigned to one of three portfolios:(1) Portfolio UPP, (2) Portfolio LOW, or (3) Portfolio MID. PortfolioUPP comprises observations for which the bonus contract upper limit is

binding. Company-years are assigned to this portfolio when cash flowsfrom operations exceed the upper bound defined in the bonus plan. Thetheory implies that observations should be assigned to portfolio UPP whencash flows from operations plus nondlscretlonary accruals exceed theupper bound. Cash flows are a proxy for the sum of cash flows andnondlscretlonary accruals because nondlscretlonary accruals areunobservable . This method of Identifying company-years when the upperbound Is binding leads to mlsclasslflcatlons which increase theprobability of Incorrectly rejecting the null hypothesis. Discussion ofthis problem and tests to control for the bias are presented later inthis section.

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-15-Portfollo LOW comprises observations for which the bonus plan lower

bound Is binding. Company-years are assigned to this portfolio Ifearnings are less than the lower bound specified in the bonus plan. Thetheory implies that observations should be assigned to portfolio LOW whencash flows from operations plus nondlscretlonary accruals are less thanthe lower threshold L'. This threshold is a function of the bonus planlower bound, the managers' risk preferences and their expectations offuture earnings. Since the threshold is unobservable , the method ofassigning company-years to portfolio UPP, using cash flows as a proxy forcash flows plus nondlscretlonary accruals, cannot be used for portfolioLOW. Instead, company-years are assigned to portfolio LOW when earningsare less than the lower bound since no bonus is awarded in these years,and managers have an incentive to select income-decreasing discretionaryaccruals. This assignment method Induces a selection bias whichIncreases the probability of incorrectly rejecting the null hypothesis.Discussion of this problem Is deferred to later in the section.

Portfolio MID contains observations where neither the upper nor lowerbounds are binding. Company-years that are not assigned to portfoliosUPP or LOW are included in portfolio MID, and are expected to have ahigher proportion of positive accruals than the other two portfolios.

The incidence of positive and negative accruals for portfolios LOW,MID and UPP is presented in the form of a contingency table in Table 2.The row denotes the portfolio to which each company-year is assigned.The column denotes the sign of the accrual and each cell contains theproportion of observations fulfilling each condition. Mean accruals,deflated by the book value of total assets at the end of each

10company-year are also displayed for each portfolio. If managers

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-16-select accruals to Increase the value of their bonus compensation, therewill be a higher Incidence of negative accruals and lower mean accrualsfor portfolios LOW and UPP than for portfolio MID. Chl-Square and tstatistics, testing these hypotheses, are reported In Table 2. TheChl-Square test Is a two-tailed test which compares the number ofobservations in each contingency table cell with the number expected bychance. The t tests are one-tailed tests of differences In mean

12deflated accruals for the three portfolios.

INSERT TABLE 2Sample A reports results for plans with a lower bound, but no upper

bound. There is a lower proportion of negative accruals for portfolioLOW than for portfolio MID, inconsistent with the theory. However, theChl-Square statistic is not statistically significant. The meanstandardized accruals support the theory: the mean for portfolio LOW isless than the mean for portfolio MID and the t statistic, comparing thedifference in means, is statistically significant at the .010 level.This result suggests that managers are more likely to take a bath, thatis, select income-decreasing accruals, when the lower bound of theirbonus plan is binding than when it is not.

Sample B comprises plans which specify both an upper and lowerbound. The Chl-Square statistic is significant at the .005 level,indicating that there is a greater incidence of negative accruals whenthe bonus plan lower and upper limits are binding than otherwise. Testsof mean standardized accruals reinforce the Chi Square results: themeans for portfolios LOW and UPP are less than the mean for the MID

portfolio. The t tests, evaluating differences in means, are

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-17-statlstlcally significant at the .005 level. These results areconsistent with the hypothesis that managers are more likely to selectIncome-decreasing accruals when the lower and upper bounds of their bonusplans are binding. Sample C aggregates Samples A and B and confirms theresults.

There are several differences In the results for Samples A and B.First, the results for the MID portfolio are stronger for the sample ofplans with upper bounds. One explanation Is that bonus planadministrators enforce an Informal upper bound when one Is not specifiedIn the contract. If this Informal bound Is binding, some of thecompanies Included In the MID portfolio for Sample A are mlsclasslfled;they should be Included In Sample B and assigned to portfolio UPP. Asecond difference between the samples is the stronger result forportfolio LOW for Sample B than Sample A. I have no explanation for thisresult.

Contingency tables are constructed for the following subcomponents ofaccruals: changes In Inventory, changes In receivables, depreciation,changes In payables and, where relevant to the bonus award, changes InIncome taxes payable. The changes In Inventory and receivable accrualsubcomponents are most strongly associated with management compensationincentives. Contingency table results for the aggregate sample are

13presented for these two subcomponents In Table 3. There are morenegative Inventory accruals when the upper and lower constraints arebinding than for the MID portfolio. The results for receivable accrualsconfirm the theory for portfolios LOW and MID. However, there Is nodifference in the proportion of negative accruals for portfolios MID andUPP. The Chi-Square statistics for both Inventory and receivable

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-18-accruals are significant at the .005 level. Differences In meanInventory and receivable accruals for portfolios LOW, MID and UPP areconsistent with the theory: the means for portfolios UPP and LOW aresignificantly lower than the mean for portfolio MID at the .005 level.

INSERT TABLE 3In summary, the evidence in Tables 2 and 3 Is generally Inconsistent

with the null hypothesis that there Is no association betweendiscretionary accruals and managers' Income-reporting Incentives underthe bonus plan. There is a greater incidence of negative accruals when

the upper and lower bounds In the bonus contracts are binding. Thecontingency tables for decomposed accruals identify changes In Inventoryand accounts receivables as the accrual subcomponents most highly relatedto managers' bonus plan incentives.

There are several limitations of the contingency tests. First, themethod of assigning observations to portfolio LOW induces a selectionbias. Company-years are assigned to Portfolio LOW when reported earningsare less than the lower bound. A high incidence of negative accruals areobserved for this portfolio, consistent with the theory. However, bothreported earnings and total accruals Include nondlscretlonary accruals.Company-years with negative nondlscretlonary accruals are thereforelikely to be assigned to portfolio LOW and they will also tend to havenegative total accruals. This selection bias increases the probabilityof incorrectly rejecting the null hypothesis.

A second limitation of the contingency tests arises from errors inmeasuring discretionary accruals. Total accruals are used as a proxy fordiscretionary accruals. Measurement errors for this proxy are correlatedwith the firm's cash flows from operations and earnings, the variables

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-19-used to assign company-years to portfolio UPP, MID and LOW. Thisrelation could explain the contingency results. For example, inventory

14accruals reflect physical Inventory levels. If there is anunexpected Increase in demand, physical inventory levels andnondiscretlonary accruals will fall and cash flows from operationsincrease, consistent with the results reported for portfolio UPP in Table3. However, an unexpected decrease in demand will Increase physicalinventory levels and nondiscretlonary accruals and decrease cash flowsfrom operations, opposite to the theory's predictions for portfolio LOW.

A third limitation of the contingency tests arises from errors inmeasuring earnings before discretionary accruals. Cash flows are a proxyfor this variable and are used to assign company-years to portfolios MIDand UPP. Errors in measuring earnings before discretionary accruals areperfectly negatively correlated with measurement errors in discretionaryaccruals since the sum of the actual variables (earnings before

discretionary accruals and discretionary accruals) are constrained toequal the sum of the measured variables (cash flows and total accruals)by the accounting earnings identity. This Implies that adisproportionate number of company-years with positive measurement errorin earnings before discretionary accruals will be assigned to portfolioUPP. These observations have negative measurement errors indiscretionary accruals, increasing the probability of Incorrectlyrejecting the null hypothesis.

The tests presented in Sections 5.2 and 6 are designed to controlfor the effects on the contingency results of measurement errors indiscretionary accruals and in earnings before discretionary accruals.

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-20-5.2 Additional Tests and Results

Additional tests compare accruals for firms whose bonus plansinclude an upper bound with accruals for firms whose plans contain noupper limit. The theory predicts that managers whose bonus plans Includean upper bound have an incentive to select income-decreasingdiscretionary accruals when that limit is triggered. Ceteris paribus,managers compensated by schemes with no ceilings on earnings are expectedto select income-increasing discretionary accruals. This Implies that,holding earnings before discretionary accruals constant, discretionaryaccruals are lower for company plans with a binding upper bound than forfirms whose bonus plans exclude an upper bound. This relation reverseswhen the upper bound is not binding since I assume that discretionaryaccruals affect only the timing of reported earnings. Discretionaryaccruals are therefore higher for company plans with a nonbindlng upperbound than for firms whose plans do not include an upper bound.

Tests of these implications of the theory control for measurementerrors in discretionary accruals. They compare measured discretionaryaccruals (total accruals) for company-years with equivalent cash flowsbut different bonus plans - plans with and without an upper bound. Ifthe measurement errors are independent of the existence of an upper boundin the bonus plan, the tests Isolate discretionary accrualdifferences between companies with these different types of bonus plans.

The tests also control for errors in measuring earnings beforediscretionary accruals by comparing accruals for company-years withequivalent measured earnings before discretionary accruals (cash flows)but with bonus plans that include and exclude an upper bound. If

measurement errors are Independent of the existence of an upper bound In

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-21-the bonus plan, the estimates of discretionary accrual differencesbetween companies with these two types of bonus plans are unbiased.

The additional predictions of the theory are tested using allcompany-years for which earnings exceed the lower bound (I.e., portfoliosMID and UPP). The observations are divided Into two samples:company-years when the bonus plan specifies an upper bound, andcompany-years when no such limit Is defined. The tests are constructedto compare accruals for these two samples holding cash flows constant.The following test design Is Implemented:(1) Company-years with a bonus plan upper bound are assigned to one of

two portfolios. The first comprises observations whose cash flowsexceed the upper bound. The second contains company-years when theupper bound Is not binding.

(2) Company-years with a binding upper bound are arrayed on the basis ofcash flows (deflated by the book value of total assets) and deciles

are constructed. Mean accruals and cash flows (both deflated bytotal assets) are estimated by decile.

(3) Company-years with no bonus plan upper bound are assigned to one often groups. The groups are constructed to have mean deflated cashflows approximately equal to the means of the deciles formed In Step2. The high and low deflated cash flows for each decile are used ascutoffs to form the ten groups; a company-year with no upper boundIs assigned to a group If deflated cash flows are within Itscutoffs. Mean deflated accruals and cash flows are estimated foreach group.The mean deflated accruals and cash flows are reported In Table 4 by

decile for company-years with a binding upper bound and by group for

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-22-company-years with no upper bound. The theory predicts that, holdingcash flows constant, accruals are lower for companies with a bindingbonus plan upper bound, than for companies with no upper bound. Theresults support the theory: mean accruals are less for company-years

with a binding upper bound in nine of the ten pairwise comparisonsreported in Table 4, Panel A. The Sign and Wilcoxon Signed-Ranks testsare used to evaluate whether this result is statisticallysignificant. The Sign test is significant at the .0107 level and theWilcoxon Signed-Ranks test at the .0020 level.

INSERT TABLE 4

The test design is replicated to compare company-years whose upperbound is not binding with company-years whose bonus plan contains noupper bound. The theory predicts that, holding cash flows constant,accruals are higher for companies with a nonbinding bonus plan upperbound, than for companies whose plan contains no upper bound.Company-years for which the upper bound is not binding are arrayed on thebasis of cash flows and deciles are formed. The high and low cash flowsfor these deciles are used to form ten groups for company-years with noplan upper bound. Mean deflated accruals and cash flows are reported inTable 4, Panel B by decile for company-years with a nonbinding upperbound, and by group for company-years with no upper bound. The resultsare consistent with the theory: mean accruals for company-years when thebonus plan upper bound is not binding are greater than mean accruals forcompany-years with no upper bound in nine of the ten pairwisecomparisons. The Sign test is significant at the .0107 level and theWilcoxon Signed-Ranks test at the .0068 level.

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-23-7. CHANGES IN ACCOUNTING PROCEDURE TESTS AND RESULTS

The effect of voluntary changes In accounting procedures on earningsIs also used to test the Implications of the theory. The proxy used InSection 6, accruals, reflects both discretionary and nondlscretlonaryaccruals and accounting procedures. Voluntary changes In accountingprocedures reflect purely discretionary accounting procedure decisions.

Reported changes In accounting procedures are available from twosources: the sample of depreciation switches used by Holthausen (1981)and changes reported by Accounting Trends and Techniques. Accountingchanges are collected from these sources for the sample companies from1968 to 1980. Procedure changes are decomposed according to the type ofchange and a summary Is presented In Table 5 for the full sample (342changes) and for the changes whose effect on earnings Is disclosed In thefootnotes (242).

INSERT TABLE 5

The effect of each accounting procedure change on earnings and equity Iscollected from the financial statement footnotes. In 100 cases theeffect of the change is described as immaterial or not disclosed. Afurther 49 changes report only the sign of the effect on earnings. Theseare coded to indicate whether the effect is positive or negative.

7.1 Contingency TestsThe contingency tests are replicated using the effect of changes in

accounting procedures on earnings available for bonuses as a proxy for

discretionary accounting decisions. Earnings available for bonuses are

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-24-reported earnings, defined In the bonus plan, less the lower bound. Ifthe effect of the accounting change on this variable Is positive(negative), the change is classified as Income-increasing(Income-decreasing). Company-years are assigned to portfolios LOW, MIDand UPP using the method adopted in Section 6, and contingency tables areconstructed to compare the incidence of income-increasing andincome-decreasing accounting procedure changes for each portfolio. Theresults do not support the theory. However, there are several potentialexplanations of this finding:(1) Casual evidence suggests that it is more costly for managers to

transfer earnings between periods by changing accounting proceduresthan by changing accruals. Companies rarely change accountingprocedures annuallyfor example, changes to straight linedepreciation in one year are typically not followed by a change toother depreciation methods in succeeding years. Managers appear to

have greater flexibility to change accruals. For example, they canaccelerate or defer recognition of sales, and capitalize or expenserepair expenditures.

(2) Changes in accounting procedures affect earnings and the bonus planlower bound in the current and future years. Managers consider theeffect of alternative accounting methods on the present value oftheir bonus awards. However, the effect of a procedure change onthe accounting numbers is only publicly disclosed for the year ofthe change. This proxy therefore fails to control for the effect ofaccounting procedures on bonus awards in future years.

The tests presented in Section 7.2 control for these problems.

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-25-7.2 Tests of the Association between Bonus Plan Changes and Changes InAccounting Procedures

Watts and Zimmerman (1983) postulate that changes In the contractingor political processes are associated with changes In accountingmethods. For example, companies are more likely to voluntarily changeaccounting procedures during years following the adoption or modificationof a bonus plan, than when there Is no such contracting change. To testthis hypothesis, useable sample companies are partitioned Into twoportfolios for each of the years 1968 to 1980. One portfolio comprisescompanies that adopt or modify their bonus plan; the other containscompanies that have no such contracting change.

Bonus plans are adopted or modified at the annual meeting, whichtypically occurs three or four months after the fiscal year end. Themean number of voluntary accounting changes per firm reported at the endof the following fiscal year Is estimated for companies that modify andadopt bonus plans and for companies with no bonus plan change for each ofthe years 1968 to 1980. A greater number of voluntary changes areexpected for the sample of firms adopting or modifying bonus plans, thanfor firms with no such change. The Sign and Wllcoxon Ranked-Slgn testsare used to evaluate whether the mean number of changes per firm differfor firms with and without a bonus plan change.

The test mitigates one of the limitations of the contingency tests.The proxy for the managers' accounting decisions In those tests, theeffect of an accounting procedure change on bonus earnings In the year ofthe change. Ignores the effect on future years' bonus earnings. Tests ofthe association between bonus plan modifications/adoptions and theincidence of changes In accounting procedures avoid estimating thiseffect.

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-26-

INSERT TABLE 6

Test results are reported In Table 6. The mean number of voluntarychanges In accounting procedures Is greater for firms with bonus planchanges than for firms with no such change In nine of the twelve years.No means are reported for 1979 because no sample companies Introduced ormodified bonus plans In that year. The Sign and Wllcoxon Slgned-Ranktests are statistically significant at the .0730 and .0212 levelsrespectively, consistent with the hypothesis that changes In bonusschemes are associated with changes In accounting procedures.

8. CONCLUSIONSBonus schemes create Incentives for managers to select accounting

procedures and accruals to maximize the value of their bonus awards.

These schemes appear to be an effective means of Influencing managerialaccrual and accounting procedure decisions. There Is a strongassociation between accruals and managers* Income-reporting Incentivesunder their bonus contracts. Managers are more likely to chooseIncome-decreasing accruals when their bonus plan upper or lower boundsare binding, and Income-Increasing accruals when these bounds are notbinding. Results of tests comparing accruals for firms whose bonus plansInclude and exclude an upper bound further support the theory: holdingcash flows constant, accruals are lower for company-years with bindingbonus plan upper bounds than for company-years with no upper bound. Thisdifference In the timing of reported earnings Is offset when bonus planupper limits are not binding.

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-27-Tests of the theory also use voluntary changes In accounting

procedures as a proxy for discretionary accounting decisions. Theresults suggest that there Is a high Incidence of voluntary changes Inaccounting procedures during years following the adoption or modificationof a bonus plan. However, managers do not change accounting proceduresto decrease earnings when the bonus plan upper or lower bounds arebinding.

The paper raises several questions for future Investigation. First,why do bonus contracts reward managers on the basis of earnings, ratherthan stock price? Second, what are the other Incentive effects of bonuscontracts? Finally, what are the joint Incentive effects of bonusschemes and other forms of compensation, such as performance plans?

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-28-FOOTNOTES

1. These studies Include Watts and Zimmerman (1978), Hagerman andZmljewskl (1979), Holthausen (1981), Zmljewskl and Hagerman (1981),Collins, Rozeff and Dhallwal (1981) and Bowen, Noreen and Lacey(1981).

2. See Holthausen (1981) and Watts and Zimmerman (1983).3. For a discussion of these types of compensation see Smith and Watts

(1982).4 Contracts taking this form create an Incentive for the manager to

Increase dividend payments when the upper limit Is binding, therebycounteracting the over-retention problem noted In Smith and Watts(1983).

5. Dividend equivalents are claims which vary with the dividend paymentson common stock.6. The theory does not explain the form of bonus contracts or why

executives are awarded earnings-based bonuses. For a discussion ofthese Issues see Jensen and Meckllng (1976), Holmstrom (1979), Millerand Scholes (1980), Fama (1980), Hlte and Long (1980), Holmstrom(1982), Smith and Watts (1983), Larcker (1983) and Demskl , Patell andWolfson (1984).

7. The manager's accrual decision is motivated by factors other thancompensation. Watts and Zimmerman (1978) suggest that the manageralso considers the effect of accounting choices on taxes, politicalcosts, and the probability and associated costs of violating lendingagreements.

8. See Ronen and Sadan (1981) for an extensive review of the smoothingliterature.

9. Fox (1980) provides evidence that the probability of a corporationemploying a bonus plan is not Independent of size or industry. Theinferences drawn from this study are, therefore, strictly limited tothe sample population. Nonetheless, that population is a non-trivialone - the largest 250 industrials account for more than 40 percent ofsales of all U.S. industrial corporations.

10. Accruals are also deflated by sales and the book value of assets atthe beginning of the year. The test results are insensitive toalternative size deflators.

11. The Chl-Square test assumes that the sample is a random one from thepopulation, and the sample size is large. The statistic is drawnfrom a Chi-Square distribution with (R - 1)(C - 1) degrees offreedom, where R is the number of rows and C the number of columns inthe contingency table.

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-29-12. This statistical test assumes that the populations are normal with

equal variances. Each t value is then drawn from a t distributionwith (N + M - 2) degrees of freedom, where N Is the number ofobservations In one sample and M the number In the other. Both the tand Chl-Square tests assume that accruals are Independent. Thisassumption Is violated If accruals are autocorrelated or sensitive tomarket-wide and Industry factors. Accruals exhibit significantpositive first order autocorrelation. The test statistics reportedin Table 2 are therefore overstated.

13. Results for other subcomponents, and for different plan forms - thosewith and without an upper bound - are reported in Healy (1983). Theupper bound results for depreciation, changes in accounts payable andchanges in taxes payable are consistent with the theory, but thelower bound results are inconsistent.

14. Managers therefore have an incentive to manage Inventory levels, aswell as to select accounting procedures, to maximize the value oftheir bonus compensation (see Biddle, 1980).

15. Weak evidence to support this assumption is presented in Healy(1983). He finds that companies whose bonus plans include andexclude an upper limit do not have different means and variances ofleverage, firm value, the ratio of gross fixed assets to firm value,and systematic risk. Leverage is defined as the ratio of long-termdebt to firm value, and firm value is the sum of the book values ofdebt and preferred stock and the market value of common stock.

16. The Sign test and Wllcoxon Signed-Ranks test assume that assignmentsto test and control groups are random. For a detailed description ofthe tests see Slegel (1956) pp. 67-83.

17. The sample Includes the 94 companies used In earlier tests and the 27companies formerly excluded because their bonus plan upper limit wasa function of participating employees' salaries.

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-30-REFERENCES

Blddle, Gary C, 1980, Accounting methods and management decisions: Thecase of inventory costing and Inventory policy, Supplement to theJournal of Accounting and Research, 18, 235-280.

Bowen, Robert M. , Eric W. Noreen and John M. Lacy, 1981, Determinants ofthe corporate decision to capitalize Interest, Journal of Accountingand Economics, 3, 151-179.

Collins, Daniel W., Michael S. Rozeff and Dan S. Dhaliwal, 1981, Theeconomic determinants of the market reaction to proposed mandatoryaccounting changes in the oil and gas Industry: a cross-sectionalanalysis. Journal of Accounting and Economics, 3, 37-72.

Demskl, Joel, James Patell and Mark Wolfson, 1984, Decentralized Choiceof monitoring systems. Accounting Review, January, 16-34.

Fama, Eugene F., 1980, Agency problems and the theory ofthe firm. Journal of Political Economy, 88, 288-307.Fox, Harland, 1980, Top executive bonus plans, (the Conference Board,

New York).Hagerman, Robert L. and Mark E. Zmijewski, 1979, Some economic

determinants of accounting policy choice. Journal of Accounting andEconomics, 1, 141-162.

Healy, Paul M., 1983. The impact of bonus schemes on accounting choices.Dissertation, University of Rochester.

Hlte, Gallen L. and Michael S. Long, 1980, Taxes and executive stockoptions. Journal of Accounting and Economics, 4, 3-14.

Holmstrom, Bengt, 1979, Moral hazard and observability. Bell Journalof Economics, 10, 74-91.

Holmstrom, Bengt, 1982, Managerial Incentive Problems, in Essays inEconomics and Management in Honor of Lars Wahlbeck, (Swedish Schoolof Economics, Helsinki), 209-230.

Holthausen, Robert W. , 1981, Evidence on the effect of bond covenants andmanagement compensation contracts on the choice of accountingtechniques: The case of the depreciation switch-back. Journal ofAccounting and Economics, 3, 73-109.

Jensen, Michael C. and William H. Meckling, 1976, Theory of the firm:Managerial behavior, agency costs, and capital structure. Journalof Financial Economics, 3, 305-360.

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-31-

Larcker, David, 1983, The association between performance plan adoptionand corporate capital Investment, Journal of Accounting andEconomics, 5, 3-30.

Miller, Merton H. and Myron S. Scholes, 1980, Executive compensation,taxes and Incentives, In Financial economics: Essay In honor of PaulCootner, W. F. Sharpe and C. M. Cootner (eds), (Prentice-Hall,Englewood Cliffs, New Jersey) , 170-201.

Ronen, Joshua and Slmcha Sadan, 1981, Smoothing Income numbers:Objectives, means, and Implications, (Addlson-Wesley, Reading,Massachusetts)

Slegel, Sidney, 1956, Nonparametrlc statistics for the behavioralsciences, (McGraw-Hill, New York).

Smith, Clifford and Ross Watts, 1982, Incentive and tax effects ofexecutive compensation plans, Australian Journal of Management,December, 139-157.

Smith, Clifford and Ross Watts, 1983, The structure of executivecompensation contracts and the control of management. Unpublishedpaper. University of Rochester.

Watts, Ross, 1977, Corporate financial statements, a product of the marketand political processes, Australian Journal of Management,April, 53-75.

Watts, Ross and Jerold Zimmerman, 1978, Towards a positive theory of thedetermination of accounting standards. Accounting Review,January, 112-134.

Watts, Ross and Jerold Zimmerman, 1983, Positive theories of thedetermination of accounting theories. Unpublished paper.University of Rochester.

Zmljewskl, Mark E. and Robert Hagerman, 1981, An income strategyapproach to the positive theory of accounting standardsetting/choice. Journal of Accounting and Economics, 3, 129-149.

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-32-

DlscretionaryAccruals(DAjl)

K -

-K _

Case 3

Earnings beforediscretionaryaccruals(Ci + NA^)

Figure 1.Managerial Discretionary Accrual Decisions

as a Function of Earnings before DiscretionaryAccruals and Bonus Plan Parameters In theFirst Period of a Two-Period Model

LUL'

KC

= the lower bound defined In the bonus plan= the upper bound on earnings= a cutoff point which Is a function of the lower bound, themanager's risk preference, expected earnings In period twoand the discount rate= the limit on discretionary accruals= cash flows from operationsNA = nondlscretlonary accruals

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-33-Table 1

Summary of Useable Bonus Plan Definitions for a Samplefrom the Fortune 250 over the Period 1930-1980

Total number of sample companiesTotal number of company-yearsNumber of company-years subject to

an upper bound constraintAdjustments to Earnings Specified

in the Bonus Contract

941527447

Percentage of CompanyYear Observations

Additions to net incomeIncome TaxExtraordinary itemsInterest

Deductions from net incomePreferred dividends

Variables Used to Define Lower Boundsin the Bonus Contract

52.7%27.533.5

12.1

Net worthNet worth plus long-term liabilitiesEarnings per shareOther

42.037.28.3

17.8Variables Used to Define Upper Bounds

in the Bonus ContractCash dividendsNet worth or net worth plus long-termliabilitiesOther

22.42.54.5

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-34-Table 2

Summary of the Association betweenAccruals and Bonus Plan Parameters

Sample A: Plans with a Lower Bound but No Upper Bound

PortfolioProportion of accrualswith given signPositive Negative

Number ofCompanyYears

Meant Test forDifference

Accruals in Means

Portfolio LOWPortfolio MIDx2 (d.f. = 1)

0.380.36

0.1618

0.620.64

741006

-0.0367-0.0155 2.5652d

Sample B: Plans with Both a Lower Bound and Upper Bound

Proportion ofn ^c tj with givenPortfolio ^

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-35-Table 3

Summary of the Association between AccrualSubcomponents and Bonus Plan Parameters

Change In Inventory

Portfolio'Proportion of Inventory

a accruals with given signPositive Negative

Mean ,Accrualst Test forDifferenceIn Means

Portfolio LOWPortfolio MIDPortfolio UPP

x2 (d.f. = 2)

0.59 0.410.80 0.200.69 0.31

26.3171^

0.00960.02460.0078

2.6880C4.0515C

Change In Accounts Receivable

^c ij accruals withPortfolio

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-36-Table 4

Results of Tests Comparing Accruals for Companies Whose BonusPlans Include and Exclude An Upper Bound Holding Cash Flows Constant

A. Accruals for company-years when the bonus plan's upper bound Isbinding compared with accruals for company-years with no upper limitdefined in their bonus plan.

Average Cash Flows" byDecile for Company-Years

Whose Bonus PlanAverage Accruals" by Decile

for Company-Years WhoseBonus Plan

Decile^Includesan UpperBound

Excludesan UpperBound

DifferenceIncludes Excludes inan Upper an Upper AverageBound Bound Accruals^

1

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-37-Table 4 (cont.

Accruals for company years when the bonus plan's upper bound Is not bindingcompared with accruals for company-years with no upper limit defined In theirbonus plan.

Average Cash Flows"by Decile for Company-YearsWhose Bonus Plan

Average Accruals" byDecile for Company-YearsWhose Bonus Plan

Decile^Includesan UpperBound

Excludesan UpperBound

Includes Excludesan Upper an UpperBound Bound

Differencein

AverageAccruals^

1

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-38-Table 5

Summary and Decomposition of Changes In Accounting Procedures for aSample from the Fortune 250 over the Period 1968-1980

Type of Change Full Sample(342 changes)

Subsample withEarnings EffectDisclosed(242 changes)

Miscellaneous 19 12Inventory

MiscellaneousTo LIFOTo FIFO

16643

9633

DepreciationMlscellaneouTo acceleratedTo straight-lineTo replacement cost

Other erpensesMiscellaneousTo accrualTo cash

113

272

20125

61

251

1284

Actuarial assumptions forpensionsRevenue recognitionEntity accountingMiscellaneous

To Inclusion In consolidationTo equity from unconsolidated

683212147

342

54181

34242

Disclosure of effect on net IncomeEffect on earnings disclosed

Estimate given in dollarsDirectional effect reported

Effect undisclosed or describedas immaterial

19349

242

100342

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-39-

Table 6Association between Voluntary Changes In Accounting

Procedures and the Adoption or Modification of a Bonus Plan

Year^

Mean Number of VoluntaryAccounting Changes per FirmSamplechangingbonus plan

Sample notchangingbonus plan

DifferenceIn means

1968

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3790 u5S

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TDfiD DOM Mfi3 335

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Date Sue

Lib-26-67

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BASEMENT

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