question archive You are an advisor to Sheila Strong
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?
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1. According to fairness and reasonableness of each of the income measurement policies :
1. Revenue can be recognized as and when the ownership of goods transferred to the buyer. Its not mandatory to recognize revenue when payment has received. So Bob has to record cash as well as credit sales.
2. Salary paid to Bob is correct but if wife and daughters of Bob will not work regularly than such a big expenditure on salary is not justifiable. It clearly seems that Bob hiked the expenses by paying unnecessary salary to wife and daughters. So they must be paid according to their work done.
3. Personal expenses should be treated as drawings and not as company's supply expenses. So the treatment of automobile expenses is not correct and because of this profit is reduced as expenditure increase.
4. The rental expense should be charged for 5 years as the life of equipment is for 5 years. Bob has charged full expense in year 1 and it is not correct. As per the matching concept the expenses should be recognized and recorded when those expenses can be matched with the revenue those expenses helped to generate. And the benefit generate from equipment is for 5 years so expenses will also be charged in 5 years. So this expense will reduced to the expense for 1 year.
2.The cash flow from the business is higher than the net income presented by Bob because Bob hiked all the expenses to reduce the profit as described above. So if he correct .all the adjustments than automatically profit will increase and he has to pay more share to sheila .
