A £250 million black hole discovered in Tesco's accounts last week has raised questions over the governance of the UK's biggest retailer.

When the news broke - just three weeks after Dave Lewis started work as the supermarket giant's chief executive - the already troubled company's shares plunged by 12%, reaching their lowest level for 11 years.

Although an inquiry into the scandal is expected to report soon, it appeared to analysts that Tesco's UK arm had been booking rebates from suppliers on unsold goods as "income" while at the same time understating the costs of completed sales.

Tesco is by no means an isolated case, and this accounting practice is only one of a number of sleights-of-hand that companies can and do use to paint a more flattering picture of their financial affairs.

The Sunday Herald has consulted accountants, academics and corporate lawyers to learn the most popular fudges, fixes and tricks that help corporate Britain to airbrush its annual accounts.


One of the oldest tricks of the accounting trade, where reserves from fat trading years are dipped into to offset losses in the lean years. Companies help themselves to the "cookie jar" reserves to smooth profit levels or ensure they meet internal targets or analyst expectations. The practice effectively deprives investors from receiving dividend payments during the good years.

A high-profile recent example occurred in 2010 when the computer giant Dell paid a $100 million penalty to settle allegations of fraud and false accounting. According to the US's Securities & Exchange Commission (SEC), Dell had "manipulated its accounting over an extended period to project financial results that the company wished it had achieved, but could not". It had covered the shortfall using payments it had received from microchip firm Intel as part of a deal for exclusive use of Intel chips in its PCs.

The SEC claimed that Dell would have failed to meet market earnings expectations in every quarter between 2002 and 2006 were it not for the accounting legerdemain. According to the SEC, Dell subsequently dipped into these "cookie-jar reserves" to cover shortfalls in operating results. At its peak, the payments from Intel accounted for as much as 72% of Dell's quarterly operating income.

Another example of a "cookie-jar reserve" is a liability created when a company records an expense not linked to a specific accounting period. As expenses can be recorded in any accounting period, companies prefer to record them when profits are high and they can afford to take the hit.


During the financial crisis that started in 2008, the value of many securities on banks' balance sheets could not be calculated efficiently as markets collapsed.

Partly as a result, regulators sometimes demand "marking-to-market" or "fair value" accounting - recording the current market value of an asset rather than its book value - to provide a more realistic snapshot of a company's financial situation. But this approach can be misleading when unusual market conditions mean that an asset's underlying true value cannot be accurately calculated and companies ascribe a value convenient to themselves.

According to Dr Mohammad Hudaib of Glasgow University, a supermarket with a 10-year contract with a supplier might use mark-to-market practice to its own advantage to book all the profit from the contract in the first year, rather than spreading the profit evenly over the lifetime of the contract.


The "big bath" technique is a deliberate attempt to concentrate or consolidate losses into one set of a company's annual accounts, effectively making a company's poor performance look even worse in the short-term. By burying bad news in one fell swoop - for example, by confining the reporting of losses that might have been incurred over a five-year period to a single financial year - they can be explained away as an exceptional one-off event. The hope is that, by the time the following year's annual accounts are due, business will have returned to relative normality.

Sometimes the manipulative technique is used to artificially enhance the following year's earnings, with the rise in earnings resulting in bigger bonuses for executives.

The "big bath" is also sometimes used by incoming chief executives as a means of pinning the blame on the company's previous management team, and as a way of taking credit for any improvement the following year.

According to Hudaib, a company that is in financial trouble might start by using some cookie-jar accounting to paint a rosier picture of its financial position.

If this doesn't work, it might indulge in some mark-to-market, before plunging into the "big bath".


Many hard-bargaining supermarkets demand a rebate, or "discount", from their suppliers as a condition of selling their lines, payable once sales reach an agreed level.

These cash payments, which have become a major part of the grocery business, come in many forms and are offered by suppliers as an inducement to supermarkets to stock and promote their products.

International Accounting Standard 18 stipulates that receipts can be recognised as revenue when "it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably".

The safest way of interpreting this provision would be to book a rebate in a retailer's accounts following payment by the supplier, but this is not a legal requirement. Internal and external auditors are therefore free to exercise discretion on how rebates are treated in accounts.

In their most recent annual reports for the UK's three largest retailers - Tesco, Sainsbury's and Morrisons - auditors warned investors that the companies faced material risks over the reporting of supplier rebates. The auditors of the smaller online retailer Ocado also did so.

Jack McLaren, a partner in the Glasgow branch of accountancy firm Johnston Carmichael, said it was often hard for a supermarket buyer to estimate when the firm would reach the targets that would trigger a rebate. Buyers sometimes overestimate volumes of future orders, meaning that no rebate becomes payable by the supplier. There are no hard and fast rules on when to book rebates and this is largely a matter of management judgment.

"This is a grey area where it is hard for auditors to say there is a right or wrong answer," he said. "There is some scope to cover up bad news in good years, but it in bad times there is often no place to bury it."


Another supermarket speciality. When it comes to stocks of perishable food, there is a judgment call to be made on whether to assume that items can be sold at full cost up to their expiry date, whether they will have to be discounted or if they should be thrown away. In any case, there is nothing to stop a grocer from marking assumed sales on its books.


Companies also have considerable leeway on deciding the timescales for the "depreciation" or "amortisation" of fixed assets or intangible assets such as goodwill. For example, most companies will choose to spread the capital cost of buying a new vehicle over around four years, but there is nothing to stop them spreading that cost over two years or 20.

Some businesses, such as film production companies, will have vehicles that do very little mileage as they remain stationary on location for months at time. As a result, they will need replacing less often than the lorries of a haulage firm which clock up thousands of miles a week.

Using the flexibility to spread the cost of an asset over a shorter or longer timescale than necessary allows companies to massage profitability levels.


Not all supermarket customers cash in their reward points for cash vouchers on a regular basis. This makes the issue of loyalty card bonus points an accounting headache as, at the end of a financial year, there will be millions of pounds worth of unspent points. Although points are technically a liability for the supermarket, they know from previous experience that some customers never get around to redeeming their points, and there is a clear incentive for their finance departments to write the assumption that they will not into the annual accounts. For an auditor, the question is whether to defer income to the point that the customer cashes in.


The question with bad debt is whether a company can assume that an outstanding debt that it is owed will eventually be paid and whether to book payment of the debt in its accounts. There are often good reasons for thinking that a longstanding debt will be paid, but debts often have to be written off by companies. Again, companies can disingenuously assume repayment when they know very well the debt has gone bad.



Alarm bells over accounting practices at Tesco had been ringing for at last a couple of years before the horsemeat scandal broke in 2013.

Julie Palmer, a partner with the specialist business recovery firm Begbies Traynor, said that as early as 2011 market analysts had been raising concerns about how Tesco was maintaining its profit margins at a time when recession had hit food sales.

"It appears that Tesco has used the flexibility in the rules to their own advantage by reporting income early and deferring the costs of transactions. Seemingly they have reported to their own advantage the income side of transactions but not the costs."

Palmer said that accounting is an "inexact science" as so many of the auditing parameters are open to interpretation. A company in financial trouble often has the opportunity to exploit that flexibility to its own advantage, she said.

But changing accounting standards is not the answer to improving corporate governance, she said: "You are always going to end up with grey areas. These rules have to be applied to a myriad of different kinds of businesses and it is not possible to have standards for one size that fit all."

Tesco has long had a reputation for its "aggressive" treatment of suppliers, particularly when it comes to negotiating rebates (see main piece), Palmer said. An example of such behaviour is the fact that Tesco insists on terms - which are widely resented by the supermarket's suppliers - that allow it to extract payment for rebates directly from suppliers' bank accounts.

Jack McLaren, a partner in the Glasgow branch of accountancy firm Johnston Carmichael, said that with so many variables, making a decision about whether a set of accounts give a "true and fair" picture of a company's financial position is largely subjective.

A fundamental tenet of accounting is the flexibility to provide a "true and fair" view of a company's financial health, but that flexibility also enables "creative accounting".

According to Edinburgh-based regulatory lawyer Tom Stocker of Pinsent Masons, the inquiry into the Tesco scandal by accountancy company Deloitte is likely to be concluded within a matter of days rather than weeks as it is in Tesco's interest to "rectify any mistakes as quickly as possible".

The main question is whether there was deliberate misrepresentation of the company's financial position or whether its interpretations of accounting standards are deemed to be within acceptable bounds.

Meanwhile, Dr Mohammad Hudaib of the Adam Smith Business School of the University of Glasgow said that introducing more forensic accounting techniques to the auditing of a company would be a considerable improvement on the traditional audit process, under which a sample of transactions are assessed for their accuracy.

If the sampled transactions are found to have been correctly accounted for, the working assumption is that the rest of the company's accounts are likely to be correct. Forensic accounting attempts to analyse the factors that might motivate a company to book transactions in a particular way and is more likely to uncover irregularities.

Hudaib also deplores the fact that plans to force companies to "rotate" their external auditors every five years were considerably watered down before new rules were introduced 10 years ago. Instead of companies being required to change their accounting company every five years, the only requirement is for the accountant in charge of the account to be changed. This is a missed opportunity, according to Hudaib, as there is nothing to stop a company retaining its external auditors indefinitely, which can lead to an unhealthily close relationship, making it hard for auditors to challenge the decisions of their clients, who are the paymaster.

Large corporations almost exclusively use one of the "Big Four" accountancy companies to carry out their external audits. This also encourages over-cosy relationships between the company and its auditors. It would also have been desirable, Hudaib said, to break up the external audit work of large companies into smaller chunks. This would allow smaller accountancy firms to carry out parts of an audit - for instance, a company's sales or its payroll cycle could be audited separately.

And Hudaib criticised a stewardship code on corporate governance published by the Financial Reporting Council in 2012 which aimed to reduce the incentives for top executives to obtain bonuses - these can be triggered by massaging the company's figures and statements using the techniques detailed elsewhere in this article. But as the stewardship code is not compulsory, it does not have the teeth to make a difference.