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management compensation agreement

Aretail company begins operations late in 2000 by purchasing $600,000of 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 $600,000. 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 2001,ending inventory would be $700,000and 1,000,000 respectively under LIFO and FIFO.

How accounting numbers used to monitor this agency contract between owners and managers.Evaluate management's incentives to choose FIFO and also to choose LIFO.

Devise an alternative bonus system to avoid the problem.

Why is the management compensation agreement potentially counter productive as an agency monitoring mechanism?

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

Solution Summary

Devise an alternative bonus system to avoid the problem.

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