J Sainsbury Plc Reports: 2003-2006

J Sainsbury plc Reports: 2003-2006

A Brief Backgrounder

J. Sainsbury plc owns Sainsbury's Supermarkets (hereafter Sainsbury's), the U.K.'s third largest retailer after Tesco and Asda. For many years since it opened for business in 1869, Sainsbury's was the country's biggest supermarket, the undisputed market leader. A series of mis-steps allowed competitor Tesco to catch up in 1995. In 2003, Asda passed Sainsbury's, relegating the latter to third position where it stays.

Sainsbury's is now playing catch up, regaining market share one percentage point at a time. A publicly listed corporation since 1973, the company is on the renewal trail as it attempts to regain its leading position in the industry. Using a combination of common management tools in a wide range of areas, from stocking its shelves full with items customers want to buy to executing on a complete revamp of its information technology and supply chain management systems, a new senior management team is revitalising the whole organisation from top to bottom.

This brief history helps us analyse the period 2003 to 2006, during which Sainsbury's hit the dust with their first-ever revenues slump in history (in the year ended March 2005) and then as nimbly picked itself up and began staging a comeback. We can learn how they are doing by studying the company's annual reports which are the "official" snapshots of the whole corporation each year. Just like any other company at the mercy of its stakeholders (Freeman, 1984), Sainsbury's is expected to behave to satisfy everyone.

First Question

Identify significant areas of the accounts for 2006 where judgment has been used in determining the appropriate accounting policy for the company (for example depreciation of fixed assets). Critically discuss how such judgments have materially affected the accounts in terms of valuation and profitability.

There are several portions in Sainsbury's 2006 report indicating where judgment has been used to determine the appropriate accounting policies. Note 2 on Accounting Policies (Sainsbury's, 2006a, p. 56-59) is the second longest portion of the report's general section of Notes to the Financial Statements (p. 51-101), next to Note 42 which is on the financial reporting transition to IFRS (p. 91-98).

From the long list of accounting policies, we note the following that in our opinion materially affected the accounts in terms of valuation and profitability:

 The 2006 reports are the Group's and Company's first financial statements prepared under IFRS and therefore, IFRS 1 'First-time Adoption of International Financial Reporting Standards' was applied. The last statements under UK Generally Accepted Accounting Principles ("UK GAAP") were for the 52 weeks to 26 March 2005. An explanation of the transition to IFRS is provided in Note 42. A comparison of the GAAP-based 2005 and IFRS-based 2005 reports showed that whilst non-current assets declined by almost Ј3 billion, total equity declined by only Ј33 million thanks to adjustments in net current liabilities of over Ј2.9 billion. This shows how numbers can surprisingly appear and vanish like magic.

 Early adoption of the standard Amendment to IAS 19 'Employee Benefits' is effective for annual periods beginning 1 January 2006, i.e. beginning 26 March 2006. However, Sainsbury's elected to early adopt this amendment and has applied the requirements of the amendment to the financial statements for the 52 weeks to 25 March 2006. This led to gross actuarial gains of Ј128 million (Note 42, p. 95), cutting the pension deficit from Ј672 million to only Ј375 million due to a deferred income tax asset. This allowed Sainsbury's to conveniently finance the pension fund and contribute towards improving employee motivation.

 The treatment of Subsidiaries and Goodwill allowed Sainsbury's to manufacture current year profits growth from its sale of Shaw's in 2004 by recycling Ј123 million of the goodwill write down from its 2005 results (p. 96), adding net Ј86 million to profits (See note on p. 95). Goodwill is now not allowed under IFRS.

 Intangible and tangible assets are carried at cost less accumulated amortisation and any impairment loss and amortised on a straight-line basis over their useful economic life (15 years for pharmacy licences and three to five years for computer software). Impairment loss is based on annual valuation, for which management utilises its own judgment. Note 13 (p. 66) shows that there was a total amortisation and impairment loss (thus, a decrease in book value) of only Ј53 million in 2006. The fine print at the bottom of the page details how this happened (for Goodwill, pharmacy licences, and computer software) and how management decided that there was no impairment of Goodwill in the year based on future performance. How they valued (or decided not to devalue) such an intangible asset is mystical but, we hope, generally accepted.

 Property and other tangible assets are stated at cost less accumulated depreciation and any recognised impairment loss. Depreciation is calculated to write down the cost of the assets to their residual values, on a straight-line method ranging from zero (freehold land), 3 to 15 years (fixtures, equipment, and vehicles), or to 50 years (or the lease term if shorter) for freehold buildings and leasehold properties. The longer the depreciation period, the lower the expenses and the higher would be the profits, earnings, the valuation of the company, and its stock price. Voila! Incentives for managers and employees with stock options would improve.

 Capitalisation of interest for capital acquisition or construction and capitalisation of lease incentives are accounting tricks designed to convert interest and rental expenditures from an operating expense to a manner of inflating asset values. We find this similar to owning a part of the airline company every time we buy a plane ticket. Alright, it is unbelievable, but an accepted accounting manoeuvre.

 In the heat of the option back-dating scandals in many companies, we note with optimism the amount of forfeited stock options at Sainsbury's (50.2 million in 2006) due to poor stock price performance. The company stopped granting options under their Colleague Share Option Plan and then re-designed their stock incentives plan based not only on share price performance but on total shareholder returns in comparison with its industry peers. This is a good way of protecting other shareholders from greedy managers and the agency costs