Reading 34- LOS c ～ Q6－7 problem, example, following, black, class

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6.Which of the following scenarios is NOT an example of a principal-agent problem?

A)   Managers give themselves lavish perquisites that are expensed as normal business expenses.

B)   A senior manager also serves as a director on the board of another company.

C)   Top management is awarded large amounts of executive stock options.

D)   A board member also serves as a consultant to the company.

7.Kimi Hatcher is a consultant for Druson Corporate Consultants. Hatcher recently evaluated the management team at Burnett Television Productions and wrote a report of her observations. 

Observation 1:	Over 65 percent of senior management compensation is in the form of executive stock options. Management tends to aggressively take on risky projects that will generate large profits if the projects succeed.
Observation 2:	Management frequently uses retained profits to purchase potential competitors as well as business unrelated to television production in an effort to diversify their revenue base.
Observation 3:	Management makes a practice of setting aside provisions for loss contingencies.

A Burnett shareholder that is reading the report is particularly concerned about ways that management may act for their own best interests rather than those of shareholders. Which of observations in Hatcher’s report should alarm the shareholder?

A)   Observations 2 and 3 only.

B)   All of the observations.

C)   Observation 1 only.

D)   Observations 1 and 2 only.

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6.Which of the following scenarios is NOT an example of a principal-agent problem?

A)   Managers give themselves lavish perquisites that are expensed as normal business expenses.

B)   A senior manager also serves as a director on the board of another company.

C)   Top management is awarded large amounts of executive stock options.

D)   A board member also serves as a consultant to the company.

The correct answer was B)

A senior manager may serve on the board of another company so long as there are no other circumstances that may compromise objectivity. For example, problems arise if the boards of two companies are “interlinked” by way of managers of Company A serving on the board of Company B, and managers of Company B serving on the board of Company A.

7.Kimi Hatcher is a consultant for Druson Corporate Consultants. Hatcher recently evaluated the management team at Burnett Television Productions and wrote a report of her observations. 

Observation 1:	Over 65 percent of senior management compensation is in the form of executive stock options. Management tends to aggressively take on risky projects that will generate large profits if the projects succeed.
Observation 2:	Management frequently uses retained profits to purchase potential competitors as well as business unrelated to television production in an effort to diversify their revenue base.
Observation 3:	Management makes a practice of setting aside provisions for loss contingencies.

A Burnett shareholder that is reading the report is particularly concerned about ways that management may act for their own best interests rather than those of shareholders. Which of observations in Hatcher’s report should alarm the shareholder?

A)   Observations 2 and 3 only.

B)   All of the observations.

C)   Observation 1 only.

D)   Observations 1 and 2 only.

The correct answer was D)

While managers are hired to make decisions to maximize shareholder wealth, they may make decisions to maximize their own wealth. Examples of ways that management may act for their own interests include expanding the size of the firm, which can increase the manager’s job security and power, and managers compensated largely by stock option taking large risks that will generate huge payoffs for the managers if successful, but cost the managers nothing if they do not. Note that setting aside provisions for loss contingencies is considered a conservative accounting practice.