Paul Seger, a friend of yours, is negotiating the purchase of an exterminating company called Complete Pest Control. Seger has been employed by a national pest control service and knows the technical side of the business. However, he knows little about accounting, so he asks for your assistance. The owner of Complete Pest Control, Greg Krum, provided Seger with income statements for the past three years, which showed an average net income of \(\$ 75,000\) per year. The latest balance sheet shows total assets of \(\$ 360,000\) and liabilities of \(\$ 60,000\). Seger brings the following matters to your attention:

1. Krum is asking \(\$ 375,000\) for the firm. He told Seger that because the firm has been earning a 20 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. Seger noticed that there was no salary expense reported for Krum on the income statements, even though he worked half-time in the business. Krum explained that, because he had other income, he withdrew only \(\$ 15,000\) each year from the firm for personal use. If he purchases the firm, Seger will hire a full-time manager to run the firm at an annual salary of \(\$ 30,000\).

3. Krum's tax returns for the past three years report a lower net income for the firm than the amounts shown in the financial statements. Seger is skeptical about the accounting principles used in preparing the company's financial statements.

Required

a. If Seger accepts Krum's average annual income figure of \(\$ 75,000\), what would Seger's return on stockholders' equity be, assuming that the net income remained at the same level and that the firm was purchased for \(\$ 375,000\) ?

b. Should Krum's withdrawals of \(\$ 15,000\) per year affect the net income reported in the financial statements? What will Seger's percentage return be if he takes into consideration the \(\$ 30,000\) salary he plans to pay a full-time manager?

c. 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 Seger obtain additional assurances about the propriety of the company's financial statements?