Unbiased Analysis of Today's Healthcare Issues

Today’s Recipe: How to cook the books

Written By: Jason Shafrin - Jun• 22•07

Giving corporate executives bonuses based on the performance metrics of the company they manage is one way to incentivize managers to increase profits, sales, company stock price or any other financial measure. But is this the best way to run a company?

In 1985, Paul Healy wrote prescient paper of how corporate executives can alter accounting practices to maximize their bonus payments. Unlike prior articles, Healy claimed that executives will have incentives to both increase and decrease stated earnings by choosing the timing of discretionary accruals.

Let us look at a bonus compensation scheme where executives receive a bonus based on the pre-tax earnings of the company, whenever they exceed a specified lower bound L. Further, bonus payments are also assumed to be capped at an upper limit of earnings U. Thus we have that bonus payments are equal to:

  • B=p{min[U, max(E-L,0)]}

Thus when earnings, E, are below L, the executive receives no bonus. When earnings are between L and U, the executive receives a payment of p(E-L). If earnings are greater than or equal to U, the bonus is capped at pU.

Healy found that one easy way to change earnings between different time periods is to alter the timing of discretionary accruals. For instance, if accountants believe there is a non-preforming asset that they will need to write off in the six-month period, managers can instruct accountants whether to write off the asset in the current quarter or the subsequent quarter. When I worked at GE, managers would alter sales and inventory accruals in order to meet their quarterly goals. While these changes were not illegal (when to charge an accrual is a subjective decision), the timing was heavily influenced by middle manager incentives.

In the Healy paper, the author showed that when earnings, E, are below the lower limit L, managers have an incentive “to take a bath” by charging income-decreasing accruals in the current period. This way, income in the subsequent period will be higher and they will not be losing any bonus income in the current period since they are already below the lower bound, L. Managers with earnings well above the upper limit U, also have an incentive to shift earnings from the current period to subsequent periods. Those with earnings between the upper and lower limits do have an incentive to use income-increasing accruals in the current period in order to maximize their bonus.

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  1. Rick says:

    I was always told that earnings are really easy to manipulate, but I wasn’t sure how. Thanks for making it clear.

    I have also been told that the cash flow from operations is a better indicator of the financial health of a company than earnings, mainly because it can’t be manipulated as easily.

    So would it be better to come up with a bonus formula based on cash flow from operations? And if so what might that look like?