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DGSE > SEC Filings for DGSE > Form 10-K on 31-Oct-2012All Recent SEC Filings

Show all filings for DGSE COMPANIES INC

Form 10-K for DGSE COMPANIES INC


31-Oct-2012

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.

Unless the context indicates otherwise, references to "we," "us," "our," "the Company" and "DGSE" refer to the consolidated business operations of DGSE Companies, Inc. (the parent) and all of its direct and indirect subsidiaries.

CAUTIONARY STATEMENT REGARDING RISKS AND UNCERTAINTIES THAT MAY AFFECT FUTURE RESULTS

Forward-Looking Statements

This Form 10-K, including but not limited to this Item 7, information concerning our business prospects or future financial performance, anticipated revenues, expenses, profitability or other financial items, including the outcome of the investigation by the SEC, described in more detail in Item 1, "BUSINESS" or other pending litigation, and our strategies, plans and objectives, together with other statements that are not historical facts, includes "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Forward-looking statements generally can be identified by the use of forward-looking terminology, such as "may," "will," "would," "expect," "intend," "could," "estimate," "should," "anticipate" or "believe." We intend that all forward-looking statements be subject to the safe harbors created by these laws. All statements other than statements of historical information provided herein are forward-looking and may contain information about financial results, economic conditions, trends, and known uncertainties. All forward-looking statements are based on current expectations regarding important risk factors. Many of these risks and uncertainties are beyond our ability to control, and, in many cases, we cannot predict all of the risks and uncertainties that could cause our actual results to differ materially from those expressed in the forward-looking statements. Actual results could differ materially from those expressed in the forward-looking statements, and readers should not regard those statements as a representation by us or any other person that the results expressed in the statements will be achieved. Important risk factors that could cause results or events to differ from current expectations are described under the section of this Form 10-K entitled "Risk Factors" and elsewhere in this Form 10-K. These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to release publicly the results of any revisions to these forward-looking statements which may be made to reflect events or circumstances after the date hereon, including without limitation, changes in our business strategy or planned capital expenditures, store growth plans, or to reflect the occurrence of unanticipated events.

Critical Accounting Policies and Estimates

Our significant accounting policies are disclosed in Note 1 of our consolidated financial statements. The following discussion addresses our most critical accounting policies, which are those that are both important to the portrayal of our financial condition and results of operations and that require significant judgment or use of complex estimates.

Inventories. All inventory is valued at the lower of cost or market. We acquire a majority of our inventory from individual customers, including pre-owned jewelry, watches, bullion, rare coins and collectibles. We acquire these items based on our own internal estimate of the fair market value of the items at the time of purchase. We consider factors such as the current spot market price of precious metals and current market demand for the items being purchased. We supplement these purchases from individual customers with inventory purchased from wholesale vendors. These wholesale purchases can take the form of full asset purchases, or consigned inventory. Consigned inventory is accounted for on our balance sheet with a fully offsetting contra account so that consigned inventory has a net zero balance. The majority of our inventory has some component of its value that is based on the spot market price of precious metals. Because the overall market value for precious metals regularly fluctuates, these fluctuations could have either a positive or negative impact on the value of our inventory and could positively or negatively impact our profitability. We monitor these fluctuations to evaluate any necessary impairment to its inventory.

Impairment of Long-Lived and Amortized Intangible Assets. We perform impairment evaluations of our long-lived assets, including property, plant and equipment and intangible assets with finite lives whenever business conditions or events indicate that those assets may be impaired. When the estimated future undiscounted cash flows to be generated by the assets are less than the carrying value of the long-lived assets, the assets are written down to fair market value and a charge is recorded to current operations. Based on our evaluations, no impairment was required as of December 31, 2011 or 2010.

In relation to the acquisition of SBT, described in Item 1, "BUSINESS," of this Form 10-K, the excess of purchase price over tangible assets acquired was calculated at $3,412,896. After review and analysis, our Current Management believes this excess value should be treated as an Intangible, with a 15-year life. Specifically this intangible value is attributed to the "Southern Bullion Coin & Jewelry" trade name. While our management currently plans to continue and expand use of the trade name indefinitely, as matter of conservatism it believes that using a 15 year life is appropriate. Given this determination, this Intangible asset valued at $3,412,896 will be amortized over its 15 year life, generating a non-cash amortization expense of $227,526 annually.

Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform our annual review at the end of each fiscal year, unless events occur that dictate testing on an interim basis.

As of December 31, 2009, we were carrying Goodwill of $837,117 related to the acquisition of Fairchild , and $2,464,006 million of Intangible Assets related to the purchase of Superior . An analysis was performed by our prior management as of December 31, 2009 which determined that neither amount should be impaired. As part of the current review and restatement, our Current Management has reviewed these earlier analyses, including review of the assumptions used at that time, as well as comparison of projections with actual results achieved in subsequent periods. Our Current Management believes that these assets should have been fully impaired as of December 31, 2009, and as a result these assets have been written off with a corresponding reduction to retained earnings as of that point. As of December 31, 2011 and 2010, we had no goodwill recorded.

Revenue Recognition. Revenue is generated from wholesale and retail sales of jewelry, rare coins and currency, bullion and scrap. The recognition of revenue varies for wholesale and retail transactions and is, in large part, dependent on the type of payment arrangements made between the parties.

We sell jewelry, rare coins and currency to other wholesalers/dealers within our industry on credit, generally for terms of 14 to 60 days, but in no event greater than one year. We grant credit to new dealers based on extensive credit evaluations and for existing dealers based on established business relationships and payment histories. We generally do not obtain collateral with which to secure our accounts receivable when the sale is made to a dealer.

Revenues for monetary transactions (i.e., cash and receivables) with dealers are recognized when the merchandise is shipped to the related dealer.

We do not grant credit to retail customers, however we do offer a structured layaway plan. When a retail customer utilizes the our layaway plan, we collect a minimum payment of 25% of the sales price, establish a payment schedule for the remaining balance and hold the merchandise as collateral as security against the customer's receivable until all amounts due are paid in full. Revenue for layaway sales is recognized when the merchandise is finally paid for in full and delivered to the retail customer.

In limited circumstances, we exchange merchandise for similar merchandise and/or monetary consideration with both dealers and retail customers, for which we recognize revenue in accordance with ASC 845, Nonmonetary Transactions. When we exchange merchandise for similar merchandise and there is no monetary component to the exchange, we do not recognize any revenue. Instead, the basis of the merchandise relinquished becomes the basis of the merchandise received, less any indicated impairment of value of the merchandise relinquished. When we exchange merchandise for similar merchandise and there is a monetary component to the exchange, we recognize revenue to the extent of the monetary assets received and determines the cost of sale based on the ratio of monetary assets received to monetary and non-monetary assets received multiplied by the cost of the assets surrendered.

We have a return policy (money-back guarantee). The policy covers retail transactions involving jewelry and graded rare coins and currency only. Customers may return jewelry and graded rare coins and currency purchased within 30 days of the receipt of the items for a full refund as long as the items are returned in exactly the same condition as they were delivered. In the case of jewelry and graded rare coins and currency sales on account, customers may cancel the sale within 30 days of making a commitment to purchase the items. The receipt of a deposit and a signed purchase order evidences the commitment. Any customer may return a jewelry item or graded rare coins and currency if they can demonstrate that the item is not authentic, or there was an error in the description of a graded coin or currency piece. Returns are accounted for as a reversal of the original transaction, with the effect of reducing revenues, and cost of sales, and returning the merchandise to inventory.

Accounts Receivable. We record trade receivables when revenue is recognized. When appropriate, we will record an allowance for doubtful accounts, which is primarily determined by review of specific trade receivables. Those accounts that are doubtful of collection are included in the allowance. These provisions are reviewed to determine the adequacy of the allowance for doubtful accounts. Trade receivables are charged off when there is certainty as to their being uncollectible. Trade receivables are considered delinquent when payment has not been made within contract terms. As of December 31, 2011 and 2010, we did not have an allowance for doubtful accounts recorded.

Income Taxes. Income taxes are accounted for under the asset and liability method prescribed by ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not such assets will be realized.

We account for our position in tax uncertainties in accordance with ASC 740, Income Taxes. The guidance establishes standards for accounting for uncertainty in income taxes. The guidance provides several clarifications related to uncertain tax positions. Most notably, a "more likely-than-not" standard for initial recognition of tax positions, a presumption of audit detection and a measurement of recognized tax benefits based on the largest amount that has a greater than 50 percent likelihood of realization. The guidance applies a two-step process to determine the amount of tax benefit to be recognized in the financial statements. First, we must determine whether any amount of the tax benefit may be recognized. Second, we determine how much of the tax benefit should be recognized (this would only apply to tax positions that qualify for recognition.) No additional liabilities have been recognized as a result of the implementation. We have not taken a tax position that, if challenged, would have a material effect on the financial statements or the effective tax rate during Fiscal 2011 and Fiscal 2010, respectively.

Restatement of our Consolidated Financial Statements

We previously filed our Form 10-K for Fiscal 2010 on April 15, 2011. We were obligated to file our Form 10-K for Fiscal 2011 by March 30, 2012. On March 30, 2012, we filed a Form 12b-25 with the SEC stating that we were unable to file the Form 10-K by the prescribed filing date. On April 16, 2012 we filed a Current Report on Form 8-K disclosing that our Board had determined the existence of certain Accounting Irregularities beginning approximately during the second calendar quarter of 2007 and continuing in periods subsequent thereto, which could affect financial information reported since that time. We also announced that we had engaged forensic accountants to analyze the Accounting Irregularities, and that financial statements and information reported since the inception of the Accounting Irregularities, believed to be the second calendar quarter of 2007, should not be relied upon for investment purposes.

In addition to engaging new independent auditors, we have removed and replaced the Chairman of the Board, the Chief Executive Officer, the President and all senior finance staff members, including the Chief Financial Officer and our previous Controller. Since the departure of all individuals who had critical decision making authority during the Accounting Irregularities, we have had very limited access to most of these individuals. As a result, the reasoning behind or motivation for the many and significant Accounting Irregularities remains largely unknown. Our Current Management has focused a very significant amount of time, energy, money and human resources on uncovering and correcting these Accounting Irregularities to provide our shareholders with restated information that can be relied upon for investment purposes, as well as assurance that financial information provided by us going forward is true and correct and may be properly relied upon.

The following sections present information on all material restatements made to Fiscal 2010 and Fiscal 2011, as well as changes that impacted prior periods which are represented by an adjustment in December 31, 2009 retained earnings.

Remediation Efforts To Date Under Current Management

With the appointments of Mr. Vierling as Chairman of the Board, Chief Executive Officer and President, Mr. Burford as Chief Financial Officer, Mr. Clem as Chief Operating Officer, along with other key additions, we believe that we have significantly increased the integrity, professionalism, and quality of our senior leadership team

In order to maintain an effective system of internal controls over financial reporting, we have appointed qualified and experienced senior officers and finance professionals, and implemented appropriate checks and balances on their authority, to ensure the integrity of our financial statements. In addition, Current Management has utilized the expertise of a respected national accounting firm, whom it has engaged to assist management in preparing and documenting an improved system of internal controls. Current Management has already enacted the following changes, in order to prevent a recurrence of the deficiencies which previously led to the Accounting Irregularities.

Changes in Independent Auditors

The engagement of an independent registered accounting firm, reporting directly to the Audit Committee, is an essential component of our internal controls over financial reporting. On May 29, 2012, we dismissed Cornwell Jackson and Company, P.C. ("Cornwell Jackson") as our independent registered public accounting firm. On that same date, we retained Whitley Penn LLP ("Whitley Penn") as our independent registered public accounting firm.

Changes in Accounting Systems and Financial Reconciliation Procedures

Prior to mid-2010, we used an older, unsupported version of the MAS90 accounting system. In mid-2010, Prior Management implemented the AccountMate Enterprise Resource Planning system ("AccountMate"). During that process, Prior Management made significant errors in the set-up, conversion and implementation of AccountMate, which caused discrepancies and irregularities in balancing the detailed subsystem to the general ledger. In early 2012, as we began to prepare this Form 10-K, we recognized these errors.

In order to remediate the errors, Current Management engaged a national consulting firm that specializes in AccountMate. Management believes that the issues identified in early 2012 have been addressed, and we have implemented sufficient controls to ensure inadequate or inappropriate changes to AccountMate are not repeated. We have continued to implement improvements to AccountMate, including added enhancements for Point-Of-Sales transactions, RFID for inventory control, more robust journal entry processes and procedures, more robust periodic reconciliation processes and procedures, and additional detailed cash management reporting. In addition, we have utilized a respected, national accounting firm to assist in the reconciliation of prior year inventory discrepancies and to balance the general ledger to our physical inventory counts.

Changes in Inventory Control Processes and Procedures

Current Management identified several weaknesses in the processes and procedures we historically utilized to control our inventory. In order to remediate these deficiencies, Current Management has taken the following steps:

We have created an Inventory Control Department ("ICD") which reports directly to the Chief Operating Officer. This department's main purpose is to provide an internally independent reconciliation of the detailed inventory subsystem to the general ledger, and propose appropriate adjustments. All adjustments must be approved by the Chief Operating Officer prior to entry into AccountMate. These inventory adjustments are audited on a monthly basis by the Controller, utilizing AccountMate's system-generated reports. This audit is then reviewed with the Chief Financial Officer for validity.

Each of our locations performs a monthly blind inventory that is reconciled independently by the ICD and monitored by the Chief Executive Officer and Chief Operating Officer for accuracy and completeness.

The cost requirement for an item to receive a unique inventory item number in the AccountMate Inventory Module has been systematically reduced from $250 to $50. Current Management plans to continue to reduce this cost ceiling over time.

All inventory items at key locations with a value of greater than $50 per unit are physically tagged with an RFID device. These devices allow accurate and timely scanning of inventory by Store Managers and the ICD, as well as serving as a deterrent to inventory loss and/or theft when paired with store level door portals. RFID tags also allow the Store Managers to conduct a blind count of inventory that can be independently reconciled by the ICD.

December 31, 2009 - Adjustment to Retained Earnings

A review of journal entries made by Prior Management at year-end 2009 revealed an $8,283,469 entry that increased inventory by $7,004,063, reduced customer deposits by $1,000,000, and increased other assets by $279,406. No support could be found for this adjustment and Current Management does not believe this entry to be appropriate. As a result these amounts have been reversed, with the impact being an $8,283,469 reduction of retained earnings.

Additional review and analysis related to inventory balances in various inventory accounts determined that as of December 31, 2009 inventory was additionally overstated by $4,660,824, which has been corrected with a resulting charge to retained earnings.

As of December 31, 2009, we were carrying goodwill of $837,117 related to the acquisition of Fairchild, and $2,464,006 of Intangible Assets related to the purchase of Superior. Analysis was performed by prior management as of December 31, 2009, which determined that neither amount should be impaired. As part of the current review and restatement, Current Management has reviewed these earlier analyses, including review of the assumptions used at that time, as well as comparison of projections with actual results achieved in subsequent periods. Current management believes that these assets should have been deemed to be fully impaired as of December 31, 2009, and as a result these assets have been written off with a corresponding reduction to retained earnings as of that point.

On November 29, 2011, we and our subsidiary, Superior, entered into a settlement agreement with FASNAP in relation to a lawsuit filed against us in California. The lawsuit resulted from a transaction under Prior Management in which we sold rare coins in our possession which belonged to FASNAP, who had not given us authorization to sell the coins. Under the terms of the settlement agreement, we returned the remaining coins which were still in our possession, and we agreed to pay FASNAP the approximate market value of those coins which had been sold. The total cost of the settlement agreement was $2,560,713. Upon review of the facts leading to the lawsuit and settlement, our Current Management believes that under U.S. GAAP we had sufficient information to accrue for this settlement as a contingent loss, as early as 2009. As a part of the current review and restatement, we have has recognized this accrual through a reduction to retained earnings as of December 31, 2009.

As of December 31, 2009, we had a deferred tax asset of $1,731,175 on our balance sheet, related to our prior net operating losses. Pursuant to GAAP, such a tax asset should be reviewed as to the likelihood of us being able to utilize the asset in the future, to offset future tax liabilities related to taxable earnings. Current Management believes that based on our cumulative three year losses at that point, that a full valuation allowance was warranted. As part of the current restatement process, this valuation allowance has been recorded, along with a corresponding $1,731,175 reduction to 2009 retained earnings. A federal income tax receivable for $639,372 was also established by Prior Management as of December 31, 2009 and no support can be found for this amount, nor has it been subsequently received by us. As a result, this receivable is being written off to retained earnings as well.

We acquired Superior in May of 2007. As part of this transaction we assumed an existing $11,500,000 credit facility that Superior had with Stanford International Bank, Ltd. ("SIBL"). Per the credit agreement, interest on this facility was to be paid at the prime rate. Upon review, no interest was accrued or paid on this debt from inception until the debt was extinguished as part of the larger settlement with SIBL in January of 2010. Interest that should have been accrued from January of 2007 through December of 2009 has been calculated at $1,350,000, with a corresponding reduction being made to retained earnings as of December 31, 2009.

On February 26, 2010, Prior Management entered into a settlement agreement for a lawsuit filed by the previous landlord of our Superior facility in Beverly Hills, CA, DBKK for $385,000 to be paid over three years, bearing interest at 8%. The lawsuit resulted from a lease transaction entered into by certain officers of Superior. As of December 31, 2010, we had recorded a $385,000 loss related to the settlement of this litigation in other (income) expense. Upon review of the facts leading to the lawsuit and settlement, Current Management believes that under U.S. GAAP we had sufficient information to accrue for this settlement as a contingent loss, as early as 2009. As a part of the current review and restatement, we are recognizing this accrual through a reduction to retained earnings as of December 31, 2009.

A review by Current Management of prepaid expenses on the balance sheet as of December 31, 2009 revealed many items that either had no supporting documentation, had no future value to us, or should have been partly or fully amortized and were not. The total value of these items was $373,176, and this amount has been charged to retained earnings as of December 31, 2009.

In addition to the above amounts, a review under the guidance of Current Management has revealed numerous other accounting errors, primarily in relation to amounts posted to the balance sheet with missing, insufficient or incorrect supporting data. In many cases it has been difficult or impossible to accurately match detail or sub-ledger amounts to the general ledger balances. In these situations, Current Management has chosen to adjust balances to amounts that can be reasonably supported with an appropriate level of detail. These areas include accounts payable, accounts receivable, customer deposits, fixed assets and associated accumulated depreciation, as well as rent and escrow payments on leased properties. The cumulative adjustments related to all of these areas, results in an additional $884,443 reduction to retained earnings as of December 31, 2009.

The total of all adjustments related to Fiscal 2009 and prior years, results in a $24,169,295 reduction of retained earnings, as of December 31, 2009.

December 31, 2010 - Restatement

As noted in the Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as part of our year-end close, we adjusted inventory by approximately $3,771,702 (the "2010 Inventory Adjustment") in order to reflect multiple book to physical and other inventory reconciling items. Based on the recent review and restatement efforts, Current Management has determined that the 2010 Inventory Adjustment was improperly accounted for in Fiscal 2010, and should have been accounted for in earlier periods. Accordingly, the 2010 Inventory Adjustment has been incorporated in its entirety into the 2009 adjustments detailed above. As a result, the 2010 Inventory Adjustment has been reversed out of Fiscal 2010, eliminating the previously reported Inventory Impairment of $3,771,702. The analysis of December 31, 2010 inventory accounts also indicated that the previously reported Cost of Sales had been overstated by $607,005, which has been restated as well.

As noted in the previous section entitled "December 31, 2009 - Adjustment to Retained Earnings", we assumed an existing $11,500,000 credit facility with SIBL upon our acquisition of Superior in May of 2007. Interest that should have been accrued from January, 2007 through December, 2010 was subsequently calculated, as part of the current restatement, at $1,350,000 with a corresponding reduction being made to retained earnings as of December 31, 2009. On January 27, 2010, we and SIBL entered into a Purchase and Sale Agreement and a Debt Conversion Agreement to settle our lawsuit against SIBL. Upon closing of the transaction, SIBL terminated all agreements, converted all of its subsidiary's debt, interest and other receivables for 1,000 shares of our common stock issued to its subsidiary, and sold 3,000,000 shares of common stock held by SIBL to our assignee, NTR for $3,600,000 under a Partial Assignment Agreement. As a result of the transaction, SIBL cancelled all our debt obligations to it, including principal and interest. In relation to this transaction, and as part of the current restatement, we will reverse the $1,350,000 interest accrual noted above, and recognize a corresponding gain in Other Income for the year ended December 31, 2010.

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