Internal earnings targets represent an important tool in motivating managers to increase sales efforts, control costs, and use resources more efficiently. Such internal targets also can cause managers to resort to extreme measures in order to meet goals

Question

established by upper management. Earnings management often appears in a variety of forms as a means of reaching these internal goals. Earnings management also is associated with earnings-based internal bonus plans which are also a form of internal target. Explain how earnings management is related to earnings-based internal bonus plans and how managers behave in response to such plans.

Answer 1

Academic research has shown that managers subject to an earnings-based bonus plan are indeed motivated to manage earnings. Managers are likely to manage earnings upward if they are close to the bonus threshold. Conversely, research has shown that managers are more likely to manage earnings downward if reported earnings are substantially in excess of the maximum bonus level, causing managers to defer these excess earnings for use in future periods when operating results may be less favorable.

Bonus plans typically provide a maximum amount that can be transferred to the bonus pool from which bonuses are paid. The maximum transfer usually is some percentage of earnings over a target earnings number, the target frequently being a percentage of shareholder equity or total assets. When earnings are below the target, no bonuses are awarded.

If actual earnings are above the upper bound, managers have an incentive to reduce reported earnings by deferring earnings. Failure to defer the earnings in excess of the upper bound would resort in the loss of the bonus on the excess earnings. Alternatively, deferring the excess earnings increases expected future bonuses.

If actual earnings are between the target and the upper bound, managers will take steps to ensure that the current period's earnings are equal to the upper bound in an effort to maximize the amount received currently. If earnings are below the target, then manager may engage in "big bath" accounting and recognize as much expense as possible in the current period in order to avoid recognizing such expenses in the future.