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Tesco scandal exposes lax accounting rules

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25th Nov 2014
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The accounting scandal at Tesco has caused a crisis for the UK’s biggest supermarket and put its auditor PwC under scrutiny.

But some accounting experts say Tesco’s overstatement of profits by £263m isn’t just an isolated corporate problem but latest sign that accounting regulators and audit standards aren’t good enough.

Tesco’s accounting problems have worsened since its profit shortfall was first revealed in September.

An investigation carried out by Deloitte revealed Tesco’s accounting irregularities were worse than first originally estimated. Now, the Serious Fraud Office is taking an interest in Tesco’s accounting treatments.

The Big Four firm and law firm Freshfields found Tesco overstated its profits by £263m - £13m more than the initial estimate - for the last two years, and not six months.

Profits were overstated by £118m in the first half of this year, £70m in 2013-2014 and £75m before that, the investigation found.

Part of the problem appears to have been caused by payment from suppliers (who pay to run in-store promotions on their behalf) being booked too early as income in the accounts.

PwC mentioned potential difficulties over how these payments are recognised in the company’s 2014 annual report.

In its auditor report for the year to 22 February 2014, PwC said that the recognition of commercial income was an area of focus “because of the judgment required in accounting for the commercial income deals and the risk of manipulation of these balances”.

Supply chain

PwC’s audit report also said: “Commercial income recognised during the year is material to the income statement and amounts accrued at the end of the year are judgmental.”

There isn’t any evidence that PwC has done anything wrong in its audit of Tesco but it’s under growing pressure. Once again a corporate scandal is raising doubts over the value of auditors’ work for big companies.

The Financial Reporting Council, the UK’s accounting and corporate governance regulator, said it is “monitoring” the situation. It hasn’t decided if there is enough evidence to investigate PwC’s audit of Tesco.

Crawford Spence, professor of accounting at Warwick University, urged the FRC to investigate PwC’s audit of Tesco. He added that the regulator was not “sufficiently rigorous” in deciding whether PwC applied the concept of “materiality” correctly in Tesco’s accounts.

Judgement call

There isn’t an accounting standard to determine when an error in the accounts is “material”.

The International Accounting Standards Board (IASB) defines materiality as any information which if omitted or misstated “could influence the economic decisions of” people (ie investors) reading the report.

In other words, material information is subjective. Auditors have to use their professional judgement. Disclosures of material information may trigger a profit warning.

PwC said that its threshold for when a profit overstatement by Tesco was judged “material” was £150m.

Spence says that this threshold for materiality “seems like a big margin” of error, although at about 5% of pre-tax profits, it’s in line with the audit profession’s rule of thumb on materiality.

But if Tesco overstated its profits by a significant of amount for three consecutive years, PwC may have to show that it spotted the problems at an early stage. And did the auditor do enough to warn about it?

Dysfunctional rules

Last week, the Independent newspaper reported that Tesco could be on the verge of dumping its auditor of 31 years over its apparent failure to identify the accounting problems.

PwC declined to comment but someone familiar with the matter said that PwC had not heard anything from Tesco to corroborate the Independent’s report.

For some experts, though, Tesco’s accounting saga is about more than one company and its auditor.

Stella Fearnley, professor in accounting at Bournemouth University, said this episode was the latest example of accounting rules producing “dysfunctional” results.

“Materiality is not just a number thing,” she said. “If you are auditing directors’ pay it has to be right. It’s all to do with whether you trust the management. Trying to attach a number to it is nonsense.”

The FRC denies criticism that it isn’t assertive enough about the Tesco audit.

An FRC spokesman said it does not know when it will decide whether to investigate PwC audit of Tesco, or any members of the accounting profession involved with the matter. It’s still gathering evidence.

Replies (5)

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By Roland195
26th Nov 2014 12:38

What's new?

I can't claim to be a much of an expert as these two university academics, but nothing about this seems new - Tesco have been caught using a scheme as old as double entry book-keeping and the Auditor's either didn't spot it, understand it or care about it if they did.

If the accounting & audit standards we have at the moment where properly applied then that alone would have prevented this in the first place.

But then we have to keep the FRC occupied. Maybe they could have another go at having the Americans use our system...

 

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By RedTapeDoc
26th Nov 2014 14:11

It’s a bleak time for Britain

It’s a bleak time for Britain’s biggest supermarket.....

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Chris M
By mr. mischief
26th Nov 2014 16:34

The official definition of materiality

From the ICAEW handbook:

"An amount is material if the auditor might get found out and lose the fee."

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Time for change
By Time for change
27th Nov 2014 08:14

You would have hoped that-

Spence says that this threshold for materiality “seems like a big margin” of error, although at about 5% of pre-tax profits, it’s in line with the audit profession’s rule of thumb on materiality.

would have brought about a revisit to the policy, by those in the audit profession.

Materiality (5%) =  margin for error (5%) = £150m!

When I first joined this profession, in 1973, my boss "sold" the concept of accountancy, on the basis that it was simply "common sense". The bedrock being, balance to the penny = accuracy.

Over time, it seems to me that, our peer's, have taken their eye of the ball, so to speak and "developed" accounting policy by way of the rule of thumb mentioned in the opening post.

This "condition" also begs the question, how many more of these giant Plc's will be keeping their heads down, at the moment? Now, lets have a wager (on who the next one will be).

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By daveforbes
27th Nov 2014 14:45

timing issues

There was a debate on another thread about the new simplified cash basis for smaller entities and how accruals basis was less open to absue. Hmmm. So there was a (large) chunk of essentially pre-payments entered as income. One article I read said "it may even be worse - it could have been going on for years".  I don't quite see how that could work.

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