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    FASB Disclosures regarding inventory, agency and security

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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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    Solution Preview

    See the attached file. Thanks

    How accounting numbers used to monitor this agency contract between owners and managers.
    The ultimate goal of a firm is to maximize the worth of the shareholders. There is separation of the ownership and management of a firm. The philosophy behind this is that the firm should be run by the professionals who have expertise in running the firm and not by the owners, just because they happen to own the business. The separation of ownership adds efficiency to the firm business but creates agency problem. The aim of the firm is to maximize the shareholder's wealth and this is the ultimate objective for the managers. However, as organizations grow bigger and the distance between the owners and managers increase, it becomes difficult for the owners to supervise the activities of the managers. In this scenario, the managers drift away from the ultimate goal of the firm and engage in activities, which maximize their own benefits. The agency cost is the cost spent to keep the managers goal aligned to the firms goal. This is accomplished through several methods. More supervisions, regulatory disclosures and procedures, incentives for managers to align their goals to as that of the firm, etc.
    Accounting numbers play vital role in monitoring the agency contract between the owners and managers. The accounting numbers at periodic intervals provide the owners the idea about how the firm is ...

    Solution Summary

    The problem evaluates certain situations for the companies given the FASB and disclosure guidelines and norms. The problem discusses different management decision-making situations such as agency problem and how it can be handled well. Then it evaluates the LFO and FIFO methods of inventory valuation. In all it is a good post for the students to understand how management evaluate the different methods.

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