Question

BTN1-3. Business Decision Problem Paul Seale, a friend of yours, is negotiating the purchase of an exterminating company called Total Pest Control. Seale has been employed by a national pest control service and knows the technical side of the business. However, he knows little about ac- counting, so he asks for your assistance. The owner of Total Pest Control, Greg Krey, provided Seale with income statements for the past three years, which showed an average net income of $72,000 per year. The latest balance sheet shows total assets of $285,000 and liabilities of $45,000. Seale brings the following matters to your attention: 1. Krey is asking $300,000 for the firm. He told Seale that because the firm has been earning a 30 percent return on stockholders' equity, the price should be higher than the net assets reported on the balance sheet. (Note: The return on stockholders' equity is calculated as net income divided by total stockholders' equity.) 2. Seale noticed that there was no salary expense reported for Krey on the income statements, even though he worked half-time in the business. Krey explained that, because he had other income, he withdrew only $18,000 each year from the firm for personal use. If he purchases the firm, Seale will hire a full-time manager to run the firm at an annual salary of $36,000. 3. Krey's tax returns for the past three years report a lower net income for the firm than the amounts shown in the financial statements. Seale is skeptical about the accounting principles used in preparing the company's financial statements. Required a. If Seale accepts Krey's average annual income figure of $72,000, what would Seale's per- centage return on stockholders' equity be, assuming that the net income remained at the same level and that the firm was purchased for $300,000? b. Should Krey's withdrawals of $18,000 per year affect the net income reported in the finan- cial statements? What will Seale's percentage return be if he takes into consideration the $36,000 salary he plans to pay a full-time manager? Could there be legitimate reasons for the difference between net income as shown in the financial statements and net income as reported on the tax returns, as mentioned in point 3? How might Seale obtain additional assurances about the propriety of the company's financial statements?

Answer 1

a)	Average Net Income	$72,000
	Investment by Seale	$3,00,000
	Rate of return for Seale	24%
b)	Kreys withdrawal will not affect the net income reported as it will be accounted as drawings. It affects balance sheet rather than P&L
	Avergae Net Income after Salary($72,000-$36,000) = $36,000
	Rate of return is $36,000/$300,000 = 12%