Total cost of sales and ending inventory

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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:

1. How are accounting numbers used to monitor this agency contract between owners and
managers?

a. (How this question is to be answered) This question is subjective – based on your
knowledge of accounting. Please support your answer.

#2 and #3 questions are to be answered as such.

2. Evaluate management’s incentives to choose FIFO.
3. Evaluate management’s incentives to choose LIFO.

b. Format for FIFO and LIFO

Sales
•
- Cost of Sales
•
= Gross margin
•
- Operating Expense
•
=Operating profit
•
x (1 – Tax rate)
•
= Basis for Bonus
•
x 1% after-tax income
•
=Bonus
•

What is the total cost of sales and ending inventory numbers to determine the
cost of sales for (1) LIFO and (2) FIFO methods

4. Assuming an efficient capital market, what effect should the alternative policies have on
security prices and shareholder wealth?

c. (#4 should be answered as such) Which one (LIFO vs. FIFO) would increase the
firm value, and why?

5. Why is the management compensation agreement potentially counter-productive as an
agency-monitoring mechanism?
6. Devise an alternative bonus system to avoid the problem in the existing plan.

d. Question #5 and #6 is subjective and I need references to support the answers.