Journal of Accounting and Economics 7 (1985) 85-107. North-Holland THE EFFECT OF BONUS SCHEMES ON ACCOUNTING DECISIONS* Paul M. HEALY Massachusetts Institute of Technology, Cambridge, MA .02139, USA Received October 1983, final version received September 1984 Studies examining managerial accounting decisions postulate that executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation. The em- pirical results of these studies are conflicting. This paper analyzes the format of typical bonus contracts, providing a more complete characterization of their accounting incentive effects than earlier studies. The test results suggest that (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. 1. Introduction Earnings-based bonus schemes are a popular means of rewarding corporate executives. Fox (1980) reports that in 1980 ninety percent of the one thousand largest U.S. manufacturing corporations used a bonus plan based on account- ing earnings to remunerate managers. This paper tests the association between managers' accrual and accounting procedure decisions and their income- reporting incentives under these plans. Earlier studies testing this relation postulate that executives rewarded by bonus schemes select income-increasing accounting procedures to maximize their bonus compensation. 1 Their em- pirical results are conflicting. These tests, however, have several problems. First, they ignore the earnings' definitions of the plans; earnings are often defined so that certain accounting decisions do not affect bonuses. For exam- * I am indebted to Ross Watts for many valuable discussions and for his insightful remarks on this paper. I also wish to thank the remaining members of my Ph.D. committee, Andrew Christie, Cliff Smith and Jerry Zimmerman, for their helpful comments. The paper has benefited from the comments of Bob Kaplan, Rick Antle, George Benston, Tom Dyckman, Bob Holthausen, Michael Jensen, Rick Lambert, David Larcker, Richard Leftwich, Tom Lys, Terry Marsh, Ram Rama- krishnan, and Rick Ruback. I am grateful to George Goddu and Peat Marwick for allowing me to use their library and financing my preliminary data collection, and to Bob Holthausen and Richard Rikert for letting me use their data bases of changes in accounting procedures. Financial support for this paper was provided by the Ernst and Whinney Foundation and the American Accounting Association. :These studies include Watts and Zimmerman (1978), Hagerman and Zmijewski (1979), Holthausen (1981), Zmijewski and Hagerman (1981), Collins, Rozeff and Dhaliwal (1981), and Bowen, Noreen and Lacey (1981). 0165-4101/85/$3.30©1985, Elsevier Science Publishers B.V. (North-Holland)