caseism

Marvel Soup And Earnings Management Case Solution & Answer

Marvel Soup And Earnings Management Case Solution 

Introduction

Emma Monroe, was the Chief Executive Officer of the Marvel Soup Company, which had been manufacturing canned soup line since years, including different colors (red, blue, purple). Vito Moriarty was recently appointed by the company as the Chief Financial Officer. The Marvel Soup Company was facing funding issue and the company’s CEO was determined about maximizing the firm’s value till the fund raising time, as the investors look at the multiple earnings potential of the company in their evaluation of the company’s financial statements. The company’s CEO wanted to maximize the value of the company’s shares while complying with the rules and standards established by Securities and Exchange Commission of the United States of America.

During a meeting with the Chief Financial Officer, Emma had assigned the earnings management task to Vito Moriarty, which required him to identify possible alternative for the earnings management and increasing the value of the firm and its shares, while following eth SEC’s rules and regulations. Vito had few options in front of him, which could maximize the perceived value of the company’s shares but he had to make sure that the chosen alternatives are in alignment with the objectives and principles of SEC and MD&A (Management Discussion and Analysis), which included the financial statements’ explanation in order to provide the convenience to investors, complete financial statements’ disclosures for a better analysis of financial statements and providing a quality disclosure about the company’s earnings and cash flows, so that the investors can perform a better comparison between the current and the past year performance and earnings of the company.

Problem Statement

Marvel Soup Company was a manufacturer of canned soups colored red, blue and purple. The company’s Chief Executive Office i.e. Emma Monroe, was concerned about the earnings management of the company. She wanted to maximize the value of the company’s share while meeting the set rules and standards by the Securities and Exchange Commission of the United States of America. She had given the task of maximizing the value of the company’s to the recently appointed Chief Financial Officer i.e. Vito Moriarty, who had few options in front of him, which could maximize the perceived value of the company’s shares but he had to make sure that the chosen alternatives are in alignment with the objectives and principles of SEC and MD&A (Management Discussion and Analysis), which included the financial statements’ explanation in order to provide the convenience to investors, complete financial statements’ disclosures for a better analysis of financial statements and providing a quality disclosure about the company’s earnings and cash flows, so that the investors can perform a better comparison between the current and the past year performance and earnings of the company. The option chosen byVito Moriarty included the decisions related to product pricing, uncertain accounts receivables, purchasing or leasing (operating lease or capital lease) a new machine, inventory and the sale or the valuation of the securities held by the Marvel Soup Company.

Earnings Management Options

In order to perform the earnings’ management task, Vito Moriarty had different alternatives to consider before going for his next meeting the company’s CEO. The different options included the decision of purchasing or leasing a new canning machine, deciding about the product pricing, its production and promotion, decisions related to uncertain accounts receivables and the valuation of sale of the marketable securities held by the company. Crucial to these alternatives was the compliance of the rules and standards set by the MD& A and SEC, which included

  • Providing a complete and a narrative explanation of the company’s financial statements, which could enable the investors to analyze the company’s financial statement through the eyes of the company’s management.
  • Enhancing the disclosure of the financial statements, thereby providing a context for an extended analysis of the company’s financial statements.
  • Providing exact information about the quality of the earnings and the cash flows and related variability, so that the investors get idea about the company’s future performance based on its past performance, earnings and cash flows.

The earnings management alternatives, chose by Vito Moriarty are explained as below, with supporting recommendations and justifications.

1.Decision to Buy or Lease a New Canning Machine

It was decided by the operation department of the company that the existing canning machine needed to replace with a new machine, as the older one was not reliable anymore, as the machine had been in use since the company’s establishment. It is because the reliability of the canning machine was important for the efficient and effective production. However, the company’s Chief Financial Officer had to decide between the options of acquiring a new canning machine or getting it lease. Not only this, if the lease option was selected, the CFO had to decide about making it as an operating lease or a financial lease.

1.1.Quantitative Analysis

The purchase of the new machine would cost the company about $ 1 million with a useful of twenty years. Vito Moriarty was pretty much sure about generating the required funding for the purchase of the canning machine and to make the whole payments in a mortgage style payment profile, which would require the payments to be made within a period of 18 years at an interest rate of 5% annually. On the other, Marvel could obtain the canning machine within same conditions i.e. over a period of 18 years with an annual payment of $85,550 (See Appendix 1). Moreover, the company would have the option to purchase the machine at the end of the leasing period at $1. The other option was to obtain the machine at an operating lease of 14 years with a payment of $85,750 annually.

In order to know, which option is better for the new canning machine, a quantitative analysis has been carried out (Appendix 1). It can be observed that the annual payment required for a financial lease would be 85,550 for a period of 18 years, which would cost a total of $1539900. On the other hand, if the payments are made under a 5% operating lease, it would lead to interest expense of 50,000 for the first year, with a loan repayment of 35,550 and a depreciation expense of 225,000. So, this does not seem a viable option, as with capital lease, the company would be able to get the ownership of the asset at $1 cost, and the company would be able to claim the depreciation over the lease term of the asset. So, buying a machine for 1000,000 along with an annual interest payment and an operating lease are the recommended alternatives for the Marvel Soup Company.

1.2.Qualitative Analysis

It is expected that 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 company is already facing funding and valuation problem, hence buying such expensive machinery would require greater outlay of cash.

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

A finance lease is much more appropriate to rent resources that will be utilized long-term, at the same time giving the client the rights of proprietor. The tenant does not have to be confront a tremendous capital cost, as when acquiring the asset by and large. Here, the rentals paid clear off most of the capital so taking possession of the asset at the conclusion of the finance lease comes at a reasonable cost(Toyota Fleet Management, 2020).

With an operating lease, as they have shorter terms, the asset is distant more likely to hold noteworthy ownership at the end of the lease term, hence the rental sums will be lower. Operating leases are more suitable for short-term utilize of assets, associated to leasing. They don’t ordinarily include any exchange of proprietorship or ownership.

Moreover, with a capital lease the marvel Soup Company would be able to get certain benefits, such as in the end of the lease term, the company would be able to get the ownership of the asset and it would be able to get a claim over the depreciation expense recorded. The recorded depreciation expense reduces the net income, so the claim would enable the company to enhance its profitability. Apart from this, the interest expense recorded for the lease payments would reduce the taxable income, ultimately leading the company to pay for lesser taxes.

On the other hand, in an operating lease, no depreciation expense is recorded, which would lead to a higher taxable income as compared to taxable income with a capital lease. The operating lease are better for companies which require frequent updates or change sin their machinery, however, the Marvel Soup Company does not require frequent changes in their machinery or equipment, so an ownership under a capital lease seems a good option.

Among operating lease and capital lease, capital lease is more beneficial option as interest rate upon both 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 with paying very minimum amount……………….

This is just a sample partial case solution. Please place the order on the website to order your own originally done case solution.

Share This

LOOK FOR A FREE CASE STUDY SOLUTION

JUST REGISTER NOW AND GET 50% OFF ON EACH CASE STUDY