Here is the data:
Purchased $600,000 in 2000.
Purchased $3,000,000 during 2001. 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.
Questions:
1. Evaluate management's incentives to choose FIFO.
Management will receive a larger bonus using the FIFO methodology. They will also show a larger net income that raises their earnings per share.
2. Evaluate management's incentives to choose LIFO.
Their taxes will be lower.
| LIFO |
|
FIFO |
| Beginning inventory |
$ 600,000 |
|
Beginning inventory |
$ 600,000 |
| New inventory |
$3,000,000 |
|
New inventory |
$3,000,000 |
| Ending inventory |
$ 700,000 |
|
Ending inventory |
$1,000,000 |
| Cost of goods sold |
$2,900,000 |
|
Cost of goods sold |
$2,600,000 |
|
|
|
|
|
| Sales |
$6,000,000 |
|
Sales |
$6,000,000 |
| Operating Expenses |
$ 400,000 |
|
Operating Expenses |
$ 400,000 |
| Cost of Goods sold |
$2,900,000 |
|
Cost of Goods sold |
$2,600,000 |
| Income |
$2,700,000 |
|
Income |
$3,000,000 |
| Taxes |
$ 675,000 |
|
Taxes |
$ 750,000 |
| After tax income |
$2,025,000 |
|
After tax income |
$2,250,000 |
| Bonus (1%) |
$ 20,250 |
|
Bonus (1%) |
$ 22,500 |
| Income after bonuses |
$2,004,750 |
|
Income after bonuses |
$2,227,500 |