accounting-Tesco’s Financial Reporting of Vendor Allowances1

QUESTION

Tesco’s Financial Reporting of Vendor Allowances1The Company2Tesco PLC (hereafter, Tesco, or the Company) is a British multinational retailer headquarteredin Cheshunt, United Kingdom. In 2014, Tesco was the world’s third largest retailer as measuredby profits and second-largest, as measured by revenues. The Company employed more than530,000 people, and had stores in 12 countries across Asia and Europe. It was the grocerymarket leader in Ireland, Hungary, Malaysia, Thailand, and the U.K., where it claimed a marketshare of around 30%. Tesco had a market capitalization of approximately £203 billion in August2014. Its common stock is listed on the London Stock Exchange and is a constituent of the FTSE100 Index.4 The Company also has American Depositary Receipts (ADR) traded on the over-thecounter market in the U.S. under the symbol TSCDY.5Evolution and Financial PerformanceJack Cohen founded Tesco in 1919 when he started selling surplus groceries from a stall in theEast End of London. Mr. Cohen made a profit of £1 from sales of £4 on his first day. The Tesconame first appeared in 1924, when Cohen purchased a shipment of tea from T. E. Stockwell andcombined those initials with the first two letters of his surname. The first Tesco store openedsoon after in 1929.Cohen’s U.K. business expanded rapidly. By 1939 he had opened over 100 Tesco stores acrossthe country. Starting in the early 1990s, Tesco expanded further as the Company diversifiedgeographically and expanded its product portfolio to include not only the traditional retailmarkets (such as books, clothing, electronics, furniture, toys, and petrol) but the emerging retailmarkets (such as software, financial services, telecoms and internet services) as well. Tesco’s1This case is developed by Professor Mahendra Gujarathi of Bentley University for the purpose of class discussion.Please do not quote without permission.2The information in this and the next section is obtained largely from the annual reports and web site of theCompany and from The Telegraph (October 4, 2014).3£ is the symbol denoting British Pounds, the currency of Great Britain and the United Kingdom.4The FTSE 100 Index is a share index of the 100 companies listed on the London Stock Exchange with the highestmarket capitalization.5An American depositary receipt (ADR) is a stock that trades in the United States but represents a specifiednumber of shares in a foreign corporation. Each ADR of Tesco represents three Tesco PLC ordinary shares.1diversification strategy and aggressive marketing efforts led to further store openings in the1990s and helped the Company to assume the coveted position of UK’s leading grocer. Tescooutperformed all its rivals, increasing its market share in groceries from 15.4 percent in 1998 to28 percent in 2004.Tesco won applause for its swift growth and global ambitions through the early 2000s.Although profits came under pressure in fiscal6 2009 because of the worldwide economicdownturn, the profitability growth resumed again from fiscal 2010 and continued through fiscal2012. Fiscal 2013, however, was not a good year for Tesco. Its revenues were almost stagnantand profit before tax was down by almost half compared to fiscal 2012. In January 2012, theCompany issued a profit warning for the first time in 20 years and in April 2013, Tesco reportedits first decrease in annual profit in 19 years. Profit warnings were not uncommon in fiscal 2013and 2014, however. Indeed, Tesco issued five profit warnings in twelve months endingDecember 2014.During fiscal 2013 and 2014, Tesco experienced a decline in the trading profits7. Failing to haltthe dramatic decline in the trading and pre-tax profits, Tesco announced on July 22nd 2014 thatits Chief Executive Officer (CEO) Philip Clarke, a 40-year veteran at the Company, would bereplaced by Dave Lewis, the head of personal care unit at Unilever (the world’s third largestconsumer goods company), on October 1, 2014. However, given the fast-changing situation atTesco, the new CEO was asked to join a month earlier, on September 1st, 2014.The Company’s financial performance (revenues, trading profit, profit before tax, profit aftertax, and basic earnings per share) during fiscal years 2005 to 2014 is presented in Exhibit 1.— Insert Exhibit 1 about here –Tesco’s stock price reflected its impressive operating performance from 2006 to 2011 andsubsequent deterioration from 2012 through 2014. Figure 1 presents a graph of Tesco’srevenues and profits during 2006-2014 and depicts the history of its stock price vis-à-vis theFTSE 100 index.6Tesco’s fiscal year runs for 52 or 53 week period ending in late February. The 2009 fiscal year was for 53 weekperiod ending February 28th, 2009.7Tesco’s annual report defines trading profit as an adjusted measure of operating profit. It measures theperformance before profits/losses arising on property-related items, the impact on leases of annual uplifts in rentand rent-free periods, intangible asset amortization charges and costs arising from acquisitions, and goodwillimpairment and restructuring and other one-off costs.2— Insert Figure 1 about here –The Controversy over Accounting for Commercial IncomeOn the Friday of September 19th 2014, a member of Tesco’s staff, whose identity was notdisclosed, warned the Company’s general counsel about early booking of commercial incomeand delayed booking of costs. In less than three weeks after joining Tesco, on the Monday afterthe Friday on which the staff member blew the whistle, Tesco’s new CEO Dave Lewis had theunenviable task of announcing on September 22nd, 2014 that profits for the six months endingAugust 2014 were likely overstated by £250 million. The Company suspended eight seniorexecutives and launched an internal investigation of the issue. In addition, Tesco’s Board ofDirectors appointed Deloitte (an international accounting firm that was not Tesco’s externalauditor) to undertake an independent review of the Company’s accounting issues, inassociation with Freshfields, Tesco’s legal advisers.Deloitte’s review of Tesco’s semi-annual results confirmed that the Company’s profitoverstatement was larger than the £250 million previously declared and the overstatementswent back further than Tesco originally stated. Deloitte concluded that Tesco’s overallcommercial income adjustment was £263 million, including £118 million in the first half of2014-15, £70 million relating to 2013-14, and £75 million of prior period adjustments relating topre-2013-14. On the basis that the prior period adjustments were not material, Tesco did notmake any prior period restatement and adjusted all amounts in the current period’s income.Tesco’s interim report issued on October 23rd 2014 acknowledged that the guidance (providedon August 29th 2014) regarding profit for the six months to August 23rd, 2014 was overstatedprimarily due to the accelerated recognition of commercial income and delayed accrual ofcosts. The pre-tax profit for the period fell by 92% from £1.39 billion to £112 million. Theinterim report stated:As announced on 1 October 2014, the Financial Conduct Authority8 has launchedan investigation into the issue. We will fully cooperate with the regulatoryauthorities. Given the outstanding investigation, we can make no furtherstatement at this stage about how these events came about.8The Financial Conduct Authority (FCA) is a financial regulatory body in the United Kingdom, but operatesindependently of the United Kingdom government, and is financed by charging fees to members of the financialservices industry.3Commercial Income and Its Financial ReportingConsumer products companies provide retailers with different forms of vendor allowances suchas volume discounts, cooperative advertising and slotting fees. In most cases the allowances(sometimes labelled as discounts or rebates or sales incentives or commercial income or salesallowances) are tied to the volume that retailers such as Tesco promise to buy from the vendor.Retailers also obtain reimbursements of a portion of advertising costs from vendors under thecooperative advertising arrangements. The advertising allowance can be volume-based, or itcan be a flat amount. Slotting fees represent an arrangement in which manufacturers payretailers a fee for shelving their products in prominent locations.The amounts of commercial income are significant for retailers. Business Insider (October 7th ,2014) mentioned that “Among the US supermarkets that disclose figures, vendor allowancesare equivalent to around 8 percent of the cost of goods sold, equal to virtually all their profit.”Typically, vendors pay retailers the estimated amount of the commercial income upfront.However, when and how to record the income effects of those cash flows are contentiousissues and accounting treatments vary across vendors as well as customers both.Despite the potentially significant effects on profits, accounting policies regarding vendorallowances are rarely described in IFRS-based financial statements. As stated in BusinessInsider (October 7th, 2014), “While European retailers are not obliged to, and do not, disclosecontributions to profits from vendor allowances, US retailers often do, and are subject to moredetailed accounting rules.”In Tesco’s case, the description of commercial income, or explanation regarding the accountingpolicy pertaining thereto, was not included in the Company’s financial statements which wereprepared in accordance with the International Financial Reporting Standards (IFRS).PriceWaterhouseCoopers (PwC), the auditors of Tesco, however noted a concern aboutcommercial income in their audit report for fiscal 2014. Although PwC issued a clean auditreport on Tesco’s financials, it mentioned the material risks regarding the reporting ofcommercial income as follows.99The auditors for all three of Britain’s biggest retailers – Tesco, Sainsbury’s and Morrisons – alerted investors intheir most recent annual reports that their businesses faced material risks regarding the reporting of supplierrebates (Business Insider, October 7, 2014).4Area of focusHow the scope of our audit addressedthe area of focusRecognition of commercial incomeCommercial income (promotional monies,discounts and rebates receivables fromsuppliers) recognized during the year ismaterial to the income statement and amountsaccrued at the year-end are judgmental.We tested the controls management has inplace, focusing on controls over price changesand margin reviews.We agreed commercial income recognized tocontractual evidence with suppliers, withparticular attention to the period in which theincome was recorded and the appropriatenessof the accrual at the year end.We focused on this area because of thejudgment required in accounting for thecommercial income deals and the risk ofmanipulation of these balances.We compared movements year on year inmargins for product categories based on anexpectation derived from out sample testing ofcontracts with suppliers.Illustrative Example of a Vendor Allowances ArrangementPresented below is a hypothetical example that illustrates a vendor allowances arrangement.Consistent with Jack Cohen’s business motto "pile it high and sell it cheap", Tesco routinelynegotiates contracts with its vendors for purchasing products at best prices, and passes on thesavings to its customers. One such annual contract with CPC, a leading consumer productscompany was initiated on September 1st 2013. The contract stipulated that Tesco will continueto receive 8 percent refund of the purchase price if it bought at least the same quantity (3.5billion units) of CPC products as it did in the previous contract period, regularly priced at £2 perunit (total purchases of £7 billion). In addition, depending on the level of purchases during thecontract period, the contract stipulated a lower (or higher) refund, as follows:5Purchases (units)during Sept. 1, 2013 – Aug. 31, 2014Refund Percentage on total purchasesLess than 3 billionZero3 billion to 3.299 billion6%3.3 billion to 3.499 billion7%3.5 billion to 3.699 billion8%3.7 billion to 3.899 billion9%3.9 billion and above10%The regular price of the units supplied by CPC remained constant (£2 per unit) throughout thecontract period. Not knowing the trend of sales in the forthcoming year, on September 1st2013, Tesco committed to purchase from CPC the same number of units (3.5 billion) in thecurrent contract period (12-month period ending August 31st 2014) as it did in the previouscontract period (12-month period ending August 31st 2013). Using this estimate, and based onprior experience of dealings with Tesco, on September 1st 2013, CPC paid £560 million (8percent X 3.5 billion units X £2 price per unit) in advance to Tesco. If Tesco’s actual purchasesdiffer from the contracted amounts, the Company would return the unearned portion of therefund to CPC (or receive the unpaid portion of refund from CPC) on August 31, 2014.Tesco’s Earnings Manipulation: Speculations Galore, Facts FewSeveral speculations existed about the motivations and mechanisms of manipulating earningsby Tesco’s management. The most obvious was the link between the compensation of Tesco’ssenior management and financial performance of the Company. In the retailing industry,commonly used measures of performance include annual sales growth, annuals growth incomparable store sales (open for 12 months or longer), and the gross margin rate. Tesco usedthese and other financial as well as non-financial measures to determine the remuneration ofits executive directors (i.e., senior management). As mentioned in the Directors’ RemunerationReport of the Company for 2013-14,10 “the majority of our reward is linked to the delivery ofstretching performance over the short and long term aligned with the achievement of ourbusiness vision and our strategy.” Additional details of Tesco’s remuneration policy arepresented in Figure 2.10Available at http://files.thegroup.net/library/tesco/annualreport2014/pdfs/tescoar14_gov_remunerationreport.pdf6— Insert Figure 2 about here –The remuneration policy described determinants of the executive compensation, but did notprovide details of the bonus targets. The Directors’ Remuneration Report for fiscal 2014 statedthat “Bonus targets are considered by the Board to be commercially sensitive as they wouldgive away details of our budgeting to our competitors. We therefore do not publish the detailsof targets.” The remuneration policy also stated: “Despite strong progress against strategicobjectives during the year and the exceptional effort management have put in to achieve this,the bonus profit underpin was not met and therefore the Executive Directors will not receive abonus in respect of 2013-14. Performance Share Plan awards granted in 2011 will lapse in July2014 as challenging three-year Earnings per Share (EPS) and Return on Capital Employed (ROCE)targets were not met.” Because the Company’s fiscal 2013 financial performance did not meetthe targeted results, senior management did not earn annual bonuses in 2013 also.The report by Deloitte and Freshfield indicated that the profit overstatement stemmed fromthe “booking of supplier contributions that were conditional on hitting sales targets that it wasnot going to reach.” Whether a retailer will indeed buy the required quantity of products to“earn” the volume discounts depends on the eventual quantities of products that the retailer isable to sell. David McCarthy, an analyst at HSBC, said that slowing sales growth at Tesco couldhave contributed to an inaccuracy in calculations (Reuters, September 23rd 2014). “We suspectTesco may have been booking promotional rebates based on historic precedent rather than oncurrent volumes,” he said.Tesco’s senior management may also have entered into side deals with major suppliers withoutadequately disclosing them in the financial statements. The Telegraph (October 28th 2014)stated: “A source close to the probe claimed that a “small group” of employees, realizing thesesales targets would not be hit, struck deals with suppliers to still make these payments byoffering benefits in the next financial period. These benefits were then kept secret.”Another hotly debated topic was whether PwC, Tesco’s auditors for more than 30 years 11,discharged their professional obligations responsibly. PwC mentioned the company’srecognition of commercial income as a specific area of focus, and noted that the booking ofsuch income and costs is a “grey area”. However, it continued to issue clean audit opinions on11There have been calls from politicians and campaigners for large listed companies to avoid using the sameauditor for long periods. New EU rules could force companies to change auditors after a maximum 20 years andput the position out to tender every 10 years.7Tesco’s financial statements. Tesco’s audit committee did not even consider commercialincome as a “significant area for disclosure” in its report. It is also interesting to note that twoout of the ten members of the board of directors, including the chair of Tesco’s auditcommittee, were PwC “alumni” that formerly worked for the auditing firm.Further speculation suggests that Tesco’s main suppliers, which include some of the world’slargest consumer goods companies such as Unilever, Coca-Cola, and Nestle, might havecolluded with Tesco in profit manipulation for the fear of losing a large customer. TheTelegraph (November 6th 2014) stated: “If Tesco had been overinflating commercial income,then it stands to reason that its suppliers had lower profits than they thought because theretailer was claiming money that they did not know about. Reportedly, several of Tesco’sbiggest suppliers have launched internal audits to ensure that their financial figures have notbeen distorted. However, no supplier has come out and changed their financial results as aresult of uncovering issues in their negotiations with Tesco.”In short, the issue of whether Tesco’s management manipulated Company earnings remainsunresolved. The complexity of Tesco’s promotional deals with suppliers may have left room forsubjective decisions, unintentional errors, and honest mistakes (The Economist, September 27th2014). For instance, some analysts blamed the accounting error on the lack of experience ofTesco’s Board of Directors in the retailing industry. Some have also suggested the commercialincome adjustment as an example of “kitchen sinking”12 of the accounts by the new CEO to helpreset Tesco towards future profitability (The Telegraph, September 22nd 2014).Reaction from the Financial Community to Tesco’s Profit OverstatementOn September 22nd 2014, when Tesco disclosed likely profit overstatement and theappointment of Deloitte to perform an independent review, capital markets responded bydropping Tesco’s stock price almost 12 percent in a single day, thereby wiping out more than£500 million from the Company’s market capitalization. Later in the year, when Tesco warnedthat its annual profits would fall below consensus analysts’ estimates, its stock price declined toa 14-year low of £1.65 per share. During the calendar year 2014 alone, Tesco suffered areduction in the market capitalization of almost £12 billion. The downward spiral in Tesco’sstock price during 2014 is presented in Figure 3. Some high-profile investors including thelegendary investor Warren Buffett sold their stakes in the Company, stating that their decisionto invest in Tesco was “a mistake.”— Insert Figure 3 about here –12Kitchen sinking involves front-loading the bad news to pave the way for a rebound in profit in later years.8Credit rating agencies also responded unfavorably to Tesco’s profit overstatement. Almostimmediately after Deloitte issued its review report on Tesco on October 22 nd 2014, two creditrating agencies reduced Tesco’s rating to the cusp of investment grade. Fitch dropped Tesco anotch to BBB- and Moody’s cut its rating of Tesco to Baa3 from Baa2, citing the reduced andtrading profit and “uncertainties” related to the regulatory investigations into Tesco’saccounting problems.On January 8th 2015, Dave Lewis, Tesco’s chief executive, announced drastic measures to helpturnaround the Company’s financial position, including closing Tesco’s headquarters inCheshunt, shutting down 43 unprofitable stores and scrapping plans to build 49 newsupermarkets. Lewis also announced that Tesco would close its defined benefit pension plan,consider canceling its final dividend payout and slash corporate administrative costs by 30percent. The company had met with the three major credit rating agencies (Fitch, Moody’s andS&P) the day before it unveiled its turnaround plan in the hope of preventing a downgrade.However, On January 9th 2015, Moody’s downgraded Tesco’s senior unsecured long-term ratingto Ba1 from Baa3 stating that Tesco’s attempts to protect its balance sheet will "take time toimplement". Moody’s also reported that "structural changes in the UK grocery retail marketwill continue to challenge the company’s operating performance". Less than a week later, S&Pfollowed suit on January 15th 2015, when it downgraded Tesco’s rating to non-investmentgrade, or junk status.Legal ProceedingsOn October 1, 2014, Tesco announced that the U.K.’s financial watchdog, the Financial ConductAuthority (FCA), had “commenced a full investigation” of the accounting irregularities at thecompany. Unlike the US legal system, no provision exists under English law for class-actionlawsuits, in which thousands of people can collectively file one big legal claim. In the US,lawsuits were filed on behalf of investors who purchased Tesco’s ADRs (American DepositoryReceipts).Britain’s Serious Fraud Office (SFO) recently opened a criminal investigation into accountingirregularities at Tesco. The Company said that it has been “cooperating fully with the SFO andwill continue to do so.” The Financial Conduct Authority said it would stand aside, given theSFO’s decision to investigate. The SFO declined to comment further, citing the investigation.Such investigations can take years to complete.9On February 5th 2015, the Groceries Code Adjudicator (GCA), UK’s first independent adjudicatorto oversee the relationship between supermarkets and their suppliers, joined SFO ininvestigating Tesco. The adjudicator said: “I have reasonable suspicion that Tesco breached thecode in two areas. One is reasonable payments and second is payments for better positions onshelf outside promotions.”EpilogueOn May 10th 2015, Deloitte was appointed by Tesco as its new auditor after PwC and theCompany "mutually agreed" that PwC would not take part in a re-tendering process.10RequirementsRequirement 1Financial Reporting of Sales AllowancesAs mentioned in the illustrative example of the vendor allowances agreement, assume that onSeptember 1st 2013, CPC paid £560 million to Tesco in exchange for Tesco’s commitment topurchase 3.5 billion units of CPC’s products. At the end of the contract period (August 31st2014), the amount of sales allowances was calculated based on Tesco’s actual purchases (3.65billion units at £2 per unit) during the contract period and difference was settled in cashbetween CPC and Tesco.(a)CPC recognized the payment of £560 on September 1st 2013 as SGA (Selling, Generaland Administrative) expenses, and the cash settlement on August 31st 2014 as anadjustment to SGA expenses. Explain whether or not CPC’s recording of salesallowances as SGA expenses is in compliance with U.S. GAAP. Cite paragraphs from theappropriate professional pronouncements.(b)Tesco recognized the receipt of £560 on September 1st 2013 as sales revenues, and thecash settlement on August 31st 2014 as an adjustment to sales revenues. Explainwhether or not Tesco’s recording of sales allowances as sales revenues is in compliancewith U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements.(c)Complete the following table for CPC for the 12-month contract period ending August31st 2014.ItemIncome Effects of Sales Allowances – Vendor’s books – CPC(Amounts in millions £)Current contract periodPreviousReportedCorrections, ifCorrect amountscontract periodamountsanyper U.S. GAAPSales revenuesCost of goods soldGross marginSGA expensesOperating profitSales growth over previouscontract periodGross margin Rate7,0004,9002,1005607,3005,1102,1905841,5401,606Not Applicable4.29%Not Applicable30%30%Not Applicable11(d)

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