EquitiesNov 5 2014

Bath time over for new Tesco chief

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He has cannily attempted to unearth all the bad news hidden in the supermarket’s accounts in one hit, to get them all over and done with. Deloitte found that the black hole in Tesco’s accounts amounted to £263m, with the practice of overstating profits going back three years.

Investors have seen their shares lose half their value this year with the accounting calamity coming on top of falling sales and market share in the grocery sector. The latest hammer blow saw chairman Sir Richard Broadbent announce he would be stepping down to join eight suspended executives on the sidelines. Taking a bath now rather than a year down the line means blame will not be apportioned to Mr Lewis and he can wash his hands of the old guard and start with a clean slate.

Many investors will be hoping that Mr Lewis will now be able to pull the plug on his bath and deliver a strategy that will return the one-time giant of UK business on a path back to its former glories. Tesco’s share price hit an 11-year low last week and as it still has the biggest market share in the UK plus a now supposedly clean set of accounts, now might be the time to go in. After all, Warren Buffet still has a near 3 per cent stake in the company.

But there is no reason to think this is over; in fact it could still get worse as the Serious Fraud Office has confirmed it is carrying out a criminal investigation into the accounting irregularities, while the Financial Reporting Council could also step in, with the accountancy and audit watchdog having said it is “monitoring events at Tesco closely”. There could be serious fines and more to come from these investigations that could heap more misery onto the supermarket.

There is no indication that things are getting better and there is still no clear strategy on how to drag Tesco out of its malaise, with Mr Lewis not expected to announce anything until next year. There is a lot of rhetoric about the need for strategic renewal, but very little detail has been communicated by the company.

The public and investors rely on transparent and clear accounting for their investment decisions, and to find a FTSE 100’s books embroiled in such a scandal is very disappointing to say the least. And though this one issue was flagged up internally by a whistleblower, maybe there should be a comprehensive review of how Tesco has been treating other accounting line items.

There is scope in the current rules to pull forward rebates from suppliers that are classified as income, but that must be done together with a consistent policy over time. Deloitte has found that Tesco contradicted its own policy on this – it decided to start recognising these rebates much earlier than it had in the past. The industry recognises money before it is received – that is a common practice - but the problem is changing the policy halfway through. Recognising revenue before you actually receive it is fine if you know you are going to receive the money, but it is not fine when you book it at points when you would not normally. Such a change in policy would normally have to be approved by the auditors, but it is not clear whether PricewaterhouseCoopers was aware of Tesco’s shifting approach to this.

When the fundamentals of the business are not doing well and the company is under pressure, one way to quickly turn it around is to fudge the numbers.

These overstatements have got larger and larger, with Deloitte identifying £118m in the six months to August this year, but that is still under the materiality threshold set by PwC of £150m, which brings into question the point of materiality. It is meant to focus auditors on the most significant accounting items and for profits overstated by £150m or over. But in this case the threshold was so big that it allowed Tesco to overstate by massive amounts. So should they be set so high? We need accountancy to act with integrity and in an ethical manner so that we can rely on what we see in the books. This brings into question the auditors’ role, especially as PwC has been Tesco’s auditors since 1983, despite the FRC’s declaring after the financial crash that companies should consider changing auditor at least every decade.

It remains to be seen whether PwC will stay as Tesco’s auditor, as it must be remembered that when Mr Lewis was at Unilever the Anglo-Dutch company ditched it as auditor in 2013 after 26 years of working together in order to comply with the new FRC rule.

If you take away these manipulations, you may well have a clean set of accounts, but they show a general decline in sales, with the new profit-after-tax figure for the six months to August 23 at just £112m rather than the previously stated £1.4bn. And this is in the context of a sector facing huge competition. The big supermarkets are in a tough position with the rise of the discounters, which puts pressure on margins. It is very hard to excel in this industry generally, so you can see why investors are abandoning Tesco.

Tesco has lost its way in terms of strategy. It is not sending any clear message, it is not sure whether it is focused on quality or low costs and at the moment its public announcements are still incredibly vague. It was once stated that one in every £7 spent on the high street went through Tesco, and when you reach that sort of domination it is probably easy to become complacent. It has had a disastrous foray into the US and now needs to refocus, with a probable divestment of some of its non-core assets to come. But until Mr Lewis states a clear strategy, there is still too much uncertainty around Tesco for investors to take a gamble on it.

The underlying fundamentals of Tesco have not gone down by as much as their share price, so you could argue it was overpriced in the past, though the markets are very volatile and tend to overreact. But in some ways it does not matter what Tesco says – investors have lost confidence in the supermarket giant. It will take a very bold move to win their confidence back and a strong and clear direction.

Suspending eight executives sends a strong message that the old guard are out, especially with the chairman going as well. Mr Lewis has a chance to bring in his own men and sweeping reforms to the company. The Tesco Value senior management team’s working holiday to Norfolk looks like the first step in his introducing a new culture, and that will no doubt involve cutting costs.

At least nobody is raising further questions about the accounts, but one should never completely believe any set of accounts, and Tesco is still unable to produce a full-year profit forecast. It would be nice to think that this accounting debacle will lead to a more transparent and honest appraisal of Tesco’s finances in the future, that the accounting world will look deep into its soul and decide to audit in the name of the public, a public that needs to be able to trust a set of audited accounts. But we have heard this navel-gazing before, not long after the financial crash of 2008 when institutions fell one after another despite their accounts detailing nothing of the impending doom.

As for Tesco, the longer Mr Lewis takes to decide on his strategy, the more investors will take the inaction as a sign to get out. Sooner or later he is going to have to get out of the bath and set out a vision for rebuilding Tesco’s battered reputation.

Crawford Spence is professor of accounting at Warwick Business School

Key points

* Tesco’s chief executive has cannily attempted to unearth all the bad news hidden in the supermarket’s accounts in one hit.

* The overstatements have got larger and larger, with Deloitte identifying £118m in the six months to August this year, but that is still under the materiality threshold set by PwC of £150m.

* Suspending eight executives sends a strong message that the old guard are out, especially with the chairman going as well.