Tesco’s Financial Reporting of Vendor Allowances1
The Company2
Tesco PLC (hereafter, Tesco, or the Company) is a British multinational retailer headquartered
in Cheshunt, United Kingdom. In 2014, Tesco was the world’s third largest retailer as measured
by profits and second-largest, as measured by revenues. The Company employed more than
530,000 people, and had stores in 12 countries across Asia and Europe. It was the grocery
market leader in Ireland, Hungary, Malaysia, Thailand, and the U.K., where it claimed a market
share of around 30%. Tesco had a market capitalization of approximately £203 billion in August
2014. Its common stock is listed on the London Stock Exchange and is a constituent of the FTSE
100 Index.4 The Company also has American Depositary Receipts (ADR) traded on the over-thecounter market in the U.S. under the symbol TSCDY.5
Evolution and Financial Performance
Jack Cohen founded Tesco in 1919 when he started selling surplus groceries from a stall in the
East End of London. Mr. Cohen made a profit of £1 from sales of £4 on his first day. The Tesco
name first appeared in 1924, when Cohen purchased a shipment of tea from T. E. Stockwell and
combined those initials with the first two letters of his surname. The first Tesco store opened
soon after in 1929.
Cohen’s U.K. business expanded rapidly. By 1939 he had opened over 100 Tesco stores across
the country. Starting in the early 1990s, Tesco expanded further as the Company diversified
geographically and expanded its product portfolio to include not only the traditional retail
markets (such as books, clothing, electronics, furniture, toys, and petrol) but the emerging retail
markets (such as software, financial services, telecoms and internet services) as well. Tesco’s
1
This case is developed by Professor Mahendra Gujarathi of Bentley University for the purpose of class discussion.
Please do not quote without permission.
2
The information in this and the next section is obtained largely from the annual reports and web site of the
Company and from The Telegraph (October 4, 2014).
3
£ is the symbol denoting British Pounds, the currency of Great Britain and the United Kingdom.
4
The FTSE 100 Index is a share index of the 100 companies listed on the London Stock Exchange with the highest
market capitalization.
5
An American depositary receipt (ADR) is a stock that trades in the United States but represents a specified
number of shares in a foreign corporation. Each ADR of Tesco represents three Tesco PLC ordinary shares.
1
diversification strategy and aggressive marketing efforts led to further store openings in the
1990s and helped the Company to assume the coveted position of UK’s leading grocer. Tesco
outperformed all its rivals, increasing its market share in groceries from 15.4 percent in 1998 to
28 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 economic
downturn, the profitability growth resumed again from fiscal 2010 and continued through fiscal
2012. Fiscal 2013, however, was not a good year for Tesco. Its revenues were almost stagnant
and profit before tax was down by almost half compared to fiscal 2012. In January 2012, the
Company issued a profit warning for the first time in 20 years and in April 2013, Tesco reported
its first decrease in annual profit in 19 years. Profit warnings were not uncommon in fiscal 2013
and 2014, however. Indeed, Tesco issued five profit warnings in twelve months ending
December 2014.
During fiscal 2013 and 2014, Tesco experienced a decline in the trading profits7. Failing to halt
the dramatic decline in the trading and pre-tax profits, Tesco announced on July 22nd 2014 that
its Chief Executive Officer (CEO) Philip Clarke, a 40-year veteran at the Company, would be
replaced by Dave Lewis, the head of personal care unit at Unilever (the world’s third largest
consumer goods company), on October 1, 2014. However, given the fast-changing situation at
Tesco, 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 after
tax, 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 and
subsequent deterioration from 2012 through 2014. Figure 1 presents a graph of Tesco’s
revenues and profits during 2006-2014 and depicts the history of its stock price vis-à-vis the
FTSE 100 index.
6
Tesco’s fiscal year runs for 52 or 53 week period ending in late February. The 2009 fiscal year was for 53 week
period ending February 28th, 2009.
7
Tesco’s annual report defines trading profit as an adjusted measure of operating profit. It measures the
performance before profits/losses arising on property-related items, the impact on leases of annual uplifts in rent
and rent-free periods, intangible asset amortization charges and costs arising from acquisitions, and goodwill
impairment and restructuring and other one-off costs.
2
— Insert Figure 1 about here –The Controversy over Accounting for Commercial Income
On the Friday of September 19th 2014, a member of Tesco’s staff, whose identity was not
disclosed, warned the Company’s general counsel about early booking of commercial income
and delayed booking of costs. In less than three weeks after joining Tesco, on the Monday after
the Friday on which the staff member blew the whistle, Tesco’s new CEO Dave Lewis had the
unenviable task of announcing on September 22nd, 2014 that profits for the six months ending
August 2014 were likely overstated by £250 million. The Company suspended eight senior
executives and launched an internal investigation of the issue. In addition, Tesco’s Board of
Directors appointed Deloitte (an international accounting firm that was not Tesco’s external
auditor) to undertake an independent review of the Company’s accounting issues, in
association with Freshfields, Tesco’s legal advisers.
Deloitte’s review of Tesco’s semi-annual results confirmed that the Company’s profit
overstatement was larger than the £250 million previously declared and the overstatements
went back further than Tesco originally stated. Deloitte concluded that Tesco’s overall
commercial income adjustment was £263 million, including £118 million in the first half of
2014-15, £70 million relating to 2013-14, and £75 million of prior period adjustments relating to
pre-2013-14. On the basis that the prior period adjustments were not material, Tesco did not
make 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 (provided
on August 29th 2014) regarding profit for the six months to August 23rd, 2014 was overstated
primarily due to the accelerated recognition of commercial income and delayed accrual of
costs. The pre-tax profit for the period fell by 92% from £1.39 billion to £112 million. The
interim report stated:
As announced on 1 October 2014, the Financial Conduct Authority8 has launched
an investigation into the issue. We will fully cooperate with the regulatory
authorities. Given the outstanding investigation, we can make no further
statement at this stage about how these events came about.
8
The Financial Conduct Authority (FCA) is a financial regulatory body in the United Kingdom, but operates
independently of the United Kingdom government, and is financed by charging fees to members of the financial
services industry.
3
Commercial Income and Its Financial Reporting
Consumer products companies provide retailers with different forms of vendor allowances such
as 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 sales
allowances) 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 the
cooperative advertising arrangements. The advertising allowance can be volume-based, or it
can be a flat amount. Slotting fees represent an arrangement in which manufacturers pay
retailers 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 allowances
are 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 contentious
issues and accounting treatments vary across vendors as well as customers both.
Despite the potentially significant effects on profits, accounting policies regarding vendor
allowances are rarely described in IFRS-based financial statements. As stated in Business
Insider (October 7th, 2014), “While European retailers are not obliged to, and do not, disclose
contributions to profits from vendor allowances, US retailers often do, and are subject to more
detailed accounting rules.”
In Tesco’s case, the description of commercial income, or explanation regarding the accounting
policy pertaining thereto, was not included in the Company’s financial statements which were
prepared in accordance with the International Financial Reporting Standards (IFRS).
PriceWaterhouseCoopers (PwC), the auditors of Tesco, however noted a concern about
commercial income in their audit report for fiscal 2014. Although PwC issued a clean audit
report on Tesco’s financials, it mentioned the material risks regarding the reporting of
commercial income as follows.9
9
The auditors for all three of Britain’s biggest retailers – Tesco, Sainsbury’s and Morrisons – alerted investors in
their most recent annual reports that their businesses faced material risks regarding the reporting of supplier
rebates (Business Insider, October 7, 2014).
4
Area of focus
How the scope of our audit addressed
the area of focus
Recognition of commercial income
Commercial income (promotional monies,
discounts and rebates receivables from
suppliers) recognized during the year is
material to the income statement and amounts
accrued at the year-end are judgmental.
We tested the controls management has in
place, focusing on controls over price changes
and margin reviews.
We agreed commercial income recognized 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 focused on this area because of the
judgment required in accounting for the
commercial income deals and the risk of
manipulation of these balances.
We compared movements year on year in
margins for product categories based on an
expectation derived from out sample testing of
contracts with suppliers.
Illustrative Example of a Vendor Allowances Arrangement
Presented 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 routinely
negotiates contracts with its vendors for purchasing products at best prices, and passes on the
savings to its customers. One such annual contract with CPC, a leading consumer products
company was initiated on September 1st 2013. The contract stipulated that Tesco will continue
to receive 8 percent refund of the purchase price if it bought at least the same quantity (3.5
billion units) of CPC products as it did in the previous contract period, regularly priced at £2 per
unit (total purchases of £7 billion). In addition, depending on the level of purchases during the
contract period, the contract stipulated a lower (or higher) refund, as follows:
5
Purchases (units)
during Sept. 1, 2013 – Aug. 31, 2014
Refund Percentage on total purchases
Less than 3 billion
Zero
3 billion to 3.299 billion
6%
3.3 billion to 3.499 billion
7%
3.5 billion to 3.699 billion
8%
3.7 billion to 3.899 billion
9%
3.9 billion and above
10%
The regular price of the units supplied by CPC remained constant (£2 per unit) throughout the
contract period. Not knowing the trend of sales in the forthcoming year, on September 1st
2013, Tesco committed to purchase from CPC the same number of units (3.5 billion) in the
current contract period (12-month period ending August 31st 2014) as it did in the previous
contract period (12-month period ending August 31st 2013). Using this estimate, and based on
prior experience of dealings with Tesco, on September 1st 2013, CPC paid £560 million (8
percent X 3.5 billion units X £2 price per unit) in advance to Tesco. If Tesco’s actual purchases
differ from the contracted amounts, the Company would return the unearned portion of the
refund to CPC (or receive the unpaid portion of refund from CPC) on August 31, 2014.
Tesco’s Earnings Manipulation: Speculations Galore, Facts Few
Several speculations existed about the motivations and mechanisms of manipulating earnings
by Tesco’s management. The most obvious was the link between the compensation of Tesco’s
senior management and financial performance of the Company. In the retailing industry,
commonly used measures of performance include annual sales growth, annuals growth in
comparable store sales (open for 12 months or longer), and the gross margin rate. Tesco used
these and other financial as well as non-financial measures to determine the remuneration of
its executive directors (i.e., senior management). As mentioned in the Directors’ Remuneration
Report of the Company for 2013-14,10 “the majority of our reward is linked to the delivery of
stretching performance over the short and long term aligned with the achievement of our
business vision and our strategy.” Additional details of Tesco’s remuneration policy are
presented in Figure 2.
10
Available at http://files.thegroup.net/library/tesco/annualreport2014/pdfs/tescoar14_gov_remunerationreport.pdf
6
— Insert Figure 2 about here –The remuneration policy described determinants of the executive compensation, but did not
provide details of the bonus targets. The Directors’ Remuneration Report for fiscal 2014 stated
that “Bonus targets are considered by the Board to be commercially sensitive as they would
give away details of our budgeting to our competitors. We therefore do not publish the details
of targets.” The remuneration policy also stated: “Despite strong progress against strategic
objectives 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 a
bonus in respect of 2013-14. Performance Share Plan awards granted in 2011 will lapse in July
2014 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 meet
the targeted results, senior management did not earn annual bonuses in 2013 also.
The report by Deloitte and Freshfield indicated that the profit overstatement stemmed from
the “booking of supplier contributions that were conditional on hitting sales targets that it was
not 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 is
able to sell. David McCarthy, an analyst at HSBC, said that slowing sales growth at Tesco could
have contributed to an inaccuracy in calculations (Reuters, September 23rd 2014). “We suspect
Tesco may have been booking promotional rebates based on historic precedent rather than on
current volumes,” he said.
Tesco’s senior management may also have entered into side deals with major suppliers without
adequately 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 these
sales targets would not be hit, struck deals with suppliers to still make these payments by
offering 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’s
recognition of commercial income as a specific area of focus, and noted that the booking of
such income and costs is a “grey area”. However, it continued to issue clean audit opinions on
11
There have been calls from politicians and campaigners for large listed companies to avoid using the same
auditor for long periods. New EU rules could force companies to change auditors after a maximum 20 years and
put the position out to tender every 10 years.
7
Tesco’s financial statements. Tesco’s audit committee did not even consider commercial
income as a “significant area for disclosure” in its report. It is also interesting to note that two
out of the ten members of the board of directors, including the chair of Tesco’s audit
committee, were PwC “alumni” that formerly worked for the auditing firm.
Further speculation suggests that Tesco’s main suppliers, which include some of the world’s
largest consumer goods companies such as Unilever, Coca-Cola, and Nestle, might have
colluded with Tesco in profit manipulation for the fear of losing a large customer. The
Telegraph (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 the
retailer was claiming money that they did not know about. Reportedly, several of Tesco’s
biggest suppliers have launched internal audits to ensure that their financial figures have not
been distorted. However, no supplier has come out and changed their financial results as a
result of uncovering issues in their negotiations with Tesco.”
In short, the issue of whether Tesco’s management manipulated Company earnings remains
unresolved. The complexity of Tesco’s promotional deals with suppliers may have left room for
subjective decisions, unintentional errors, and honest mistakes (The Economist, September 27th
2014). For instance, some analysts blamed the accounting error on the lack of experience of
Tesco’s Board of Directors in the retailing industry. Some have also suggested the commercial
income adjustment as an example of “kitchen sinking”12 of the accounts by the new CEO to help
reset Tesco towards future profitability (The Telegraph, September 22nd 2014).
Reaction from the Financial Community to Tesco’s Profit Overstatement
On September 22nd 2014, when Tesco disclosed likely profit overstatement and the
appointment of Deloitte to perform an independent review, capital markets responded by
dropping 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 warned
that its annual profits would fall below consensus analysts’ estimates, its stock price declined to
a 14-year low of £1.65 per share. During the calendar year 2014 alone, Tesco suffered a
reduction in the market capitalization of almost £12 billion. The downward spiral in Tesco’s
stock price during 2014 is presented in Figure 3. Some high-profile investors including the
legendary investor Warren Buffett sold their stakes in the Company, stating that their decision
to invest in Tesco was “a mistake.”
— Insert Figure 3 about here –12
Kitchen sinking involves front-loading the bad news to pave the way for a rebound in profit in later years.
8
Credit rating agencies also responded unfavorably to Tesco’s profit overstatement. Almost
immediately after Deloitte issued its review report on Tesco on October 22 nd 2014, two credit
rating agencies reduced Tesco’s rating to the cusp of investment grade. Fitch dropped Tesco a
notch to BBB- and Moody’s cut its rating of Tesco to Baa3 from Baa2, citing the reduced and
trading profit and “uncertainties” related to the regulatory investigations into Tesco’s
accounting problems.
On January 8th 2015, Dave Lewis, Tesco’s chief executive, announced drastic measures to help
turnaround the Company’s financial position, including closing Tesco’s headquarters in
Cheshunt, shutting down 43 unprofitable stores and scrapping plans to build 49 new
supermarkets. Lewis also announced that Tesco would close its defined benefit pension plan,
consider canceling its final dividend payout and slash corporate administrative costs by 30
percent. The company had met with the three major credit rating agencies (Fitch, Moody’s and
S&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 rating
to Ba1 from Baa3 stating that Tesco’s attempts to protect its balance sheet will "take time to
implement". Moody’s also reported that "structural changes in the UK grocery retail market
will continue to challenge the company’s operating performance". Less than a week later, S&P
followed suit on January 15th 2015, when it downgraded Tesco’s rating to non-investment
grade, or junk status.
Legal Proceedings
On October 1, 2014, Tesco announced that the U.K.’s financial watchdog, the Financial Conduct
Authority (FCA), had “commenced a full investigation” of the accounting irregularities at the
company. Unlike the US legal system, no provision exists under English law for class-action
lawsuits, 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 Depository
Receipts).
Britain’s Serious Fraud Office (SFO) recently opened a criminal investigation into accounting
irregularities at Tesco. The Company said that it has been “cooperating fully with the SFO and
will continue to do so.” The Financial Conduct Authority said it would stand aside, given the
SFO’s decision to investigate. The SFO declined to comment further, citing the investigation.
Such investigations can take years to complete.
9
On February 5th 2015, the Groceries Code Adjudicator (GCA), UK’s first independent adjudicator
to oversee the relationship between supermarkets and their suppliers, joined SFO in
investigating Tesco. The adjudicator said: “I have reasonable suspicion that Tesco breached the
code in two areas. One is reasonable payments and second is payments for better positions on
shelf outside promotions.”
Epilogue
On May 10th 2015, Deloitte was appointed by Tesco as its new auditor after PwC and the
Company "mutually agreed" that PwC would not take part in a re-tendering process.
10
Requirements
Requirement 1
Financial Reporting of Sales Allowances
As mentioned in the illustrative example of the vendor allowances agreement, assume that on
September 1st 2013, CPC paid £560 million to Tesco in exchange for Tesco’s commitment to
purchase 3.5 billion units of CPC’s products. At the end of the contract period (August 31st
2014), the amount of sales allowances was calculated based on Tesco’s actual purchases (3.65
billion units at £2 per unit) during the contract period and difference was settled in cash
between CPC and Tesco.
(a)
CPC recognized the payment of £560 on September 1st 2013 as SGA (Selling, General
and Administrative) expenses, and the cash settlement on August 31st 2014 as an
adjustment to SGA expenses. Explain whether or not CPC’s recording of sales
allowances as SGA expenses is in compliance with U.S. GAAP. Cite paragraphs from the
appropriate professional pronouncements.
(b)
Tesco recognized the receipt of £560 on September 1st 2013 as sales revenues, and the
cash settlement on August 31st 2014 as an adjustment to sales revenues. Explain
whether or not Tesco’s recording of sales allowances as sales revenues is in compliance
with U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements.
(c)
Complete the following table for CPC for the 12-month contract period ending August
31st 2014.
Item
Income Effects of Sales Allowances – Vendor’s books – CPC
(Amounts in millions £)
Current contract period
Previous
Reported
Corrections, if
Correct amounts
contract period
amounts
any
per U.S. GAAP
Sales revenues
Cost of goods sold
Gross margin
SGA expenses
Operating profit
Sales growth over previous
contract period
Gross margin Rate
7,000
4,900
2,100
560
7,300
5,110
2,190
584
1,540
1,606
Not Applicable
4.29%
Not Applicable
30%
30%
Not Applicable
11
(d)
