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What is managements incentive to choose FIFO or LIFO?

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I would like to see if I am on the right track with my answers to the following questions about FIFO/LIFO, etc.

(See attached file for full problem description)
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A retail company begins operation late 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 the 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 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.

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

Evaluate management's incentive to choose FIFO.

Evaluate management's incentive 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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(See attached file for full problem description)

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A retail company begins operation late 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 the 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 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.

Let us consider the figures for 2000 and 2001. The purchases made in 2000 are 600,000; the purchases made in 2001 are 3,000,000 giving us total purchases of 3,600,000. If we add the operating expenses to this we get a total cost of 4,000,000. Now the total sales are 6,000,000.
If we use FIFO then the value of inventory deducted from the total cost will be 1,000,000 so the taxable income will be 6,000,000 - 3,000,000 = 3,000,000. The taxes will be @ 25% that is 750,000 giving us 2,250,000. Calculated on this the bonus will be @ 1% that is 22,500 and the net ...

Solution Summary

This solution discusses LIFO and FIFO in 815 words.

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