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Design issues in bonus contracts

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Bonus plans have become a popular tool for compensating managers and employees. While other accounting studies on bonus plans typically focus on earnings management, for example by examining the association between cash bonuses and stock returns or the incentive for management to manage earnings, our study discusses specific issues that are relevant in designing and understanding bonus plans based on financial performance measures.Bonus contracts should be designed so they align the interest of management and owners. In practice, this is far more difficult than it sounds. We discuss issues that require special attention in preparing bonus contracts: Choice of performance measure(s), accounting issues, link between performance and bonus, and bonus threshold.Our study should be of interest to managers, compensation committees, investors and others interested in bonus plans. A proper bonus plan is essential to ascertain that management compensation is closely linked to management’s ability to create value.

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Christian Petersen, Thomas Plenborg

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