Positive accounting theory suggests that managers usually have incentives to report more income now than later—for instance, to increase their bonus compensation. This is expected given the substantial evidence from stimulus-response experiments dating back to the early 20th century' by Ivan Pavlov. However, management’s tendency to exaggerate reduces the reliability of the financial statements. In light of this problem, consider the following proposals:
Companies should not pay bonuses based on income. Instead, they should either (i) pay them a fixed salary, or (ii) pay them using stock options. The accounting information given by management will then be more reliable for making investment decisions.
Required:
Evaluate the two proposed alternatives to paying income-based bonuses.