Saturday, 28 October 2017

Tesco accounting fun: A new broom sweeps clean? We've seen it all before.

I've seen this pattern a hundred times before. The recent Tesco saga is a good illustration of the overall pattern:

1. Somebody (Terry Leahy in this example) is in charge for years and years and the business appears to be doing very well.

Guardian, April 2011:

Tesco, Britain's biggest retailer, has reported record profits of £3.8bn – more than £10m a day – but admitted that it needs to do better in its core UK operations. Results for the year to end February, released on Tuesday, showed the bulk of Tesco's 12.3% profit increase came from its growing Asian operations.

Total group sales were £68bn and in Britain sales grew 5.5% to £45bn, with trading profits ahead by 3.8% to £2.5bn. But the performance was not good enough, Tesco's new boss Philip Clarke admitted…

As a matter of fact, Tesco had been resting on the laurels of its super-cheap land acquisitions in the 1990s and early 2000s for far too long. To cut a long story, Tesco makes a lot of money by simply renting out shelf space. The rapid expansion dried up in the late 2000s when land became very expensive again, but of course there was still plenty of existing shelf space to rent out.

2. As we found out later, Tesco had been flattering their profit figures by treating advance payments of rent for shelf space as earned in the year it is received/agreed instead of "spreading" it out over the term of the agreement. This is just a timing thing, if the supplier pays £100 for a five year deal, you can book £100 profit in Year One or you can book £20 a year profit in each of Years One to Five. Given a large number of such transactions, it doesn't really matter which approach you take as long as you are consistent. By Year Five, you would still be booking £100 a year profit, it's neither here nor there whether that represents Year Five receipts of £100 or time apportioned £20 from Year One, £20 from Year Two etc.

The interim new boss didn't have the nerve do the obvious thing and was soon booted out again.

3. The next new boss (Dave Lewis) and his team did have the nerve to do the obvious thing and blew the whistle on their own business, which led to the so called accounting scandal. From the BBC October 2014:

At its simplest it appears that profits were "booked" early - ie moved into the first half of the year. At the same time, expenditure on costs associated with the deals was delayed. Now, this can be done in any number of ways, some of which may have been used by Tesco.

Suppliers pay retailers for promotions that could mean more of their product being sold. Payments can be made for better positions on shelves, for visibility on "plinths" at the end of aisles where customers are more likely to see products, or for two-for-one offers.

One senior figure in the grocery industry said there was evidence across the sector that payments are sometimes taken unilaterally from suppliers. The payments may be disputed later, and a refund or new agreement made later in the second half of the year. By then, the original payment has been taken as revenue...

The clever bit is that past profits were revised downwards with the inevitable result that future profits would be flattered. If you revise earlier accounts using the "spreading method" then reported past profits fall and it is inevitable that the income will simply be recognised in future years instead.

4. Dave Lewis then went for broke and wrote down the value of all the land Tesco had overpaid for in the late 2000s. From The Guardian April 2015:

Tesco has crashed to the biggest loss ever recorded on the UK high street, slumping £6.4bn into the red as a result of huge writedowns on the value of its property portfolio and stock.

Dave Lewis, the chief executive parachuted in to mastermind a turnaround last year, described the loss as a “big significant number”. But the former Unilever executive insisted the supermarket was on the road to recovery after a tough 2014 in which it suffered a £263m accounting scandal and the exit of the former chief executive, Philip Clarke, following slumping sales and profits.

“This patient is okay … Our job is to allow it to be healthier. There is nothing critical about its finances,” he said.

The point being that if you are going to report a large loss, you might as well report a loss of staggering proportions and get it over with. The numbers are so huge that people just remember "big loss" and not quite how big it was.

5. Hey presto, David Lewis can blame everything on their predecessors, portray themselves as honest and contrite businessmen and sit back will all those write downs are quietly written back up again and the "spread" income from earlier years boosts future profits.

From City AM, October 2015:

Tesco has resumed its dividend for the first time in three years, after reporting a 667 per cent increase in pre-tax profit in the first half of the year.

Profit before tax rose to £562m from £71m this time last year. Operating profit was up 67.4 per cent, from £515m to £885m.

6. I don't wish to discredit Dave Lewis who might well be a retail genius, but the only way to find out whether this turnaround is real, is to wait until he retires in a few years' time and see whether his successor does the same thing - revise the last few years' profits downwards, play the honest and contrite businessman etc.


Lola said...

This is not even tiresome. It really just reveals the shallow ignorance of journalists too lazy to investigate join the dots and do the numbers.

Kj said...

Also notice that the auditors of a multinational choose to ignore obvious breaches of accounting principles.

Shiney said...

I couldn't possibly comment....... :wink:

Graeme said...

Surely everyone knows the 3 envelopes joke

James Higham said...

"flattering their profit figures by treating advance payments of rent for shelf space as earned in the year it is received/agreed"

As one does of course.

Mark Wadsworth said...

L, even if they did, nobody would read it. People want salacious headlines.

Kj, I'm a great believer in cash accounting. The smoothing is the suspect bit.

Sh, your business, your rules.

G, can you enlighten us with the three envelopes?

JH, the point is, doing that is fine provided you do it consistently. Tesco receive so many relatively small payments each year that it all averages out.

Graeme said...

A fellow had just been hired as the new CEO of a large high tech corporation. The CEO who was stepping down met with him privately and presented him with three numbered envelopes. "Open these if you run up against a problem you don't think you can solve," he said.
Well, things went along pretty smoothly, but six months later, sales took a downturn and he was really catching a lot of heat. About at his wit's end, he remembered the envelopes. He went to his drawer and took out the first envelope. The message read, "Blame your predecessor."

The new CEO called a press conference and tactfully laid the blame at the feet of the previous CEO. Satisfied with his comments, the press -- and Wall Street - responded positively, sales began to pick up and the problem was soon behind him.

About a year later, the company was again experiencing a slight dip in sales, combined with serious product problems. Having learned from his previous experience, the CEO quickly opened the second envelope. The message read, "Reorganize." This he did, and the company quickly rebounded.

After several consecutive profitable quarters, the company once again fell on difficult times. The CEO went to his office, closed the door and opened the third envelope.

The message said, "Prepare three envelopes."

Mark Wadsworth said...

G, I didn't know that one, thanks!