Paula Manolakos purchased La Fort Inc., a bakery, from Gianni Fiori. The purchase agreement included a provision

Paula Manolakos purchased La Forêt Inc., a bakery, from Gianni Fiori. The purchase agreement included a provision that required Paula to pay Gianni 25 percent of the bakery’s net earnings in each of the next five years. The agreement stated that the bakery’s net earnings would be measured in a “ fair and reasonable manner,” but did not state that it would be measured in accordance with the applicable financial reporting standards. Neither Paula nor Gianni was familiar with accounting concepts.

In measuring net earnings, Paula used the following accounting policies:

a. Revenue was recognized when cash was received from customers. Because of the nature of the business, most customers paid in cash, but a few customers purchased merchandise on account and were allowed to pay in 30 days.

b. Paula set her annual salary at $ 60,000, which Gianni has agreed was reasonable. She also paid $ 30,000 per year to her spouse and to each of her two teenage children. These family members did not work in the business on a regular basis, but they did help during busy periods.

c. Weekly expenditures for eggs, milk, flour, and other supplies were charged directly to supplies expense, as were the weekly groceries for Paula’s family.

d. The bakery had modern baking equipment valued at $ 50,000 at the time Paula purchased the company. The statement of earnings for the first year included a $ 50,000 equipment expense related to these assets.

e. Income taxes expense included the amount paid by the corporation (which was computed correctly), as well as the personal income taxes paid by various members of Paula’s family on the salaries they earned for working in the business. Gianni was disappointed, however, when Paula reported net earnings for the first year that was far below his expectations.

Required

1. Discuss the fairness and reasonableness of Paula’s accounting policies. Identify the accounting principle or assumption that may have been violated.

2. Do you think that the net cash flow from operations (cash receipts minus cash payments) is higher or lower than the net earnings reported by Paula? Explain.

3. What advice would you give Gianni to ensure that the bakery’s net earnings would be measured properly in future years?