Collapse Of Dick Smith: Reasons, Auditors' Responsibility - An Essay.

1. Provide a brief history of Dick Smith Electronics Ltd (no more than a page) and an explanation of what caused the collapse of the company.

2. The directors are being accused of breaching Australian Accounting Standards? Which standards are in question? Explain what was done (or allegedly done) by the directors.

3. What signs should the auditor have looked for to indicate there might be a going concern problem.

4. Provide a brief analysis of the 2014/15 Annual Report for any evidence that the company might not be a going concern.

5. Why do you think the auditors gave an unmodified audit opinion for the financial year ended 30 June 2015?

Dick Smith's history and network

Dick Smith was an Australian based retail company for dealing with the products related to consumer electronics. It sells wide range of products in 4 categories that is mobility, office, entertainment and various other services and products. It had 2 segments – Dick Smith New Zealand and Dick Smith Australia. Its store network includes more than 393 stores all over Australia and New Zealand (Dicksmith Australia, 2018).  

In the year 1968, Dick Smith was formed as the young electronics technician. In the initial period the company focussed it energy towards servicing and installing the car radios. However, eventually the term business success for the company was not only meant the bigger shop but it meant more shops. By the year 1980 the company grown to 20 stores and it sold the working share of the company to Woolworths. The company continued adding main street stores to its network in regional cities and suburbs all over Australia. Within few years hundreds of stores were there that included various David Jones Electronics those were powered by Dick Smith Stores. However, in May 2016, the company brand name was acquired by Kogan.com and it continued carrying out Dick Smith’s Operations (Dicksmith Australia, 2018).

Collapse of Dick Smith meant shortfall amounting to more than $ 260 million to the creditors. Further, though the banks will get back some of their dues, little prospect was there for the unsecured creditors. As per the report of McGrathNicol, administrator of the company major reasons for the company’s collapse were as follows –

• Changes in the network – market for the consumer electronics are highly competitive with fast changes in the pattern of consumer demand.
• High cost for network store – the company had the store network that was significantly larger as compared to its competitors. Therefore, the base of higher cost with the considerable exposure and reliance towards the market of computer products and fast moving office product led to involvement of higher level of cost (SmartCompany, 2016).
• Too fast – expansion plan needed significant commitment for finance, utilisation of entire cash resources. It further required significant commitment from suppliers and bank borrowings.
• Fall in sales and shrinking of market share – growth in revenue was based on the growth of stores and sales of commercials at the low margins
• Sales of the company did not work – company’s clearance sales did not created sufficient margin or sales for alleviating the pressure of cash.
• Too much on the shelves – decisions regarding inventories made under the existing environment were not regular with regard to the demand of the consumers. Ultimately the company was left with significant level of inactive and obsolete stock that required considerable write – down (SmartCompany, 2016).
• Too expensive cost of finance – the company was not able raise finance with favourable terms of credit. It had an impact on the product mix, store presentation and stock levels.
• Demand for loan was crushing – pressure with regard to cash flow led the company towards banking covenants for breaching and it was not repairable (SmartCompany, 2016).    

Eight executives and directors of Dick Smith were charged for breaching series of their duties and the damage claim amounted to more than $ 10 million. It has been alleged that the earnings of the company during the 2015 were inflated owing to various questionable activities related to the manner in which rebates to the suppliers were manipulate (Brochet, Jagolinzer & Riedl, 2013). It was claimed that if the executives and directors had performed the duties in proper manner, the company would have recorded loss or significantly lower profit during 2015. Major allegation was regarding use or the alleged misuse of rebates that was not complied with the Australian Accounting Standards (AAS). It was claimed that the policy facilitated the gross profit reporting, amortisation and depreciation, profit before tax and interest and net profit. It was supposed to be reported in accordance with AAS particularly AASB 102 (Aasb.gov.au, 2018). The director’s strategy resulted into purchase of the stock those were motivated by rebates and not by customer demand. It created stockpile of the bad or unsalable products.

Reasons for the collapse

It further enabled them to pay the dividends that was not actually affordable by the company and eventually put further burden on the company. Further, the company failed to record write – offs and provisions with regard to bad debt held by the company or were expected to be held as on 28^th December 2014. It was found that for paying interim dividend of 7 cents per share the company required extension for its overdraft limit. The amount of claimed damages included recovery of dividend that was allegedly paid amounted to more than $ 27 million, in addition to losses generated from purchase of the bad stock amounted to $ 10 million. Further, treating the rebates in violation with AASB 102, cash flow of the company became strained and it became dependent on external borrowing for funding its requirement of cash flow (Aasb.gov.au, 2018).  In broader terms the receivers claimed that non-executive directors were breached the duties of care through failing to put adequate systems in place as compared to management of inventories and rebates. 

Analysis of the auditor regarding substantial doubt of the company’s ability to be continued as going concern over the reasonable time period is made on the basis of the auditor’s knowledge. This knowledge is based on the relevant events and conditions that occurred or existed before completion of the field work (Arens, Elder & Beasley, 2013). Various indications that the auditor must have been looked into while auditing the financial statements of Dick Smith for indication of going concern problem were as follows 

• Analytical procedure – it is used as substantive test or is used for the planning and overall states of review for the audit. It may indicate – (a) negative trends (b) issues in collection of dues (c) slow-movement for inventories and (d) solvency and liquidity issues (Svanberg & Öhman, 2014).
• Review of the subsequent events – various subsequent events, for instance, bankruptcy of any major customer indicates unfavourable condition that is existed on the date of balance sheet (Dhaliwal et al., 2013). Other events can further indicate likelihood of going concern risks, for instance, asset expropriation of the company, reduction in the market value of the company’s inventory or line of credit withdrawal by bank.
• Review of the compliance – violation of loan arrangements and debt terms may lead to default of debt
• Inquiry for the legal counsel – company’s responses to the inquiries with regard to legal counsel including claims, assessments and litigation may indicate likelihood of considerable losses owing to patent or copyright infringements, illegal acts, contract violations and claims for product liability (Arens et al., 2013).
• Reading of the minutes – meeting minutes of the shareholders, board committees and board of directors may reveal – (1) loss of any major supplier (2) likelihood of expensive litigation (3) loss of the lines of credit from lender and (4) changes in business operation may lead to significant losses.
• Confirmations of financial support – confirmations from the third parties and associated parties regarding the details arrangements for maintaining or providing financial support that may reveal loss from 3^rdparty guarantees or loss of the lines of credit from bank may increase the indebtedness of the company (Krishnan & Wang, 2014).

Apart from the above indications the following events and conditions may warn as the red flags or signs for going concern risks –

• Internal matters – various internal matter that may indicate the going concern issues are – (1) requirement for revise of significant operation (2) labour difficulties or stoppage of work (3) loss of operational or key managerial personnel (4) significant dependence on success of any particular project (5) inefficient system for accounting
• Negative trends – it includes (1) negative cash generated from operation (2) increase of costs (3) recurring losses from operations (4) deficiencies in working capital (5) unfavourable key financial ratios (6) increase in borrowings and (7) reduction of sales (Sundgren & Svanström, 2014).
• External events – it includes (1) loss of license, patent or key franchise (2) loss of principle supplier or customers (3) legislation or same kind of matters that may create issues for operating ability. 

Indication for going concern issues were as follows –

• Borrowings – borrowings impact the financial performance of any company adversely as the financial leverage overburden the company with interest payment and repayment of borrowing. Further, it may lead the company the unstable situation. From the annual report of the company for the year ended 28^thJune 2015 the company raised new short term borrowing amounted to $ 70,500,000. Borrowing of company amounted to 13.86 of the company’s total asset which is quite big. This is a indication for the going concern risk of the company (Dicksmith Australia, 2018).
• Cash provided by operating activities – it has been observed from the cash flow statement of the company that the cash provided by the operating activities has been reduced from $ 52,177,000 to - $ 39,40,000 over the years from 2014 to 2015. Significant reduction in the cash flow led the company with liquidity risk as it has fewer current assets for paying off the short – term obligations (Chui & Pike, 2013).
• Inventories – it has been observed from the balance sheet of the company that the amount of inventories has been increased from $ 253,814,000 to $ 293,044,000 over the years from 2014 to 2015 (Dicksmith Australia, 2018). Purchasing of excessive inventories was done with the motive of rapid expansion of the stores when the company was actually running with loss.
• Increase of costs – it can be identified from the income statement of the company for the year ended 28^thJune 2015 that various expenses have been increased in 2015 as compared to previous year. These costs were – (1) rental and occupancy expenses increased from $ 79,257 thousand to $ 93,288 thousand (2) administration costs increased from $ 45,173 thousands to $ 57,287 thousand and (3) finance costs increased from $ 2,854 thousand to $ 4,111 thousands (Dicksmith Australia, 2018). All these negative trends indicate issues regarding going concern status of the company. 

Unmodified opinion is that where the auditor expresses the opinion that the financial statements in all the material aspects are presented in accordance with the applicable framework for financial reporting (Johnstone, Gramling & Rittenberg, 2013). The financial statements of Dick Smith for the year ended 28th June 2015 were audited by its long time auditor Deloitte Touche Tohmatsu. As per the auditor’s opinion –

1. The company’s financial report was prepared as per Corporation Act, 2001 and it included –
2. True and fair view of consolidated financial position of the company as on 28^thJune 2015 and regarding its financial position as on that date and
3. The financial statements were complied with Corporation Regulations 2001 and Australian Accounting Standards
4. Consolidated financial statements of the company were also complied with the IFRS (International Financial Reporting Standards).

It is the duty of the auditor to take reasonable care for ascertaining that the financial statement is presented in true and fair manner. Further, he must take reasonable care while ascertaining that. In addition to these the other duties of the auditor as per Auditing and Assurance Standard Board are as follows –

• Analyse the appropriateness of the accounting policies and reasonableness of the accounting estimates and associated disclosures made by the company (Maroun, 2017).
• Evaluation of overall content, structure and presentation of financial report. It further includes the disclosures made by the company and whether financial report presents the underlying events and transactions in true manner or not
• Must obtain appropriate and sufficient evidence with regard to the financial information of the company to express audit opinion (Liu, 2015).

Auditors' role in detecting fraudulent activities

However, the auditors are not bound for exercising more than reasonable skill and care while carrying out investigations and enquiries. The fact is that the auditor is not insurer and therefore he is not supposed to provide guarantee regarding the true and correct position of the affairs of the company. Further, it is not the auditor’s duty to provide advice to directors or any other executives of the company regarding the way in which the business shall be carried out (Auasb.gov.au, 2018). Hence, the auditors may have been provided unmodified audit report based on their analysis of financial statements as it might be the case that the auditors did not find any misstatement while evaluated the financial statements. 

It raised various questions to the auditors as even after realising that inventories were overvalued the auditors valued the company as going concern. The conceptual framework provided by AASB set out particular concepts for preparation and presentation of financial statements for the purpose of using it by the external users. AASB framework helps the auditors of any company to form opinion on the company’s financial statements. The opinion is given regarding whether the financial statements of the company are complied or not with the Australian accounting standards (AAS) (Johnstone, Gramling & Rittenberg, 2013). Further, the framework helps the users in interpreting the information provided in financial statements that is prepared in conformity with AAS. Therefore, using the financial information the auditors were in a position to verify whether the company prepared its financial statements in accordance with AASB or not (Linsmeier, 2016). It was clear evident that the company violated AASB 102 regarding treatment of rebates in income statement that was overlooked by the auditors.  These could have save the company from collapsing as AAS framework recognizes the objective of financial statements, its qualitative objectives for determining usefulness of information and for illuminating the concepts of capital maintenance and capital.

One major feature of fundamental qualitative element is materiality. Concept of materiality is regarded as company specific aspect for relevance and it is prepared on the basis of nature or magnitude of the items included in the financial report of the company. Therefore, auditors of Dick Smith, Deloitte should have focussed on particular element for materiality. This would have assisted the auditors to identify or understand the omitted or misstated information in financial statements of the company (Legoria, Melendrez & Reynolds, 2013). It could further saved the company from being collapsed. Further, as per the requirements of APES 110 – code of ethics the auditors of Dick Smith should have followed ethics for avoiding error or confusion while auditing the financial statements of the company (Barker & Penman, 2016). Therefore, if the auditors had followed and implemented APES 110 they could have found the misstatements from the financial statement presentation. Apart from that the AASB conceptual framework and APES 110 Code of ethics provide guidance to the auditors with regard to perform and conduct of professional services in accurate manner (Maroun, 2017).

Auditors' responsibility in ensuring compliance with accounting standards

Therefore, from the above discussion it can be concluded that Deloitte, the auditors of Dick Smith Electronics Ltd are answerable for issuing unmodified audit report to the company. The reason behind this is that various indications were there regarding the issues like the company did not follow AASB framework while preparing their financial statements.

Reference 

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Barker, R., & Penman, S. (2016). Moving the conceptual framework forward: Accounting for uncertainty. Unpublished paper, Oxford University and Columbia University.

Brochet, F., Jagolinzer, A.D. & Riedl, E.J. (2013). Mandatory IFRS adoption and financial statement comparability. Contemporary Accounting Research, 30(4), pp.1373-1400.

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Dicksmith Australia., (2018). Dick Smith | The Best in Tech at Amazing Prices. [online] Available at: https://www.dicksmith.com.au/da/ [Accessed 9 Aug. 2018].

Johnstone, K., Gramling, A., & Rittenberg, L. E. (2013). Auditing: a risk-based approach to conducting a quality audit. Cengage learning.

Krishnan, G. V., & Wang, C. (2014). The relation between managerial ability and audit fees and going concern opinions. Auditing: A Journal of Practice & Theory, 34(3), 139-160.

Legoria, J., Melendrez, K. D., & Reynolds, J. K. (2013). Qualitative audit materiality and earnings management. Review of Accounting Studies, 18(2), 414-442.

Linsmeier, T. J. (2016). Revised model for presentation in statement (s) of financial performance: Potential implications for measurement in the conceptual framework. Accounting Horizons, 30(4), 485-498.

Liu, C. (2015). The conflict between public interest and self-interest in public accounting. International Journal of Services and Standards, 10(3), 103-115.

Maroun, W. (2017). Assuring the integrated report: Insights and recommendations from auditors and preparers. The British Accounting Review, 49(3), 329-346.

SmartCompany. (2016). Dick Smith collapse: Four things we learnt from the administrators' report - SmartCompany. [online] Available at: https://www.smartcompany.com.au/finance/dick-smith-collapse-four-things-we-learnt-from-the-administrators-report/ [Accessed 9 Aug. 2018].

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