Accounting Forum

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.