Paula Seale is negotiating the purchase of an extermination firm called Total Pest Control. Seale has been employed by a national pest control service and knows the technical side of the business. However, she knows little about accounting data and financial statements. The sole owner of the firm, Meg Krey, has provided Seale with income statements for the past three years, which show 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 and requests advice.

1. Krey is asking $300,000 for the firm. She has told Seale that because the firm has been earning 30% on its investment, the price should be higher than the net assets on the balance sheet (net assets equals total assets minus total liabilities).

2. Seale has noticed no salary for Krey on the income statements, even though she worked half-time in the business. Krey explained that because she had other income, the firm only paid$18.000 in cash dividends to Krey (the sole shareholder). If she purchases the firm, Seale will hire a full-time manager for 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 financial statements.

REQUIRED:

a. How did Krey arrive at the 30% return figure in point 1? If Seale accepts Krey's average annual net income figure of $72,000, what would Seale's percentage return be, assuming that the net income remained at the same level and that the firm was purchased for $300.000?

b. Should the dividend to Krey affect the net income reported in the financial statements? What will Seale's percentage return be if she takes into consideration the $36,000 salary she plans to pay a full-time manager?

c. Could there be legitimate reasons for the difference between net income shown in the financial statements and net income reported on the tax returns. as mentioned in point 3? How might Seale obtain additional assurance about the propriety of the financial statements?