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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:

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.

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The response addresses the queries posted in 848 words with references.

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The response addresses the queries posted in 978 words with references.

// Prior to talking about the use of accounting used for monitoring the agency contract between owners and managers, we will first of all talk in general terms about accounting as only knowledge of accounting aids in supporting this answer. So, firstly we will talk about accounting under the Introduction and also the use of accounting numbers. //

Introduction:

Accounting knowledge aids in collecting data, processing, analyzing and interpreting as well as presentation of the same in a numerical form to fulfill the need of managerial staff at each level. Accounting deals in the data projection that is to be used for planning and also for efficient business operations. To monitor the agency contract between owners and managers, accounting numbers are used to evaluate the analytical information in terms of contracting costs, prices, income or profit, etc. Pertaining to the various alterative actions.

Besides that, accounting numbers are also used to determine the cost of agency, I.e., monitoring cost, bonding cost & residual loss as well as risk associated with contracts that would endlessly reflect incentives earned by owner and managers from the agency contract. With the accounting numbers, performance of managers & owners can be easily evaluated as well as terms & conditions of agency contract. If the accounting numbers in terms of net revenues or profit is high, it entitles that agency contract renders good returns to both, I.e., owners and managers and also helps in deriving the contribution made by both in attaining high net revenues. Overall, accounting numbers are used to monitor the managers' behavior in the contract. Thus, ...

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Ashish Sharma, MBA (IP)
Education
  • MBA (IP), International Center for Internationa Business
  • BBA, University of Rajasthan
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