Case Study

MEASURING NET INCOME AS A BASIS FOR SETTING THE SALES PRICE OF A BUSINESS

On January 2, 20X1, Tameka Essendoh opened the Essendoh Tailor and Alterations Service. She invested $9,000 in the venture and set up a bank account in the company's name. Also on that day, she rented a small area in a laundry and cleaning shop at a cost of $300 per month; all utilities were provided by the building owner. On January 3, 20X1, she purchased tailoring equipment (sewing machines, pressing machines, and other equipment) which had an expected life of 5 years and cost $5,600. She paid $2,600 in cash; the balance was on account. She agreed to pay the balance in four quarterly payments of $750 each, with payments due on April 4, July 5, and October 5, 20X1; the final payment was due on January 5, 20X2. On January 4, 20X1, Tameka purchased furniture which had an expected life of 10 years and cost $3,000. She paid $1,000 in cash and agreed to pay the balance on March 3, 20X2.

Tameka decided to pay herself a monthly salary of $2,000, with the payment for each month to be made on the first business day of the following month. The first payment, for January, was made on February 2.

During 20X1, Tameka received cash of $28,000 for services rendered. Her cash outlays during the year for equipment and furniture were as follows:

Tailoring equipment (down payment of $2,600, plus three quarterly payments totaling $2,250)	$4,850
Furniture	$1,000

On December 31, 20X1, Tameka decided to get married and join her husband in another city. Samatha Dewbury, who had previous tailoring experience, learned that Tameka was leaving the city and discussed with Tameka the possibility of purchasing her shop. Tameka prepared and gave to Samatha the following income statement for the year and balance sheet as of December 31.

ESSENDOH TAILOR AND ALTERATIONS
SERVICE
Income Statement
for Year 20X1

Income
Cash Received From Tailoring and Alterations	$28,000
Additional Cash Invested in June, 20X1	3,000
Total Income		$31,000
Cash Expenses
Tailoring Supplies	1,000
Insurance	1,200
Salary Withdrawn by Tameka Essendoh	22,000
Rent	3,900
Repairs to Equipment	100
Advertising	400
Office Supplies and Postage	250
Membership in Organization of Tailor Shops	100
Telephone	520
Subcontract of Tailoring Services for Rush Jobs	500
Miscellaneous Expenses	500
Total Expenses		$30,470
Net Income for Year
		$530

ESSENDOH TAILOR AND ALTERATIONS
SERVICE
Balance Sheet
December 31, 20X1

Assets		Owner's Equity
Cash	$3,680	Tameka Essendoh, Capital	$9,130
Tailoring Equipment	4,850
Furniture	1,000
Total Assets	$9,530	Total Liabilities and Equity	$9,130

After some negotiation about the purchase price, the parties agreed that Samatha would purchase the business according to the following conditions.

1. The purchase price would be an amount equal to twice the net income for 20X1, computed under generally accepted accounting principles and standards.
2. Samatha would assume all liabilities of the business. The balance of the purchase price would be paid in cash by Samatha.
3. Because the two parties were unsure that the statements were exactly in accord with generally accepted accounting principles and standards, they have asked you to review the statement and make whatever changes are necessary.

Assume that you discover the following additional information in your review:

1. The insurance premiums paid covered a period of 2 years, beginning January 2, 20X2.
2. On December 31, 20X1, amounts owed by customers who had picked up tailoring work totaled $235.
3. Unused tailoring supplies on hand on December 31, 20X1, were estimated to have cost $120. Unused office supplies on that date cost $60.
4. There is an unpaid bill of $280 for November and December advertising.
5. The rent expense includes payments for 20X1 and for January, 20X2.

Instructions

1. Prepare an income statement for 20X1 and a balance sheet as of December 31, 20X1, based on generally accepted accounting principles.
2. Compute the amount of cash to be paid by Samatha for the business.
3. Using the buyer's viewpoint, evaluate this approach to establishing the sales price of the business.