Company accounts: turning losses into gains.
The Warehouse phone numbers don’t add up
By Alan J Robb (Alan Robb is a senior lecturer in accountancy at the University of Canterbury, New Zealand) He holds no shares in the Warehouse.
The recent half yearly report of The Warehouse proclaimed profits up $11.3 million or 31% compared with the corresponding six months of the previous year.  The profit margin on sales is said to be up from 7.2% to 8%.  A closer examination of the report shows that these improvements are largely the result of a policy of capitalising losses on the sale of mobile telephones.  As was commented earlier (NBR 3 March) the justification for treating trading losses as assets is very questionable.  This is even more so as the amount capitalised has risen by $6.638 million.  Capitalising this amount has had a material effect on the profit performance as Table 1 shows.
                                                            Table 1

                                         Warehouse figures     Restated to recognise
                                        (unaudited)                  losses on phones
                                            $ million
Profit after tax 6 months
to 31 Jan 2000                            $48.259                       $41.621
Increase over 6 months
to 31 Jan 1999                            30%                             12%
After-tax profit to total turnover
 (31 Jan 1999 and 2000)             7.14% and 7.85%           7.14% and 6.77%
                                                 Increase                         Decrease
Return on Equity
(31 Jan 1999 and 2000)         22.9% & 28.6%                22.9% & 25.8%

                                            Up 5.7%                             Up 2.9%

The unaudited result was an after-tax profit of $48.259 million, up 30% from $37.029 million.  Had The Warehouse treated the losses for what they are the result would have been an increase in profit of only 12%. Likewise the ratio of net profit to total revenue actually falls, to 6.77% and the increase in the return on equity is virtually halved, when the loss on the phones is not treated as an asset. The amount of the capitalised losses is increasing in relation to the numbers of phones sold as Table 2 shows.

                                                Table 2
                             Year to                 6 months to            18 months to
                            31 July 1999      31 January 2000       31 January 2000

Phones sold          75,000                 37,000                             112,000
Average revenue
per phone                  $42                 $198                                 $94
Average cost
capitalised per phone   $54                  $377                                 $161
Loss per phone           $12                 $179                                 $67

In the previous annual report shareholders were told that between May and 31 July the company had sold “in excess of 75,000  phones”.  Sales revenue was reported as being $3.199 million and the loss on sales was $866,000.  That equates to an average cost per phone of $54, sales revenue of $42 and a loss of $12 per phone.  In the latest report shareholders are told that The Warehouse has quickly established itself as an important retailer of pre-paid mobile phones “with over 112,000 phones sold since May 1999”.

If that is so then simple arithmetic tells us that about 37,000 phones were sold in the last six months.  The revenue from those sales is reported as $7.337 million and the loss as $6.638 million.  This gives an average cost per phone of $377, a selling price of $198 and a loss per phone of $179. Perhaps The Warehouse is now allocating overheads to the cost of phones.  Arguably such a policy would not be inconsistent with generally accepted accounting practice although it is repugnant to commonsense.

A recent advertisement showed that The Warehouse was giving 200 free minutes call time with each phone.  The equivalent amount in July 1999 was 50 minutes.  Perhaps the company is now capitalising the extra free minutes as part of the cost.  If so, the logic becomes very questionable – they sell the phones at a loss to encourage the sale of phone cards and make a loss giving away extra phone cards to encourage the sale of phones.  And these losses are treated as an asset!
Whatever the explanation it will still be a mystery to many how the loss can increase eightfold from $866,000 to $6,638 million when in dollar terms sales of the same product increased only two and a half times from $3.2 million to $7.3 million and in unit terms the sales halved. The mental gymnastics which allow The Warehouse to consider losses as assets lead to more confusion for shareholders when it comes to reading the statement of cash flows.  The loss capitalisation should be shown as part of the “Adjustments for non-cash items” in the note reconciling net profit and operating cash flow.  Instead the company has created  a subsection headed “Items classified as investing or financing activities”.  Within this is shown “Telephone handset capitalisation (6,638)”  It would be very natural to interpret this as meaning that cash flows of $6.638 million have been reclassified and reported as an investing cash outflow.  This is not so and is prohibited under financial reporting standard FRS10.

Paragraph 4.14 states specifically that “cash flows from investing activities do not include receipts and payments relating to current assets, such as accounts receivable, or inventories which are routine and repetitive in the ordinary course of business”. Prepaid telephones are indisputably part of the inventories of The Warehouse.  Their purchase and sale is routine and repetitive in the ordinary course of business. Consequently the cash flows must be shown as arising from operating activities.

In fact the Warehouse does include the cash flows relating to phones in its operating cash flows, but the implication is that they are a part of the reported investing cash flows.  The presentation used by The Warehouse is misleading and unhelpful.

The Warehouse is currently making expansionary moves into Australia and may be expected to face strong pricing competition as its seeks market share.  It may find its accounting policy of capitalising losses less acceptable there.  Losses carried forward are not financial resources – they are simply evidence of wishful thinking.

It is to be hoped that when the results for the full year are prepared the auditors will heed the warning of the chairman of the US Securities and Exchange Commission that “wishful thinking may be winning the day over faithful representation”.  The auditors will improve the quality of the Warehouse report if they reject the reporting of trading losses as assets.