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.

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.

“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.