In the study conducted by Flora Guidry, Andrew J. Leone and Steve Rock (l997) entitled Earnings-Based Bonus Plans and Earnings Management by Business Unit Managers, tests the Fixed-Target Hypothesis, wherein it is hypothesized that managers make discretionary accrual decisions to maximize their short-term bonuses.
The analyses conducted was based on business unit-level rather than firm-level information.
Their study shows that, business unit manager incentive compensation is based solely on business unit earnings. The possibly confusing effects of long-term performance and stock-based incentive compensation present in previous research are absent.
Using multiple measures of discretionary accruals, they find evidence that those managers with bonus- related incentives to make income-increasing discretionary accruals do so relative to managers with incentives to use accrual discretion to decrease earnings.
To the extent that external financial reporting represents an aggregation of business unit financial reports, the results highlight the importance of internal contracting as a determinant of external reporting (Page 1).
Further, According to Paul M. Healy and James M. Wahlen in A Review of the Earnings Management Literature and Its Implications for Standard Setting (l999), studies have been conducted and examined actual compensation contracts to identify managers’ earnings management incentives.
The evidence reported in these studies is consistent with managers using accounting judgment to increase earnings-based bonus awards. Those divisional managers for large multinational companies are likely to defer income when the earnings target in their bonus plan will not be met and when they are entitled to the maximum bonuses permitted under the plan (Page 376).
Moreover, the studies show that firms with caps on bonus awards are more likely to report accruals that defer income when that cap is reached than firms that have comparable performance but which have no bonus cap (Page 376).
Studies show that compensation and lending contracts cause some firms to manage earnings to increase bonus awards, improve job security and extenuate possible violation of debt agreements.
Nonetheless, whether this behavior is widespread or infrequent, there is very little evidence and no evidence on which accruals are most likely being used to manage earnings for contracting purposes (Page 377).
However, tests provide convincing evidence that some firms do manage earnings when they anticipate reporting a loss, reporting an earnings decline or falling short of investor’s expectations (page 379).
Other findings indicate that earnings management occurs for a variety of reasons, including influencing stock market perceptions, to increase management’s compensation, to reduce the likelihood of violating lending agreements, and to avoid regulatory intervention (Page 380).
Internal auditors were more likely to consider fraud when income surpassed, than when it fell short of, expectations. They also bore fraud in mind when debt covenants were restrictive in a situation where income was better than expected. In this circumstance, managers might beef up earnings to maintain a particular ratio of assets to liabilities required by a lien holder.
It was also discovered internal auditors considered fraud to be even more probable if income surpassed expectations and managers had an earnings-based bonus plan. This was also true in cases when income was more than expected and managers had an earnings-based bonus plan and debt covenants were restrictive (Church, B. K. McMillan J. J. & Schneider, A. 2001).
Anything that is not allowed by law is illegal. Financial reporting not in conformity with generally accepted accounting principles does not present fairly the financial position and results of operations of the business. Regulatory bodies have been created and funded by the government to protect the interest of the public.
Whatever reason or whether or not it is beneficial to any party in the organization for as long as it defrauds, mislead the public, earnings management must be prohibited and penalized.