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.