You are the CEO of a firm. Your cash pay comes from a bonus plan. The performanc

Question

You are the CEO of a firm. Your cash pay comes from a bonus plan. The performance measure used in your bonus plan is earnings before interest and taxes. You do not receive a bonus unless earnings before interest and taxes are $50,000. You receive a minimum cash bonus of $100,000 when earnings before interest and taxes are $50,000. Each additional dollar of earnings before interest and taxes above $50,000 gives you an additional $3 in cash bonus. You receive your maximum cash bonus of $190,000 once earnings before interest and taxes reach $80,000. Your cash bonus stays at $190,000 even if earnings before interest and taxes exceed $80,000.

What accounting choices does this bonus plan encourage you to make?

Explanation / Answer

In the given situation, the CEO gets paid cash bonus when the EBIT is $50,000 for the minimum amount of $100,000 and every 1 dollar increase in EBIT, cash bonus of $3 is paid to him. The maximum cash bonus of $190,000 is paid when EBIT is $80,000 and beyond.

Hence, the CEO will try to maximise the cash bonus by maintaining an EBIT to $80,000 and try to defer the profitability accounting beyond $80,000 for the next year.

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