How are accounting numbers used to monitor this agency contract between owners and managers?
Accounting gives an analysis of the operation of a business. It is through them that the way a business is run can be evaluated. There are various ratios that are used to analyze the financial strength of a business as well as profitability; all these are for the benefit of the shareholder. In most published accounting, there is the comparison of various years' income. For example, income statements of 2009, will have a similar 2007 copy that is used for comparison.
Evaluate management's incentives to choose FIFO.
The directors may opt for this method since the taxes paid are small.
Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth?
The higher the profits that a company gets the higher the returns on capital If this is the case, then the cost of shares will increase. Under FIFO, which is having the higher return on capital, the cost of shares will increase.
Why is the management compensation agreement potentially counter-productive as an agency monitoring mechanism?
This is because the management can decide to work for their benefit and leave the need of the company to suffer. Like it has been seen above, using LIFO is giving more gain to the management but the value of the stock is definitely not the true figure; they opt to use this method for the benefit of earning more bonuses. There are other policies that give a flat figure to management so the tendency that management after reaching that level slows productivity is high.
Devise an alternative bonus system to avoid the problem in the existing plan.
Sales pegged bonus; instead of focusing on profit the focus and drift to sales. In this system, a rate should be set to pay divided pegged with the amount of sales that the management is able to do in a particular period. This will make the shift to management be to how to increase sales and eventually benefiting themselves and shareholders.