Case 2
In Case 2, the manager has an incentive to choose income-increasing
discretionary accruals. If first-period earnings before discretionary accruals
exceed the threshold L', the present value and certainty advantages of accelerating
income and receiving a bonus in period 1 outweigh foregone expected
awards in period 2. The manager, therefore, selects positive discretionary
accruals. When earnings before accounting choices are less than (U- K), he
chooses the maximum accrual (DA 1 = K). When earnings before accounting
choices are within K of the upper bound, the manager selects less than the
maximum discretionary accrual because income beyond the upper bound is
lost for bonus calculations. He chooses DA 1 = (U- C 1 - NA1) , thereby reporting
earnings equal to the upper bound. If the bonus plan does not specify an
upper bound, the manager selects the maximum discretionary accrual (DAI =
K) when earnings before accounting choices exceed the threshold L'.