Dragon Soup and Earnings Management (A)

Jason Phillips departed a meeting with his companys chief executive officer (CEO)

somewhat in shock. Phillips had recently joined Dragon Soup, a private company that

manufactured a line of canned soups colored red, green, and even purply-blue based loosely on an

idea from a British television cartoon called The Clangers. Phillips had not expected to hear from

his boss that the company was preparing for another round of fund-raising early the following

year.

As Dragon Soups chief financial officer (CFO), Phillips had been given the task of

maximizing the value of the firm at the time of the fund-raising. Although he did not want to

break any laws or violate any accounting standards, Phillips needed to investigate what

accounting choices or changes in the firms operations could enhance the companys financial

position and increase its perceived value to investors.

Background

In their meeting, Rebecca Dunwoody, Dragon Soups CEO, had been adamant that investors

were not always careful when analyzing financial statements; she said she thought they generally

just assumed a multiple of earnings for the valuation. This frustrated her because she saw Dragon

as a growth story for which current costs represented investments to build brand loyalty and

future business. Dunwoody believed this growth was not reflected in most other soup companies

valuation multiples, which typically ran in the region of fifteen times sustainable earnings for

large public companies (ten times for private ones), in addition to the value of cash and

marketable investments on the balance sheet.

Dunwoody had stressed repeatedly during her discussion with Phillips the importance of

boosting the companys stock price. This emphasis did not surprise Phillips; Dunwoody had

founded the company almost ten years before, and with more than 70 percent of the shares, she remained its largest shareholder and had the most to gain from the sale of shares at a high price.

Based on previous discussions, Phillips had assumed Dunwoody wanted to push for a public

offering of shares, which might provide her a way to sell part of her holdings while retaining a

minority interest. In contrast, todays discussion revealed that Dunwoody might now consider an

outright sale of the company or settle for a private offering to a small group of investors if the

company could issue a smaller number of shares at the right price, and if she could retain

effective control. Because almost twelve months remained before the planned offering or sale, Phillips

wondered whether this was just a way for Dunwoody to test whether he was up to the task of

being CFO. After all, his predecessor had left suddenly, and Phillips had been recruited

surprisingly quickly as a replacement; he doubted that Dunwoody fully appreciated his abilities.

Such thoughts would have to wait, however. Phillips opened the spreadsheet he had been

working on earlier in the day, which contained Dragons base case financial projections as shown

in Exhibit 1A, Exhibit 1B, and Exhibit 1C. Dunwoody had been clearshe would implement

any action Phillips recommended as long as it boosted the stock price at the time of the fund-

raising. The question for Phillips was how aggressive he should be and what the consequential

accounting disclosures might be. One useful feature of the spreadsheet was that it provided

suggested footnote disclosures depending on the business and accounting choices that were input.

As he considered his options, Phillips reminded himself that the U.S. Securities and Exchange Commission (SEC) recognized that a companys management had a unique perspective on its business that only it could present. That being the case, the SECs specific requirements for the management discussion and analysis (MD&A) section of a companys statutory filings went beyond those required by auditors. The SECs MD&A requirements were intended to satisfy three principal objectives:

to provide a narrative explanation of a companys financial statements that enabled

investors to see the company through the eyes of management;

to enhance the overall financial disclosure and provide the context within which financial

information should be analyzed; and

to provide information about the qualityand potential variabilityof a companys

earnings and cash flow, so that investors could ascertain the likelihood that past

performance might be indicative of future performance.1

Given the possibility of a future public offering of shares, Phillips also wanted to be able to

provide certification of the financial statements in compliance with the Securities and Exchange

Act of 1934 (the Securities Act), as shown in Exhibit 2. Phillips considered it critical, therefore,

that all disclosures complied with the SEC guidelines and the requirements of the Securities Act.

Phillips had several options to consider before his next meeting with Dunwoody.

QUESTION:

In the case, Phillips questioned how far should he push the envelope. Why should he be concerned if all the actions you recommend are legal? Do you think that the associated disclosures satisfy the SEC (also a CICA requirement) requirement for the MD&A that a company provides a narrative explanation of its financial statements that enables investors to see the company through the eyes of management?