There is a long history of companies misstating their financial position and performance, and on Monday Tesco plc became the latest with its announcement that it had overstated its half-year profit forecast by £250 million. This revelation, arising from information provided by an internal whistle-blower, resulted in an 11 per cent reduction in the supermarket giant’s share price, putting the share value at an 11-year low. How can an error this large have occurred?

Tesco has admitted the errors are principally a result of accelerated recognition of commercial income and delayed accrual of costs. Standards for financial reporting by companies are enshrined in International Financial Reporting Standards (IFRS). IFRS-based accounts are prepared on the accruals basis, which means that income is included in a set of accounts if it has been earned, and costs are included in a set of accounts if they have been incurred regardless of whether any cash has been paid.

On face value this may seem like questionable practice, but for an investor to understand a company’s financial position, it is necessary. If Company A sells goods to Company B, investors want this information regardless of whether or not the cash has been received (provided there is a realistic expectation that the cash will arrive at some point in the future).

While this is important information for investors, this basis of accounting does require an element of judgement to determine the timing and magnitude of cost and revenue. Where judgement is required there is an opportunity for error or manipulation, and this seems to be the root cause of Tesco’s misstatement.

But if judgement is required when it comes to preparing a set of financial statements, why don’t more serious errors occur? The answer is that companies such as Tesco have controls in place to correct, identify and prevent both intentional and unintentional errors. These controls will be reviewed by an internal team to make sure they are operating effectively. Did these controls exist at Tesco and were they sufficient?

In Tesco’s 2013–2014 annual report, PwC, Tesco’s independent auditor, noted ‘commercial income’ as an area of audit focus. This means that when PwC planned their audit procedures they determined that this area could contain an intentional or unintentional error which could affect the quality of the accounts. PwC also noted that controls over this area were in place and issued an audit opinion that the accounts were ‘true and fair’. How PwC arrived at this decision and the nature of the communication they had with Tesco's management is not public information. But the fact remains that the audit team had flagged it as a key risk, so why did Tesco not take it seriously?

For the last six months Tesco has been operating without a Finance Director. On 1 September Tesco appointed a new Chief Executive, Dave Lewis, to reverse declining performance. Research by Dechow et al (2011) looked at accounting misstatements and why they occurred. Their analysis showed that misstatements occur most frequently in companies where financial performance is deteriorating and management are under pressure to maintain high stock market valuations. A study by Murphy and Zimmerman (1993) found that incoming management teams may take the opportunity to ‘clean the books’ at a time where they face no personal reputational risk. If the outgoing board members were under pressure to maintain performance and the new board is trying to ‘clean the books’, then the whistle-blower may have done the new board a favour.

Deloitte has been brought in to unpick exactly what has happened at Tesco. We must wait to see its verdict on how, but probably not why, such a significant accounting misstatement occurred.

Lucy Dilley
Teaching Fellow in Accounting, University of Birmingham

Dr Dan Herbert
Head of Department of Accounting, University of Birmingham