Accounting theory

QUESTION 1- 15 marks| Martha owns and operates a small successful sporting goods store. She has not had a holiday for three years. She decides to take an extensive one-year trip around the world and is negotiating with Gregory to operate the store while she is away. The store's earnings are highly dependent on how hard the manager works, as per the following table: Gregory, like most people, is risk-averse and effort-averse. His utility for money is equal to the square root of the amount of money received. If he works hard, his effort disutility is 130. If he shirks, his effort disutility is 100. Gregory informs Martha that he is willing to accept the manager position but that he must receive at least an expected utility of 68, or he would be better off to work somewhere else. Martha, who is not an agency theory expert, offers Gregory a salary of $20,000 plus 10% of the store earnings (after deducting $20,000 salary from the earnings in the table). Gregory immediately accepts. Required 1. a) If Martha hires him, which act will Gregory take? Why did he immediately accept? Show calculations. 2. b) Martha's bank manager, to whom she has turned for advice, suggests that if she hires an agent, the store's annual earnings should be audited by a professional accountant. Explain why. 3. c) Assume that Martha hires Gregory under the contract proposed, that is, $20,000 salary plus 10% of profits after salary. Shortly after she leaves, a new accounting standard requires that estimated customer liability be accrued. This lowers the high earnings to $286,000 and the low earnings to $40,000 in the table above (i.e., before salary). The payoff probabilities are unaffected. Which act will Gregory now take? Show calculations. Will Gregory be concerned about the new standard? Explain why or why not. ai: Work Hard laz: Shirk Net Income Probability Net Income Probability x1: High Earnings $300,000 0.75 $300,000 0.20 x2: Low Earnings $80,000 0.25 $80,000 0.80