You are an advisor to Sheila Strong

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You are an advisor to Sheila Strong. Sheila sold her successful construction equipment rental business to Bob Shadie on 1/1/2018. Bob paid Sheila cash down payment and agreed to pay Sheila 30% of the company's net income over the next three years. (These "earn-outs" are a common technique in financing small business purchases).

Sheila was VERY disappointed when she received her first earn-out payment from Bob - as the net income was FAR BELOW what she had expected and what the business had earned in the past. In their agreement, Bob and Sheila did not precisely define how the net income should be calculated, only that the calculation be "fair and reasonable".

In measuring net income, Bob applied the following policies:

1. Revenue was recognized when cash was received from customers. Many customers paid in cash, others had credit terms allowing them to pay after 30 or 60 days. Customer rentals were all paid or billed when the equipment was returned if borrowed for less than 10 days, otherwise, rentals were billed every 15 days.

2. Bob set his own salary at $75,000, which Sheila agreed was reasonable. Bob also paid his wife and two daughters $25,000 each, although they did not work regularly in the business.

3. Bob charged his personal automobile expenses to the company's Supplies Expense

4. Bob purchased some additional rental equipment, valued at $200,000, shortly after taking over the business. This rental equipment was expected to last five years under normal conditions. Bob included the entire expenditure in the first year calculation of net income.

Instructions:

1. Discuss the fairness and reasonableness of each of these income-measurement policies. (These policies do not need to conform to GAAP, but they do need to be fair and reasonable - as that is what the parties agreed to)

2. Do you believe the net cash flow of the business was higher than lower than the net income presented by Bob? Why or Why not?