Increased pressures on the UK grocery chain's finance team helped create conditions for a financial crisis
Tesco’s leadership team and its board of directors are under fire for accounting errors that led to an overstated profit forecast for the first half of 2014. The company’s stock has fallen by 27 percent, five executives have been placed on leave, and the chairman of the audit committee is planning to step down after his six-year tenure concludes later this year. Just last week the company reported the results of its internal investigation, which found that the error extended back two more years, and revised the profit overstatement to $422 million. That also prompted an announcement that Chairman Richard Broadbent will step down, though no date has been specified.
What’s remarkable about Tesco’s error is that the mistake comes from a basic accounting principal: matching revenue and costs, a universal accounting rule regardless of geography. Admittedly, the matching of revenues against multi-month marketing promotions is complicated, but the setup is common in the retail industry, and this mistake should have been spotted. The area was even flagged by Tesco’s auditors, but was reviewed and deemed appropriate by the Audit Committee. According to Tesco’s 2014 annual report:
The Committee notes that commercial income was an area of focus for the external auditors based on their assessment of gross risks. It is the Committee’s view that whilst commercial income is a significant income for the Group and involves an element of judgment, management operates an appropriate control environment which minimizes risks in this area. As a result, the Committee does not consider that this is a significant issue for disclosure in its report.
The Committee has certainly come to regret its position. This crisis should serve as a warning bell for executive teams, audit committee members and compliance officers that the growing pressures on the finance team can create conditions for such errors at any company.
From my experience as CEO at Trintech, I see these pressures both internally while running our business, and externally from a number of the clients with which we work. Finance departments are under stress from changing regulations, accounting standards, M&A and international growth. Many finance departments use inadequate or outdated procedures to drive the financial close process. This often results in low visibility and ineffective use of a talented staff that spends two-thirds of its time on activities that do not translate to action (e.g., time spent to prepare spreadsheets). Because the closing process occurs over a defined time period set by regulators, if personnel spend all of their time gathering numbers and preparing financial reports, precious little time remains for the analysis that might help a company spot accounting irregularities before reporting its numbers to the Street.
I don’t have any first-hand knowledge of the accounting problems at Tesco. But based on my work with many companies in the retail and other sectors, better processes and controls could have brought this issue to light earlier and enabled Tesco to avert both a financial and reputation crisis. Here are five steps companies can take to avoid a similar experience:
1. Automate mundane tasks: Highly educated finance and accounting personnel who spend most of their time on manual tasks are an underutilized resource. Automating such activities frees the finance team to focus on forecasting, reporting and analysis, including uncovering irregularities and scrutinizing accounting decisions.
2. Strengthen the control framework: A robust control framework would require mandatory assessment of any accounting policies and processes that are identified as risks by auditors, as was the case at Tesco. Integrating that framework into the daily processes followed by the finance team would highlight issues sooner and allow sufficient time for them to be addressed. Additionally, requiring individual sign-offs by the CFO and Audit Committee for US and UK companies would help ensure that any potential issues are carefully reviewed. As a rule, additional executive and Audit Committee approvals for accounting decisions that involve high degrees of discretionary judgment can prevent similar errors in the future.
3. Use technology to facilitate personnel transitions: Companies are at risk of losing ‘institutional memory’ when employees leave. A financial system that maintains data, records and outlines of processes can ensure that changes in the finance team don’t result in delays or errors.
4. Take a comprehensive approach to the financial closing process: At most companies today, the closing process is defined by function-specific technology silos, isolated teams and manual spreadsheet entry. The communication gaps between these silos create risks that a change in one function may be missed by other functions, which can lead to delays or reporting errors. Companies should also consider an end-to-end automation solution and not just tools designed for a particular area, often called a ‘point solution’, which Tesco had in place. Such a comprehensive approach allows a holistic, analytical view of all activities occurring during the closing process.
5. Increase scrutiny when business conditions deteriorate: Employees at all levels of an organization will be more tempted to present numbers in the best light possible when business conditions get tough, whether it’s to meet a monthly sales goal or hit quarterly earnings targets. It’s crucial that executives and directors ask more questions and scrutinize results when such temptations are highest; they also need to establish a tone and corporate culture that prioritizes transparency and honesty above business targets. Discipline, accuracy and integrity can be saving graces to any enterprise.
Tesco’s new CEO Dave Lewis mentioned this last point in an email to employees: ‘Turning our business around will require a change in our culture, as well as in our processes and our brand proposition... We want to work in a business which is open, transparent, fair and honest. We all expect Tesco to act with integrity and transparency at all times.’
Lewis has a big task ahead of him. But Tesco is one of Europe’s great companies, and if he can successfully steer it back on course, it can serve as a model for other companies.
Paul Byrne is CEO of Trintech, a financial technology company that works with more than half of the Fortune 50 and FTSE 100 and one-quarter of the Fortune 500.
