F H L M Karmen has $10,000 to invest for 1 year. She has narrowed her choice to 1 of 2 companies: Act al: Invest $10,000 in shares of Gas Ltd. Act a2: Invest $10,000 in shares of Coffee Ltd. The payoff from these investments depends on the future price of Natural Gas. If the price is high, Karmen will earn a net return of $1,000 on Gas shares and $500 on Coffee shares. If the price is low, she will earn $500 on Gas shares and $1,000 on Coffee shares. Karmen's prior probabilities on the future price of Natural Gas are: P(H) = 0.45 P(L) = 0.55 where H means the future price of Natural Gas is high, and L means it is low. Karmen is a rational, risk-averse decision-maker with utility equal to the square root of the net return on his investment.

Required a) Before acting, Karmen decides to obtain more information. She obtains the recent annual report of Gas and studies its reserve recognition accounting (RRA) disclosure. Karmen knows that it is Gas company management that has the best (inside) information on future Gas and gas prices and that some of this information will be revealed in RRA disclosures such as development costs, purchases of reserves in place, and changes in the timing of extraction. Her examination reveals good news (GN), that is, management's development, acquisition, and timing actions suggest it expects Gas prices will be high. Karmen knows that if future Gas prices are going to be high, there is a 0.7 probability that RRA will show GN. However, if future Gas prices are going to below, there is a 0.4 probability that RRA will show GN. The table below summarizes Karmen posterior probability about the future price of Natural Gas BRA Information ON BN High State 0.7 0.3 Low 04 0.6 Given the BN in RRA, which act should Karmen take now? Hint: us the Bayes Theorem 4

States: GN. BN.

High. 0.7. 0.3

Low. 0.4. 0.6

b) Reserve recognition accounting (RRA) for oil and gas operations is an example of the application of accounting under ideal conditions when conditions are not ideal. Indeed, management frequently expresses serious reservations about RRA. State and explain three reasons why management has such reservations. 3