Reprinted from National Business Review, 3 March 2000

Worthless assets boost Warehouse’s balance sheet
By Alan J Robb

The Warehouse is a very successful business.  Its stated policy of putting the customer first is reflected in many statistics in its latest report.

Retail floor space was up by 19%, group sales were up by 24%, market share of department store sales nationally rose from 36% to 40%, and 55% of all toys sold in New Zealand were bought at the Warehouse.

Financially, shareholders should have been pleased too.  Reported profits rose 35% to 37.7 cents per share.

The annual report contains a commendable level of information, far beyond the minimum required.  What could be a mass of data is in fact well summarised and presented in a bright and cheerful layout with clear graphics and snappy typefaces.

It seems rather unsporting to criticise such a report; but there is one aspect which mars an otherwise very informative publication.  It is the presentation of $14 million of dubious debits as assets  —  confusion of expectations with resources.

The financial section has an eye-catching headline “Show me the money!”.  Great stuff, for that is what the three financial statements are about.

The Statement of Financial Position shows the economic resources of the company; the Statement of Financial Performance shows the return a company obtains on those resources, both reports being prepared on an accrual basis.  The Statement of Cash Flows shows the movements of one specific group of resources – cash.

“Resources” are properties and property rights including debts owed to and by the company.  They are cash and items having a money value, or cash equivalent, at the time of the report.  As such they are objective and verifiable. They are not imaginary; they are not expectations about some future occurrence which has yet to occur.

Such “phoney assets” are not resources. So why then does the Warehouse include “assets” which exist largely in an accountant’s imagination in its statement of financial position?
Since May 1999 the Warehouse has sold over 75,000 pre-paid mobile phones.  It has sold them below cost as an inducement for customers to purchase telephone cards.  The loss of $866,000 is being treated as an asset and will be allocated “over the period during which benefits from the sale of telephone cards are expected to be received.”

A loss is an asset?  How can a loss be a resource?  In my view the reported profits for 1999 have been overstated and the assets at balance date are also overstated.  This intangible asset is very phoney in my view.

An equally dubious but larger asset is $4.4 million shown as Deferred Option Scheme.  During the 1999 financial 9,527,000 options to subscribe for ordinary shares were issued to 194 management team members.  Three directors were awarded a total of 780,000 options as part of this scheme.
The options have no nominal value and had no cash issue price.  They can be exercised after 27 months and entitle the holder to subscribe for ordinary shares.  The price will be based on the Warehouse share price relative to the NZSE 40 Gross Index over the 27 months.

A “fair value” of $6.046 million was calculated for the options and has been recognised as part of equity and as an intangible asset “representing the future service to be provided to the company by the management team members.”  Part of that “asset”, $1.6 million, was amortised in 1999 and the balance will be written off on a straight line basis until the options are exercised.

No part of this $4.4 million is a financial resource in any normal sense of the word.  Its inclusion in a statement of financial position brings an element of unreality to what is meant to be a factual statement of resources.

Another equally unreal and unverifiable item reported is deferred taxation asset of $7.049 million.  This has risen from just over $4 million in the last two years.  This is the amount by which management expects taxes to be reduced in the future.

The commercial reality is that this is a contingency and does not form part of the resources available at balance date to meet the Warehouse’s liabilities.  It is paradoxical that the company is able to put a precise value on these “assets” but claims in note 19 that it cannot reliably estimate the liability for discounts accruing to customers under its Warehouse Card.

Goodwill and other intangible assets bring the total of these dubious debits to just over $14 million.  This is a material percentage of the equity of the Warehouse.

One can infer that the Warehouse itself has major doubts about the importance of these dubious debits.  In its nine year review they are totally omitted from all ratios involving assets.  They are treated as having zero value.

In my view the Warehouse should be consistent and write off these valueless assets even though the earnings per share would fall from the reported 37.7c to 32.6c.

This overstatement in earnings of 5c per share is material.  At a recent P/E ratio of 22.1 this translates into an overstatement of about $1.10 in the share price.
Alan Robb is a senior lecturer in accountancy at the University of Canterbury.  He holds no shares in the Warehouse but is an occasional customer.