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Wednesday, 24 September 2014

Crime of the Week: Every little helps

Tesco says it has overstated its half-year profits by an estimated £250m because of irregular movements in “commercial income”, the revenue that it receives from its large multinational suppliers.  But how can that be? Selling (mostly) groceries should be a simple business, with simple accounting. The shopkeeper buys stock from its suppliers and pays for it on normal credit terms.  The stock is then sold for cash (mostly), and the unsold stock is written off.  Simple apart from that it should just be a simple matter of normal corporate items (fixed assets, borrowings, subsidiaries and other investments, minority interests, taxes, unfunded pension commitments etc, etc). Or so you would think. The issue is all in the payments that suppliers make to Tesco,apparently.

Why do suppliers pay Tesco, surely it should be the other way round?

Not so fast dear reader.  Part of the brand management culture that pervades modern grocery is the price that big companies are willing to pay to get the best spot on the supermarkets' shelves.  The premium price that you pay for a tin of Campbell's Soup or Heinz Baked Beans over the equivalent own brand product doesn't just cover the superior ingredients, hand crafted cooking and superior marketing. It also covers the extra cost (listing fee) of having the suppliers' products placed at eye-level, as well as other promtional activity.

Suppliers also often pay to have their products carried in Tesco’s stores, and a higher fee for the smaller Express stores that carry fewer product lines. .

OK, but that doesn't really explain any over-estimation of income. Either the fees are paid or they aren't so what gives?

The accounting problem apears to relate to additional payments called "supplier rebates”. Suppliers will pay Tesco and other supermarkets when they achieve an agreed level of sales in a year. Typically the rebates would kick in when a certain growth level is achieved in annual sales. The few percent rebate may not seem much but when the industry operates on 2-3% margins it goes a long way to explaining how Tesco could achieve high margins while growing.

But Tesco hasn't been growing

Tesco's sales volumes have actually been declining for a few years as it loses market share to Aldi, Lidl (& Poundland and Waitrose), so it will probably receive less in the way of rebates than it did last year. The trouble is that Tesco, and for all I know all the other retailers do the same, has decided that it should book some of the rebate income in its half year profits.

Accountants call this the accrual principle.  I call it fantasy accounting.  Essentially the finance department will ring round all the product managers and ask them to estimate full year sales, and thus guess the amount of the full year rebate.  Now as far as I know nobody at Tesco gets paid bonuses on the basis of full-year sales forecasts, but with stagnant or declining sales the loss of the rebate is going to hit a product line's profitability and may cost someone a job, hence the incentive to make optimistic full year sales forecasts.

Should Tesco’s auditors (PwC) have spotted this issue?

On Monday the new Tesco Chief Executive said that the problems had occurred in its unaudited first-half results. But in the auditor’s report in Tesco’s 2014 Annual Report, PwC highlighted the recognition of commercial income as an area of focus “because of the judgment required in accounting for the commercial income deals and the risk of manipulation of these balances”. “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 end of the year are judgmental.”

So how bad is this?

Even if it is a practice that has been going on for years, if the rebate measurement period matches the accounting period, all this would do is boost the interim results because the full year sales would result in the correct amount of rebate.  If the periods don't match then the £250m writedown would appear to be a correction for a persistent overestimate of rebate values.

A large amount (and certainly enough to warrant serious attention from regulators and possibly prosecutors) but in the context of £45bn of annual sales neither unexpected or unmanageable.  The good news is that it seems to be as a result of a combination of bullishness and incompetence, but at least it doesn't appear to be Enron or Worldcom-style habitual fraud.

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