Section C of the UK Corporate Governance Code 2016 (‘the code’) addresses accountability. This section can be further divided into three sections, namely; ‘Financial and Business Reporting’, ‘Risk Management and Internal Control’ and ‘Audit Committee and Auditors’. This paper will analyse where Tesco Plc (‘Tesco’) went wrong.
C1 of the code states that it is the boards responsibility to present a ‘fair, balanced and understandable’ assessment of the company’s position and prospects (FRC, 2016). Tesco deliberately and intentionally misled the auditors in order to ‘flatter’ its dire financial position. As a result of this, Tesco overstated its half-year profits by £263 million. Analysts have argued that there had been warning signs in the years preceding the scandal. However, the were duly ignored. (Welfare, 2014)
The key question is what motivated the individuals to take such drastic measures? The deliberate misstatement of the financial position of Tesco can be fundamentally linked to the poor corporate culture at the time. Tesco had lost its focus and there was a ‘lack of investment in its stores’ (Wood, 2012). Consequently, this led to a frenzy in which staff were overwhelmed in their attempts to meet targets. This corporate climate provoked the manipulation of commercial income. Commercial income is the revenue retailers receive from its suppliers. They come in the form of rebates and are recorded as revenue. The rebates serve as incentives to meet predetermined targets. The retailer must then estimate halfway through the year how much these rebates will be worth at the end of the year. The practise of commercial income is poor corporate governance as the concept relies upon predictions of estimated income that have not yet been received. It is entirely discretionary and the manager is unlikely to be expected to provide any evidence for his or her decision. Therefore, due to the subjective nature of commercial income there is the danger of being too ambitious in estimating rebates. It appeared that Tesco were booking commercial income early and delaying the accrual of costs, which resulted in an overestimation of £263million.
C2 states that ‘the board should maintain sound risk management and internal control systems’ (FRC, 2016). It would seem that Tesco was very lax in its approach in maintaining risk management and effective internal controls, and for that reason the negligent environment which was created allowed accounting malpractices to flourish. The overstated profits were made known through a whistle-blower. Whistleblowing is only deemed effective when employees are able to express their grievances freely. Sasha Wass QC described the three defendants as ‘generals’, in positions of trust. However, they used their managerial authority to bully subordinate employees to falsify the figures (Harley, 2017). It was only a mere three weeks after Dave Lewis replaced Philip Clarke as chief executive that the scandal erupted. From this, it is clear that that Clarke dominated the board and that his reign cultivated an environment of ‘anxiety’ and ‘tension’ (Colson, 2017), which discouraged employees from coming forward. All of the above are indications of a poor control environment. To add to this, the whistle blower raised the alarm via the legal team. This further reinforces the lack of transparency of the board. It is clear that the issues of corporate governance were rooted at board level and thus disseminated to the rest of the company.
Lastly, C3 states that ‘the board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles’ (FRC, 2016).
The main role of the audit committee is to monitor the integrity of the financial statements, to review the company’s internal financial controls and to make recommendations to the board (FRC,2012). At the time of the scandal PricewaterhouseCoopers LLP (PwC) was the auditors for Tesco. In 2014-2015 PwC raised concerns about the ‘risk of manipulation’ of the financial statements, however this was quickly dismissed by Ken Hanna (chairman of the audit committee) who persuaded PwC that the ‘numbers stacked up’ (Willmott, 2014). It is at this point where the seeds of the scandal were first sewn. Had the audit committee taken heed of PwC’s warnings or if PwC challenged the issue more seriously the scale of the overstated profit could have been drastically minimised. It is a matter of debate of who ultimately is to blame, however collectively they ‘presided over a serious failure of oversight’ (Willmott, 2014). Despite this, previous scandals have demonstrated that the audit firms are unlikely to challenge the practises of their clients. It is also useful to mention the ‘cosy and lucrative’ relationship between Tesco and PwC (The guardian, 2014). PwC had been auditing for Tesco since 1983 and had inevitably established a strong relationship. This relationship raises questions around the issue of auditor independence. If both parties enjoyed this advantageous relationship (In 2013 PwC was paid £10.4 million by Tesco) (The guardian, 2014) then it would be foolish for either party to want to jeopardise this. This could possibly explain why both Tesco and PwC overlooked the issue.