The news that Tesco overstated its half-year profit guidance by £250m has sent the company’s share price tumbling – and poses serious questions about its auditing and corporate governance.
The company has appointed accounting firm Deloitte and law firm Freshfields to investigate the matter and has put a number of key personnel on gardening leave. But the story won’t end here.
In common with other major corporations, Tesco boasts non-executive directors, an ethics committee and an audit committee, but the accounting problems have been highlighted by a whistleblower. The official statement says that the discrepancy is “due to the accelerated recognition of commercial income and delayed accrual of costs”. In other words, the company recognised income which it has not yet made or received, and ignored the costs that it incurred, with the result that profits were inflated. Tesco’s new chief executive, Dave Lewis, with 27 years of experience at Unilever, said that “he had never seen revenue accounted for in this way”.
PricewaterhouseCoopers (PwC) has audited Tesco since 1983. PwC reported on Tesco’s accounts for the year to February 22 2014 and gave it a clean bill of health on May 2. It also reports on the company’s interim accounts in accordance with the rules specified by the UK’s accounting regulator.
PwC knew that recognition of commercial income and costs is a key issue for Tesco. In explaining its duties, on page 66 of the accounts, auditors said this:
Commercial income (promotional monies, discounts and rebates receivable from suppliers) recognised during the year is material to the income statement and amounts accrued at the year end are judgemental. We focused on this area because of the judgement required in accounting for the commercial income deals and the risk of manipulation of these balances. We tested the controls management has in place, focusing on controls over price changes and margin reviews. We agreed commercial income recognised to contractual evidence with suppliers, with particular attention to the period in which the income was recorded and the appropriateness of the accrual at the year end. We compared movements year on year in margins for product categories based on an expectation derived from our sample testing of contracts with suppliers.
The above statement was made on May 2. Such a statement could only be made after consideration of company accounting policies, including changes, if any, made between February 22 and May 5. However, by August of this year, through whistleblowers the company was made aware that all was not well. How can something go so pear-shaped so quickly? So what exactly did the directors of Tesco check before they signed-off the annual accounts? What did the auditors do before giving a clean bill of health?
PwC is major player in the auditing of companies, but its audit practices have been questioned by the Financial Reporting Council (FRC), the UK’s accounting regulator. In its most recent report, the FRC accused PwC of not being sceptical enough and too easily accepting management explanations of contentious matters. Its procedures for checking the robustness of controls at client companies for recognition of income, now an issue at Tesco, were criticised. There is a long standing concern about auditors selling consultancy services to audit clients because this necessarily impairs their ability to objectively report on the resulting transactions. This area is subject to an ethical guideline by the FRC, but its report noted that PwC had a number of breaches, and some were serious. In 2008, the firm was criticised for using audit as a stall for selling consulting services to audit clients.
In principle, shareholders of Tesco and other companies can ask questions about the conduct of audits at company annual general meetings, but the reality is very different. Resolutions relating to auditor appointment or reappointment are rarely accompanied by any meaningful information. No information is provided about composition of the audit team, time spend on the job, explanations received from directors or replies given by auditors. Shareholders approve auditor remuneration, but cannot see auditor’s files and thus are not in any position to make any judgement about the quality of audit work. When things go wrong there is little recourse against auditors because auditors generally owe a “duty of care” to the company and not to any individual shareholder.