QUESTION 1- 10 marks

1. Use the following payoff table and the concept of a Nash equilibrium to determine whether each party (corporations and standard setters) will play strong and not compromise with respect to a proposed accounting standard or will compromise to find a solution both parties can live with. In other words, identify the Nash equilibrium solution. Assume the game is non-cooperative. Payoffs are listed in the order (corporations, standard setter).

(4 marks)

2. Does the Nash equilibrium change if the corporations’ payoffs for playing strong are decreased by 5 no matter what the standard setter decides to do? Explain why they do or do not change. (3 marks)

3. This table is a model to predict how a change in accounting standards would be negotiated between corporations and standard setters. What actual event or events might cause corporations’ payoffs to decrease as described in (b)? (3 marks)

QUESTION 2- 10 marks

James’ small business has grown and he is looking to hire you as a full-time manager. In the past, when James has worked hard at managing the business the net income before manager compensation was $300,000 85% of the time and only $135,000 15% of the time. The reverse is true when James has not worked hard (i.e., net income is $300,000 only 15% of the time and

$135,000 85% of the time). James expects the same outcomes with the new manager as well.

You are both risk and effort adverse, with your utility equal to the square root of your compensation. Your disutility for work is 120 if you work hard and 90 if you do not work hard (i.e., shirk). You also have a reservation utility of 160.

James offers a salary of $60,000 plus 10% of net income for the year to you if you accept the manager position.

Required

1. 1. Will you accept the job and will you work hard? (Show calculations) (3 marks)
   2. Now assume that after three years your contract term is up and James wants to renegotiate with you. He proposes a salary of $10,000 plus 25% of net income. Will you accept and will you work hard? (Show calculations) (4 marks)
   3. Assuming that you accept and work hard under the new contract proposed in b (that is not necessarily the correct response for b but please assume that for part c), is James’ expected utility higher or lower as compared to under the original contract? James is risk neutral with the amount of profit after manager compensation is his utility. (Show calculations) (3 marks)

QUESTION 3 – 8 marks

We discussed two theories of regulation in this course

• Public interest theory
  • Objective of regulator is to maximize social welfare
• Interest group theory
  • Regulator takes own interests into account, while balancing demands of investors and managers
  • Implies conflict between constituencies
    • Constituencies compete by lobbying the regulator to get what they want, taking other constituencies lobbying into account
    • Benefits of regulation go to the most effective lobbying constituency

1. Applying one of those theories (be specific about which you are applying), discuss why regulators in India might choose to require an additional sustainability report for public companies in that country. This report would disclose metrics related to environmental, social, and governance practices of the companies. (4 marks)

2. Now apply concepts from the second theory of regulation (whichever one you did not use in part [a]) and explain why self-constructed intangible assets are not capitalized by firms. (4 marks)

QUESTION 4 – 10 marks

On January 26, 2022, it was reported in the financial that Simple Computers Inc. (SCI) posted record 2021 fourth-quarter results. Despite $20.5 million in losses from a foreign currency devaluation and losses on currency hedging, earnings grew to $0.90 per share from $0.58 in the same quarter of 2015, on a revenue growth of 48%. Furthermore, SCI captured the No. 1 market share spot, with shipments up 50% from 2020 and with slightly higher profit margin.

Nevertheless, on the same day, SCI’s share price fell by $5.00, a decline of about 12%. A newspaper article reported that analysts had been expecting earnings of about $0.95 per share. Also, there were concerns about SCI’s scheduled introduction of new products in March 2022, following a warning by SCI’s CEO that first-quarter, 2022 earnings were likely to be “flat.”

Required

1. a) Use single-person decision theory and efficient securities market theory to explain why the market price fell. (3 marks)
2. b) Assume that the $20.5 million in losses from currency devaluation and currency hedging are a provision (i.e., an accrual), not a realized cash loss, at the end of the fourth quarter. Use the anomalous securities market results to explain why the market price fell (Sloan’s 1996 study on accruals might be helpful in your explanation). (3 marks)
3. c) The Journal quoted an analyst as stating “the market overreacted.” Use prospect theory to explain why the market might overreact to less-than-expected earnings news. (3 marks)
4. d) Which of the above three explanations for the fall in SCI’s share price do you find most reasonable? Explain. (1 mark)