Anyone can help me with requirement 3? Effect of assumed sales growth on vendor allowances.

Tesco's Financial Reporting of Vendor Allowances1 The Company2 Tesco PLC (hereafter, Tesco, or the Company) is a British multinational retailer headquartered in Cheshunt, United Kingdom. In 2014, Tesco was the world's third largest retailer as measured by profits and second-largest, as measured by revenues. The Company employed more than 530,000 people, and had stores in 12 countries across Asia and Europe. It was the grocery market leader in Ireland, Hungary, Malaysia, Thailand, and the U.K., where it claimed a market share of around 30%. Tesco had a market capitalization of approximately 203 billion in August 2014. Its common stock is listed on the London Stock Exchange and is a constituent of the FTSE 100 Index.4 The Company also has American Depositary Receipts (ADR) traded on the over-thecounter market in the U.S. under the symbol TSCDY.5 Evolution and Financial Performance Jack Cohen founded Tesco in 1919 when he started selling surplus groceries from a stall in the East End of London. Mr. Cohen made a profit of 1 from sales of 4 on his first day. The Tesco name first appeared in 1924, when Cohen purchased a shipment of tea from T. E. Stockwell and combined those initials with the first two letters of his surname. The first Tesco store opened soon after in 1929. Cohen's U.K. business expanded rapidly. By 1939 he had opened over 100 Tesco stores across the country. Starting in the early 1990s, Tesco expanded further as the Company diversified geographically and expanded its product portfolio to include not only the traditional retail markets (such as books, clothing, electronics, furniture, toys, and petrol) but the emerging retail markets (such as software, financial services, telecoms and internet services) as well. Tesco's 1 This case is developed by Professor Mahendra Gujarathi of Bentley University for the purpose of class discussion. Please do not quote without permission. 2 The information in this and the next section is obtained largely from the annual reports and web site of the Company and from The Telegraph (October 4, 2014). 3 is the symbol denoting British Pounds, the currency of Great Britain and the United Kingdom. 4 The FTSE 100 Index is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. 5 An American depositary receipt (ADR) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. Each ADR of Tesco represents three Tesco PLC ordinary shares. 1 diversification strategy and aggressive marketing efforts led to further store openings in the 1990s and helped the Company to assume the coveted position of UK's leading grocer. Tesco outperformed all its rivals, increasing its market share in groceries from 15.4 percent in 1998 to 28 percent in 2004. Tesco won applause for its swift growth and global ambitions through the early 2000s. Although profits came under pressure in fiscal6 2009 because of the worldwide economic downturn, the profitability growth resumed again from fiscal 2010 and continued through fiscal 2012. Fiscal 2013, however, was not a good year for Tesco. Its revenues were almost stagnant and profit before tax was down by almost half compared to fiscal 2012. In January 2012, the Company issued a profit warning for the first time in 20 years and in April 2013, Tesco reported its first decrease in annual profit in 19 years. Profit warnings were not uncommon in fiscal 2013 and 2014, however. Indeed, Tesco issued five profit warnings in twelve months ending December 2014. During fiscal 2013 and 2014, Tesco experienced a decline in the trading profits7. Failing to halt the dramatic decline in the trading and pre-tax profits, Tesco announced on July 22nd 2014 that its Chief Executive Officer (CEO) Philip Clarke, a 40-year veteran at the Company, would be replaced by Dave Lewis, the head of personal care unit at Unilever (the world's third largest consumer goods company), on October 1, 2014. However, given the fast-changing situation at Tesco, the new CEO was asked to join a month earlier, on September 1st, 2014. The Company's financial performance (revenues, trading profit, profit before tax, profit after tax, and basic earnings per share) during fiscal years 2005 to 2014 is presented in Exhibit 1. --- Insert Exhibit 1 about here --Tesco's stock price reflected its impressive operating performance from 2006 to 2011 and subsequent deterioration from 2012 through 2014. Figure 1 presents a graph of Tesco's revenues and profits during 2006-2014 and depicts the history of its stock price vis--vis the FTSE 100 index. 6 Tesco's fiscal year runs for 52 or 53 week period ending in late February. The 2009 fiscal year was for 53 week period ending February 28th, 2009. 7 Tesco's annual report defines trading profit as an adjusted measure of operating profit. It measures the performance before profits/losses arising on property-related items, the impact on leases of annual uplifts in rent and rent-free periods, intangible asset amortization charges and costs arising from acquisitions, and goodwill impairment and restructuring and other one-off costs. 2 --- Insert Figure 1 about here --The Controversy over Accounting for Commercial Income On the Friday of September 19th 2014, a member of Tesco's staff, whose identity was not disclosed, warned the Company's general counsel about early booking of commercial income and delayed booking of costs. In less than three weeks after joining Tesco, on the Monday after the Friday on which the staff member blew the whistle, Tesco's new CEO Dave Lewis had the unenviable task of announcing on September 22nd, 2014 that profits for the six months ending August 2014 were likely overstated by 250 million. The Company suspended eight senior executives and launched an internal investigation of the issue. In addition, Tesco's Board of Directors appointed Deloitte (an international accounting firm that was not Tesco's external auditor) to undertake an independent review of the Company's accounting issues, in association with Freshfields, Tesco's legal advisers. Deloitte's review of Tesco's semi-annual results confirmed that the Company's profit overstatement was larger than the 250 million previously declared and the overstatements went back further than Tesco originally stated. Deloitte concluded that Tesco's overall commercial income adjustment was 263 million, including 118 million in the first half of 2014-15, 70 million relating to 2013-14, and 75 million of prior period adjustments relating to pre-2013-14. On the basis that the prior period adjustments were not material, Tesco did not make any prior period restatement and adjusted all amounts in the current period's income. Tesco's interim report issued on October 23rd 2014 acknowledged that the guidance (provided on August 29th 2014) regarding profit for the six months to August 23rd, 2014 was overstated primarily due to the accelerated recognition of commercial income and delayed accrual of costs. The pre-tax profit for the period fell by 92% from 1.39 billion to 112 million. The interim report stated: As announced on 1 October 2014, the Financial Conduct Authority8 has launched an investigation into the issue. We will fully cooperate with the regulatory authorities. Given the outstanding investigation, we can make no further statement at this stage about how these events came about. 8 The Financial Conduct Authority (FCA) is a financial regulatory body in the United Kingdom, but operates independently of the United Kingdom government, and is financed by charging fees to members of the financial services industry. 3 Commercial Income and Its Financial Reporting Consumer products companies provide retailers with different forms of vendor allowances such as volume discounts, cooperative advertising and slotting fees. In most cases the allowances (sometimes labelled as discounts or rebates or sales incentives or commercial income or sales allowances) are tied to the volume that retailers such as Tesco promise to buy from the vendor. Retailers also obtain reimbursements of a portion of advertising costs from vendors under the cooperative advertising arrangements. The advertising allowance can be volume-based, or it can be a flat amount. Slotting fees represent an arrangement in which manufacturers pay retailers a fee for shelving their products in prominent locations. The amounts of commercial income are significant for retailers. Business Insider (October 7th , 2014) mentioned that \"Among the US supermarkets that disclose figures, vendor allowances are equivalent to around 8 percent of the cost of goods sold, equal to virtually all their profit.\" Typically, vendors pay retailers the estimated amount of the commercial income upfront. However, when and how to record the income effects of those cash flows are contentious issues and accounting treatments vary across vendors as well as customers both. Despite the potentially significant effects on profits, accounting policies regarding vendor allowances are rarely described in IFRS-based financial statements. As stated in Business Insider (October 7th, 2014), \"While European retailers are not obliged to, and do not, disclose contributions to profits from vendor allowances, US retailers often do, and are subject to more detailed accounting rules.\" In Tesco's case, the description of commercial income, or explanation regarding the accounting policy pertaining thereto, was not included in the Company's financial statements which were prepared in accordance with the International Financial Reporting Standards (IFRS). PriceWaterhouseCoopers (PwC), the auditors of Tesco, however noted a concern about commercial income in their audit report for fiscal 2014. Although PwC issued a clean audit report on Tesco's financials, it mentioned the material risks regarding the reporting of commercial income as follows.9 9 The auditors for all three of Britain's biggest retailers - Tesco, Sainsbury's and Morrisons - alerted investors in their most recent annual reports that their businesses faced material risks regarding the reporting of supplier rebates (Business Insider, October 7, 2014). 4 Area of focus How the scope of our audit addressed the area of focus Recognition of commercial income Commercial income (promotional monies, discounts and rebates receivables from suppliers) recognized during the year is material to the income statement and amounts accrued at the year-end are judgmental. We tested the controls management has in place, focusing on controls over price changes and margin reviews. We agreed commercial income recognized to contractual evidence with suppliers, with particular attention to the period in which the income was recorded and the appropriateness of the accrual at the year end. 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. We compared movements year on year in margins for product categories based on an expectation derived from out sample testing of contracts with suppliers. Illustrative Example of a Vendor Allowances Arrangement Presented below is a hypothetical example that illustrates a vendor allowances arrangement. Consistent with Jack Cohen's business motto "pile it high and sell it cheap", Tesco routinely negotiates contracts with its vendors for purchasing products at best prices, and passes on the savings to its customers. One such annual contract with CPC, a leading consumer products company was initiated on September 1st 2013. The contract stipulated that Tesco will continue to receive 8 percent refund of the purchase price if it bought at least the same quantity (3.5 billion units) of CPC products as it did in the previous contract period, regularly priced at 2 per unit (total purchases of 7 billion). In addition, depending on the level of purchases during the contract period, the contract stipulated a lower (or higher) refund, as follows: 5 Purchases (units) during Sept. 1, 2013 - Aug. 31, 2014 Refund Percentage on total purchases Less than 3 billion Zero 3 billion to 3.299 billion 6% 3.3 billion to 3.499 billion 7% 3.5 billion to 3.699 billion 8% 3.7 billion to 3.899 billion 9% 3.9 billion and above 10% The regular price of the units supplied by CPC remained constant (2 per unit) throughout the contract period. Not knowing the trend of sales in the forthcoming year, on September 1st 2013, Tesco committed to purchase from CPC the same number of units (3.5 billion) in the current contract period (12-month period ending August 31st 2014) as it did in the previous contract period (12-month period ending August 31st 2013). Using this estimate, and based on prior experience of dealings with Tesco, on September 1st 2013, CPC paid 560 million (8 percent X 3.5 billion units X 2 price per unit) in advance to Tesco. If Tesco's actual purchases differ from the contracted amounts, the Company would return the unearned portion of the refund to CPC (or receive the unpaid portion of refund from CPC) on August 31, 2014. Tesco's Earnings Manipulation: Speculations Galore, Facts Few Several speculations existed about the motivations and mechanisms of manipulating earnings by Tesco's management. The most obvious was the link between the compensation of Tesco's senior management and financial performance of the Company. In the retailing industry, commonly used measures of performance include annual sales growth, annuals growth in comparable store sales (open for 12 months or longer), and the gross margin rate. Tesco used these and other financial as well as non-financial measures to determine the remuneration of its executive directors (i.e., senior management). As mentioned in the Directors' Remuneration Report of the Company for 2013-14,10 \"the majority of our reward is linked to the delivery of stretching performance over the short and long term aligned with the achievement of our business vision and our strategy.\" Additional details of Tesco's remuneration policy are presented in Figure 2. 10 Available at http://files.thegroup.net/library/tesco/annualreport2014/pdfs/tescoar14_gov_remunerationreport.pdf 6 --- Insert Figure 2 about here --The remuneration policy described determinants of the executive compensation, but did not provide details of the bonus targets. The Directors' Remuneration Report for fiscal 2014 stated that \"Bonus targets are considered by the Board to be commercially sensitive as they would give away details of our budgeting to our competitors. We therefore do not publish the details of targets.\" The remuneration policy also stated: \"Despite strong progress against strategic objectives during the year and the exceptional effort management have put in to achieve this, the bonus profit underpin was not met and therefore the Executive Directors will not receive a bonus in respect of 2013-14. Performance Share Plan awards granted in 2011 will lapse in July 2014 as challenging three-year Earnings per Share (EPS) and Return on Capital Employed (ROCE) targets were not met.\" Because the Company's fiscal 2013 financial performance did not meet the targeted results, senior management did not earn annual bonuses in 2013 also. The report by Deloitte and Freshfield indicated that the profit overstatement stemmed from the \"booking of supplier contributions that were conditional on hitting sales targets that it was not going to reach.\" Whether a retailer will indeed buy the required quantity of products to \"earn\" the volume discounts depends on the eventual quantities of products that the retailer is able to sell. David McCarthy, an analyst at HSBC, said that slowing sales growth at Tesco could have contributed to an inaccuracy in calculations (Reuters, September 23rd 2014). \"We suspect Tesco may have been booking promotional rebates based on historic precedent rather than on current volumes,\" he said. Tesco's senior management may also have entered into side deals with major suppliers without adequately disclosing them in the financial statements. The Telegraph (October 28th 2014) stated: \"A source close to the probe claimed that a \"small group\" of employees, realizing these sales targets would not be hit, struck deals with suppliers to still make these payments by offering benefits in the next financial period. These benefits were then kept secret.\" Another hotly debated topic was whether PwC, Tesco's auditors for more than 30 years 11, discharged their professional obligations responsibly. PwC mentioned the company's recognition of commercial income as a specific area of focus, and noted that the booking of such income and costs is a \"grey area\". However, it continued to issue clean audit opinions on 11 There have been calls from politicians and campaigners for large listed companies to avoid using the same auditor for long periods. New EU rules could force companies to change auditors after a maximum 20 years and put the position out to tender every 10 years. 7 Tesco's financial statements. Tesco's audit committee did not even consider commercial income as a \"significant area for disclosure\" in its report. It is also interesting to note that two out of the ten members of the board of directors, including the chair of Tesco's audit committee, were PwC \"alumni\" that formerly worked for the auditing firm. Further speculation suggests that Tesco's main suppliers, which include some of the world's largest consumer goods companies such as Unilever, Coca-Cola, and Nestle, might have colluded with Tesco in profit manipulation for the fear of losing a large customer. The Telegraph (November 6th 2014) stated: \"If Tesco had been overinflating commercial income, then it stands to reason that its suppliers had lower profits than they thought because the retailer was claiming money that they did not know about. Reportedly, several of Tesco's biggest suppliers have launched internal audits to ensure that their financial figures have not been distorted. However, no supplier has come out and changed their financial results as a result of uncovering issues in their negotiations with Tesco.\" In short, the issue of whether Tesco's management manipulated Company earnings remains unresolved. The complexity of Tesco's promotional deals with suppliers may have left room for subjective decisions, unintentional errors, and honest mistakes (The Economist, September 27th 2014). For instance, some analysts blamed the accounting error on the lack of experience of Tesco's Board of Directors in the retailing industry. Some have also suggested the commercial income adjustment as an example of \"kitchen sinking\"12 of the accounts by the new CEO to help reset Tesco towards future profitability (The Telegraph, September 22nd 2014). Reaction from the Financial Community to Tesco's Profit Overstatement On September 22nd 2014, when Tesco disclosed likely profit overstatement and the appointment of Deloitte to perform an independent review, capital markets responded by dropping Tesco's stock price almost 12 percent in a single day, thereby wiping out more than 500 million from the Company's market capitalization. Later in the year, when Tesco warned that its annual profits would fall below consensus analysts' estimates, its stock price declined to a 14-year low of 1.65 per share. During the calendar year 2014 alone, Tesco suffered a reduction in the market capitalization of almost 12 billion. The downward spiral in Tesco's stock price during 2014 is presented in Figure 3. Some high-profile investors including the legendary investor Warren Buffett sold their stakes in the Company, stating that their decision to invest in Tesco was \"a mistake.\" --- Insert Figure 3 about here --12 Kitchen sinking involves front-loading the bad news to pave the way for a rebound in profit in later years. 8 Credit rating agencies also responded unfavorably to Tesco's profit overstatement. Almost immediately after Deloitte issued its review report on Tesco on October 22 nd 2014, two credit rating agencies reduced Tesco's rating to the cusp of investment grade. Fitch dropped Tesco a notch to BBB- and Moody's cut its rating of Tesco to Baa3 from Baa2, citing the reduced and trading profit and \"uncertainties\" related to the regulatory investigations into Tesco's accounting problems. On January 8th 2015, Dave Lewis, Tesco's chief executive, announced drastic measures to help turnaround the Company's financial position, including closing Tesco's headquarters in Cheshunt, shutting down 43 unprofitable stores and scrapping plans to build 49 new supermarkets. Lewis also announced that Tesco would close its defined benefit pension plan, consider canceling its final dividend payout and slash corporate administrative costs by 30 percent. The company had met with the three major credit rating agencies (Fitch, Moody's and S&P) the day before it unveiled its turnaround plan in the hope of preventing a downgrade. However, On January 9th 2015, Moody's downgraded Tesco's senior unsecured long-term rating to Ba1 from Baa3 stating that Tesco's attempts to protect its balance sheet will "take time to implement". Moody's also reported that "structural changes in the UK grocery retail market will continue to challenge the company's operating performance". Less than a week later, S&P followed suit on January 15th 2015, when it downgraded Tesco's rating to non-investment grade, or junk status. Legal Proceedings On October 1, 2014, Tesco announced that the U.K.'s financial watchdog, the Financial Conduct Authority (FCA), had \"commenced a full investigation\" of the accounting irregularities at the company. Unlike the US legal system, no provision exists under English law for class-action lawsuits, in which thousands of people can collectively file one big legal claim. In the US, lawsuits were filed on behalf of investors who purchased Tesco's ADRs (American Depository Receipts). Britain's Serious Fraud Office (SFO) recently opened a criminal investigation into accounting irregularities at Tesco. The Company said that it has been \"cooperating fully with the SFO and will continue to do so.\" The Financial Conduct Authority said it would stand aside, given the SFO's decision to investigate. The SFO declined to comment further, citing the investigation. Such investigations can take years to complete. 9 On February 5th 2015, the Groceries Code Adjudicator (GCA), UK's first independent adjudicator to oversee the relationship between supermarkets and their suppliers, joined SFO in investigating Tesco. The adjudicator said: \"I have reasonable suspicion that Tesco breached the code in two areas. One is reasonable payments and second is payments for better positions on shelf outside promotions.\" Epilogue On May 10th 2015, Deloitte was appointed by Tesco as its new auditor after PwC and the Company "mutually agreed" that PwC would not take part in a re-tendering process. 10 Requirements Requirement 1 Financial Reporting of Sales Allowances As mentioned in the illustrative example of the vendor allowances agreement, assume that on September 1st 2013, CPC paid 560 million to Tesco in exchange for Tesco's commitment to purchase 3.5 billion units of CPC's products. At the end of the contract period (August 31st 2014), the amount of sales allowances was calculated based on Tesco's actual purchases (3.65 billion units at 2 per unit) during the contract period and difference was settled in cash between CPC and Tesco. (a) CPC recognized the payment of 560 on September 1st 2013 as SGA (Selling, General and Administrative) expenses, and the cash settlement on August 31st 2014 as an adjustment to SGA expenses. Explain whether or not CPC's recording of sales allowances as SGA expenses is in compliance with U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements. (b) Tesco recognized the receipt of 560 on September 1st 2013 as sales revenues, and the cash settlement on August 31st 2014 as an adjustment to sales revenues. Explain whether or not Tesco's recording of sales allowances as sales revenues is in compliance with U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements. (c) Complete the following table for CPC for the 12-month contract period ending August 31st 2014. Item Income Effects of Sales Allowances - Vendor's books - CPC (Amounts in millions ) Current contract period Previous Reported Corrections, if Correct amounts contract period amounts any per U.S. GAAP Sales revenues Cost of goods sold Gross margin SGA expenses Operating profit Sales growth over previous contract period Gross margin Rate 7,000 4,900 2,100 560 7,300 5,110 2,190 584 1,540 1,606 Not Applicable 4.29% Not Applicable 30% 30% Not Applicable 11 (d) Explain the plausible motivations of CPC's management to recognize sales allowances as SGA expenses. (e) Complete the following table for Tesco for the 12-month contract period ending August 31st 2014. Assume that all inventory purchased from CPC is sold by Tesco before the end of the 12-month period. Income Effects of Sales Allowances - Customer's Books - Tesco (Amounts in millions ) Item Sales revenues Cost of goods sold Gross margin Sales growth over previous contract period Gross margin Rate (f) Previous contract period Reported amounts Current contract period Corrections, if Correct amounts any per U.S. GAAP 7,190 6,270 920 8,390 7,300 1,090 Not Applicable 16.69% Not Applicable 12.80% 12.99% Not Applicable Explain the plausible motivations of Tesco's management to include sales allowances in sales revenues. For this requirement, assume that the for the contract period, the target gross margin rate for management bonus purposes was the same as in the previous contract period. Requirement 2 Timing of recognition of sales allowance and journal entries Continue with the data provided in requirement 1. In addition, assume the following: 13 From September 1st 2013 to February 22nd 2014, Tesco purchased 1.75 billion units from CPC at 2 per unit. Before the end of its fiscal year 2014 on February 22nd 2014, Tesco sold 80 percent of the units purchased at a price of 2.12 per unit 13, and carried the remaining 20 percent in inventory to the next fiscal year (2015). Tesco generally prices its products at approximately six percent above its \"regular\" purchase cost. 12 At the end of fiscal 2014, Tesco estimated that it would purchase additional 1.75 billion units from CPC before the end of the contract period. During fiscal 2015, Tesco purchased additional 1.9 billion units at 2.00 each from CPC, and sold at a price of 2.12 per unit all the units purchased as well as the units in its inventory at the beginning of fiscal 2015. Please note that the first half of the contract period (September 1st 2013 to February 22nd 2014) coincides with Tesco's second half of fiscal year 2014, and the second half of the contract period (February 23rd 2014 to August 31st 2014) coincides with Tesco's first half of fiscal year 2015. (a) Compute (i) the amounts of sales allowances earned by Tesco in fiscal 2014 and fiscal 2015, and (ii) the amounts of sales allowances Tesco should recognize in its income statements for fiscal 2014 and fiscal 2015. Show supporting computations and explain your rationale. (b) Prepare the fiscal 2014 journal entries in Tesco's books for the following transactions in accordance with the existing U.S. GAAP. Assume that all purchases and sales are made with cash. a. b. c. d. (c) Receipt of cash for sales allowances from CPC Purchase of inventory during fiscal 2014 (assume perpetual inventory system) Sale of 80% of the inventory purchased at 2.12 per unit Recording cost of goods sold (present supporting calculations) for fiscal 2014 Prepare the fiscal 2015 journal entries in Tesco's books for the following transactions in accordance with existing U.S. GAAP. Assume that all purchases and sales are made with cash. a. Purchase of additional inventory during fiscal 2015 b. Sale of the inventory brought forward from fiscal 2014 and inventory purchased in fiscal 2015 at 2.12 per unit c. Recording cost of goods sold (present supporting calculations) for fiscal 2015 d. Cash settlement with CPC at the end of the contract period 13 Requirement 3 Effect of assumed sales growth on vendor allowances This requirement builds on the accounting concepts and mechanics addressed in Requirement 2. As in Requirement 2, assume that from September 1st 2013 to February 22nd 2014, Tesco purchased 1.75 billion units from CPC at 2 per unit. During fiscal year 2014 (ending on February 22nd 2014), it sold 80 percent of the units purchased at a price of 2.12 per unit, and carried the remaining 20 percent in inventory to the next fiscal year (2015). During fiscal 2015, Tesco sold all the units in its inventory at a price of 2.12 per unit. (a) At the end of fiscal 2014, Tesco expected that the past trajectory of sales growth will continue. As such, it estimated that it would purchase an additional 1.95 billion units from CPC before August 31st 2014. However, the actual quantity purchased was higher (2.15 billion units). The resulting change, if any, in the sales allowance is treated as a cumulative catch-up adjustment by Tesco. To comply with existing U.S. GAAP, Tesco should report the following (fill in the blanks in the table). Tesco - Income Effects if Sales Growth Continues (Amounts in millions ) Current contract period Previous contract period September 1, September 1, Feb 23, 2014 - Item (September 1, 2013 - Feb 22, 2013 - August August 31, 2014 2012 - August 2014 (Fiscal 31, 2014 (Total (Fiscal 2015) 31, 2013) 2014) contract period) 7,190 Sales revenues 2,968 5,300 8,268 6,270 Cost of goods sold 920 Gross margin 12.80% Gross margin % (b) Now assume that before the end of fiscal year 2014, Tesco estimates that its sales of CPC's products are unlikely to grow. Indeed, it estimated sales to decline from the previous year. At the end of fiscal 2014, Tesco estimated that it would purchase only 1.65 billion units during February 23rd 2014 to August 31st 2014. However, the actual purchases were lower (1.45 billion units). The resulting change, if any, in the sales allowance is treated as a cumulative catch-up adjustment by Tesco. To comply with existing U.S. GAAP, Tesco should report the following (fill in the blanks in the table). 14 Tesco - Income Effects if Sales Growth Deteriorates (Amounts in millions ) Current contract period Previous contract period September 1, September 1, Feb 23, 2014 - Item (September 1, 2013 - Feb 22, 2013 - August August 31, 2014 2012 - August 2014 (Fiscal 31, 2014 (Total (Fiscal 2015) 31, 2013) 2014) contract period) 7,190 Sales revenues 2,968 3,816 6,784 6,270 Cost of goods sold 920 Gross margin 12.80% Gross margin % (c) As mentioned in the case, David McCarthy, an analyst at HSBC, stated that slowing sales growth at Tesco could have contributed to an inaccuracy in calculations because Tesco may have booked promotional rebates based on historic precedent rather than on current volumes (Reuters, September 23rd 2014). Do you agree with this statement in light of your answers in 3(a) and 3(b) above? Elaborate. (d) Would you consider the misstatements in the financial statements resulting from the incorrect assumption about sales growth an error or a fraud? Why? Explain. Requirement 4 Accounting treatment of sales allowances - New Standard on Revenue Recognition On May 28th 2014, the International Accounting Standards Board (IASB) the Financial Accounting Standards Board (FASB) jointly issued a converged standard on the recognition of revenue from contracts with customers. Determine whether or not CPC's accounting of vendor allowances complies with the newly issued standard in the U.S. - Accounting Standards Update 2014-09.14 Cite the appropriate paragraph(s) of the new standard in support of your answer. 14 The Standard is available at: http://www.fasb.org/cs/ContentServer?pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176164076069 15 Requirement 5 Miscellaneous Topics Answer to each part should be focused, thoughtful and brief. Explain YOUR understanding of the issues and YOUR views; minimize quoting from the published sources. (a) Principle-based versus rules-based standards Business Insider (October 7th 2014) noted that \"While European retailers are not obliged to, and do not, disclose contributions to profits from vendor allowances, US retailers often do, and are subject to more detailed accounting rules.\" Identify a U.S. retailer from the 2014 Fortune 500 list and describe whether the financial reporting of vendor allowances in its most recent annual report is adequate or not. Include the excerpts of the disclosures as an appendix to your report. (b) Profit warning Tesco, a company that had not issued any profit warning in the two decades ending fiscal 2012, issued five profit warnings in twelve months ending December 2014. What is a profit warning? Why do companies issue profit warnings? How do financial analysts typically respond to the frequent profit warnings? Why? (c) American Depository Receipts (ADRs) In addition to listing its shares on the London Stock Exchange, Tesco has American Depositary Receipts (ADR) traded on the over-the-counter market in the U.S. What are the benefits of ADRs to the companies issuing them and for the investors purchasing them? How does the Securities and Exchange Commission regulate ADRs? (e) Where were the auditors? Do you think that PwC - Tesco's auditors - discharged their professional responsibility when it issued a clean audit report for Tesco's fiscal 2014 financial statements? Why? 16 References Business Insider, 2014. \"The UK Supermarket Sector Is In Free Fall Right Now.\" 7 October. Accessed at: http://www.businessinsider.com/tesco-fires-kevin-grace-in-accountingscandal-2014-10 The Economist, 2014. \"Booking revenues, like comedy, is all about timing.\" 27 September. Accessed at: http://www.economist.comews/business/21620227-booking-revenuescomedy-all-about-timing-not-so-funny Reuters, 2014. \"Tesco-style accounting risks well known in retail industry.\" 23 September. Accessed at: http://www.reuters.com/article/2014/09/23/tescoaccountingidUSL6N0RO52120140923 Tesco, PLC, Annual and Interim reports, accessed at: http://www.tescoplc.com/index.asp?pageid=548 The Telegraph, 2014. \"Tesco accounting scandal Q&A: What happens next?\" 22 September. Accessed at: http://www.telegraph.co.uk/financeewsbysector/epic/tsco/11113002/Tescoaccounting-scandal-QandA-what-happens-next.html The Telegraph, 2014. \"A History of Tesco: The rise of Britain's biggest supermarket.\" 4 October. Accessed at http://www.telegraph.co.uk/finance/markets/2788089/A-history-of-TescoThe-rise-of-Britains-biggest-supermarket.html The Telegraph, 2014. \"Tesco suppliers call in audit teams over accounting scandal.\" 28 October. Accessed at: http://www.telegraph.co.uk/financeewsbysector/epic/tsco/11193968/Tescosuppliers-call-in-audit-teams-over-accounting-scandal.html The Telegraph, 2014. \"The unanswered questions in Tesco's accounting scandal.\" 6 November. Accessed at: http://www.telegraph.co.uk/finance/comment/11214948/Unansweredquestions-in-Tescos-accounting-scandal.html 17 Exhibit 1 Tesco's Financial Performance 2005-2014 Profit before tax from Profit after tax from continuing operations continuing (m) operations (m) Basic earnings per share (pence) 52/53 weeks ended Revenues (m) Trading Profit (m) 22 February 2014 63,557 3,315 2,259 1,912 23.75 23 February 2013 64,826 3,453 1,960 1,386 17.30 25 February 2012 64,539 3,761 3,835 2,956 36.75 26 February 2011 60,931 3,679 3,535 2,671 33.10 27 February 2010 56,910 3,412 3,176 2,336 29.33 28 February 2009 54,327 3,090 2,954 2,166 27.50 23 February 2008 47,298 2,751 2,803 2,130 26.95 24 February 2007 42,641 2,478 2,653 1,881 23.61 25 February 2006 39,454 2,230 2,235 1,586 20.20 26 February 2005 33,974 Not Avail. 1,962 1,366 17.72 Source: Group income statements in Tesco Plc. annual reports. The trading profit data was obtained from financial review, group performance, business review and notes to the group financial statements of Tesco Plc. 18 Figure 1 Revenues, Trading Profit, PBT, PAT and Stock Prices of Tesco (2006-2014) (Source: Annual Reports of Tesco and Yahoo Finance) Revenues (m) Trading Profit (m) 80,000 5,000 4,000 60,000 3,000 40,000 2,000 20,000 1,000 0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2006 2007 2008 2009 2010 2011 2012 2013 2014 Profit before tax (m) Profit after tax (m) 5,000 4,000 4,000 3,000 3,000 2,000 2,000 1,000 1,000 0 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2006 2007 2008 2009 2010 2011 2012 2013 2014 Tesco Stock Price vis-a-vis FTSE 100 Index 8000.0 6.00 7000.0 5.00 6000.0 4.00 5000.0 4000.0 3.00 3000.0 2.00 2000.0 1.00 1000.0 0.0 0.00 FTSE 100 Index Stock Price - Tesco 19 Figure 2 20 Figure 3 Note: 1 pence = .01 21 Tesco's Financial Reporting of Vendor Allowances1 The Company2 Tesco PLC (hereafter, Tesco, or the Company) is a British multinational retailer headquartered in Cheshunt, United Kingdom. In 2014, Tesco was the world's third largest retailer as measured by profits and second-largest, as measured by revenues. The Company employed more than 530,000 people, and had stores in 12 countries across Asia and Europe. It was the grocery market leader in Ireland, Hungary, Malaysia, Thailand, and the U.K., where it claimed a market share of around 30%. Tesco had a market capitalization of approximately 203 billion in August 2014. Its common stock is listed on the London Stock Exchange and is a constituent of the FTSE 100 Index.4 The Company also has American Depositary Receipts (ADR) traded on the over-thecounter market in the U.S. under the symbol TSCDY.5 Evolution and Financial Performance Jack Cohen founded Tesco in 1919 when he started selling surplus groceries from a stall in the East End of London. Mr. Cohen made a profit of 1 from sales of 4 on his first day. The Tesco name first appeared in 1924, when Cohen purchased a shipment of tea from T. E. Stockwell and combined those initials with the first two letters of his surname. The first Tesco store opened soon after in 1929. Cohen's U.K. business expanded rapidly. By 1939 he had opened over 100 Tesco stores across the country. Starting in the early 1990s, Tesco expanded further as the Company diversified geographically and expanded its product portfolio to include not only the traditional retail markets (such as books, clothing, electronics, furniture, toys, and petrol) but the emerging retail markets (such as software, financial services, telecoms and internet services) as well. Tesco's 1 This case is developed by Professor Mahendra Gujarathi of Bentley University for the purpose of class discussion. Please do not quote without permission. 2 The information in this and the next section is obtained largely from the annual reports and web site of the Company and from The Telegraph (October 4, 2014). 3 is the symbol denoting British Pounds, the currency of Great Britain and the United Kingdom. 4 The FTSE 100 Index is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. 5 An American depositary receipt (ADR) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. Each ADR of Tesco represents three Tesco PLC ordinary shares. 1 diversification strategy and aggressive marketing efforts led to further store openings in the 1990s and helped the Company to assume the coveted position of UK's leading grocer. Tesco outperformed all its rivals, increasing its market share in groceries from 15.4 percent in 1998 to 28 percent in 2004. Tesco won applause for its swift growth and global ambitions through the early 2000s. Although profits came under pressure in fiscal6 2009 because of the worldwide economic downturn, the profitability growth resumed again from fiscal 2010 and continued through fiscal 2012. Fiscal 2013, however, was not a good year for Tesco. Its revenues were almost stagnant and profit before tax was down by almost half compared to fiscal 2012. In January 2012, the Company issued a profit warning for the first time in 20 years and in April 2013, Tesco reported its first decrease in annual profit in 19 years. Profit warnings were not uncommon in fiscal 2013 and 2014, however. Indeed, Tesco issued five profit warnings in twelve months ending December 2014. During fiscal 2013 and 2014, Tesco experienced a decline in the trading profits7. Failing to halt the dramatic decline in the trading and pre-tax profits, Tesco announced on July 22nd 2014 that its Chief Executive Officer (CEO) Philip Clarke, a 40-year veteran at the Company, would be replaced by Dave Lewis, the head of personal care unit at Unilever (the world's third largest consumer goods company), on October 1, 2014. However, given the fast-changing situation at Tesco, the new CEO was asked to join a month earlier, on September 1st, 2014. The Company's financial performance (revenues, trading profit, profit before tax, profit after tax, and basic earnings per share) during fiscal years 2005 to 2014 is presented in Exhibit 1. --- Insert Exhibit 1 about here --Tesco's stock price reflected its impressive operating performance from 2006 to 2011 and subsequent deterioration from 2012 through 2014. Figure 1 presents a graph of Tesco's revenues and profits during 2006-2014 and depicts the history of its stock price vis--vis the FTSE 100 index. 6 Tesco's fiscal year runs for 52 or 53 week period ending in late February. The 2009 fiscal year was for 53 week period ending February 28th, 2009. 7 Tesco's annual report defines trading profit as an adjusted measure of operating profit. It measures the performance before profits/losses arising on property-related items, the impact on leases of annual uplifts in rent and rent-free periods, intangible asset amortization charges and costs arising from acquisitions, and goodwill impairment and restructuring and other one-off costs. 2 --- Insert Figure 1 about here --The Controversy over Accounting for Commercial Income On the Friday of September 19th 2014, a member of Tesco's staff, whose identity was not disclosed, warned the Company's general counsel about early booking of commercial income and delayed booking of costs. In less than three weeks after joining Tesco, on the Monday after the Friday on which the staff member blew the whistle, Tesco's new CEO Dave Lewis had the unenviable task of announcing on September 22nd, 2014 that profits for the six months ending August 2014 were likely overstated by 250 million. The Company suspended eight senior executives and launched an internal investigation of the issue. In addition, Tesco's Board of Directors appointed Deloitte (an international accounting firm that was not Tesco's external auditor) to undertake an independent review of the Company's accounting issues, in association with Freshfields, Tesco's legal advisers. Deloitte's review of Tesco's semi-annual results confirmed that the Company's profit overstatement was larger than the 250 million previously declared and the overstatements went back further than Tesco originally stated. Deloitte concluded that Tesco's overall commercial income adjustment was 263 million, including 118 million in the first half of 2014-15, 70 million relating to 2013-14, and 75 million of prior period adjustments relating to pre-2013-14. On the basis that the prior period adjustments were not material, Tesco did not make any prior period restatement and adjusted all amounts in the current period's income. Tesco's interim report issued on October 23rd 2014 acknowledged that the guidance (provided on August 29th 2014) regarding profit for the six months to August 23rd, 2014 was overstated primarily due to the accelerated recognition of commercial income and delayed accrual of costs. The pre-tax profit for the period fell by 92% from 1.39 billion to 112 million. The interim report stated: As announced on 1 October 2014, the Financial Conduct Authority8 has launched an investigation into the issue. We will fully cooperate with the regulatory authorities. Given the outstanding investigation, we can make no further statement at this stage about how these events came about. 8 The Financial Conduct Authority (FCA) is a financial regulatory body in the United Kingdom, but operates independently of the United Kingdom government, and is financed by charging fees to members of the financial services industry. 3 Commercial Income and Its Financial Reporting Consumer products companies provide retailers with different forms of vendor allowances such as volume discounts, cooperative advertising and slotting fees. In most cases the allowances (sometimes labelled as discounts or rebates or sales incentives or commercial income or sales allowances) are tied to the volume that retailers such as Tesco promise to buy from the vendor. Retailers also obtain reimbursements of a portion of advertising costs from vendors under the cooperative advertising arrangements. The advertising allowance can be volume-based, or it can be a flat amount. Slotting fees represent an arrangement in which manufacturers pay retailers a fee for shelving their products in prominent locations. The amounts of commercial income are significant for retailers. Business Insider (October 7th , 2014) mentioned that \"Among the US supermarkets that disclose figures, vendor allowances are equivalent to around 8 percent of the cost of goods sold, equal to virtually all their profit.\" Typically, vendors pay retailers the estimated amount of the commercial income upfront. However, when and how to record the income effects of those cash flows are contentious issues and accounting treatments vary across vendors as well as customers both. Despite the potentially significant effects on profits, accounting policies regarding vendor allowances are rarely described in IFRS-based financial statements. As stated in Business Insider (October 7th, 2014), \"While European retailers are not obliged to, and do not, disclose contributions to profits from vendor allowances, US retailers often do, and are subject to more detailed accounting rules.\" In Tesco's case, the description of commercial income, or explanation regarding the accounting policy pertaining thereto, was not included in the Company's financial statements which were prepared in accordance with the International Financial Reporting Standards (IFRS). PriceWaterhouseCoopers (PwC), the auditors of Tesco, however noted a concern about commercial income in their audit report for fiscal 2014. Although PwC issued a clean audit report on Tesco's financials, it mentioned the material risks regarding the reporting of commercial income as follows.9 9 The auditors for all three of Britain's biggest retailers - Tesco, Sainsbury's and Morrisons - alerted investors in their most recent annual reports that their businesses faced material risks regarding the reporting of supplier rebates (Business Insider, October 7, 2014). 4 Area of focus How the scope of our audit addressed the area of focus Recognition of commercial income Commercial income (promotional monies, discounts and rebates receivables from suppliers) recognized during the year is material to the income statement and amounts accrued at the year-end are judgmental. We tested the controls management has in place, focusing on controls over price changes and margin reviews. We agreed commercial income recognized to contractual evidence with suppliers, with particular attention to the period in which the income was recorded and the appropriateness of the accrual at the year end. 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. We compared movements year on year in margins for product categories based on an expectation derived from out sample testing of contracts with suppliers. Illustrative Example of a Vendor Allowances Arrangement Presented below is a hypothetical example that illustrates a vendor allowances arrangement. Consistent with Jack Cohen's business motto "pile it high and sell it cheap", Tesco routinely negotiates contracts with its vendors for purchasing products at best prices, and passes on the savings to its customers. One such annual contract with CPC, a leading consumer products company was initiated on September 1st 2013. The contract stipulated that Tesco will continue to receive 8 percent refund of the purchase price if it bought at least the same quantity (3.5 billion units) of CPC products as it did in the previous contract period, regularly priced at 2 per unit (total purchases of 7 billion). In addition, depending on the level of purchases during the contract period, the contract stipulated a lower (or higher) refund, as follows: 5 Purchases (units) during Sept. 1, 2013 - Aug. 31, 2014 Refund Percentage on total purchases Less than 3 billion Zero 3 billion to 3.299 billion 6% 3.3 billion to 3.499 billion 7% 3.5 billion to 3.699 billion 8% 3.7 billion to 3.899 billion 9% 3.9 billion and above 10% The regular price of the units supplied by CPC remained constant (2 per unit) throughout the contract period. Not knowing the trend of sales in the forthcoming year, on September 1st 2013, Tesco committed to purchase from CPC the same number of units (3.5 billion) in the current contract period (12-month period ending August 31st 2014) as it did in the previous contract period (12-month period ending August 31st 2013). Using this estimate, and based on prior experience of dealings with Tesco, on September 1st 2013, CPC paid 560 million (8 percent X 3.5 billion units X 2 price per unit) in advance to Tesco. If Tesco's actual purchases differ from the contracted amounts, the Company would return the unearned portion of the refund to CPC (or receive the unpaid portion of refund from CPC) on August 31, 2014. Tesco's Earnings Manipulation: Speculations Galore, Facts Few Several speculations existed about the motivations and mechanisms of manipulating earnings by Tesco's management. The most obvious was the link between the compensation of Tesco's senior management and financial performance of the Company. In the retailing industry, commonly used measures of performance include annual sales growth, annuals growth in comparable store sales (open for 12 months or longer), and the gross margin rate. Tesco used these and other financial as well as non-financial measures to determine the remuneration of its executive directors (i.e., senior management). As mentioned in the Directors' Remuneration Report of the Company for 2013-14,10 \"the majority of our reward is linked to the delivery of stretching performance over the short and long term aligned with the achievement of our business vision and our strategy.\" Additional details of Tesco's remuneration policy are presented in Figure 2. 10 Available at http://files.thegroup.net/library/tesco/annualreport2014/pdfs/tescoar14_gov_remunerationreport.pdf 6 --- Insert Figure 2 about here --The remuneration policy described determinants of the executive compensation, but did not provide details of the bonus targets. The Directors' Remuneration Report for fiscal 2014 stated that \"Bonus targets are considered by the Board to be commercially sensitive as they would give away details of our budgeting to our competitors. We therefore do not publish the details of targets.\" The remuneration policy also stated: \"Despite strong progress against strategic objectives during the year and the exceptional effort management have put in to achieve this, the bonus profit underpin was not met and therefore the Executive Directors will not receive a bonus in respect of 2013-14. Performance Share Plan awards granted in 2011 will lapse in July 2014 as challenging three-year Earnings per Share (EPS) and Return on Capital Employed (ROCE) targets were not met.\" Because the Company's fiscal 2013 financial performance did not meet the targeted results, senior management did not earn annual bonuses in 2013 also. The report by Deloitte and Freshfield indicated that the profit overstatement stemmed from the \"booking of supplier contributions that were conditional on hitting sales targets that it was not going to reach.\" Whether a retailer will indeed buy the required quantity of products to \"earn\" the volume discounts depends on the eventual quantities of products that the retailer is able to sell. David McCarthy, an analyst at HSBC, said that slowing sales growth at Tesco could have contributed to an inaccuracy in calculations (Reuters, September 23rd 2014). \"We suspect Tesco may have been booking promotional rebates based on historic precedent rather than on current volumes,\" he said. Tesco's senior management may also have entered into side deals with major suppliers without adequately disclosing them in the financial statements. The Telegraph (October 28th 2014) stated: \"A source close to the probe claimed that a \"small group\" of employees, realizing these sales targets would not be hit, struck deals with suppliers to still make these payments by offering benefits in the next financial period. These benefits were then kept secret.\" Another hotly debated topic was whether PwC, Tesco's auditors for more than 30 years 11, discharged their professional obligations responsibly. PwC mentioned the company's recognition of commercial income as a specific area of focus, and noted that the booking of such income and costs is a \"grey area\". However, it continued to issue clean audit opinions on 11 There have been calls from politicians and campaigners for large listed companies to avoid using the same auditor for long periods. New EU rules could force companies to change auditors after a maximum 20 years and put the position out to tender every 10 years. 7 Tesco's financial statements. Tesco's audit committee did not even consider commercial income as a \"significant area for disclosure\" in its report. It is also interesting to note that two out of the ten members of the board of directors, including the chair of Tesco's audit committee, were PwC \"alumni\" that formerly worked for the auditing firm. Further speculation suggests that Tesco's main suppliers, which include some of the world's largest consumer goods companies such as Unilever, Coca-Cola, and Nestle, might have colluded with Tesco in profit manipulation for the fear of losing a large customer. The Telegraph (November 6th 2014) stated: \"If Tesco had been overinflating commercial income, then it stands to reason that its suppliers had lower profits than they thought because the retailer was claiming money that they did not know about. Reportedly, several of Tesco's biggest suppliers have launched internal audits to ensure that their financial figures have not been distorted. However, no supplier has come out and changed their financial results as a result of uncovering issues in their negotiations with Tesco.\" In short, the issue of whether Tesco's management manipulated Company earnings remains unresolved. The complexity of Tesco's promotional deals with suppliers may have left room for subjective decisions, unintentional errors, and honest mistakes (The Economist, September 27th 2014). For instance, some analysts blamed the accounting error on the lack of experience of Tesco's Board of Directors in the retailing industry. Some have also suggested the commercial income adjustment as an example of \"kitchen sinking\"12 of the accounts by the new CEO to help reset Tesco towards future profitability (The Telegraph, September 22nd 2014). Reaction from the Financial Community to Tesco's Profit Overstatement On September 22nd 2014, when Tesco disclosed likely profit overstatement and the appointment of Deloitte to perform an independent review, capital markets responded by dropping Tesco's stock price almost 12 percent in a single day, thereby wiping out more than 500 million from the Company's market capitalization. Later in the year, when Tesco warned that its annual profits would fall below consensus analysts' estimates, its stock price declined to a 14-year low of 1.65 per share. During the calendar year 2014 alone, Tesco suffered a reduction in the market capitalization of almost 12 billion. The downward spiral in Tesco's stock price during 2014 is presented in Figure 3. Some high-profile investors including the legendary investor Warren Buffett sold their stakes in the Company, stating that their decision to invest in Tesco was \"a mistake.\" --- Insert Figure 3 about here --12 Kitchen sinking involves front-loading the bad news to pave the way for a rebound in profit in later years. 8 Credit rating agencies also responded unfavorably to Tesco's profit overstatement. Almost immediately after Deloitte issued its review report on Tesco on October 22 nd 2014, two credit rating agencies reduced Tesco's rating to the cusp of investment grade. Fitch dropped Tesco a notch to BBB- and Moody's cut its rating of Tesco to Baa3 from Baa2, citing the reduced and trading profit and \"uncertainties\" related to the regulatory investigations into Tesco's accounting problems. On January 8th 2015, Dave Lewis, Tesco's chief executive, announced drastic measures to help turnaround the Company's financial position, including closing Tesco's headquarters in Cheshunt, shutting down 43 unprofitable stores and scrapping plans to build 49 new supermarkets. Lewis also announced that Tesco would close its defined benefit pension plan, consider canceling its final dividend payout and slash corporate administrative costs by 30 percent. The company had met with the three major credit rating agencies (Fitch, Moody's and S&P) the day before it unveiled its turnaround plan in the hope of preventing a downgrade. However, On January 9th 2015, Moody's downgraded Tesco's senior unsecured long-term rating to Ba1 from Baa3 stating that Tesco's attempts to protect its balance sheet will "take time to implement". Moody's also reported that "structural changes in the UK grocery retail market will continue to challenge the company's operating performance". Less than a week later, S&P followed suit on January 15th 2015, when it downgraded Tesco's rating to non-investment grade, or junk status. Legal Proceedings On October 1, 2014, Tesco announced that the U.K.'s financial watchdog, the Financial Conduct Authority (FCA), had \"commenced a full investigation\" of the accounting irregularities at the company. Unlike the US legal system, no provision exists under English law for class-action lawsuits, in which thousands of people can collectively file one big legal claim. In the US, lawsuits were filed on behalf of investors who purchased Tesco's ADRs (American Depository Receipts). Britain's Serious Fraud Office (SFO) recently opened a criminal investigation into accounting irregularities at Tesco. The Company said that it has been \"cooperating fully with the SFO and will continue to do so.\" The Financial Conduct Authority said it would stand aside, given the SFO's decision to investigate. The SFO declined to comment further, citing the investigation. Such investigations can take years to complete. 9 On February 5th 2015, the Groceries Code Adjudicator (GCA), UK's first independent adjudicator to oversee the relationship between supermarkets and their suppliers, joined SFO in investigating Tesco. The adjudicator said: \"I have reasonable suspicion that Tesco breached the code in two areas. One is reasonable payments and second is payments for better positions on shelf outside promotions.\" Epilogue On May 10th 2015, Deloitte was appointed by Tesco as its new auditor after PwC and the Company "mutually agreed" that PwC would not take part in a re-tendering process. 10 Requirements Requirement 1 Financial Reporting of Sales Allowances As mentioned in the illustrative example of the vendor allowances agreement, assume that on September 1st 2013, CPC paid 560 million to Tesco in exchange for Tesco's commitment to purchase 3.5 billion units of CPC's products. At the end of the contract period (August 31st 2014), the amount of sales allowances was calculated based on Tesco's actual purchases (3.65 billion units at 2 per unit) during the contract period and difference was settled in cash between CPC and Tesco. (a) CPC recognized the payment of 560 on September 1st 2013 as SGA (Selling, General and Administrative) expenses, and the cash settlement on August 31st 2014 as an adjustment to SGA expenses. Explain whether or not CPC's recording of sales allowances as SGA expenses is in compliance with U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements. (b) Tesco recognized the receipt of 560 on September 1st 2013 as sales revenues, and the cash settlement on August 31st 2014 as an adjustment to sales revenues. Explain whether or not Tesco's recording of sales allowances as sales revenues is in compliance with U.S. GAAP. Cite paragraphs from the appropriate professional pronouncements. (c) Complete the following table for CPC for the 12-month contract period ending August 31st 2014. Item Income Effects of Sales Allowances - Vendor's books - CPC (Amounts in millions ) Current contract period Previous Reported Corrections, if Correct amounts contract period amounts any per U.S. GAAP Sales revenues Cost of goods sold Gross margin SGA expenses Operating profit Sales growth over previous contract period Gross margin Rate 7,000 4,900 2,100 560 7,300 5,110 2,190 584 1,540 1,606 Not Applicable 4.29% Not Applicable 30% 30% Not Applicable 11 (d) Explain the plausible motivations of CPC's management to recognize sales allowances as SGA expenses. (e) Complete the following table for Tesco for the 12-month contract period ending August 31st 2014. Assume that all inventory purchased from CPC is sold by Tesco before the end of the 12-month period. Income Effects of Sales Allowances - Customer's Books - Tesco (Amounts in millions ) Item Sales revenues Cost of goods sold Gross margin Sales growth over previous contract period Gross margin Rate (f) Previous contract period Reported amounts Current contract period Corrections, if Correct amounts any per U.S. GAAP 7,190 6,270 920 8,390 7,300 1,090 Not Applicable 16.69% Not Applicable 12.80% 12.99% Not Applicable Explain the plausible motivations of Tesco's management to include sales allowances in sales revenues. For this requirement, assume that the for the contract period, the target gross margin rate for management bonus purposes was the same as in the previous contract period. Requirement 2 Timing of recognition of sales allowance and journal entries Continue with the data provided in requirement 1. In addition, assume the following: 13 From September 1st 2013 to February 22nd 2014, Tesco purchased 1.75 billion units from CPC at 2 per unit. Before the end of its fiscal year 2014 on February 22nd 2014, Tesco sold 80 percent of the units purchased at a price of 2.12 per unit 13, and carried the remaining 20 percent in inventory to the next fiscal year (2015). Tesco generally prices its products at approximately six percent above its \"regular\" purchase cost. 12 At the end of fiscal 2014, Tesco estimated that it would purchase additional 1.75 billion units from CPC before the end of the contract period. During fiscal 2015, Tesco purchased additional 1.9 billion units at 2.00 each from CPC, and sold at a price of 2.12 per unit all the units purchased as well as the units in its inventory at the beginning of fiscal 2015. Please note that the first half of the contract period (September 1st 2013 to February 22nd 2014) coincides with Tesco's second half of fiscal year 2014, and the second half of the contract period (February 23rd 2014 to August 31st 2014) coincides with Tesco's first half of fiscal year 2015. (a) Compute (i) the amounts of sales allowances earned by Tesco in fiscal 2014 and fiscal 2015, and (ii) the amounts of sales allowances Tesco should recognize in its income statements for fiscal 2014 and fiscal 2015. Show supporting computations and explain your rationale. (b) Prepare the fiscal 2014 journal entries in Tesco's books for the following transactions in accordance with the existing U.S. GAAP. Assume that all purchases and sales are made with cash. a. b. c. d. (c) Receipt of cash for sales allowances from CPC Purchase of inventory during fiscal 2014 (assume perpetual inventory system) Sale of 80% of the inventory purchased at 2.12 per unit Recording cost of goods sold (present supporting calculations) for fiscal 2014 Prepare the fiscal 2015 journal entries in Tesco's books for the following transactions in accordance with existing U.S. GAAP. Assume that all purchases and sales are made with cash. a. Purchase of additional inventory during fiscal 2015 b. Sale of the inventory brought forward from fiscal 2014 and inventory purchased in fiscal 2015 at 2.12 per unit c. Recording cost of goods sold (present supporting calculations) for fiscal 2015 d. Cash settlement with CPC at the end of the contract per