Paula Manolakos purchased La Eoret Inc., a bakery, from Gianni Eiori. The purchase agreement included a provision that required Paula to pay Gianni 25 percent of the bakery’s profit in each of

the next five years. The agreement stated that the bakery's profit 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 were familiar with accounting concepts. In measuring profit, 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 income statement 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 profit 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 profit reported by Paula? Explain.
3. What advice would you give Gianni to ensure that the bakery's profit would be measured properly in future years?