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Dragon Soup and Earnings Management Case Solution & Answer

Dragon Soup and Earnings Management Case Solution

Introduction

Rebecca Dunwoody is the current CEO of the Dragon Soup company. Dunwoody is facing the problem of funding and considering maximizing the company’s value at the time of fund raising as the investor’s only look at multiples of earnings while evaluating the financial statements. She is seeking to maximize the value of earnings without breaking the laws and procedures set by the Securities and Exchange Commission of USA.

Jason Phillips is the Chief Financial Officer of the business and Rebecca has given the responsibility of earnings’ management to Jason. Therefore Jason’s main responsibility is to identify those accounting choices and operations that can maximize the perceived investors without breaching or breaking the legal rules.

Actions to Improve Earnings

It is expected that Jason has certain options available in order to maximize the perceived value with respect to investors but Jason has to make sure that recommended options are according to the three basic principle’s objectives of SEC’s and MD&A, which include: explanation of the financial statements for the convenience of investors, increased disclosures of financial statements for a better analysis of financial statements with respect to investors and the provision of quality information about the company’s earnings and cash flows for a better comparison of the company’s performance against its last year’s earnings.

Lease or Buy Decision

It is expected that the company’s existing canning machine is not working according to the required standards as it acquired a decade ago, hence there is a need of new canning machine in order to run the operations effectively. It is expected that the replacement cost of the machine is one million dollars with twenty years’ useful life. Therefore buying the new machinery on cash would not be a suitable option as the company is already facing funding and valuation problems, hence buying such expensive machinery would require a greater outlay of cash.

Generating more cash through debt would result in an increase in gearing ratio, which would last a negative impact over the company’s short-term valuation. As the company has the facility to borrow the entire amount with mortgage style repayment with a very low interest rate, therefore leasing is the best option available.

Between operating lease and capital lease; capital lease is an advanced beneficial option as interest rate upon both the terms is almost same while capital lease is for greater period as compared to operating lease and it is also providing ownership of the machinery at the end of the lease period through paying a very minimal amount.

Price and Promotion related Decisions

Currently the company is following the traditional liners regression techniques in order to derive the annual demand of Dragon’s soup. Selling price of the soup is greatly dependent upon the production and it is expected that the production cost of the soup will increase in future instead of using the new machinery.

Management of the company claims that they can sell their product at any price, therefore following the future expectancy of increase in the company’s production cost should increase the selling price of the soup as minimum increase, for example: from 1.83 dollar to 1.90 dollar, will not affect the demand but it will surely enhance the company’s value by generating greater returns.

In addition to this, the company had arranged an aisle display promotion with the collaboration of its suppliers which clearly helpedit by providing 20% cumulative growth in that week as compared to the normal week. As the demand of the soup is seasonal and high during summers, therefore continuing with the same promotional activity coupled with an accurate timing would help the company in increasing its value.

Although it is not increasing the sales at the customers end and it is also expected that it would affect the company’s growth just after the promotional activity, but discontinuing such promotional activities could create a negative impact over investors and dealers and they might prefer those companies who are facilitating the dealers with such incentives………………………..

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