Dick Smith Electronics - Conservatism, budgeting and inventory valuation

Dick Smith’s in Crisis• Gone into voluntary administration

• High level of debt

• Poor liquidity

Debt Ratio (Gearing) = 67%

WCR = 1.23

Material Information• As a public company on the ASX, Dick Smith must publicly announce all

“material information” to the public

RelevanceInformation is relevant if it influences the decision-making of the user by helping them:

• Evaluate past, present or future decisions

• Confirm or correct past decisions

Materiality testInformation should be included if it is:

• Large enough to influence the decision-making of the business

• Omitting or misstating it would result in a bad decision

Shareholders (owners)

Potential shareholders

Banks and lenders

Suppliers Government Employees Customers

Budgeting• One “material announcement” public companies provide is their budgets

• In particular, budgeted profit (called a “guidance” report)

• Usually done every quarter – helps users make decisions

1 Jan 31 Dec

“Our profit was $90m last year”

1 Jan 1 Apr 1 Jul 1 Oct 31 Dec

“We think profit will be

$70m”


$100m”


$80m”


$90m”

Budgeting – Relevance vs Reliability• Why do public companies provide “guidance” when it

will most likely not be 100% accurate?

• One way companies try and balance these qualitative characteristics is by providing a “guidance” range

RelevanceInformation is relevant if it influences the decision-making of the user by helping them:

• Evaluate past, present or future decisions

• Confirm or correct past decisions

ReliabilityInformation is reliable if it:

• Is free from opinions and estimates

• Is based on data that can be checked or verified with a source document


“We think profit will be $60-80m”


$90-110m”

“We think profit will be $70-90m”


$80-100m”

Shareholders (owners)

Potential shareholders

Banks and lenders Suppliers

Government Employees

Make decisions based on this information…

Dick Smith’s Profit Budget• Dick Smith’s “guidance” in 2015

• Then a “material announcement” was made on 30 November


“We think profit will be…

$45-48m”


$37-43m”

Special “material announcement”

• “Management has initiated a review of inventory”.

• “Stock holdings remain above management’s preferred levels”.

• “We remain cautious on the outlook for the Christmas trading period.”

• “We will continue to drive sales, maintaining flexibility on gross margin to reduce inventory.”

• “A non-cash impairment of $60 is required.”

• “The company is unable to re-affirm the profit guidance previously provided”.

A New Announcement• “Management has initiated a review of

inventory”.

• “Stock holdings remain above management’s preferred levels”.

• “We remain cautious on the outlook for the Christmas trading period.”

• “We will continue to drive sales, maintaining flexibility on gross margin to reduce inventory.”

• “A non-cash impairment of $60 is required.”

• “The company is unable to re-affirm the profit guidance previously provided”.

Understandability

Information is understandable if:

• Users can comprehend its meaning easily

• Assuming a reasonable knowledge of business and economics

“We had a bunch of old inventory sitting there for ages

that we couldn’t sell.”“We’ve got way more stock leftover than we thought we’d have this close to Christmas.”

“Christmas sales will be much lower than we thought they

would be”“To sell all this old stock, we’re going to lower the price… if we have to, we’ll sell it below cost.”“The old stock we can’t sell is

now worth $60m less than we bought it for.”“Our last profit guidance of

$37-43m will now decrease at least $60m. We can’t say if we’ll

even make a profit this year.”

A New Announcement



$45-48m”


$37-43m”

Special “material announcement”

70% fall in one day

The Sales BeginAs they said they would, during December 2015 Dick Smith tried to sell the old stock at heavily reduced prices.

• Dick Smith is offering discounts of up to 60 per cent smartphones, tablets, fitness, toys, GPS and printers, and up to 70 per cent on TVs, Blu-ray players and audio equipment.

• Dick Smith has kicked off its “mammoth clearance” fire sale offering discounts of up to 80 per cent off unwanted stock in what rival retailer Gerry Harvey earlier this week described as a “suicidal” move.

• “They are not making any money if they sell everything in a fire sale. They will lose a lot of money. Why would they do that — that’s committing suicide”, Mr Harvey said.

Lower of Cost v Net Realisable Value (NRV)• The “$60m non-cash impairment” simply meant that the stock could only be sold for

$60m less than its cost.

• This is an application of the rule…

Inventory should be valued at the lower of:

Cost Net Realisable Value (NRV)or$400m $340m

This is called a Stock Write

Down$60m Expense

NRV = Estimated selling price of stock

Selling, marketing and distribution costs

Dick Smith’s in CrisisRecording a Stock Write Down Expense…

Stock Write Down [E]31 Dec Stock control 60m

Stock Control [A]31 Dec Balance 400m 31 Dec Stock write down 60m

General JournalDate Particulars

General Ledger Subsidiary Ledger

Debit Credit Debit Credit

31 Dec Stock write down [E] 60mStock Control [A] 60m













$45-48m”


$37-43m”

“A $60m Stock Write Down

expense has occurred”

Lower of Cost v Net Realisable Value (NRV)Why did Dick Smith’s record a $60m Stock Write Down expense before they’d sold the stock?

Conservatism

Caution must be used when preparing financial reports

• Losses are recorded when they are expected to occur

This is done so:

• Assets and revenues are not overstated (too high)

• Liabilities and expenses are not understated (too low)



Education

Dick Smith Electronics - Conservatism, budgeting and inventory valuation