Tom operates a small, fast growing electronics business. His workload has expanded to the point where he decides to hire a full-time manager. He will then take one year off to travel, and on his return he will concentrate on the technical aspects of the business. Tom is negotiating with Lily for the manager job. He ascertains that Lily is risk averse, with utility for money equal to the square root of the dollar compensation received. Lily advises Tom that she already has a job offer, which yields her an expected utility of 6. She is not willing to work for less than this, but would accept an expected utility of 6 from Tom. Lily also advises that she is effort averse, with disutility of effort of 2 if she works hard, and 1 if she does not work hard. Toms business has, in previous years, earned net income (before manager compensation) of $725 75% of the time and net income of $0 25% of the time. Tom has always worked hard and reckons that if he did not work hard, net income would have been $725 only 20% of the time and zero for 80% of the time. He expects this earnings pattern to continue into the future with a new manager. Tom realizes that he must motivate Lily to work hard, and he offers her a one-year contract, with compensation based on a proportion of reported net income before manager compensation. a) What proportion of net income must Torn offer Lily so that she will accept the position and work hard? Show calculations. b) Suppose that Tom cannot observe if income is managed, only what Lily reports. Suppose Lily can opportunistically manage earnings to ensure that net income of $725 is reported, even if she doesnt work hard. Is Lily better off managing earnings? Show calculations defending your answer. c) Suppose GAAP rules make it impossible to manage earnings from $0 to $725, income can only be managed in the range of [$700-$784] when unmanaged income is $725 or [$0-$9] when unmanaged income is $0. What proportion of net income needs to be offered to ensure Lily works hard? Show calculations

This questions is based for a theory accounting class that uses the book; Financial Accounting Theory, Scott & Brien Edition 8th