What are some of the pitfalls of a company basing a managers or CEOs compensation on the companys earnings?

This week the course designers gave us a whole bunch of questions to answer. This week, fortunately,
they did give us links to websites that might help us answer the question.

For Question
1, pay particular attention to the first website at http://www.ur.umich.edu/0304/Jan19_04/10.shtml,
(you might have to use the Open in New Window command) which contains
an article title CEO Pay, Earnings Manipulations Linked. The article
discusses how CEOs whose pay is based in part on the earnings (net
income) of the companies run will sometimes use
questionable accounting techniques to distort earnings, making net
income look higher than it really is to get more pay.

GAAP
allows us to use one of three inventory cost-flow assumptions for a
merchandising company
like JCPenny: FIFO, LIFO or weighted average. GAAP requires us to
choose one cost-flow assumption and stick with it for a while. GAAP
doesnt have a hard and fast rule about how often you can change
cost-flow assumptions, but you certainly cant change it
every year or even every couple of years. You need a good reason to
change, and then you need to stick with it for years.

Which
cost-flow assumption is best for a merchandising company depends on
whether the economy
has rising prices (inflation) or falling prices (deflation). LIFO puts
the latest inventory costs on the income statement as Cost of Goods
Sold (COGS) and keeps the oldest inventory costs on the balance sheet. Putting
the newest inventory costs on the income statement as COGS gives us the
lowest net income and lowest income tax during times of inflation. Over
the about the past three-quarters of a century, the US economy has had inflation for all but three years (1949,
1955 and 2009). So
the best inventory cost-flow assumption for three-quarters of a century has been LIFO.

Switching
to FIFO after years or decades of LIFO would put very, very old
inventory costs on
the income statement, shrinking COGS and artificially inflating net
income. Artificially inflating net income will not only mislead
investors, but also artificially inflate the companys income tax. A
company switching from LIFO to FIFO, and its investors, would be worse
off by the inflated income tax bill, while the CEO would be better off
with higher compensation. Does
that sound ethical? 🙂

To make sure youve answered each question and that I can quickly see that youve answered
each question, please label (number
and letter) your answers as follows. I recommend that you just
copy the questions and paste them into your answer and use them to make sure youve answered each little piece of this
weeks discussion question:

1a. Is
Jason’s decision to select FIFO appropriate? Is it ethical?

1b. Is
Jason wrong if this will help the company and also benefit him too?

2.
What are some of the pitfalls of a company basing a managers or CEOs compensation on the companys earnings?

3.
Inventory Turnover Ratio = COGS/AVERAGE Inventory.

COGS refers to Cost of Goods Sold.

Average Inventory
= (Beginning Inventory + Ending Inventory)/2.

Remember that last year’s ending inventory = this year’s beginning inventory.

For JCPenny you can find COGS on page 26 of the 2018
(Year Ended February 2, 2019) 10K.
You can find beginning inventory and ending (merchandise) inventory on page 61.

For Macy’s, you can find COGS (Cost of Sales) on page 17 (page
53 of the pdf) of the 2018-2019 Annual Report. You can find beginning inventory and ending inventory (merchandise inventories)
on page F-7
(page 55 of the pdf).

Hint for Question 3 and Question 4:
The number one error that students make on the inventory turnover ratio and the number of days in inventory is that they use ending inventory rather than average inventory.

3a. Determine
the inventory turnover ratio for JCPenney.

3b. Determine
the inventory turnover ratio for Macys.

3.c. What
does this ratio tell you about these companies?

4. Number
of Days in Inventory = Average Inventory/Average
Daily Cost of Goods Sold.

Average Daily Cost of Goods Sold = COGS/365.

4a. Calculate
the number of days in inventory for JCPenney.

4b. Calculate
the number of days in inventory for Macys.

4c. What
does this ratio tell you about these companies?

On Question 3, don’t confuse the inventory turnover ratio with the apple turnover ratio–the
inventory turnover ratio doesn’t have hot fruit filling!

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