Bonus Plan Hypothesis, Accounting Information, and Stock Prices - Assignment Example

Short Answer Name: Institution: Date: Question (1): Bonus plan hypothesis The bonus plan hypothesis outlines that managers apply accounting policies that are likely to shift reported earnings from the anticipated future periods to the current period. This is normally done in order to maximize their personal compensation since by reporting a high net income, their utility is maximized through other incentives and bonuses. Consequently bonus plan hypothesis holds that managers of firms that apply the bonus plans are most likely to make use of accounting methods that result in increase of the current financial period reported income. The managers strive to achieve the bonus and other incentives that are set for them after the attainment of a benchmark profit (Parker, 2007). Positive theories in accounting have an assumption that the stock price depends on the cash flows as opposed to reported earnings. Sunrise Company has been in operation for three decades and its C.E.O tries as much as possible to keep the cost at its lowest. The managers are compensated using short-term salaries and short-term accounting performance-based bonus. This is one of the positive accounting theory hypotheses. It is given as an incentive to managers in order to keep the cost down and report high margins of profits. The company’s shareholders have been impressed with the past performance of the company. At the end of 2011, the cost of raw materials increased owing to the adverse economic situations and had the effect of affecting profits negatively. The existence of a bonus plan based accounting exposes the C.E.O. to the challenge of maintaining his income while reporting the actual performance of the company. Since the situation is grim and all indicators show a decline in the profits of the company, the CEO will most likely be tempted to manipulate numbers in order to achieve bonus targets despite the hard economic times. The existence of a positive accounting theory in terms of bonus plan hypothesis can mostly expose the CEO to mischief since he may not be ready to part with the bonuses and other incentives that he is used to. The adverse economic conditions cannot be predicted when it will come to an end, and the manager can try to manipulate earnings numbers in order to achieve bonus targets. In this case, Sunrise Company earn a 12% on the positive difference reported between the benchmark $350,000 and actual reported profit. Any negative difference or existence of no difference does not attract the 12% bonus. Therefore, before the CEO succumbs to circumstance to report the actual performance of the company, he will most likely manipulate figures to post a positive difference between the benchmark $350,000 and actual reported profit. The use of the bonus plan creates a temptation for the CEO to manipulate figures so that he continues enjoying the previous bonuses. It is dangerous to maintain such a bonus plan hypothesis in hard economic times. Sunrise Company can learn a lot from the Enron scandal that occurred in 2001 and led to bankruptcy and total collapse of Enron Company. The company continued to post positive profits despite the fact that they were making huge losses. When the reality surfaced, Enron was a bygone case due to manipulation of accounting figures (Rezaee, 2005). The bonus plan being used by Sunrises Company exposes its managers to the temptation of altering the figures in order to post positive gains of profits that will attract a bonus. The cost has to be at its lowest and crooked methods of accounting can be used to manipulate the figures to post the lowest cost. It will be hard for Sunrise Company to observe accounting ethics in order to be accountable in adverse economic conditions that are anticipated. Negative postings in the performance of the company will attract the wrath of the shareholders since the share prices are likely to drop leading to losses. Some may even resort to selling their shares in the company (Sloan, 2001). The Enron case study that happened in America is a good example where accounting reporting can be compromised in order to falsify the actual performance of the company. Sunrise Company is at the same risk owing to the predicted hard economic conditions which may affect the profits negatively. Question (2): Accounting information and stock prices There is a strong association between accounting earnings and stock prices from the perspective of the investor. The fall or rise in the accounting earnings will positively or negatively affect the stock prices. The stock market is very volatile and anything that has an effect on the stock prices has to be considered seriously. Investors want to be associated with a firm or company that indicates potential of growth. The direction given by the stock prices point predicts the future performance of the company (Deegan, 2009). The tidings from the stock market are taken very seriously by the shareholders and other investors in the company. Bad signs are indicated by shrinking in the prices of stock. The case in the article portrays how a drop in earnings forecast affects share prices. The share prices are reported to have dropped by 4.6% when it was reported that the company cut its earnings forecast as opposed to what had been predicted earlier. The stock price within a short time dropped to $3.72 up from $3.90. The forecast profit had dropped by a margin of $140 Millions. This move is enough to cause worry amount the investors and reduce the trading of the company’s stock because they are no longer attractive. Investors who are holding the stocks from the company are wary of future prices of stock and hence they will be quick to off load them than wait for future drops in prices. There is a positive relationship between stock prices and accounting earnings such that firms which had negative earnings changes also reported negative stock prices changes. There is a directly proportional relationship. Aggregate market of stock reacts to a negative reported earnings or positive reported earnings. Accounting earnings are normally calculated applying different methods of treatment using a range of items in the profit and loss. Some of the items are the depreciation and the inventory that possess various ways of valuation or calculating them. This makes a firm to have different accountancy earning. Earnings which are distributed to the shareholders are known as dividends and are the amount agreed upon by the organization’s board of directors. Investors want earn dividend and see the prices of shares grow to extend of even recording a split and hence increasing the number of shares held. If the forecast of earnings show a negative growth then the shareholders have no morale or attraction of investing further in the company’s stocks. Price revaluation accounting earnings affect the perception of investors towards the performance of the company. Sky City Entertainment revaluation of its accounting earnings forecast had a negative effect on the share prices. The stock prices dropped to $3.72 because the company announced that its earnings forecast had been reviewed downwards in the low of $140 millions. The previous year profits forecast had been $130.9M, the current year had forecast of $140M. This amount was reviewed downwards to reflect a drop in earnings forecast owing to softening in trading conditions especially in Adelaide. The V.E.O expressed his fears in the delay of the economy picking up as anticipated. Reviewing downwards of the company’s accounting earnings shows reduced performance of the company in future. The C.E.O indicates that although there are signs of recovery in the New Zealand economy, the pace is slower than the company anticipated. The company therefore feared that the forecast earnings were way above the predicted actual performance of the company at the forecast time. This action of reviewing downwards the earnings of the company scared the investors who were eager to sell their stocks in order to avoid reduction in dividends and other earnings in future. Measurement of capital gains and losses of marketable market securities has a bearing of future performance of the securities in the stock market. Changes in earnings have a direct impact on the changes of prices of stock in the stock market. As indicated earlier, the stock market is very volatile and any effect on the performance of the company has a direct effect on the share prices of the company (Deegan, 2009). The bad news about shrinking of the accounting earnings of the company sent a bad message to the investors who must have taken drastic steps to avoid a loss of their money if the earnings of the company were to drop. The prediction in the drop of the performance of the company sent wrong signals to shareholders making them to worry about future returns. Forecasting cash flow performance shows the trading activities that the company anticipates to be involved in and the expected returns. From these cash flows, a company can determine its accounting earnings. Traditionally, investors invest in stocks that have a potential of growth. If the stocks indicate chances of deviating negatively from the forecast performance, then the share prices will drop due to reduced activity on the stock market. The fear of further drop in earnings inform cash dividends, stock dividends, and other bonus can lead to the drop in share prices as the stocks for the company become unattractive for the potential investors. The predictability of a fall in prices of shares is made possible through analysis of the earnings forecast. If the earnings forecast are anticipated to reduce, it is automatic that the stock prices will reduce. Earnings for shareholders are distributed basing on the profitability of the company and the type of shares held by the stockholders (Parker, 2007). Preference shareholders are paid before ordinary shareholders in terms of dividends. The ordinary shareholders cannot be paid if the company has not made any profits. Predicting the fall in earnings of the company dampens the spirit of the investors and some sell their shares at low prices in anticipation of a further fall in price. Investors will invest their money and put trust in a company that has a potential of growth. Earnings per share demonstrate how much the company generated for every share of stock. Projections into the future performance of the company against expectations of investors affect the price of stock. Prior to companies reporting their quarterly financial results, analysts can predict the Earnings Per Share (EPS) for the quarter according to the guidance of the company and other factors. If the company registers amount higher that its projected earnings, its stock price will definitely go up (Belkaoui, 2004). When a company fails to reach the forecasted earnings, its stock prices will most likely decline as in the Sky City Entertainment Company. Despite a company having a productive quarter but it is below the projected earnings, the stock prices will definitely do down. Sky City entertainment had projected a growth in its earnings only to turn around and review this value downwards, consequently the stock prices reduced as a result of the fall in the projected earnings. On the other hand, if a company incurs losses but the losses are less than what was projected, the stock price will definitely go up. If a company does not produce consistent growth or lower price per earnings ratio over time, investors might opt to sell their stock hence making its price to be low. When the Sky City Entertainment Company advertised that the projected earnings will drop, some of the shareholders definitely sold their stock to avoid a later fall in prices. When the stocks of a company reduce, its Earning per share will also reduce. When the investors know that the earnings per share will go down, they rush to sell their stocks that had purchased in that company. The reductions in the projected earnings of Sky City Entertainment was reason enough to cause a drop in the share prices. The investors tend to withdraw their cash from stocks that they anticipate to bring little or no returns. Investors want to avoid losses in case the company performs badly and they are forced to sell their stock at a loss. The worst scenario is when the company has to be liquidated due to insolvency problems. The company has to try as much as possible to maintain a positive projected growth curve so as not to cause fear in investors. Investors always want to be associated with the growth and not possibility of losses. The company has to be careful in making its projections about the future performance with regard to share prices. The share prices have a direct relationship with the projected accounting earnings. A fall in price of shares is occasioned by negative growth in projected earnings. References Belkaoui, R.A. (2004). Accounting Theory, Melbourne: Cengage Learning EMEA. Deegan, C. M. (2009). In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill. Parker, Lee D. (2007), Financial and external reporting research: the broadening corporate governance challenge, Accounting and Business Research, 37 (1): 39-54. Rezaee, Z. (2005). Causes, consequences, and deterrence of financial statement fraud, Critical Perspectives on Accounting, 16 (3): 277–298. Sloan, R.G. (2001), Financial accounting and corporate governance: a discussion, Journal of Accounting & Economics, 32: (1-3): 335-347. Read More