A retail company begins operations late in by purchasing $ of merchandise. There are no sales in During additional merchandise of $ is
purchased. Operating expenses excluding management bonuses are $ and sales are $ The management compensation agreement provides for incentive bonuses
totaling of aftertax income before the bonuses Taxes are and accounting and taxable income is the same.
The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended ending inventory is $ and $ respectively, under
LIFO and FIFO.
Required:
a How are accounting numbers used to monitor this agency contract between owners and managers?
b Evaluate management incentives to choose LIFO versus FIFO.
c Assuming an efficient capital market, what effect can the alternative policies have on security prices and shareholder wealth?
d Why is the management compensation agreement potentially counterproductive as an agencymonitoring mechanism?
e Devise an alternative bonus system to avoid the problem in the existing plan.
