Thursday, September 25, 2014

Tesco income overstatment and the financial press

I don't know the details of Tesco's income overstatement -- the total looks large from here but not earth-shattering.  There are clear problem there but not really of my concern.  I know little about the company aside from the fact that I think my sister works there -- but in a non-retail division (maybe there are two Tesco's?) and that I used to shop there for groceries. Now this is a big company with annual profits in the STG 2 billion range (USD 3 billion with US$ 100 billion turnover) , so a STG 250 million error in net profit is a problem but its not about to kill the company (another story for its management).

This story is about analyst and financial reporters.  Last night flying back from Europe (on Air France -- man were we lucky that our flight was not cancelled) I was reading "Les Echos"  which is the French equivalent to the Financial Times.  There was a long winded article on the Tesco saga.  I was not very interested but one bit of information was fascinating:

The journalist was quoting an analyst that said that Tesco was overstating its revenues by not paying its suppliers.  According to the analyst Tesco would only pay 95% of the invoice and declare the balance as a profit.  My first reaction is that this has to be the most stupid comment on earth!  If you have an invoice for $100 and you only pay $95 aside from gross stupidity there is no way for the $5 difference to end up in profits... unless you decide not to eventually pay the $5 that you owe to the suppliers.  Even then this would not be ordinary income it would be extraordinary (not from operations).

Now this is where it gets tricky (and by the way the journalist never mentioned this bit).  Lets say that you buy $100 from a supplier -- but you have a deal with the supplier, if you order another $100 you get a 5% discount on your order.  In other words the next $100 of goods you buy only cost you $95. So it would be possible for Tesco to realize an additional profit on the next $100 of goods in bought of $5.

The question is then, when do you book this real profit.  As soon as you've order the next $100 of goods or once you have sold them?  This is not an easy question -- in fact there's a famous case study of discounts with the Arthur Murray School of danse ("AMS"). Guess what in AMS' american operations this kind of discount is accounted as profit at after the sale of the goods (the second $100) but in Australia the profit is booked as soon as the second $100 of good is bought.  Clearly there are different ways at looking at profits.

As a side note its always interesting to look at companies account in different jurisdiction (dual listing) the P&L are often very different -- for the same company.

Overall, and this is what is important as with regards to the article.  The fact that Tesco didn't pay the whole amount due to suppliers doesn't constitute a potential profit event; the only thing it does is that paying the $95 invoice will reduce payable by that amount -- in itself it has no profit impact.  if Tesco decided not to pay the $5 balance this is not an "ordinary profit"!

This is my point, this is a complex problem:  little of the information is available on why Tesco mis-stated profits by such a significant amount.  Grocery stores are notorious bad payers (to suppliers) because they operate in such tight margins.  But the article gave a false impression as to the nature of the problem.  I have serious doubts that an analyst (this was  a quoted statement in the article) actually said something as stupid, but I am confident that the journalist didn't understand what the nature of the problem was that could have generated this mis-statement of profits.

anyway that's it!

I have no position on Tesco (or any grocery operator for that matter)


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