October 20, 2018

When is revenue not revenue?

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One of the accounting challenges that face businesses is the timing of the recognition of revenue – exactly when can revenue be recognised in the income statement. The answer to that question is crucial as it has a huge impact on when profits are earned and reported to shareholders.

For some sectors – like construction – the recognition of revenue involves complex assessments of the current status of projects and the expected future incomes. For sectors like manufacturing, it seems straightforward, with revenue recognition related to the point of despatch of products to customers. In the retail sector, a sale is revenue when the customer pays for the goods and walks out of the shop.

However, recent developments at Tesco PLC have thrown a different light on how retail businesses measure revenue. It appears that the major UK supermarket chain has developed its own way of recognising revenue, not from its customers, but from its suppliers!

Like all supermarket chains, Tesco has a wide range of suppliers for each of the products that occupy its shelves. When its suppliers deliver, Tesco’s inventory increases and its liabilities also increase by the same amount. In due course, these suppliers are paid by Tesco and this process rolls on and on as future orders and deliveries are made.

However, in the retail sector, suppliers also enter into special arrangements with supermarkets so that their goods are ‘promoted’ ahead of their competitors, thereby maximising their sales. These promotions include special product displays and the placing of products on eye-level shelves. Due to the need for pre-planning of such promotions, their costs are agreed in advance – and billed by the supermarkets to the suppliers. The suppliers then ‘pay’ the supermarkets for these promotions with the agreed cost being deducted from the liabilities due to the suppliers.  In some cases, these promotional costs have been linked to future sales revenue achievements by the supermarket.

Hence, these promotional arrangements result in additional revenue for the supermarket but place a responsibility on the supermarket to ensure that the revenue is recognised in the correct accounting period.

Accountants would argue that this source of revenue should be recognised in the accounting period when the promotion occurs and the related costs are incurred. Unfortunately, the process of offsetting current liabilities to suppliers means that it gives a supermarket some scope in deciding for themselves when that revenue should be recognised in its income statement.

In recent years, the UK food supply market has been successfully penetrated by companies like Aldi and Lidl – challenging the former dominance of Tesco (and others) and pressurising their financial results. These more difficult trading conditions created the pre-conditions for management to seek to report as high an operating profit as possible – encouraging the maximising of revenue recognition into current periods, but without including the related promotional costs, to be incurred in later accounting periods.

On 1 September 2014, Tesco’s newly appointed  CEO, Dave Lewis began his tenure by announcing that its profits for the six months to August 2014 had been overstated by £250m due to the ‘accelerated recognition of commercial income and delayed accrual of costs’.  Further independent investigation by Deloittes raised this overstatement to £263m, of which £118m affected the current accounting year with the balance relating to previous accounting periods. (View the release and see more details here).

The discovery of this ‘accounting error’ – which led to the suspension of four senior staff – occurred during a time when the company – one of the UK’s largest businesses – was operating without a CFO and with only one executive director on its Board: this questions the degree of seriousness with which the Board took its corporate governance responsibilities.

It appears that the uncovering of this issue was the starting point of further bad news for Tesco and its shareholders. Its annual results – issued on 22 April 2015 – posted one of the largest corporate losses in UK history. Although Tesco made £1.4bn trading profit, it also incurred one-off costs of £6.5bn – led by impairment losses of £5.6bn on its property portfolio, inventory write-downs and the impact of their ‘accounting problem’ (See Preliminary Results here). Some analysts have seen these financial statements as the new CEO seizing the opportunity to recognise massive provisions – whilst, at the same time, blaming these misfortunes on previous management regimes.

Yet again, the emergence of accounting errors, whether accidental or intentional, has been the major catalyst in a major reversal in the fortunes of a large quoted company.