Analysis Of The Internal Control Weaknesses, Inventory Management, And Rebate Strategies Of Dick Smith Holdings

Internal Control Weaknesses

Dick Smith Holdings was a wide- chain of retail stores in Australia, which deals in consumer electronics. The company was founded in 1968 by a well-known entrepreneur Dick Smith. In 1981, the founder sold 60% of its shares to Woolworths limited and after two years that is in 1983, the remaining 40% was also sold to Woolworths. After having almost 30 years of ownership, Woolworths sold the company to an investment firm operating in Australia named as Anchorage Capital Partners in November 2012. The sale price was $115 and only $10-15 million were being paid by Anchorage with their own money and the remaining amount was derived through the liquidation of the company’s assets (Anon, n.d.).

Later in 2013, DSH issued the offer to the public for sale of share at $2.20 each. This initial public offering was highly successful and resulted in the capitalization of the market of $520 million. The company went into liquidation after two years providing various causes for its failure such as over purchasing of the inventory, the surplus it earned in 2013 get invested in its expansion plan which was not successfully implemented, changes in the consumer preferences and many more to it (Anchorage Capital, n.d.). This report contain the analysis of the different reasons which led to the liquidation of the company. Evaluation of internal control measures, key auditing standards and various other things are mentioned in the report which gives an overview about the dissolution of Dick Smith Holdings.

Weakness in internal control system of DSH was also a reason for its failure. Lack of adequate controls in the management of the financials decreased the company’s performance and became a cause for its break down (Goh, 2009). Internal control issues with dick smith were that they provided dissimilar financial information to the investors on irregular intervals of time. The policies adopted by the company gave them the uneconomic results and the clashes between the directors or the conflicts of interest also became the reason for weakness in internal control. Incompatible accounting of the transactions was done. Proper documentation was not there due to which it was impossible to track who was responsible for which action, final accounts were not prepared as per Australian standards of accounting and tracking of employees’ authorization for certain functions was neglected. All these factors became the weakness of the system and led to the liquidation of DSH (Mahadeen et al. 2016).

Final accounts of DSH was audited by the auditors of Deloitte. The main internal control weakness was that the directors of DSH rely on the audit reports provided by the auditors without giving a management review to them. Falsifications of the accounts was done and manipulations were being there in the figures of final statements. According to the case filed in NSW Supreme Court, Abboud puts a cross claim on Deloitte for the damages and the involvement in the case. The financial statements of 2014 and 2015 of DSH was audited by the Deloitte. The claim stated that during the period, the auditors did not aware the company’s directors about the issues related to the inventory control and accounting treatment of the rebates. The documents also said that the decisions were taken on the basis of the description of the audit report of 2015, given by Deloitte, which did not show any kind of variances or errors in the control system, calculation of rebates and recording them (Spencer, 2017). Manipulations in the rebates led to the rapid increase in the sales of the company in year 2015 which raises various allegations on DSH that if management had performed well then there would have been a loss or decrease in profits in 2015. Sudden increase in revenues forces the company to pay dividends which they actually cannot afford. It was also said that the accounting done for rebates was not according to the Australian Accounting Standards. The reports showed the profits, EBIT, depreciation at an increased level than their actual value which was not in compliance with the Australian standards particularly AASB 102. Many questions were raised on Deloitte as it did the testing of the stock. It said in its defence that they did not find any errors and differences in the report on the basis of the work done by them. The reports prepared by them showed that there was no reason to say that the financial information was not presented in a fair manner and also the forecast done was unreasonable (ABC News, 2016).

Inventory Management and Rebate Strategies

Inventory is the stock of raw materials and goods which are used at different level of productions. For the successful operations of the business, it became necessary to control the inventory with the help of proper policies, tools and techniques of control (Bendavid, et al. 2017). Inventory management means managing and controlling the inventory at different stages to ensure the optimum utilisation of stock with the reduced cost. It also helps the company in maintaining stability in their financial position (Shubham and Kumar, 2017; Ashrafzadeh, et al. 2017). As far as DSH is concerned, one of the major reason for its breakdown is its improper or poor inventory management policies. The decisions taken at that time related to inventory were not appropriate and also not as per the customer demand which eventually led to the obsolete and unsaleable stock. Changes in the consumer preferences, left DSH with a high level non-tradable stock. Falsified policies were accepted by the company. McGrath Nicol states in his report that even after facing a year by year decline, decision related to the purchasing were made on bases of rebates rather than consumer demand. Inventory tends to grow and new stores were opened irrespective of the decline in sales of the stores. Despite this reason of “bad stock”, the directors and other officials of the company failed at implementing proper systems and procedure to control the inventory and to monitor the purchase.

The rebate strategies which were used by Dick Smith was to choose the products which maximise the rebates on the money paid by the suppliers for the promotion and stock of their good, to the company irrespective of what customer wanted to purchase. It was the only company who got accused for showing its rebates as profits before even selling the product. It violated the accounting standards. Anchorage Capital Partners, the equity firm who acquired the company said that it carried forward the legacy of the formal owner Woolworth’s of making rebates strategies for the company. It also adopted the same strategies of maximising the rebates (Chung, 2016; The Sydney Morning Herald. 2016). But all this was opposed by Receivers and managers Ferrier Hodgson who said that company’s dependency on rebates and other incentives from suppliers had screwed up the buying capacity and practice of the management and also led to the formation of unused and obsolete inventory. The accounting of the rebates was done by the auditors of Deloitte and it was their responsibility to correctly report it in the accounts. Apart from that the stock turnover also raised questions on the company.

The former chief executive of Dick Smith Nick Abboud gave a statement to the court, defending the rebates policies of the company. He said that it was a job of the suppliers to pay for the promotion of the product in order to sell it in the market. He mentioned that the strategy was not only to buy the product but also to make sure that the supplier provide the full support in the promotion of the product to sell it (New Zealand Herald, 2016). Many contradictory statements were given by different people on Dick Smith’s rebate and inventory management policies. The poor management of inventory and over and above rebates became one of the reason for the liquidation of Dick Smith Holdings.

Stakeholders basically means parties or people who are interested in the performance of the company or the activities done by them. These include shareholders, employees, customers, creditors and so on. Woolworths was the stake holders of Dick Smith initially but in November 2012 DSH was acquired by Anchorage Capital Partners. It acquired 98% of DS Sub-Holdings and the remaining 2% was acquired by LMA Investments limited. After controlling for over one year, DSH became a public company in 2013 through Initial Public Offerings. It was done to raise the capital and to fund the shares acquisition from Anchorage. The IPO was successful and the ACP sold majority of its shareholdings to the shareholders of the newly formed public company. Another stake holders of the company were its secure lenders that were National Australian Bank (NAB) and HSBC, which were the in charge of almost whole of the property of DSH. Creditors, suppliers and the employees of the holdings were also the stakeholders at the time of collapse of Dick Smith Holdings.

As far as the social responsibility of a company is concerned, Dick Smith badly failed at this part. Social responsibility means that a business should carry those activities which provides benefits to the society and also earn profits (Vallaster, 2017). It is a responsibility of the company to give adequate returns to its shareholders and investors. The company should make sure that timely payment of creditors is done and stakeholders are getting time to time returns on their investment (Cheng, et al. 2014). The position of the DSH clearly gave an idea that nothing can be recovered from the company to pay to its stakeholders. Unsecured creditors were not able to recover their payments as there were no assets left with the company. It was already advised to the shareholders that they would not get any return on their investments. After getting into the receivership, the receivers Ferrier Hodgson decided to shut down its stores leaving thousands of people job less. Many of the shareholders had lost their investment because DSH did not follow the provisions of corporations act as it was involved in performing unethical practices related to shares (Foye, 2016). An allegation was put up on the company by them that in year 2015, the price of share increases which breaches the Act and a loss or a damage was being suffered by them.

As per the administrator’s report, the staff of DSH was been paid in their full entitlements where as banks who were the secure lenders had to face a significant amount of loss in recovering their debts. But the situation was worst for the unsecured creditors, including those who were gift card holders and the shareholders who did not get any amount in return of their investments. The news stated that the two banks NAB and HSBC were the largest creditors of the DSH before the company went into voluntary administration. It had a debt of approximate $400 million. The banks were told by the NSW Supreme Court that they also had to stand in line to get their part of return. Not getting the significant return had an impact on the banks. They claimed that the former directors of the company failed to reveal the correct finance information including the rebate strategies. If they had known about these strategies earlier, they would not have sanctioned the funds to DSH in 2015, which was further extended by HSBC (Foye, 2017). The former shareholders also file a class action lawsuit in the Supreme Court in order to compete against the claims put up by the banks for compensation. So many statements were published commenting on the relationship between the banks and the companies (Anon, 2017).

Some ethical standards are mandatory to be maintained while performing the task of internal audit. The auditor should perform its audit in compliance with some ethical requirements. The requirements consists of some fundamental principles or code of ethics for professional accountants given by International Ethics Standards Board (IESB). These principles provide an auditor a conceptual framework of auditing the financial statements (Auditing and Assurance Standards Board, 2017). These are Integrity, Objectivity, Competency, confidentiality and professional behaviour (Compiled Auditing Standard, 2017). All these key ethical auditing standards were violated by the auditors of DSH and Anchorage Capital Partners.

• Integrity: It means having the quality of being honest and strong moral values. Auditors must pursue integrity to establish trust and to make the organisation enable to rely on the judgement possessed by them. This ethical standard says that auditors must make the disclosures to the extent of the law and should respect the ethics of the organisation. DSH auditor’s had breach this standard to a great extent. They did not provided the information in compliance to law. Improper accounting of the transactions was done and figures were being manipulated. A wrong view of financial statements was provided to the organisation, which eventually broke its trust and led to downfall of the company. No integrity was maintained by the auditors and the former owner of DSH Anchorage.
• Objectivity: This states that auditor must reveal the material facts to the organisation and should not involve in any of the activities which include interest conflicts of the business. Auditors should not accept such things that may weaken their judgement. Clear objectives of auditing should be there. On part of this, DSH auditor’s violates this by not disclosing the exact financial position of the company. They misstated the final accounts and gave a fudge review of the areas examined by them. Figures were shown at their false values. Due to which decisions taken by the company went wrong and lead it toward the stage of winding up.
• Confidentiality: Another ethical standard to be followed is to be confidential about the information gathered at the time of performing audit. Auditor must know the value of the ownership of the data and should not reveal it without the permission of appropriate authority. Confidential information include the data about profits, sales and purchases, equity and debt structure and other financial information. All this was not clearly stated by the auditors in the annual report of the company. Important and confidential information provided gave a falsified view of the position of the company.
• Competency: Adequate and necessary skills and knowledge is require to do the task of internal audit. Despite of being very much efficient in their work, having specialised knowledge and skills, Deloitte’s auditors did not performed their duties very well. Auditing was not done as per the international standards and decisions based on the reports provided brought the organisation close to liquidation (The Institute of Internal auditors Australia, n.d.). 

Summarised Balance Sheet

Particulars	Jun-13	Jun-14	Jun-15
	$’m	$’m	$’m
Current Assets
Cash & Equivalents	46.5	29.9	29.5
Trade and other Receivable	10.4	46.7	53.3
Inventory	171	254	293
Other Current Assets	13.5	5.5	14.1
Total Current Assets	241.2	335.9	389.9
Non Current assets
Plant and Equipment	60.3	78.8	92.5
Deferred Tax Assets	42.9	36.5	26.0
Total non-current assets	103.1	115.3	118.5
Total Assets	344.3	451.2	508.4
Current Liabilities
Trade and other Payables	-153.3	-247.7	-228.4
Borrowings			-70.5
Provisions	-16.1	-13.6	-13.3
Other Current Liabilities	-2.9	-5.5	-4.3
Total Current Liabilities	-172.3	-266.8	-317
Non Current Liabilities
Provisions	-13.9	-7.3	-6.1
Lease Liabilities	-1.7	-10.1	-16.8
Total Non Current Liabilities	-15.6	-17.4	-23
Total Liabilities	-187.9	-284.2	-339.4
Net Assets	156.5	166.9	169.1
Equity
Issued Capital	10.0	346.1	346.1
Reserves	6.3	-339.2	-339.4
Retained Earnings	140.2	160.0	162.4
Total Equity	156.5	166.9	169.1

(Source: DS Holdings 2014 Annual Report and 2015 Annual Report)

Most of the items of balance sheet had increased due to the expansion activities done by the DSH and because of the opening of new retail stores. Such as:

• Level of inventory had increased due to the adoption of rebate strategies and inauguration of the new stores. This led the situation of unsalable stock within the company
• Increase in trade debtors was also there due to the increased rebates from suppliers as stock was purchased.
• Because the decision of expanding the business was taken, it raised the need of additional furniture and fixture and as a result an increase was there in plant and equipment of DSH.
• To fund the additional inventory, credit was taken from the suppliers which increased trade payables from $153 million in 2013 to $220 million in year 2014 and 2015.
• To meet the establishment cost of new stores, borrowings was also increased.
• Every year raise in lease liabilities was also there as different and new locations were added.

Summarised Income Statements

Particulars	Jul-15	Aug-15	Sep-15	Oct-15	Nov-15	Dec-15	Total
Sales	97	94	131.1	89	85.2	200.1	696.5
Cost of Sales	-80	-77	-93.9	-74.1	-131.6	-186.4	-643.1
Gross Profit	17	17	37.2	14.8	-46.4	13.7	53.4
Gross Profit Margin	18%	18%	28%	17%	54%	7%	8%
Opex	-17	-16	-32.9	-17.8	-12.7	-71	-167
EBITDA	0	1	4.3	-3	-59.1	-57.3	-113.9
EBITDA Margin	0%	1%	3%	-3%	-69%	-29%	-16%
Depreciation	-1	-1	-1.7	-1.4	-1.4	-43	-50.2
Interest Expense	0	0	0	0	0	0	-2
Tax	1	0	-0.7	1.4	18	30.1	49.5
Net Profit After Tax	-1.3	-0.3	-1.6	-3.4	-42.8	-70.5	-116.7

(Source: DS Holdings 2014 Annual Report and 2015 Annual Report)

• Losses of EBITDA for the six months were $114 million.
• November 2015 and December 2015 reported continuous losses.
• The main reasons for such losses were those estimated sales targets set in dec. 2015 were not met by the DSH. Low profit margin products affected gross profit to a great extent.

Following information was also recognised:

• DSH came to know that $60 million inventory was written down in November 2015.
• A $14 million lease provision was also made as the cost of retail lease exceeds the forecasts done for economic benefits.
• DSG had inadequate cash for purchasing the new and high profit margin products which eventually affected the profitability of the firm.

All these were being recorded and reported in the annual report of Dick Smith (Asx.com.au. 2015).

Inherent risk means an omission or misstatement in the financial statements of an organisation occurred due to the factors which are not caught during the audit. Risk in financial report level means possibility of incorrect data in the final accounts that can affect the several different transactions occurred during a year (Merna and Thani, 2011). Risk factors which had affected DSH at financial report level are:

Inventory:  DSH kept a high level of inventory and the purchasing done was not according to the consumer demand. This raised the chances of obsolete stock because it cannot be traded in the market as products were not according to customer taste and preferences. Adoption of rebate strategies resulted in the creation of bad stock. All this contributed to a high inherent risk and also lower down the revenue of DSH as the stock became unsaleable.

Interest payments: Due to lack of funds, DSH was not able to pay its interest payments which showed that the position of the company was deteriorating financially. It was not able to meet its short term liabilities. This risk was also discovered at financial report level.

Fraud: It is considered to be the pervasive risk factor as it can be found at all the levels of organisations. In case of DSH, fraud was one of the risk which had been done by the auditors and top management on their part respectively. They falsify the entries recorded and adopted the accounting procedures which were not in accordance with the Australian Accounting Standards. This is the way it was inherent in financials of the company and affected the other aspects of the company. It is the main reason for the company’s break down.

Misstatement: Another inherent risk which affected the final reports of Dick Smith was material misstatement. It arose from various sources such as its internal control system, inventory management. These were the external factors which forced the auditors to manipulate the data to meet company’s financial targets. It also showed that despite of having professional skills and knowledge, auditors mislead the organisation and its other stakeholders by giving a fake view of the financial position of the company.

All these factors affect and increases the assessment procedure of inherent risk as the auditor has to evaluate all these risk which can be found at every level and within the different functions performed in the organisation (Ahimbisibwe, et al. 2015). 

Conclusion 

The above report concluded that, the key reasons for the liquidation of Dick Smith Holdings were its poor inventory management, weaken internal control system and variance in it, rebate strategies, and a falsified disclosure of the company’s financial position. Auditors were held responsible for not doing the accounting of the transactions as per the international ethical and auditing standards (The Canberra Times. 2016). Many statements and claim were made against the company as it was not able to maintain a sound financial position in the Australian market. The irresponsibility of the directors and violation of the accounting standards by the auditors results in the severe break down of the firm.  

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