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Tesco scandal - Financial Reporting

Article · January 2017

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TESCO SCANDAL
GROUP PROJECT:
CRESPI C LAUDIO 3001
GIANMARCO P ERSIANI 3033
SIMONE R IGATTI 3058

Course: 2238-Financial Reporting-1617_T2

Professor: Xhanti Gkougkousi

Grader: Rafael Sequeira

TESCO SCANDAL 11/11/2016

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Table of content

1. Brief description of company and its operation

2. Accounting method analysis

3. How the scandal was uncovered

4. Impact of the accounting scandal on the company's financial statements

5. Impact of the accounting scandal on the company's various stakeholders

6. Appendix

7. References

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1) Brief description of the company and its operations

Tesco is one of the leading multinational grocery and general merchandising retailer in the world which was
founded in 1919 by Jack Cohen in the East End of London. The company employed almost 476,00 people
and it operates in 11 countries. Tesco’s main activities are concentrated in three areas: distribution in United
Kingdom, international distribution and financial services. In order to provide a better experience for its
customers, Tesco diversified its business portfolio. Today, it operates also as telephonic operator and it
provides fuel selling service. In fact, the company opened its first petrol stations at major sites across the UK
in 1973 and, 20 years later, Tesco started fuel selling in service station with Tesco brand.
Since 2008 Tesco Bank, founded in 1997, has been wholly owned Tesco PLC. The financial institution
offers a range of simple personal banking product like mortgages, credit cards, personal loans and savings.
Tesco is listed on the London Stock Exchange and is a component of the FTSE 100 Index. On the 09th of
December 2016, it had a market capitalization of £17.69 billion.
Since 1996, Tesco has adopted an international expansion strategy: enlarging its business in Europe, in Asia
and in USA.
In Europe, the company got market shares through some operations of acquisition as the purchase of the five
Kipa stores in Turkey, in 2003, and the retailer LeaderPrice in Poland, in 2006. It adopted the same strategy
in Hungary and in Czech Republic. In Asia, given the local customer’s expectations, Tesco had to enter into
joint ventures with local partner to start its business. In South Korea and Thailand, it founded Samsung-
Tesco Home plus and Tesco Lotus respectively with Samsung and Charoen Pokphand. Then, Tesco opened
some stores in China and Japan. As regarding the United States of America’s market, Tesco implemented a
different strategy to extend its business there. It started its activities under the name Fresh & Easy, opening
stores in California, Arizona and Nevada. The company owned more than 200 stores and employed over
5000 people until the selling of Fresh & Easy to YFE Holdings Inc in 2013.
The good reputation and the success of Tesco were shamed by an accounting scandal in 2014. Tesco has
revealed an overstatement of £250 million of its expected profit for the half year, principally due to the
accelerated recognition of commercial income and delayed accrual of costs. To interpret the reasons of
Tesco’s fraud is essential to know the competitive environment who were exposed the company.
In recent years, Tesco was suffering a fierce competition in its core market, UK. The German hard-
discounters Aldi and Lidl practised a low pricing policy that has caused difficulties to the Britain company. It
lost a large part of its market shares in favour of the German retailer. Until then, Tesco has been considered
the cheapest retailer, thus it had to retool its business plan. The Britain company has announced drastic
reorganisation of the supermarket’s management, price reductions on hundreds of items, the closed-down of
43 unprofitable stores and the selling of its non-core businesses, as BlinkBox an online entertainment system.
Subsequently, Tesco started aggressive tactics with its suppliers to create income. From there on, Tesco
scandal begins.

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2) The accounting methods used and how should have been used

This part talk about the accounting methods that was used, and the accounting methods that should have
been used by Tesco and it’s structured by reporting specific fragments of the International accounting
policies violated during the analyzed period. In this way we give a description of the correct methodology of
accounting and ( read in the opposite sense ) of the behaviour adopted by Tesco. In the fiscal year
(“2011/12”), Tesco began to misrepresent profits and losses during the Class Period, and operated in
violation of International Financial Accounting Standards (“IFRS”) reporting requirements: a) recognizing
premature and fictitious commercial income; b) delaying accrual of costs; c) overstating inventory; d)
misrepresenting “trading profit” and “underlying profit.”
Specifically, Tesco violated IFRS the reporting requirements:
-IAS 18 - Revenue: “When the outcome of a transaction involving the rendering of services can be estimated
reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion
of the transaction at the end of the reporting period. The outcome of a transaction can be estimated reliably
when all the following conditions are satisfied: (a) the amount of revenue can be measured reliably; (b) it is
probable that the economic benefits associated with the transaction will flow to the entity; (c) the stage of
completion of the transaction at the end of the reporting period can be measured reliably; (d) the costs
incurred for the transaction and the costs to complete the transaction can be measured reliably.”
Tesco violated each one of this four point, by tens or hundreds of millions (combined with commercial
income cost reductions, at least £326 million), both with respect to recording prematurely the commercial
income as revenues (meaning Tesco could not justify recording such revenue in the period it did so), and
with respect to fictitious commercial income revenue (meaning that Tesco could never justify recording such
revenue). This happened because of the great element of subjectivities used on the estimation of rebates: the
manager was asked to estimate the provisional value for the rebates by an individual judgment based on the
expected future transactions. It’s clear that in absence of a transparent methodology for the estimation there
could be the temptation to be overly optimistic.
IAS 2 – Inventories:
“rebates and purchase discounts are not recorded as revenue, but as a reduction to the cost of
inventory, or, if the inventory has already been sold, as a reduction to the cost of sales”.
Tesco instead a) recorded tens or hundreds of millions of dollars (combined with commercial income
revenue, at least £326 million) in reductions to cost of sales before the products were actually sold.
b) recorded rebates and discounts to that it was not contractually entitled to, or to which the seller had not
agreed, or was not willing to provide a discount for other reasons.
Inventories shall be measured at the lower of cost and net realizable value.”…“Trade discounts, rebates
and other similar items are deducted in determining the costs of purchase”
Tesco failed to respect this principle and based his accounting method on the only purpose to inflate the
gross margin percentage by fictitious and/or premature commercial income and/or by overstating inventory.

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Tesco also had been capitalizing store activities as inventory rather than expensing the activities.
IAS 37, a contingent asset is “a possible asset that arises from past events and whose existence will be
confirmed only by the occurrence or non occurrence of one or more uncertain events not wholly within
control of the entity(…) An entity shall not recognize a contingent asset(…).”When the realisation of income
is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate”.
Tesco violated the “bright line” rule that contingent gains may never be recorded.
IAS 34, Interim Financial Reporting, required Tesco to provide “an explanation of events and transactions
that are significant to an understanding of the changes in financial position and performance of the entity
since the end of the last annual reporting period.” Tesco failed to disclose its increased commercial income
balances, both on its balance sheets and its income statements.
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, “comparative information for
prior periods is presented as if (…) prior period errors had never occurred.”. Tesco violated IAS 8 because
in both its interim and year-end financial statements for 2014/15, it failed to correct 2013/14 for the
commercial income errors. About comparative information IAS also say that “revenues and related expenses
must be matched and recorded in the same reporting period. If the amount is either unknown or not fixed the
registration must be deferred”. Tesco recorded revenues but deferred the associated costs and also operated
by reducing cost in the right period but improperly defer the associated reduction of revenue. So saying that
Tesco “delayed accrual of costs” means that failed to record expenses.

3) How the accounting scandal was uncovered

The year 2014 represented a financial disaster for Tesco PLC. A series of signal was anticipating the
accounting scandal. For instance, the company issued fifth profits warning in only 12 months, it reported a
decline of 3,7% in like-for-like sales in Q1 on 4 th June and it slashed its dividend on 29 th August. This was
clearly a delicate situation until an internal employer triggered an investigation on Tesco’s accounting issues,
bringing these practices to the attention of management.
On 22nd September, the company shocked the market with an admission that it has overstated its half-year
profit forecast by £250m. It issued a press release where they said that the overstating was “principally due
to the accelerated recognition of commercial income and delayed accrual of costs” and “[o]n the basis of
preliminary investigations in to the UK food business, the Board believes that the guidance issued on 29
August 2014 for the Group profits for the six months to 23 August 2014 was overstated by an estimated
£250m. Some of this impact includes in-year timing differences.”. Furthermore, during the same period the
analysts were criticizing “the misstatement related to Tesco’s financial arrangements with suppliers, which
typically provide generous credit terms to big grocers in order to win contracts”.
Therefore, the CEO Dave Lewis asked Deloitte to undertake a comprehensive independent investigation
about these accounting issues, working closely with Freshfields, the Group's external legal advisers.

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4) Impact of the accounting scandal on the company's financial statements

The magnitude of the scandal denotes especially in light of the corporate balance sheet and subsequent
analysis of key ratios, although Tesco has insisted that the impact was "material" and will not mean the
results have to be restated.
The company has shown a weaker performance of production efficiency proving it hadn't the ability to
generate earnings compare to its expenses. Low profitability is a result of excessive operating costs and
inadequate revenue due to the quick recognition of commercial income and deferred accrual of costs, which
had an impact on financial statement of 2015. ROE went from 6,21 % in 2014 to -52,7% ( Table 4) in 2015
in one year, destroying value for shareholders. Indeed, also ROA and ROIC are negative in 2015.
On liquidity side it doesn't look a huge change, but the current ratio is decreased more than the quick ratio
since this one is similar to the current ratio but it takes into account the liquid assets and not the current
assets, in which inventories are excluded from the liquid assets.
Taking a look to the income statement's items(Table 1), it is possible to notice that the biggest loss came
from the cost of sales. In fact, it went from 59,5 billion in 2014 to 64,3 billion in 2015, growing
approximately of 8%. This is due to the bad recognition of supplier discount occurred in the end of 2014 and
it is observable in 2015's annual report. Instead, considering the Financial Statement, it can observed a big
decrease of Inventories of around 17 % (from £ 3576m in 2014 to £ 2957m in 2015).
These factors also impacted on efficiency ratio decreasing control over their inventory levels and on
payments to suppliers for goods sold.

5) Impact of the accounting scandal on the company's various stakeholders

A. BOARD OF DIRECTORS
Since the scandal nine senior managers were put on leave at the time and seven of those have since been
dismissed or left.
The SFO launched a criminal investigation into accounting practices at Tesco in October 2014 after the
company admitted it had overstated profits by £263m because it had incorrectly booked payments from
suppliers, relating to issues such as marketing costs or reaching sales targets. Three former Tesco executives
have been charged with fraud by abuse of position and with false accounting by the Serious Fraud Office
(SFO):Carl Rogberg, the former finance director of Tesco UK, Christopher Bush, the former managing
director of Tesco UK, and John Scouler, the former commercial director for food. Even former executives,
including ex-CEO Philip Clarke, have been called in for interviews by the SFO.

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B. SHAREHOLDERS
One of the biggest problems caused by Tesco’s mistakes was the great loss in shareholders’ equity.
Considering the trend of Tesco’s stock price ( Table 5) it is possible to catch the moment of the “scandal”.
In fact, there is a big fall down from August 2014 (before that Tesco declares the error) to October 2014
(after the declaration of the error by Tesco). Over this period the stock price fell from £ 228.41 to £ 171.
With this blow, shareholders were subjected to a potential capital loss of around 25%, which it forced them
to take legal action against the company. Taking into account the market capitalization of Tesco, during the
same period were burned more than £ 463 million.
After scandal the company was worth less than half what it was in 2013 and furthermore Moody’s has cut
Tesco's credit rating to Baa3. Tesco also had a growing pension deficit, which rose to 3.4 billion pounds
from 2.6 billion pounds in just six months during 2014. Dave Lewis didn't worked on a rights offering to
boost the company's equity base but he moved fast to raise capital .Tesco Plc Chief Executive Officer set out
his plan for reviving the U.K. grocer, a process that involved dozens of store closures and asset sales that
was worth billions of pounds.

C. INDIPENDENT AUDITORS
Another relevant factor that characterized Tesco’s stakeholders is the change of independent auditors. PwC
warned in 2014’s annual report that the company’s commercial revenues was at “risk of manipulation”,
which effectively flagged up that this could be a problem for Tesco. Since Tesco’s accelerated recognition of
commercial income and delayed accrual of costs was an isolated incident, it's not been problematic for PwC.
The company of professional services has audited Tesco’s accounts since 1983 even thought EU rules
require companies to retender their audit contract every 10 years. Indeed, after the "accounting scandal”,
Tesco nominated Deloitte as new auditor in order to work with its accountancy department to avoid that
other mistakes of misreporting happening again. It found that profits were overstated by £118m in the first
half of this year, by £70m in the 2013-2014 financial year and by £75m before that. Tesco had been doing
deals with suppliers over promotions, which is commonplace for supermarkets, but it appears Tesco had
been booking returns from those promotions too early, while pushing back the costs according to Deloitte.

D. SUPPLIERS
During 2014 Tesco paid suppliers later and taking monies from them earlier than it should have. Suppliers
have been paid to secure a prime position on Tesco’s shelves, and to fund certain promotional activities. The
problem was related to the extra incentives, called “rebates”, that Tesco received from suppliers for hitting a
certain level of sales, or for support for promotions. Furthermore he has recorded these promotional rebates
based on historical precedent rather than on current volumes. Since Tesco has been suffering meaningful
volume declines for some time then suppliers have shifted support from Tesco to other.
After scandal Dave Lewis sold many of the retailer’s assets and has refocused the brand on being a UK
grocery business rather than a global retail conglomerate companies.

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6) Appendix

Table 1: Group income statement

Table 2: Group statement of comprehensive income(loss).

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Table 3: Financial statement

Table 4: Profitability ratio, Efficiency Ratio, Liquidity Ratio.

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Table 5: Tesco’ market capitalization (October 2013- October 2014)

Source: Bloomberg

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7) REFERENCES

 https://www.tescoplc.com/
 http://securities.stanford.edu/filings-documents/1052/TP00_01/2015618_r01c_14CV08495.pdf
 http://finance.yahoo.com/quote/TSCO.L?p=TSCO.L
 “A history of Tesco: The rise of Britain's biggest supermarket”:
http://www.telegraph.co.uk/finance/markets/2788089/A-history-of-Tesco-The-rise-of-Britains-biggest-
supermarket.html
 “Tesco fights back”:
http://www.economist.com/news/business-and-finance/21638208-tesco-fights-back
 Tesco PLC Annual report and Financial Statement 2015:
https://www.tescoplc.com/
 “What went wrong at Tesco?”:
https://www.ft.com/content/5eee792c-423f-11e4-a9f4-00144feabdc0

TESCO SCANDAL 11/11/2016

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