The Effect of Adopting Accounting-Based Bonus and Performance Incentive Plans on the Earnings Response Coefficient

Abstract

This study examines the disparate market response to earnings announcements for firms adopting bonus or performance incentive plans that state plan goals in terms of an earnings-based measure of performance. Bonus plans have a one year performance horizon while performance incentive plans reward managers for improved performance over a three-to-six-year period. A reduction in the earnings response coefficient is predicted for firms that adopt bonus plans since prior research documents that managers of firms with bonus plans have incentives to manipulate earnings numbers. On the other hand, an increase in the earnings response coefficient of firms that adopt performance incentive plans is expected as prior research demonstrates that managers of firms adopting performance incentive plans are motivated to improve long-term profitability. Our results do not support the hypothesis that firms adopting bonus plans experience a decline in the earnings response coefficient. However, our results are consistent with the hypothesis that the earnings response coefficient significantly increases from the pre- to the post-adoption period for firms adopting performance incentive plans.