the auditor’s opinion
On my first day of OJT in equity securities analysis, the instructor asked our class what the most important page of a company’s annual report/10k filing is. The correct answer, which escaped most of us, is: the one that contains the auditor’s assessment of the accuracy of the financials and the state of health of the company. The auditor’s report is usually brief and formulaic. Longer = trouble.
Anything less than a clean bill of health is a matter grave concern. The worst situation is one in which the auditor expresses doubt about the firm’s ability to remain a going concern.
a new financial accounting rule
In today’s world, that class would be a little different. Yes, the auditor’s opinion is the single most important thing. But new, post-recession financial accounting rules that go into effect with the 2016 reporting year require the company itself to point out any risks it sees to its ability to remain in business.
the Sears case
That’s what Sears did when it issued its 2016 financials in late March. What’s odd about this trailblazing instance is that while the firm raised the question, its auditors issued an “unqualified” (meaning clean-bill-of-health) opinion.
what’s going on?
Suppliers to retail study their customers’ operations very carefully, with a particular eye on creditworthiness. That’s because trade creditors fall at the absolute back of the line for repayment in the case of a customer bankruptcy. They don’t get unsold merchandise back; the money from their sale will likely go to interests higher up on the repayment food chain–like employee salaries/pensions and secured creditors. So their receivable claims are pretty much toast.
Because of this, at the slightest whiff of trouble, and to limit the damage a bankruptcy might cause them, suppliers begin to shrink the amount and assortment of merchandise, and the terms of payment for them, that they offer to a troubled customer. My reading of the Sears CEO’s recent blog post is that this process has already started there.
It may also be, assuming I’m correct, that the effects are not yet visible in the working capital data from 2016 that an auditor might look at. Hence the unqualified statement. But we’re at the very earliest stage with the new accounting rules, so nothing is 100% clear.
breaking a contract?
Sears has complained in the same blog post about the behavior of one supplier, Hong Kong-based One World, which supplies Craftsman-branded power tools to Sears through its Techtronic subsidiary. Techtronic apparently wants to unilaterally tear up its contract with Sears and stop sending any merchandise.
Obviously, Sears can’t allow this to happen. It’s not only the importance of the Craftsman line. If One World is successful, other suppliers who may have been more sympathetic to Sears will doubtless expect similar treatment.
Developments here are well worth monitoring, not only for Sears, but as a template for how new rules will affect other retailers.