Tesco’s Accounting Scandal a Lesson for All Public Companies

Britain’s biggest retailer faces a crisis situation two weeks after announcing that it overstated its first-half profit expectations by some £250-million. Tesco PLC, the multinational grocery and retail giant headquartered in England, reported on September 22, 2014 that its August 29 profit warning should have forecasted trading profit totalling £850-million, rather than the £1.1-billion that the company actually reported – an inflation of nearly 25%. The market reacted swiftly, and as of October 7, 2014 had knocked 20% (a total of about £4-billion) off the value of Tesco shares. On October 1st, Britain’s financial regulator, the Financial Conduct Authority, announced that it has launched a full investigation into the accounting scandal. As the company rushes to contain the situation and events continue to unfold, it is already clear that this is a classic example of the potentially explosive risks that public companies face every time they prepare and report their financial status to the market.

Tesco has been for years the world’s second largest retailer after Walmart, though in recent times it has faced stiff competition in Britain and Europe, together with declining profits. Its September 22 announcement was the latest and most impactful blow to Tesco’s market value and reputation. Tesco has stated that the profit overstatement was caused by apparent accounting errors - including the early booking of revenue and delayed recognition of costs - which were discovered during the preparation of its forthcoming interim results. Those results have now been delayed from October 1 to October 23. The company has already begun an independent investigation into the accounting irregularities. Four senior-ranking Tesco employees have been placed on leave while the investigation proceeds. The accounting error and misreporting, together with the precipitous drop in share value and subsequent investigations, have been widely reported in the business pages around the world.

The situation unfolding at Tesco is a prime example of how the public may react to adverse news in unpredictable ways. Even after the change to its reported profit, Tesco was still profitable. In that sense, the market’s reaction could be seen as disproportionate. However, the news has clearly shaken public confidence in the company. Commentators have suggested that in the context of the other challenges facing Tesco, it may be an indicator of deeper-lying and more serious problems. Tesco’s share price seems to have been punished so severely not because the profit in one quarter was overstated, but because people are now saying “I don’t know what I don’t know” about the company in light of the fact that this happened. The same scenario has been played out numerous times in Canada (Biovail, SNC Lavalin and others) and elsewhere. It is also likely that the market has factored in that this situation will inevitably engender other expensive and distracting consequences, including the freshly initiated regulatory investigation and rumblings of a possible class action. 

Public companies must ensure that they have in place a strong corporate governance culture and robust internal systems designed to prevent accounting and other problems. Commentators have long held that the “tone at the top” is a key factor contributing to the integrity of the financial reporting process, and companies are well advised to have a careful look at the adequacy of their internal controls on a regular basis. It is always preferable to manage and minimize risk than to have to respond to a crisis. Having said that, no company, however well run, is immune to crises. Without knowing more, it is impossible to say whether the situation at Tesco could have been prevented. What is clear is that, as the Tesco case now demonstrates, a company cannot unring the bell once news of an irregularity has broken. Instead, Tesco must scramble to react to a growing crisis. People will continue to watch with interest to see how, and how well, Tesco is able to weather this storm.