Background of Dick Smith and its collapse

Dick Smith was the renowned entity of Australia that collapsed in year 2016 due to unethical accounting practices. There are many issues that have been found in financial report of the company and same has been reported by liquidator in his report. Some of the values of financial elements of the company have been wrongly reported in annual report that causes undue increase in profits but it was not actually earned. Similarly there are many accounting issues that will discussed in this essay and all these issues were the reason behind the failure of Dick Smith.

The purpose of this essay is to examine the financial reports and relevant news articles for identifying the probable causes and reasons for the collapse of the Dick Smith in very short span of time. The essay will specifically highlight the accounting standards that have been breached by the director of the company. Identification of signs that indicate that auditors provided in the annual report that there was going concern problem of Dick Smith. This essay also reports the evidences from the annual report for depicting the fraudulent accounting practices followed by Dick Smith. Further there will be discussion on reasons that has caused auditors to give unmodified audit opinion on the financial statements ended 30 June, 2015. Lastly, there will be discussion on auditor’s legal liability for not providing the modified opinion on the financial statements of Dick Smith for year ended 30June, 2015.

Dick Smith Holdings was the subsidiary of Woolworth and it is known as Dick Smith Electronics or DSE. Dick Smith had large number of electronic retails stores that sold wide variety of electronic goods for domestic as well as industrial purpose. Dick Smith was formerly listed on Australian Stock Exchange and it has successfully expanded its business in New Zealand as well as many parts of Australia. Dick Smith Electronics has been founded by Dick Smith in year 1968 and since then company has grown rapidly and Woolworth has purchased its 100% shares that makes the Dick Smith, subsidiary of Woolworth.

There are many reasons that have caused the failure of Dick Smith in year 2016 but the exact reason was not clearly known as it was management act which was not easy to identify. The Administrator appointed in case of Dick Smith has successfully found the possible causes of collapse of Dick Smith and has provided in its report. The main reason behind the collapse of Dick Smith is excessive buying to build up the stock of inventory for the purpose of expansion. In addition to inventory buildup, there were many accounting issues that were reported by the administrator in his report. In last few months of collapse of the Dick Smith it has been found that company was undergoing in losses and the main reason behind this was decrease in sales and excessive inventory (The Conversation, 2016). The decision of directors to built up the inventory and get rebates on the bulk purchases has forced to maintain inventory at very low cost in their accounts and also the non availability cash surplus also affected liquidity position of the company. During the last few month of collapse of Dick Smith it was found that company has failed to pay its liabilities and also struggling with the working capital.

Unethical accounting practices and their impact on the company’s financial position

Another big mistake that has been committed was fraud performed by Anchorage Capital. Anchorage Capital was involved accounting fraud through creating the hype in the stock market and making millions of dollars through sales of shares at very high price. A year back of Dick Smith collapse it was found that books of accounts has been manipulated and high profits are being reported that helps in increasing the market value of shares. The increasing trend in share price had attracted millions of potential shareholders to invest in company that raised the value of company to $500 million. But company fails to meet the commitment made to shareholders as revenue growth was not as expected and profits are declined and lead to losses. This has left company with significant level of stocks and outdated products that has very low value in the market. So the reasons like shortage of cash, accounting frauds, increase in debt and continue losses are the main reasons behind the collapse of Dick Smith in starting of year 2016 (News.com.au, 2016).

Dick Smith directors are accused of adopting the use of fraudulent accounting methods that are known within the industry as ‘Real Activities Management’. This accounting practice involves the use of manipulation of sales figures and inventories of stock in which it purchases excessive amount of inventory for rapid expansion of its stores and obtaining bank rebates from its suppliers for inflation of its earnings. The strategy intends to raise the share prices of the company and the director’s receives incentives for pursuing of excessive growth for increase in the stock (The ugly story of Dick Smith, from float to failure, 2016). The directors are accused for not complying effective with the Corporations Law by the use of faulty accounting practices such as RAM (Real Activities Management). It involves structuring the financial transactions in a manner that ultimately results in manipulating the financial information for misleading the end-users. The activities involves mainly achieving a  reduction in the expenses involved in research and development activities, price discounts for meeting short-term earnings targets, stimulating overproduction for generating excess inventory for reducing the cost of goods sold (Some answers, more questions over Dick Smith failure, 2016).

The directors of the company are mainly accused for violating the various provisions of the Corporations Act that also includes continuous disclosure obligations. It has been stated in the context of the company that the directors decision to buy stock is mainly based on the rebate obtained from the suppliers and not taking into account the needs and requirements of the customers (Clarke, 2003). This has resulted in increasing the bad stock of the company and ultimately raising its debt obligations. It has been claimed by the shareholders of the company that its directors were aware of the potential problems but them also violated the continuous disclosure obligations by not presenting the realistic and fair financial information to them. The directors had adopted the use of false accounting practices to deceive the investors and reflecting the inflated share prices that have negatively impacted the interest of the stakeholders. The avoidance of continuous disclosure obligation by its directors is held largely responsible for making it bankrupt by not selling profitably the excessive inventory purchases and thus resulting in shortage of cash flow. The directors and executives of the Dick Smith were legally claimed by its shareholders on account of their failure to implement adequate system related to rebates and management of inventory (The Conversation, 2016).

Accusations against Dick Smith directors for fraudulent accounting practices

A business entity need to prepare the financial statements in accordance with the going concern basis that directs an entity to view its business to be carried out on a continuing basis in the future context. Thus, in this context it is essential that management by expecting that the entity can become insolvent in the future should not prepare the financial statement under the going concern basis but with the use of a different basis such as break-up basis. The responsibility of an auditor is highly important in this regard for determining whether the financial statements can be prepared by the use of going concern assumption. The auditing standards of ISA 570 has been developed in this regard for obtaining appropriate audit evidence about the adequacy of the management use of going concern assumption. It is therefore the responsibility of the auditor in determining whether there is presence of any material uncertainty in the financial statements of an entity. As such, the auditors holds an important obligation to protect the interests of the stakeholders by ensuring that an entity would continue to run its operations in the foreseeable future and this forms the basis of their decision-making process (Putra, 2017).

It has been argued in the case of Dick Smiths that Deloitte, the auditing firm of the company, has questioned its rebates and over-valuation of its inventory. The auditing firm has also provided advise to the directors for controlling the weaknesses in their management control systems but the question arises how did they value the company as a going concern despite of identification such accounting issues. Therefore, the auditor of Dick Smith should have also considered the following points for identifying the going concern problem:

• Analytical Procedures: The procedures are used as a substantive test for determining nay negative trend within the financial statement of a firm. This can involve identifying any liquidity or solvency issues by assessing the adverse conditions indicated in the balance sheet.
• Internal matters: The presence of an inadequate control system characterized by weak accounting system can also be used the auditor for identifying the issue of going concern
• Financial issues: The financial difficulties faced by the firm such as increasing debt liabilities as in the case of Dick Smith also serves as a potential sign to indicate the problem relating to the continuing operations of the company in the future context (Going concern- who is responsible, 2017).

It is highly important for the companies to be going concern to sustain in the market for the long term. Going concern refers to the most important fundamental accounting principle that very company must follow. This accounting principle is based on the assumption that company will carry out its business for foreseeable future with no perception to close it down in future. It is highly important to report about the going concern in the annual report. It is management duty to verify and report in annual report that company has no intention to close the down the business or any of business units in future. It is highly important there must be enough evidences in the annual report that proves that company is going concern and will survive for long run (Seyam & Brickman, 2016).

Role of auditors in identifying the going concern issue

On evaluation of annual report of Dick Smith for year 2014-15 it has been found that there are few evidences that show that company will not be going concern in future. The annual report clearly shows that huge amount of cash has been provided to the suppliers in order to have surplus stock but this strategy of directors has not worked as there was cash shortage for longer period of time. The shortage of cash was due to decrease in demand of the electronics products and company has failed to collect the account receivable on time. The annual report of year 2014-15 shows the increase in sales revenue but fails to generate the free cash flows which have increased the debt liabilities (Annual Report, 2015). The director’s intention of stock piling does not work in favor of company but it was main reason behind the shortage of working capital. Through analyzing the liquidator report it was found that directors and management had purchased the large volume of inventory in order to satisfy the needs of new stores. In doing so, management has taken a huge bank loan and also received the rebates from the suppliers. The impact of this was increased debt at one side of balance sheet and lower cost inventory on other hand that has lost its value due to change in technology. Below is extracts of cash flow statement from the annual report 2014-15 that clearly shows there was no cash surplus from the operating activity in year 2015 (Annual Report, 2015). 

The other major evidence that has been seen from the annual report of Dick Smith was the transition that took place with the Anchorage Capital. Dick Smith has been sold to Anchorage Capital at very high net worth and resultant investors have invested huge amount in company. After the company was sold to Anchorage capital, the share price has been hyped in the Australian Stock Exchange through reflecting increase in profit. This had attracted many investors to invest in the company but company has failed to keep the expectation of investors. In the overall deal Anchorages Capital was benefited a lot as it has made lot of money from the sale of Dick Smith shares in the stock market. Overall it can be said that management activities are responsible for the failure of Dick Smith.

Deloitte was suspected for the huge negligence for not identifying the issues in the accounting treatment of suppliers rebate and value of inventory in Dick Smith for year 2014-15. The fact that was represented by Deloitte was that it has conducted the complete audit procedure for accounting of rebates but has failed to locate and report the material issues in the accounting system and processes of Dick Smith (Legal Liability of Auditors, 2017). To be on safer side and to remain as an external auditor of Dick Smith for longer run, Deloitte has not taken considerable steps to check the manipulation in the accounting standards and use test controls to check the material misstatement by the management. This has caused Deloitte to make the unmodified audit opinion for the financial year ended 30 June, 2015 (Annual Report, 2015).

Excessive buying and accounting fraud committed by Anchorage Capital

Deloitte, the auditor of Dick Smith Electronics, has been alleged due to providing unmodified audit opinion for the financial year 2015 despite of identifying various accounting issues present within its financial reports. Deloitte ahs raised questions on the management of the firm regarding the over-valuation of its inventory and manipulation of the sales figure for meeting the expected budget. Thus, despite of knowing the financial issues present within the company its auditors can be regarded as legally responsible for providing a justification to give unmodified audit opinions (Spencer, 2017). This is because as per the IAS 570 the auditors before classifying an entity as a going concern need to accurately assess the information provided by the management for protecting the interest of the stakeholders.  However, Deloitte has been legally claimed by Dick Smith shareholders of intentionally providing unmodified audit opinions and therefore they have a case to answer. This is because it has not reported any material deficiency in the controls and systems within the company in respect of identifying, calculating and recognition of debates. Therefore, the legal claim can be filed against the auditing firm of the company in addition to its former directors and executives (Clarke, 2003).

Conclusion

The overall assessment of collapse of Dick Smith has helped to learn the lesson on accounting fraud that management and auditors carried out to earn the huge profits. From the case of Dick Smith it was clearly held the real activities of management are hard to identify and such material misstatement can cause severe damage to the going concern accounting principle. It is the duty of auditor to test the misstatement of management and report them in annual report. 

References

Annual Report. (2015). Dick Smith. Retrieved on November 22, 2018, from https://www.asx.com.au/asxpdf/20150818/pdf/430kvhrl8cpg0l.pdf

Clarke, F. (2003). Corporate Collapse: Accounting, Regulatory and Ethical Failure. Cambridge University Press.

Going concern- who is responsible. (2017). Retrieved 22 November, 2018, from https://www.accaglobal.com/in/en/technical-activities/technical-resources-search/2012/march/going-concern-responsible.html

Legal Liability of Auditors. (2017). Retrieved on November 22, 2018, from https://corporatefinanceinstitute.com/resources/knowledge/accounting/legal-liability-of-auditors/

News.com.au. (2016). McGrathNicol releases Dick Smith report. Retrieved on November 22, 2018, from https://www.news.com.au/finance/business/retail/mcgrathnicol%C3%A2%E2%82%AC%C2%90releases%C3%A2%E2%82%AC%C2%90dick%C3%A2%E2%82%AC%C2%90smith%C3%A2%E2%82%AC%C2%90report/newsstory/%20c2897a8cf8023b3f7490b7f16c2781c2

Putra, L. (2017). How Auditors Evaluate Entity Going Concern. Retrieved 22 November, 2018, from https://accounting-financial-tax.com/2011/10/how-auditors-evaluate-entity-going-concern/

Seyam, A. & Brickman, S. (2016). The Going Concern Assumptions and Presentation on Financial Statements. Retrieved on November 22, 2018, from https://www.omicsonline.org/open-access/the-going-concern-assumptions-and-presentation-on-financial-statements-ijar-1000123.php?aid=73762

Some answers, more questions over Dick Smith failure. (2016). Retrieved 22 November, 2018, from https://theconversation.com/some-answers-more-questions-over-dick-smith-failure-62485

Spencer, L. (2017). Deloitte dragged into Dick Smith directors’ legal battle. Retrieved 22 November, 2018, from https://www.arnnet.com.au/article/625866/deloitte-dragged-into-dick-smith-directors-legal-battle/

The Conversation. (2016). The ugly story of Dick Smith, from float to failure. Retrieved on November 22, 2018, from https://theconversation.com/the-ugly-story-of-dick-smith-from-float-to-failure-55625