Broader Auditor Disclosures Shine Light On Tesco Fraud In UK
US Audit Firms Resist Similar Sunshine Proposals
PricewaterhouseCoopers LLP (PwC) in the UK is the auditor of Tesco, the UK supermarket chain that announced a £250 million ($408 million) overstatement of profits on September 22. Five Tesco executives have been sidelined and now the Chairman says he, too, will step down. An independent investigation by Deloitte — ironically the auditor of retail frauds Parmalat and Ahold — has been completed and now the UK’s Financial Conduct Authority will take over.
Tesco’s latest annual report, published in May, says that PwC warned Tesco’s audit committee that commercial income, the income statement line where the problems were hidden, was an “area of focus…”
PwC told investors and other users of the financial statements:
“We focused on this area because of the judgment required in accounting for the commercial income deals and the risk of manipulation of these balances.”
PwC missed the fraud anyway.
(Commercial income includes estimates of cash rebates to be received from suppliers based on volumes purchased by Tesco. That gross profit drops directly to the bottom line. It’s not a revenue problem but a gross margin overstatement as rebates reduce cost of good sold. It seems Tesco was recording the rebates aggressively, based on executives “estimates and judgment” in anticipation of higher purchases, even reportedly offering kickbacks to vendors to pay right away, even though sales were tanking and presumably purchases of goods would be lower as a result.)
The UK, unlike the US, has acted more aggressively to stem the renewed growth of the consultancy arms of the audit firms and the independence conflicts that consulting reintroduces. New reforms to the auditor-company relationship are intended to reverse a repeat of the issues that reforms after Enron tried to correct — the tendency for auditors to establish cozy, long-term, full service relationships with clients beyond the required audit.
PwC earned £10.4m for its auditing services at Tesco and collected £3.6m for its consultancy work. That consulting was for “organizational development” work. Two of the 10 directors on the Tesco board are formerly PwC. One is chair of the audit committee. Pretty cozy…
The UK also requires, as of June 2013, that auditors explain more about their work including an overview of the scope of the audit and how risk and materiality affected their choices of which areas to look into in more fully.
Because of its additional annual report disclosures in May, PwC may believe it can rightly disavow responsibility for the profit overstatement. Perhaps Tesco’s audit committee disagreed, dodged or decided to ignore the warnings. We don’t know what conversations took place only that PwC felt strongly enough to include the comment in the annual report. But a warning is not an actual discovery of the material misstatement in revenues and expenses.
In fact, it looks like PwC may already be suggesting to journalists and regulators, via non-attributed sources at the Deloitte investigation, that the firm was “duped”.
The investigation into the £250m accounting scandal at Tesco is understood to have uncovered evidence that a “small group” of people within Britain’s biggest retailer deliberately misled its auditors and accountants to flatter its financial results.
Pointing to audit interference and, more dramatically, “rogues” at work mucking up the audit and lying to auditors, is a powerful defense for an audit firm accused of gross negligence. The actual manipulation of profit and expenses at Tesco, now said to be £264 million, was finally disclosed, only a few months later, after an internal whistleblower brought the scope of the manipulation to in-house lawyers.
In the US, proposals by the Public Company Accounting Oversight Board (PCAOB) that are similar to the UK’s have met with fierce opposition. Audit firms don’t want to sign audit reports in the partner’s name instead of the firm’s, a requirement that has been in place in the UK for a while, because the auditors believe partners will be subject to additional personal legal liability and security threats. Auditors and their clients squelched attempts to impose mandatory audit firm rotation — mandatory tenders are now required in the UK– by getting the US House of Representatives to pass a measure forbidding he PCAOB to make such a rule.
Auditors and their company executive clients also disagree with PCAOB proposals to require additional annual report disclosures by auditors for US listed companies, like the ones that PwC used to signal problems at Tesco.
The PCAOB says that the pass/fail model of the boilerplate audit report in the US has not changed much since the 1940’s. During an audit, auditors have access to the company’s non-public financial information and an opportunity to dig as far and wide as risk, materiality and the constraints of the engagement budget, will allow. Investors have told the regulator “they would benefit from additional auditor reporting because they do not have access to, or may not be aware of, much of this information.” Investors would like to hear from the auditor about issues and concerns that were raised during the audit and that led to their final conclusions.
Auditors and their company executive clients however, believe the auditors’ place is on the side, doing the audit but not sticking its neck out making disclosures about the company’s finances that should be made only by company management. At a recent conference of the National Association of Corporate Directors I attended, Audit Committee Member and former Deloitte partner Michelle Hooper responded to a question I posed about the contrast between the UK and US attitudes by citing the “chilling effect”. Audit Committee members, company executives and the auditors fear that additional disclosures by auditors will quash open communication between auditors and their clients. If company executives and board members think auditors might publicize issues and risks the company will not, they just won’t tell them anything anymore.
At a 2012 conference Hooper explained why she’s reticent about auditors publishing more detailed comment and opinion:
I guess that leaves protection of investors up to the whistleblowers. But I don’t think company executives, Audit Committee yes-women like Michelle Hooper, or the auditors are too crazy about whistleblowers either.