Question

Jimmy is the owner of VRS Pty Ltd. Until recently, Jimmy was also the managing director, but he has decided to employ a manager to take over the daily operations of VRS as he transitions to retirement. The new manager, Beryl, agreed to a performance based contract which says that Beryl will be paid a bonus of $200,000 should the profits exceed a target of $2 million. The contract also says that Beryl must prepare financial statements and have them audited. Define the bonus plan hypothesis. Will Beryl have an incentive to manipulate profits? Will Jimmy anticipate this and if so, how would Jimmy react to this expectation? Justify your response.

Answer 1

Bonus Plan hypothesis is one of the three theories of Positive Accounting Theory

The bonus plan hypothesis dictates that managers will use accounting policies that are likely to shift reported earnings from future periods to the current period. This is to maximize their personal compensation as by reporting a high net income, their utility will be maximized through bonuses and incentives.

Financial Accounting Standards provide flexibility for management to select accounting policies that represents the actual condition of the company. This flexibility is sometimes used by management to manage earnings (earnings management).

Executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation.

• (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and
• (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan.

Since Jimmy is preparing the financial statements and is also aware of his bonus being dependent on the profit of the company, he is likely to choose accounting procedures that shift reported earnings from future periods to the current period. By doing so, they can ensure to receive the bonus for the current year.