Livy Company was started when it acquired $70,000 by issuing common stock. During the first year of operations, the company incurred specifically identifiable product costs (materials, labor, and overhead) amounting to $40,000. Livy also incurred $20,000 of product development costs. There was a debate regarding how the product development costs should be classified. Advocates of Option 1 believed that the costs should be included in the selling, general, and administrative cost category. Advocates of Option 2 believed it would be more appropriate to classify the pro duct development costs as product costs. During the first year, Livy made 10,000 units of product and sold 8,000 units at a price of $14 each. All transactions were cash transactions.

Required

a. Prepare an income statement and a balance sheet under each of the two options.

b. Identify the option that results in financial statements that are more likely to leave a favorable impression on investors and creditors.

c. Assume that Livy provides an incentive bonus to the company president that is equal to 8 percent of net income. Compute the amount of the bonus under each of the two options. Identify the option that provides the president with the higher bonus.

d. Assume a 35 percent income tax rate. Determine the amount of income tax expense under each of the two options. Identify the option that minimizes the amount of the company’s income tax expense.

e. Comment on the conflict of interest between the company president as determined in Requirement c and the stockholders of the company as indicated in Requirement d. Describe an incentive compensation plan that would avoid conflicts between the interests of the president and the owners.