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Sep 24, 2014
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Tesco-style accounting risks well known in retail industry

Sep 24, 2014

LONDON, United Kingdom - Tesco's disclosure of huge accounting mistakes over contracts with its suppliers shocked industry analysts and executives, but not because they didn't realise the potential for disaster.

On the contrary, they assumed that everyone in retailing was fully aware of the risks involved in accounting for rebates paid by suppliers to Britain's biggest supermarket groups, thanks to auditors' warnings.

Therefore Tesco's revelation on Monday that it had overstated its profit forecast for the first half of the year by 250 million pounds ($409 million) came as a nasty surprise and wiped 2 billion pounds off its stock market value.

Auditors routinely list risks that companies may face, and this year they have raised the supplier rebates - which have become a major part of the grocery business - in a number of firms' accounts following a change in disclosure rules.

The auditors for all three of Britain's biggest publicly-quoted retailers - Tesco, Sainsbury's and Morrisons - told investors in their most recent annual reports that their businesses faced material risks regarding the reporting of the supplier rebates. Those at the smaller online retailer Ocado did likewise.

These cash payment or discount deals take many different forms, but suppliers typically offer them to the retailers in return for additional efforts to promote their products.

Accountants said that such disclosures by auditors reflected more the growing importance of the supplier rebates than worries that companies didn't know how to account for them. "The rules are pretty well established," said a senior auditor at one big accounting firm who asked not to be named.

Companies can even buy software packages to help to track, analyse and account for such payments.

Nevertheless, deciding how the rebates should be treated in accounts requires companies to exercise discretion, and therein lies the risk of the kind of trouble that has hit Tesco.

Companies don't publish how much they receive in payments from suppliers. But France's Carrefour, which vies with Tesco as the world’s second largest supermarket group by revenue, said at the end of last year that it had over 1 billion euros (now $1.3 billion) in outstanding receivables from suppliers in relation to rebates and other commercial incentives.

One industry executive said that rebate programmes typically lasted less than six months so the actual payments - known as supplier or commercial income - for a group of Carrefour or Tesco's size could run to billions of pounds.

This may explain the size of writedown at Tesco.

The company blamed "accelerated recognition of commercial income and delayed accrual of costs" within its UK food business for the overstatement of its expected half-year profit.

Some analysts said the mistake could reflect grey areas that sometimes exist when accounting for complex agreements, but others were sceptical that such a big downgrade could have resulted from a mere interpretational misunderstanding.

"This, in our view, is not all an accounting issue but more a behavioural issue instilled by previous management," said Mike Dennis, retail analyst at Cantor Fitzgerald in London.

Dennis and other analysts said they expected the problem was linked to attempts by the previous leadership team, including CEO Phil Clarke who lost his job in July, to revive the flagging business. Analysts at Bernstein warned investors that the irregularities had probably gone on for years "since the pressure started on Tesco in 2011".

Reuters attempts to contact Clarke and former CFO Laurie McIlwee were unsuccessful. Tesco declined to comment on whether staff might have felt pressure to account for promotions aggressively.

A matter of judgment

Tesco gave little detail about what kinds of mistakes it suspects were made, but analysts said the statement about accelerated income recognition suggested a number of possible mechanisms.

Bernstein analyst Bruno Monteyne, who was previously a supply chain director of Tesco Asia, said managers - possibly under pressure to improve earnings - might have brought forward promotions and the right to book supplier rebates.

He said that managers might also have booked rebates that bridged more than one period, in an earlier single period.

Sales forecasts could also have been a factor.

Rebates are often tied to volumes. Last year British media reported that retailer John Lewis had told suppliers it expected a 0.75 percent discount in prices, or a reduction of over 5 percent if sales rose by 50 percent. In such a scenario, exactly how much rebate a manager could book would depend on the projected sales growth.

John Lewis declined to comment on its programme.

David McCarthy, an analyst at HSBC, said slowing sales growth at Tesco could have contributed to any inaccuracy in such calculations. "We suspect Tesco may have been booking promotional rebates based on historic precedent rather than on current volumes," he said.

Peter Pope, Professor of Accounting at the London School of Economics, said rebates were often tied to a retailer performing certain tasks. This meant a manager might also wrongly recognise revenues by booking them even when a supplier might feel they have not been earned.

Several of these methods of improving earnings were flagged up in the auditors' notes included in the Tesco, Morrisons, Sainsbury and Ocado annual reports.

This highlighted, Pope said, how internal controls should be there to avoid the kind of problems Tesco suffered. "Because there is so much need for judgment and discretion to be exercised, good internal audit procedures should really monitor the veracity of all assumptions," he said.

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