Brief Discussion of the Company:
Industry:
The Jewelry industry dates back to as much as 75,000 years. It has long been used as a symbol of status, wealth and luxury. The industry acts as timeless for the ones who are a part of it in any form. The competitive landscape of the industry is highly aggressive with companies like Tiffany & Co, Signet Jewelers Ltd, Blue Nile, Inc, Zale Corporation, Birks and Mayors Inc, and DGSE companies Inc operating in it. The industry exists in its maturity stage of the life cycle and can be not affected significantly by the economic crisis. After the awareness regarding the Blood Diamonds or Conflict Diamonds raised by several agencies, these companies have been aggressive in accommodating the responsible mining standards. Tiffany incorporated these in 2003 while Zale Corporation along with its other members of the industry formed the Council for Responsible Jewelry Practices in the year of 2005. As within this industry, the major portion of the sales depends on the repeat customers; their preferences are closely watched and adapted to as shown in the example of ethical responsibility. The companies in this industry have always been marketing jewelry as a luxury; however, with the recent financial crisis, the companies are trying to change their approach and advertise it as a thoughtful investment. For this industry, innovative designers are of key importance. They not only give the company a wider range of products, but also help in differentiating the competitors from the industry. The Jewelry industry still competes on quality rather than on price. However, brand recognition has become an asset. The high growth rate of the industry is causing the companies to open global stores to capitalize on the new market share. The old firms enjoy economies of scale regarding their physical stores, brand advertising, and investments in R&D. The company does not fear entrants like any other industry. It is that industry in which the buyers set the market price for the product. The suppliers also enjoy great leverage on the companies as the mining companies have absolute control over the selling price of the gems. Zale Corporations was founded in 1989 while DGSE in 1965, both dwell in online selling and auctions and physical store selling. While Zale Corporation is headquartered in Irving, Texas, DGSE Co is headquartered in Dallas Texas. Dallas Gold & Silver Exchange Inc
DGSE companies Inc retails, wholesales, and auctions diamonds, jewelry, precious metal, watches, rare coins to the local, and international customers via its Charleston Gold and Diamond Exchange, Dallas Gold and Silver Exchange, Superior Gold and Diamond Exchange and also via online mediums. Fairchild International Inc is also owned by this company which is the largest wholesaler of vintage watches in the US (SEC, 2011).
Zale Corporation
Zale Corporation operated through its specialty retailers and wholly owned subsidiaries in the fine jewelry industry. The company has owned about 684 kiosks and 1247 specialty stores until 2009 in the US, Puerto Rico and Canada. The company reports regarding its three business segments; Fine Jewelry which consists of five brands, the Zale Jewelers and Gordon’s Jewelers and the Mappins Jewelers and People Jewelers (SEC, 2009).
A discussion of the Accounting Issue:
The accounting issue has been reported in the DGSE Companies Inc. The Chief Financial Officer of the company I. John Benson in early 2012 was found by the Board of Directors of the company to be involved in certain irregularities. In early 2012, the board determined that several accounting irregularities may have a significant impact on the financial information reported during the years of irregularities. The company announced later that the filed information from the second quarter of the year 2007 and onwards should not be used and relied upon. The board launched an internal investigation and retained a forensic accounting firm for this purpose. The investigation of the Board determined a continuous series of accounting irregularities. The management found the reason of irregularities in the Journal entries and Adjustment entries made by the prior management of the general ledger which did not have enough support. DGSE had inadequate internal control processes, which involved the decisions of the last management, which were not aligned with the Generally Accepted Accounting Principles. Furthermore, the wrong Implementation and Set-up of DGSE Resource Planning System of Account Mate is another reason.
The identified irregularities included recording of the unsupported entries in the general ledger directly. No formal standard process of reconciliation of the intercompany accounts was followed. The company used unsupported and inadequately described entries for accounting. The absence of an audit trial which could have shown the reason for the use of adjusting entries was another irregularity. The inadequate security of data caused problems. The use of a very antiquated system for accounting and reporting, which allowed manipulation of the entries, was another reason. The company did not follow any formal process of backing up the accounting data
Because of such irregularities in the accounting system of the company, the accounting system was compromised. The inter-company accounts specifically became out of balance by millions of amounts. The ex-Chief Financial Officer of the company was responsible for making several fraudulent accounting entries to the system to back the balance. These included the preparation of the adjusting entries and overstatement of the inventory balance by millions. The Chief Financial Officer was also responsible for the execution of a false management letter stating that management is not aware of the fraud or irregularities to the auditors. The letter claimed good title to the consignment items and merchandise which was excluded from the inventory. Furthermore, the Chief Financial Officer was also responsible for knowingly filing misleading information and management certifications.
The cause of the irregularities stemmed from lack of the accounting system and internal control process of the DGSE. The lack of formal written procedures and policies, no control over reconciliation of the accounts, use of the antiquated system of accounting, and lack of enough staff in the accounting department. The investigation led the company to restate its financial which were filed from 2009 to 2011. It also undertook extensive actions on remedying the situation by replacing or removing all the prior management positions, consulting with the new independent auditor, engaging the national consulting firm for improvement in the functioning of the accounting system. It improved the reconciliation process of the inventory discrepancies, balanced the past ledgers, instituted blind inventory checking and tracking system, reconciled by Accounting Control Department, and also implemented and reinforced Code of Ethics, Business Conduct, and Related Person Transaction Policy (Pasadena Law, 2014).
The restatements caused the company to make adjustments to 2009 and prior years for a $24.2 million decline in the retained earnings account. The 2010 fiscal year restatement caused an improvement of $5.9 millions of earnings before taxes as compared to the lastly reported 2010 financial results (Miller, 2012).
Any Excerpts of News Articles:
The DGSM irregularities in the accounting information reported in the public filings were reported by several websites; however, as the internet was searched for any loopholes or articles that might have reported it or indicated towards it before the announcement of the misstatement, no such articles could be found. However, the press releases indicate that something dubious might have been happening in the company during this time. These press releases are explained here.
Before the Misstatements were announced:
The Press Releases from the year 2009 as reported in the company’s website show the sale of two pawn shops and the renewal and extension of the credit facility with a Primary bank. Afterward, it announces agreements to execute the acquisition of all equity interests and elimination of debt from Stanford International Bank. The company further announced in 2010 the closing of this transaction leading to $10,500,000 of debt owed to the superior Galleries. Soon after this, the company renews and extends its credit facility with the primary bank again in 2010. In mid-2011, the company acquires Southern Bullion Trading. In the 11th month of 2011, the CFO John Benson retirement was announced.
The conversion of all debt obligations into DGSE common stock is an important financial event which was marked by the President of that time as important for making our financial statement stronger and flexible. The President on the renewal and extension of the credit facility by the primary bank claimed that it shows the expression of confidence by the banking institution on our finances. The company was then focused on emphasizing cash generation and operational improvements. Afterward the company was engaged in the acquisition of Southern Bullion Trading as well, which was an important acquisition for the company. On the retirement announcement of the CFO, which was later charged with these irregularities, the then President thanked for his 19 years of service as the CFO of DGSE. The CFO remained as a consultant to the interim CFO for some period (DGSE Inc, 2013).
The company announced first the late filing in the 10-K for 2011 to the SEC because of the filing of the 8-K of non-reliance on the prior files annual and quarterly statements for the calendar year 2007 to 2011.
It can be said that the events that are quoted here were important enough to show a healthy and balanced financial statement to the stakeholders. However, it is evident that none of the events were dubious enough to raise any concerns in the stakeholders (DGSE, 2009).
An Analysis and Discussion:
Differences in Accounting Policies:
The accounting policies of Zale Corporation show that merchandise inventory is stated at the lower of the market or cost. All inventories are considered as finished goods valued using the LIFO method for retail inventory. The Mappins Jewelers and People Jewelers inventory, on the other hand, are valued First-in First-out method. The company uses the inventories based on their similar characteristics and their average retail selling value and segregates these into categories. The cost of the inventory is calculated by the average cost to retail ratio. 4% of the inventory is considered raw material and is valued at weighted average cost. The company develops indices for the estimation of the inflation and deflation of the merchandise components. It does not use the US BLS price indices. The company also reduces the value of the inventory for the slow-moving, damaged and discontinued inventory.
Shrinkage of the inventory is estimated from the last inventory date to the fiscal year end on a store-by-store basis. The company uses estimates of experience from its last physical inventory. The company takes the physical inventory at least once a year for all of its store locations and its distribution centers.
For revenues, the company recognizes the revenue on the sale of the product reduced by the provision of the sales return. The provision of the sales return is based on the return rate that has been historically used. When the merchandise is repaired and delivered to the customer, then the revenue from repair is recognized. The revenue from the warranties is recognized by using the five-year straight-line method. The insurance premiums are recognized during the coverage period (SEC, 2009).
For DGSE Companies Inc, the significant policies for accounting are disclosed in the annual report. The inventory section of the report showed that it is valued at the lower of the market or cost while the Bullion is also valued similarly at the lower of the cost or market basis or average cost.
For revenues, the recognition varies as per the wholesale and retail transactions and is dependent on the type of arrangement for payments between the parties. The revenue is recognized on a FOB basis of shipping point. The company deals on credit within its industry for 14 to 60 days and never greater than 1 year. The monetary transactions and revenue are recognized when it is shipped to the dealer. Coins to retail customers are also sold on credit for 30-to-60-day term. 25% of the price is collected generally, and a payment schedule is established for the balance remaining while the merchandise is considered as collateral. In case of default, the collateral is priced commercially, and proceeds are extinguished for the balance while the excess amount is disbursed to the customer. The company recognizes the revenue when the customer agrees to the credit terms, and initial payment is made. The company also exchanges merchandise with merchandise and or monetary compensation to customers and dealers. In case of merchandise exchange with no monetary compensation, no revenue is recognized, while in the case of monetary compensation, revenue is recognized for its extent and cost of sale is determined on the ratio of the monetary assets collected to the non-monetary and monetary compensation collected multiplied by the cost of the assets that have been surrendered (SEC, 2011).
Disclosure Practices:
The disclosure about the market risk in quantitative and qualitative disclosures shows that during the year 2009, the company witnessed depreciation in the Canadian currency by 10% as compared to the US Dollar. It resulted in a decline in the reported revenues by $35 million, which was offset by the decline in the cost of sales of $17.2 million and by $12.9 million declines in the administrative and selling expenses. The company also disclosed the loss reported due to the depreciation in the Canadian Dollar in the accounts payable of the company by $8.6 million in 2009 as compared to the $1 millions of gains in 2008.
The company has disclosed in its Controls and Procedures that the company evaluated the effectiveness of the operation and design of the disclosure procedures and controls under the supervision of the management. It disclosed that its disclosure procedure is not effective to record, process, summarize and report in time the important information in its periodic reports. However, it still considers that the event with the ineffectiveness of the internal control procedures for financial reporting, the financial statements conform to GAAP requirements and is fairly representing the financial condition of the company (SEC, 2009).
For the DGSE Companies Inc. the qualitative disclosures and quantitative disclosures regarding the market risk and the forward-looking statements and the Disclosure Procedures and Controls show that the evaluation of the management as the internal controls system as effective (SEC, 2011).
Quality of Reporting Practices
The quality of the reporting practices is clear after looking at the disclosure practices and the internal control procedure evaluations, and the inventory and revenue recognition policies adopted by the two companies. Zale Corporation has not only used various methods of inventory valuations for each segment of the inventory as appropriate, but it has also given full detail for it. The inventory reporting practice for DGSE Inc is not only very ineffective as all inventory is just valued for the lower of the cost or market value or the average cost. The revenue recognition for the DGSE Inc is also very all over the place, as for some sources of revenue they use credit agreements, and recognize it before the complete payment, for others revenue is recognized while the merchandise is delivered to the customer or dealer. The company then also deals in merchandise exchange which is exchanged with assets or/and monetary compensation that is recognized on a comparison of the evaluation of the asset value that is given and received.
Practices that were used to misrepresent the problems:
As we know, DGSE Inc has used its inventory valuations for misrepresentation of the balance and has made some inappropriate adjustments to the general ledger. The accounting procedure for the recognition of revenue and the recognition of inventory both shows that DGSE internal control system and the accounting policies were very confusing and ineffective. Furthermore, it is interesting to note that Zale Corporation management considered the internal control process and disclosure procedure of Zale as ineffective while DGSE found it’s as effective.
A Comparative Analysis:
Financial Ratios:
The financial ratios are used for assessment of the financial position of the company. It is the reason it is being used here to evaluate if the financial condition of the DGSE Companies Inc could have shown any indication of irregularities in the statements.
Liquidity Ratios:
The liquidity ratios include the current, quick and cash ratios. For DGSE Companies Inc, the current ratio, quick ratio, and cash ratio are higher than Zale Corporation current ratios. However, one important thing to notice about the liquidity ratios is that the quick ratio is very low as compared to the current ratio showing that much of the current assets are tied up in the inventory assets. It is also evident for the Zale Corporation liquidity ratios as shown in the graph as well.
Efficiency Ratios:
The Inventory Turnover ratio for DGSE is higher compared to the Zale Corporation, while the Fixed Assets Turnover and Asset Turnover are also higher comparatively. For both assets turnover the turnover is lower for Zale, but it is appropriate as per the company values. However, the inventory turnover for Zale is much lower when compared to DGSE Inc.
It means that DGSE Inc is quickly selling its inventory into sales as compared to Zale.
Profitability Ratios:
For the profitability analysis, it is evident that the gross profit margin for DGSE is lower as compared to Zale significantly. However, the operating Profit Margin even in the negative is higher as compared to Zale. Finally, the net profit margin is positive for DGSE Inc and negative for Zale Inc. It shows that the company is making a profit from its discontinued operations.
Solvency Ratios:
As shown in the above graph, the Times Interest Earned is negative for both companies, with lower for DGSE Inc as compared to Zale Corporation. The Total Debt to Total Assets ratio is higher for Zale, showing it has more effectively used its debt financing than DGSE Inc. Similarly, the Debt-to-Equity Ratio is much higher for Zale, showing its more dependency on the Debt as compared to DGSE Inc.
DuPont Analysis:
The DuPont Analysis of both companies shows that the ROE for DGSE is much better than Zale Corporation. The result is elaborated in the graph below showing that because of the higher Asset turnover, and lower debt to equity ratio the company DGSE Inc has greater ROE.
(DGSE Inc, 2018; Morgan Lewis, 2014; BizJournals.com, 2012)
Overall, the financial ratio analysis does not show any indication of irregularities in the DGSE Inc Financials.
Common Size Analysis
The Common Size Analysis of the DGSE Income statement shows that the company holds about 85% of its revenue as cost of sales while about 4.5% was written off in 2010 in inventory impairment. Furthermore, all operating expenses accounted for 104% of the revenue in 2010 and 98% of revenue in 2009. For Zale Corporation, the common size analysis of the income statement shows that about 49% in 2010 and 53% in 2009 of the revenue was tied into the cost of sales. Altogether, the operating expenses accounted for more than revenue in both years. It resulted in negative income for both years.
For balance Sheet, DGSE Inc most of the assets are tied up in current assets (64% in 2010 and 66% in 2009) mostly in the inventories (56% in 2010 and 56% in 2009). About 14% is tied in property and equipment. While in 2009, about 60% was debt, it was lowered to 38% in 2010. For Zale Corporation, 66% of the assets are tied to current assets with 60% tied to inventories. The debt portion is about more than 50% of the total capital.
A Brief Review of Corporate Governance & Compensation Practices:
The comparison of the corporate governance practices of both companies during the years 2009 and 2010is based on the information derived from their then filed 10-K Reports during these years. If we look at the Corporate Governance of the DGSE Companies Inc for its year 2009 via its Schedule 14A for information on Definitive Proxy Statement, it is different to that reported in 2012. The difference in formatting, flow, and organization of the proxy statement is the first change one notices. The report shows first that the company is going to pay $164,299 in Audit Fees and Taxes to Cornwell Jackson for its services as independent registered public accountant’s fees. The company maintains its Corporate Governance page on the website showing the Code of Ethics and Business Conduct including the whistleblower protection policy and charter for the board of director’s audit committees. The requirements for Corporate Governance as per the NYSE Amex and the Sarbanes Oxley Act of 2002 show that.
All members of the Audit Committee are independent while the majority of the members of the board are independent of the company and its management. The independent members meet them on a regular basis in the non-presence of management. The company has a clear cost of ethics and business conduct which is applied to directors, employees, executive officers and monitored by the Committee on Audit. The Audit committee has a procedure which ensures that anonymous submission of complaints by employees can be made regarding the auditing, internal accounting control matters. The report shows that the company does not exercise and does not have any established charter or committee for a standing nominating process. The company does not find it necessary as all of the directors were nominated under the agreement of corporate governance. The Audit Report of 2009 shows that the Audit Committee has approved the financial statements after discussion with the management and independent accounting firm to be included in the 10-K filing. John Benson, the charged chief financial officer, was the director during this time. He has been the chief financial officer since 1992 for the company and between these periods he also served on the board of directors for Superior Galleries Inc for some months. The Audit Report for 2010 is well organized, longer, including more detail of audit and corporate governance contents (SEC, 2010). The compensation of the Executives shows that John Benson had a salary of $175,000 in total (SEC, 2009).
The audit committee of DGSE Inc holds three members with an additional new independent director appointed after the reform. The board of directors of the company has four directors in which 2 new independent directors were appointed after the reform. About three-fifths of the directors of the board are independent. The company has also appointed lead independent director. The Audit Committee is required to meet at least 4 times annually. The board audit committee financial expert position is chaired by Alexandra C Griffin. All four members of the board are independent directors. The board is expected to meet quarterly and also hold an annual board meeting as well. The compensation of the executives is based on base salary, annual cash bonus and long-term incentive awards.
(SEC, 2018)
The Compensation of the Zale Corporation shows a more detailed description of the company compensation. The company has implemented and developed the compensation program of pay-for-performance, which rewards its executives for improving the stockholder value and their performance. It is done by giving the executive equity-based compensations and performance bonuses. The company uses competitive data and peer group compensations for the establishment of the compensation levels. The Executive Compensation Program is based on a base salary, annual cash incentive (performance bonuses) and long-term compensation (stock options) (SEC, 2010).
For Zale Corporation, the Audit Committee has three members who had meetings eight times in 2018. All members are independent as per SEC and NASDAQ rules. Mr. Willis is the financial expert of the audit committee. The board of directors of the Zale Corporation has seven independent directors. The board meets quarterly and annually. The compensation of the executives is based on 55% base salary, 16% long-term incentives and 29% of short-term incentives (SEC, 2018).
The Corporate Governance practices of Zale Corporation are much more extensive and detailed as compared to DGSE Inc more specifically before the enactment of their New CFO. The Audit Committee of Zale Corporation, compensation committee, Nominating, and Corporate Governance Committee workings and responsibilities are clearly stated in the 14-A Schedule of the company proxy statement.
Conclusion:
Concluding, it is evident that the company DGSE Inc irregularities in the financial statements were expected as the company lacked in its internal control procedures, inventory valuation, revenue recognition, and corporate governance practices. Furthermore, even though the ratio analysis and common size analysis did not show any indication of the irregularities during these years, the analysis of the accounting principles and estimates and revenue recognition policies and its comparison with the policies and procedures adopted by Zale Corporation shows that the company procedures were very confusing and misleading, and such loopholes surely provided aid in practicing inappropriate accounting procedures. The inventory account is found to be of a most important asset regarding this industry. Its valuation influences the financial position of the company, its liquidity, its efficiency, and to some extent its solvency as well. The irregularity and unclear valuation of the inventory in DGSE shows how inadequate the system was in its processes.
The company DGSE Inc has reportedly strengthened its corporate governance practices by making improvement and changes to the procedures, and policies for better compliance with the laws and regulations and for increasing the oversight of the compliance function by the board. It has increased its enhancement of procedures, controls, and added two directors. The establishment of Lead Independent Director and increasing functionality of Inventory control Department, modification of the Compensation recovery policy, and executive practices have been introduced. New initiatives regarding the third-party whistleblower, director education, term limits, and formation of the Nominating Committee, Governance Committee, and Compliance Committee are expected to increase the exposure of the board and help improve corporate governance.
All in all, the irregularities in the company were because of the wrong practices of the company Finance department, as headed by the CFO of the company 19 years and inadequate oversight of the board.
References:
BizJournals.com. (2012, November 1). DGSE planning stores in Atlanta. Retrieved from BizJournals.com: https://www.bizjournals.com/atlanta/news
/2012/11/01/dgse-planning-stores-in-atlanta.html
DGSE Inc. (2018). DGSE Inc. Retrieved from Yahoo Finance: https://nz.finance.yahoo.com/quote/DGSE/?p=DGSE&guccounter=1
DGSE Inc. (2013, September 30). Form 8-K DGSE Inc. Retrieved from DGSE Inc: http://www.dgsecompanies.com/
StockHolderNotice/Form8k
DGSE. (2009). Press Room. Retrieved from DGSE: http://www.dgsecompanies.com/news
Miller, J. (2012, November 1). DGSE Restates Financial Results, Discovers Irregularities. https://www.diamonds.net/News/NewsItem.
aspx?ArticleID=41467&ArticleTitle=DGSE+Restates+
Financial+Results%2C+Discovers+Irregularities#
Morgan Lewis. (2014, June 2). Financial Reporting and the Law. Retrieved from Morgan Lewis: https://www.morganlewis.com/blogs/financial
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Pasadena Law. (2014, May 29). Accounting Fraud Leads To Settlement With SEC. https://www.pasadenalaw.com/blog/2014/05
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