Tesco (ticker: TSCO.L) delivered another shock to investors on 22 September, announcing an estimated £250m overstatement of its first-half profit guidance (for the year to February 2015) “principally due to the accelerated recognition of commercial income and delayed accrual of costs” in its UK food business. Describing the issue as “serious”, the company delayed the announcement of its interim results and appointed Deloitte to conduct an independent review with the help of its external lawyers.
The announcement provides only limited information on what has happened. The implication is that the issue is primarily about the timing of profit recognition this year: first-half earnings have been inflated by pulling forward profits from future periods. Currently, there is no suggestion that income has been completely fabricated. Nonetheless, it is clear that this is more than just an accounting error.
The £250m includes “in-year timing differences”, suggesting that the full-year profit impact may be less. However, it is also possible that the issue is not limited to the current year. Profits pulled forward into the first half of this year may have filled a shortfall resulting from profits pulled forward last year; similarly, the guidance for the second half of the year may include profits from 2016. Therefore, the £250m profit overstatement may represent a cumulative amount over a longer period, so that the net impact on first half profits is substantially lower. In which case, profits in earlier years may need to be restated.
I thought it would be useful to look at the company’s results in previous years to see whether this sheds any light on the current issue. While there is no “smoking gun”, fluctuations in Tesco’s margins raise concerns that it is not a one-off event restricted to just the current year.
Accounting treatment of commercial income
Commercial income (or supplier income as it is also known) includes any incentives, rebates, discounts and other payments given to retailers by suppliers. The accounting treatment of such income is well established, although it may require some subjective judgements. It is not recorded as revenue, but is treated as a reduction in the cost of sales. Under IAS 2, which covers the accounting treatment of inventories, “trade discounts, rebates and other similar items” are deducted from the purchase cost of inventory. This is quite strict; even payments such as product listing fees that are not directly linked to sales volumes are treated in this way. The main issue is estimating the purchase cost, when this is not known at the balance sheet date; for example, it may depend on discounts linked to the level of future sales.
Any commercial income accrued at the end of a financial period is included in the balance sheet as an asset in prepayments and accrued income (within trade and other receivables). Potential accounting issues may be indicated by inflated margins, an increased prepayments balance and a working capital cash outflow.
Increasing gross sales margin
Figure 1 shows the gross sales margin (i.e. after deducting just the cost of inventories) since 2008 for Tesco, as well as its two listed competitors. Perhaps surprisingly, given widespread talk about supermarket price wars, Tesco’s margin has increased by around 180bp in the last two years (on a like-for-like basis, adjusted for discontinued operations). The margin increase during this two-year period added more than £1bn to Tesco’s pre-tax profits in 2014. Sainsbury’s margin also increased substantially in this period. Tesco’s margin includes both the UK and international operations.
Figure 1: Gross sales margin
Source: company accounts
As the chart shows, the margin has been quite volatile. Sales mix, particularly the proportion of fuel sales, accounts for some of this. Margins on fuel are much lower than on other goods; therefore, higher fuel prices will generally depress the overall gross sales margin. Changes in the proportion of fuel sales (implied by the difference in like-for-like growth rates including and excluding fuel) broadly explain fluctuations in Tesco’s margin between 2008 and 2012. Fuel prices increased substantially in 2009, and again in 2011 and 2012, after a dip in 2010 during the financial crisis, helping to push down the margin during this period. However, fuel prices were less volatile in 2013 and 2014; fuel sales declined in both years, but only slightly faster than non-fuel sales. Therefore, changes in fuel sales do not appear to explain the substantial margin increase in 2013–2014.
Other factors may also have affected the margin, including the proportion and mix of clothing and general merchandise sales. Recently, Tesco has reduced the space allocated to lower margin electrical goods and increased the range of higher margin clothing. However, while such changes may have a noticeable impact over several years, they are unlikely to have had a material impact on year-to-year margins.
Obviously, the margin increase in 2013–2014 may have been due to either higher prices or lower purchase costs. Unfortunately, Tesco no longer provides the split in like-for-like sales growth between price and volume, which would indicate how much it raised prices during this period relative to underlying cost inflation.
However, it seems unlikely that the increase in the gross sales margin was due to higher prices. On several occasions in recent years, Tesco has announced large “investments” in price cuts, most recently an additional £200m earlier this year. Supermarket pricing is notoriously opaque and such announcements should be treated with a degree of scepticism, since no time scale is given for the cuts, or the base level from which they are made. Nonetheless, there clearly has been increased price competition in recent years. Furthermore, Tesco has regularly used money-off coupons to counter recent market share losses; such promotions almost certainly reduce the gross sales margin, even if they boost short-term sales. The company recently announced that it would reduce the amount of indiscriminate “couponing”, which it described as “unsustainable”, as part of a shift in Tesco’s strategy this year towards more stable, lower pricing on certain goods. One of the reasons given for the big drop in first-quarter like-for-like sales was a reduction in the level of couponing.
A more likely explanation for the margin increase is that Tesco put extra pressure on suppliers to share the pain of price cuts and promotions by reducing their own prices. Supplier negotiations inevitably involve various trade-offs; suppliers may have agreed to short-term, temporary price cuts, in exchange for higher future prices or volumes. During 2013, and even 2014, it would have been reasonable to think that Tesco’s problems were just temporary. Such agreements may not contravene accounting rules (depending on how they are structured), but they could inflate Tesco’s gross sales margin, and overall profits, at least in the short term.
Early recognition of commercial income could also have helped boost the gross sales margin in the last couple of years, although the size of the profit increase appears too large to be attributable solely to this. Whatever the reason for the increase, it raises questions about the sustainability of Tesco’s profitability.
Collapse in UK trading margin
Until recently, Tesco’s UK trading margin had been stable at around to 6% (see Figure 2). The trading margin is clearly a metric targeted by Tesco; the suspicion is that it tries to smooth year-to-year fluctuations. To a large degree, the company’s profits are taken on trust; it provides only limited information about the breakdown of underlying costs and their trends.
Figure 2: UK trading margin
Source: Tesco, author’s estimates
The increase in the gross sales margin did not prevent a substantial fall in the UK trading margin in the last two years, largely because of the negative impact of operating leverage as like-for-like sales declined. Tesco announced a “reset” in the UK trading margin in 2012. One of the reasons given was the need to increase price promotions. A year later, the company stated that the 5.2% margin achieved in 2013 was sustainable. It managed to hold it at this level in the first half of 2014. However, the margin slipped again in the second half of the year to 4.9%, as the decline in like-for-like sales accelerated.
The latest announcement suggests that group trading profits were around £850m in the first half of the year, compared with previous guidance of £1.1bn, which already implied a sharp drop in profits for the UK business. It now appears UK profits more than halved, falling by around £0.7bn, while the trading margin may have been just 2%.
If because of in-year timing differences, the full-year profit impact in 2015 is less than £250m, the current second-half guidance should be higher than that given in August. For example, if £150m is shifted to the second half, it suggests the second-half UK trading margin could be over 4%, around 250bps more than the first half and not far short of the second half of 2014. Historically, the difference between the first and second-half margins has been less than 50bps.
It is hard to explain this yo-yoing in the margin, unless profits from the first half of this year were pulled forward into 2014. The drop cannot be due solely to operating leverage; the gross sales margin must also have suffered a large decline. It is unlikely that either price cuts made since the start of the year or the Clubcard fuel promotion will have had such a large impact, particularly given the offsetting reduction in couponing. It is also difficult to understand how profits could bounce back so quickly in the second half.
It is possible that some profits were inadvertently pulled forward into 2014; Tesco may have been overoptimistic in estimating volume discounts, given the subsequent rapid decline in sales, although it is difficult to believe that this is the full reason. If Tesco has been recognising profits early for some time, then the £250m may represent a cumulative amount covering a longer period, so that the net profit impact on the first-half profits could be much lower. Similarly, the profit estimate for the second half of the year may be too high, if it includes profits pulled forward from 2016. Until the company provides greater clarity on what has happened, it is difficult to estimate a new profit baseline.
Balance sheet and cashflow evidence inconclusive
The prepayments balance can provide evidence of the early recognition of commercial income. Tesco’s balance, which was £0.4bn at the last year-end, has not changed materially for several years, although it does include other items in addition to commercial income. If the company has been recognising commercial income early for a number of years, the net impact in any individual year may not be particularly large. Furthermore, the transfer of several businesses to discontinued operations in recent years will have reduced it somewhat. Some commercial income balances may also have been offset against the much larger trade payables balance of nearly £6bn.
The cashflow statement does not give sufficient detail to track the prepayments balance, although Tesco’s squeeze on suppliers is apparent from a substantial working capital inflow in 2014. Overall, the evidence from the balance sheet and cashflow statement, while inconclusive, suggests that any early recognition of commercial income in prior years was limited.
While there is no clear evidence of wrongdoing before the current year, I would be surprised if the current accounting issue was a one-off. However, until further details are available, any opinion remains speculation.
Nonetheless, irrespective of this, it is difficult to argue that this is an isolated incident. The company has regularly used questionable accounting methods to boost profits (see my earlier report on Tesco at the end of August “Aggressive accounting hides financial weakness”). While this may prove to be the most egregious example, it would certainly not be the only one. Therefore, even if ultimately the impact on profits in any single year is not particularly large, it would be wrong to dismiss the issue as unimportant. As stated in my previous report, “the lack of transparency raises serious concerns about what else remains hidden”. Until the company is able to reassure investors about the quality of its financial information, concerns will remain that this is the tip of an accounting iceberg.