Areas of Increased Audit Risk
To properly assess the areas of increased audit risk faced by Tesco PLC, it is essential to explore the typical risks relevant to the retail industry, the company’s history of auditing problems, and the facts presented in its annual reports. This will facilitate a holistic approach to risk auditing, which is consistent with the spirit of integrated reporting.
Looking at the past auditing problems of Tesco, one recent event that specifically stands out is the case of the company’s accounting fraud detected in 2014. As noted by Kukreja and Gupta (2016) and Lokanan (2018), the accounting misstatements resulted in Tesco’s profits being overstated by close to £263 million, which had a substantial negative influence on the stock prices of the company and its major stakeholders. The major source of overstatement was the manipulation of financial funds related to vendor allowances through “making overoptimistic assumptions” concerning this category.
At the same time, Tesco is a multinational company operating as a grocery and general merchandise retailer, which means that it is subjected to some of the auditing risks specific to the industry. In the sphere of fast-moving consumer goods (FMCG) retailers can expect to face increased auditing risks concerning the inventory valuation and store impairment procedures. These two areas can be specifically problematic for Tesco given that in addition to the UK stores the company is operating in multiple countries (Wood, Coe, and Wrigley, 2016), such as instance Malaysia, India, Czech Republic, and Hungary. Basing on the comprehensive view of the company, it was possible to formulate the four areas of increased audit risk formulated in the following subsections.
Inventory
Inventory valuation and counts are associated with a high risk of potential material misstatements for the players of the retail industry. Handling and reporting inventories are associated with numerous subjective judgments, and to conduct prudent auditing, it is essential to define how reasonable are the related assumptions. At the most superficial level, it is possible to check if the inventory days’ estimate has shown substantial volatility in the latest reporting periods. As it is reported by AJ Bell (2019), days inventory of Tesco went down from 16.29 in 2017 to 15.38 in 2018, which doesn’t seem to be an excessive shift.
As noted on page 70 of Tesco’s 2018 annual report, the company provides for obsolescence of the inventory amounts basing on the forecasts of their usage. Based on this methodology lie the assumptions made on the provisioning percentages of the existing inventory balances. These types of assumptions can also require increased attention and audit focus.
Recognizing the Group’s Income
Given that the events of 2014 have brought up to the surface a problem with Tesco’s overstated profits, recognizing the company’s income can be one of the major spheres of auditing risks. This is primarily the case as some of the probable drivers of overstated profits of retail companies are the delayed accruals of costs and accelerated recognition of some of the fractions of commercial income.
As it is mentioned in Note1 and Note 20 of the 2018 annual report of Tesco PLC, some parts of the income of the company are closely related to the volume-related allowances, fees, and discounts with the suppliers of store merchandise. Even though the relevant income recognition should be made upon accomplishing the pre-defined performance conditions, it is not necessarily so in practice due to the complexity and a high number of various purchasing arrangements. For this reason, there is a need for certain managerial judgments which can cause both material and immaterial errors.
Current Tax Liabilities
Taking a closer look at the Group balance sheet of Tesco, it is possible to see some substantial changes in the current tax liabilities components between the years 2017 and 2018. More specifically, the amount of current liabilities attributable to this specific line is equal to negative £613 million in 2017 and negative £335 million in 2018. Considering the percentage terms of the trend for the item, this represents a decline of 45.35%. Being a very substantial shift, this kind of dynamics of Tesco’s current tax liabilities represents an area of increased auditing risk and therefore required close attention of the authorized auditors.
Store Impairment
The last area of increased audit attention to be mentioned is handling the amounts associated with store impairment. This is specifically relevant due to the increased complexity and uncertainty surrounding this item in Tesco as the company is operating close to 7,000 stores in 7 countries placed in different geographic regions of the world. In balance sheet terms, the process of store impairment is related to the property, plant, and equipment item of the Group’s balance sheet.
Some of the areas in which the subjective judgment of the company’s management is required are the definition of indicators of impairment and the factors that can trigger the reversal of impairments recognized in the past. In addition, there can exist some tangible discrepancies between the carrying value of stores can exceed the actual recoverable amount of financial funds related to them.
Reducing the Audit Risk
To reduce the previously defined auditing risk, authorized auditors should resort to standardized professional procedures that can address the specific components at risk, or the audit risk area holistically. In this way, it is possible to reduce the defined accounting and financial risks of the companies’ stakeholders to an acceptable minimum level.
Audit Procedures for Inventories
As it was mentioned previously, one essential challenge for the Group in consideration is the fact that the physical inventory of Tesco is situated in 7 different countries. This will require obtaining external confirmations on the inventory counts at various Tesco facilities, as well as a need for physical attendance of the authorized auditors in some of the randomly samples stores or warehouses.
This will help to establish the existence of various physical items at the places where they are reported to be. In addition, the auditors should evaluate the assumptions made at the base of valuation of the Groups inventories, as well as of the labor, materials, and overheads. Within the process of verifying the existence of inventory items, auditors should also review the accuracy of records of the past inventory write-offs.
The second necessary auditing procedure related to reporting of the Groups inventories is verifying if the assumptions made for reporting this category are valid and adhered to. For instance, the authorized auditors should take a random sample of some of the inventory items and verify if they are indeed reported at the lower cost and according to the principle of net realizable value as it is claimed by the company’s accountants in its annual report. This procedure can be executed in practice with the help of comparing the reported inventory values to the invoices provided by the company’s suppliers and the current sales prices of the relevant items. Within this procedure, it is also essential to take into account the factor of seasonality.
Audit Procedures for Recognizing the Group’s Income
One of the workable procedures that should be used to verify if the reported commercial income of the group is correct if the pre-defined performance conditions of the arrangements with the company’s suppliers were indeed fulfilled. This procedure requires specific attention because being done properly, could have prevented the accounting scandal that the company faced back in 2014.
To check the mentioned performance conditions fulfillment, the auditors may choose a random sample of the company’s suppliers and test whether the arrangements were properly recorded and met through communicating directly with them. In the cases when some of Tesco’s suppliers cannot be reached, the auditors can choose to rely on the careful investigations of the relevant contractual agreements and the actual sales amounts of Tesco stores.
Lastly, auditors could also use special statistical packages to conduct data analytics of the sample of relevant contractual deals of the Tesco Group with its suppliers. Carefully exploring the descriptive and inferential analytics on the deals, the auditors can detect the ones that exhibited characteristics of outliers basing on some pre-defined criteria, such as instance the unusually high values of discount to sales or bonus to sales ratios. This will help to determine the deals that require increased levels of auditing attention.
References
AJ Bell (2019) Tesco PLC (XETRA:TCO) – Share price – Key Ratios, [online] AJ Bell Youinvest. Web.
Kukreja, G. and Gupta, S. (2016) Tesco accounting misstatements: myopic ideologies overshadowing larger organisational interests. SDMIMD Journal of Management, 7(1), pp.9-18.
Lokanan, M. (2018) Theorizing financial crimes as moral actions. European Accounting Review, 27(5), pp. 901-938.
Wood, S., Coe, N.M. and Wrigley, N. (2016) Multi-scalar localization and capability transference: exploring embeddedness in the Asian retail expansion of Tesco. Regional Studies, 50(3), pp. 475-495.