A retail company begins operations late in 2000 by purchasing $600,000 of merchandise. There are no sales in 2000. During 2001 additional merchandise of $3,000,000 is purchased. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000. The management compensation agreement provides for incentive bonuses totaling 1% of after-tax income (before bonuses). Taxes are 25%, and accounting a taxable income will be the same.
The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending inventory would be $700,000 and $1,000,000 respectively under LIFO and FIFO.
Required:
How are accounting numbers used to monitor this agency contract between owners and managers?
Evaluate management’s incentives to choose FIFO.
Evaluate management’s incentives to choose LIFO.
Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth?
Why is the management compensation agreement potentially counter-productive as an agency-monitoring mechanism?
Devise an alternative bonus system to avoid the problem in the existing plan.
