The UK Corporate Governance Code Break Down at Tesco - Essay Example

Issues in Financial Reporting Discuss how the UK Corporate Governance broke down at Tesco and explain how and why the accounting scandal was able to occur Introduction This document provides a report of the financial performance of three companies; Mark $ Spenser, Next Plc and Tesco Plc. Also, it examines the UK corporate governance code and accounting scandal involving Tesco. The aim of the study is to examine the weaknesses of corporate governance code and accounting professional ethics as well as provide an analysis of the company’s performance vertically, horizontally and determine the trend analysis. Also, the report includes ratio analysis of the three companies. The three companies are in the same industry and are UK based though they have worldwide operations and have an online presence. The analysis of the enterprise’s performance is critical because it helps decision makers such as the investors and managers for effective decision-making. The analysis of performance provides information about the efficiency of allocation of resources and factors causing the business not to achieve its objectives (Hargreaves 2015) The trend analysis will enable the stakeholders in making an assessment as to whether the company is improving or not improving and how competitive the company is in the industry (Alexander, Britton & Jorissen, 2011). The report provides causes for observed performance in the particular company. The report offers a recommendation on the areas that require improvement to achieve better financial performance. Corporate governance refers to a method of directing and controlling companies. It involves balancing between social and individual goals or economic and social goals to align the interests of the businesses, individuals and the society as close as is practicable (European Accounting Review, 2015). It specifies the correlation between shareholders, the board of the company and other stakeholders. Also, it provides the structure for setting up company’s objectives, approaches for attaining these goals and determines how to monitor the performance (Alexander et al., 2011). Corporate governance eases operational, innovative and sensible management that can promote continuous performance of the business. Corporate governance is reinforced by various theories such as agency theory, stakeholders’ theory, resource dependency theory and stewardship theory. The responsibility of governing corporations is bestowed upon the board of directors. Shareholders have the responsibility of appointing the board of directors to ensure to ensure effective corporate governance (European Accounting Review, 2015) On the other hand, the board of directors sets the strategic objectives of the companies, organizations management; provide supervision to the management and report about the organisations performance to the shareholders The UK Corporate Governance Code establishes principles of moral practices about board control and efficiency, transparency, compensation, and the relationships with the shareholders (Alexander et al., 2011). All public listed companies are required under the listing rules to indicate how they applied the code in the annual report and accounts. Also, they are required to state whether they complied with the law and if not they provide the reason for noncompliance. Compliance with this regulation enables the shareholders understand the cause of decision taken by the directors of the companies and evaluate their satisfaction with the directors decisions. The UK code of corporate governance has various principles such as the principle of leadership, accountability, efficiency, remuneration and relationships. The principle of leadership is a requirement that every organization to have a well-established board whose collective responsibility is to ensure the success of the organization (Alexander et al., 2011). The leadership should be well defined regarding the board operations and the management of the organisation. There is no individual with autonomous powers to make organisational decisions. The board should be headed by the chair who oversees the efficiency of the organization. Also, the leadership includes non-executive directors with powers to challenge positively the board and assist in establishing strategic proposals. The principle of accountability requires just, clear and balanced evaluation of the present position and future expectations as viewed by the board. The board should establish internal controls and efficient management systems to avoid unnecessary risks. Furthermore, the board should maintain a sound relationship with internal and external auditors as their risk minimising strategies. The principle of effectiveness demands the board and committee of the board to possess independence, skills and expertise that can lead to efficient and appropriate discharge of their duties (Alexander et al., 2011). The procedure for appointing the new directors should be rigorous and transparent. Also, the directors should ensure timely and accurate reporting of the organisational performance. The principle of remuneration requires transparent formal policies for establishing directors’ remunerations (Taylor & Francis, 2015). This implies that directors should not be involved in deciding their own remunerations. Finally, the code contains the principle of the relationship between shareholders and the board. Tesco Company engaged in unethical issues involving overstatement of its half-year profit in 2014 by £250 million in what can be attributed to the breakdown of corporate governance code and accounting irregularities (Shapland, 2015) Towards the end of October 2014, Tesco informed its investors of about the overstated profit by £263 million against the earlier projection of £250 million (Shapland, 2015). This scandal raised two issues of concern regarding efficiency of the composition of the board of directors and application of accounting policies. The overstatement of the profit was caused by the improper realisation of income that had occurred over several years. Consequently, the company informed the investors that the board chair would be resigning to allow for investigation of the matter. Also, the Serious Fraud Office of UK declared that it had started conducting an inquiry to establish the cause alleged accounting anomalies at Tesco (Shapland, 2015) There were inadequate internal controls as observed by the external auditors and stated in the 2014 annual report in which they expressed the chance of manipulation of the report regarding the recognition of commercial income. Despite the auditors’ warning of the perceived risk the accountant engaged in accounting malpractices by recognising the revenue prematurely and estimating savings on cost (European Accounting Review, 2015). There is an assumption that the accounting practices were approved by the audit committee and the board of directors successively adopted the profit figures. Hugh Wilmot the employee who exposed the scandal attributed the failure of corporate governance to board’s composition and recognition of income (Deloitte) There was a weakness in the UK corporate governance code because it did not have a requirement that the non-executive directors should have pertinent knowledge and proficiency of higher learning. For this matter, the Tesco board of directors lacked non-executive directors with retail knowledge and that could have led to the inadequate performance of the board (Deloitte). Also, the board failed to set up control systems to restrain the abuse of corporate power which led to the acceptance of improper income estimates. The proposed changes to improve corporate governance code involve ensuring the non-executive board members have relevant qualifications and expertise to oversee the technical functions of the executives (Shapland, 2015). The non-executive members have the responsibility to inspect the performance of managers by organisational goals and objectives as well as checking the performance. They have to ascertain the transparency of the accounting procedure and control mechanisms (Alexander et al., 2011). Therefore, the UK corporate governance code should specify the relevant qualifications for the appointment of the non-executive board members to ensure they carry out their mandates efficiently and with precision. Furthermore, setting up appropriate control systems can ensure the auditors and executives comply with the accounting standards to avoid irregularities in the accounting procedures. The issues of accounting irregularities occurred at Tesco Company because the auditors and the audit committee failed to challenge the executive on adoption of figures based on uncertain estimates into the financial report (European Accounting Review, 2015). Probably this was a deliberate decision taken by the executive to showcase their performance efficiency and attract more benefits in the form of remunerations from the shareholders or attract more investors to expand business operations and profitability (Shapland, 2015). However, the disclosure of irregularities of overestimating income has adverse effects on the performance of the company and the relationship between the investors and the executives. This is because such accounting malpractices raise questions about the effectiveness of the existing control systems and the overall performance of the company (International Financial Reporting Standards). The half year revenue of company had declined from £1.6billion in 2013 to £850 million as of 29th August 2014. However, the company declared a total income of £1.1billion resulting to an overestimate of £250million. The accounting scandal at Tesco involving overstatement of half-year revenue by £250 million led in 11.5% decline in the company’s market share value and an estimated loss of £2billion of its retail market value (Shapland, 2015). Furthermore, the half-year dividend decreased by 75% as well as the annual profit that went down to £2.4billion from £3.3billion declared in 2013. Finally, the scandal led to the suspension of four Tesco’s senior executives to give way for investigations of the issues (Tesco, 2015). Comparison of Marks & Spencer Plc. with 2 of its main competitors Mark & Spencer (M&S) Plc. Mark & Spencer is a retail store operating retail stores for wide range of consumer goods such as electronics, clothes, fruits, vegetables, furniture, flowers, etc. across the UK market. It has over 600 retail stores in UK and operates franchises in more than 45 countries across the globe as well as online retailing. They deal with high-quality goods sourced from over 2,000 reliable suppliers around the world. Next Plc is a retail store operating more than 500 stores in UK and over 200 franchises across the globe (Jones & Palmer, 2014). Also, they offer online retail services to more than 3 million customers. Financial Analysis Horizontal Analysis This part involves selection of the financial data, assessing and interpreting that data into meaningful information to provide the users of such information with the basis for decision-making (Griffin & Wright, 2014). The data used for conducting the analysis is obtained from taxation, sales and assets among others. The analysis of financial data of the company provides useful information about the company’s performance at the present and predicting the future. Using the information obtained from FAME, this report will make an analysis of M &S, Next Plc and Tesco Plc as the main competitors for two years results (Shapland, 2015). The study will involve both vertical and horizontal analysis. Turnover represents the company’s revenue obtained from goods or services they offer to the market as well as the amount paid by the consumers (Griffin & Wright, 2014). The three companies indicate some improvements of their revenues. The Mark & Spencer group revenue grew by 2.8% in 2014 compared to 2013 performance analysis. However, the gross profit declined by 4.7% while before tax profit went down by 3.9% in UK. The overall profit increased by 6.1% as a result of good performance internationally. The rising cost operating cost resulted to decline in revenue from general merchandise in UK. Next Plc had good performance in 2013 and 2014 that led to growth of share earnings by 16.6% (Jones & Palmer, 2014). This was due to strong cash flow. Administrative expenses include marketing expenditure, wages and salaries, insurance, etc. (Shapland, 2015). In both companies, the administrative cost increased as a result of increased activities (Institute of Chartered Accountants). Net profit represents the investor’s bottom line of operating the business. M&S and Next Plc had performed better than Tesco Plc. Tesco Plc is also a UK based company with worldwide operations (Shapland, 2015). The company’s performance in 2014 was unsatisfactory because the company showed deteriorating profit. The poor performance was particularly due to the write-off of £30million involving of fuel debtor in Turkey. The introduction of food regulations in Hungary resulted in the closure of some food stores, and the impact is expected to be higher in 2015 due to “food supervision fees” (Tesco, 2015). The overall statutory loss for 2014 amounted to £6,376 million. Vertical Analysis The report provides an analysis of the companies’ revenues and other income items. Turnover of both companies demonstrated a good performance (Griffin & Wright, 2014). The turnover for Tesco group grew by 3%. The trading profit represented 58.2% of the sales while the sales increased by 3.0%. The pre-tax profit accounted for 68.4%. The sales for the year grew by 3% (Tesco, 2015). The tax for the period was 20.7%. The cost of sales for the three companies increased with the cost of sales accounting for more than half of the companies’ revenue. Tesco had the highest increase in the cost of sales because of the high of high promotional cost and supply chain cost (Shapland, 2015). The cost of administration for Next Plc and Mark and Spencer remained low due to the efficiency of operations. Trend Analysis In this report, 2013 financial year was taken as the base year to evaluate the continuing performance of the three companies between 2013 and 2014. The result for each company’s performance in 2014 is compared against the 2013 performance (Hargreaves, 2015). The revenue for Next Plc showed an increase in revenue by 5.4% in 2014 compared to 2013 (Jones & Palmer, 2014). The net profit also increased by 16.9% in the same period. This was attributed to increased sale price by 2.9% and decreased the cost of sales by 15% due to strategic inventory. Also, the Tax grew by 11.8%. Similarly, earning per share rose by 23% in 2014 compared to 2013. The M&S group revenue grew by 2.8% in 2014 due to good performance in UK (Institute of Chartered Accountants). The General merchandise resulted to an increase of 1.8% of the revenue while the food department had a sales increment of 2.3%. Internationally, the company had an income increment of 7.3% in 2014 compared to 2013 (Financial Times). However, the operating profit decreased by 4.7% due to high competitiveness and increasing the cost of improving supply chain and carrying out promotional activities. The taxation fell to 18.5% down from 22.7% in the previous year. However, the earning per share increased by 0.9%. Ratio Analysis Ratio analysis provides an essential basis for comparing between companies and trend analysis of the companies. Mark & Spencer (£million) Tesco Plc (£million) Next plc (£million) Year 2014 2013 2014 2013 2014 2013 Turnover 10,309.7 10,026.8 1,467 4,316 30,740.0 3,547.8 Gross profit 00 00 484 3,185 722.8 650.2 Administration expenses 3,159.6 3,052.8 2,015 2,854 531.4 544.5 Operating profit 741.9 778.6 346.2 421.4 545.2 5567 Profit before tax 580.4 564.3 372.4 426.1 695.2 621.6 Tax 74.4 106.3 370 635 142.0 148.5 Net profit 622.9 648.1 850.2 153.3 553.2 473.1 Ratios ROE 23.93 22.36% 16 13 19.3 18.2 Debt Equity Ratio 2.2 1.7 1.7 1.9 12.3 8.5 EPS 37.6p 34.8p 62 43 165p 172p Dividend per share 16.9p 16.4p 12p 17p 3.7p 4.2p Dividend Yield 8p 14p 34p 21p 63p 68p P/E Ratio 14.2 13.5 13.2 14.1 11.5 9.3 Ratio Analysis Turn on equity (ROE) provides the ratio of after-tax profit to the net worth of the company. It demonstrates the firm’s ability to generate profit. It is useful for calculating shareholders return from the enterprise (Next plc, 2013; Tesco, 2015). Debt-equity ratio denotes the total debt to the net worth of the company. The Higher ratio has adverse implication on the business because it implies higher cash outflow of the enterprise. It diminishes the owner’s equity in the business (Next plc, 2013; Tesco, 2015). Dividend per share shows the ratio of total earnings distributed to shareholders. It is the investors return. The company’s dividends per share have grown tremendously in both cases thus increasing investors’ income (Next plc, 2013; Tesco, 2015). Earnings per share represent the ratio of company’s profit based on the number of shares. Apart from Tesco the other businesses have enjoyed increasing earning per shares (Tesco, 20150. Dividend Yield is the ratio of dividend per share to the market value of the shares. It represents returns to the investors. All the three companies recorded growth in divide yield for the years 2013 and 2014 (Tesco, 2015). P/E Ratio represents the market price of shares to EPS ratio. The price per share ratio of the three companies demonstrated positive change (Tesco, 2015). Conclusion The horizontal, vertical and trend analysis of Tesco, Next Plc and M&S indicates a strong competition in the industry. The companies have continued to expand their revenue base over years, and the earning of their shares has continued to grow as well. Next Plc and M&S are strong competitors in the industry, and their performance has continued to grow mainly as a result of adopting better marketing strategies. However, Tesco performance has been deteriorating over time due to stiff competition in the market and inability to comply with the new market regulations. Furthermore, Tesco has. Therefore, Tesco should comply with the market standards to improve performance and avoid high cost due to penalties. It may take time for Tesco to restore investor’s confidence which means the share value may continue declining even more. However, the company can quickly restore the investor confidence and regain the market value of the shares by setting up adequate controls and modifying corporate governance code. Such controls will ensure compliance with regulations and hold all employees and other stakeholders accountable for their undertakings. List of References Alexander, D., Britton, A. and Jorissen, A., 2011. International Financial Reporting and Analysis. 5th ed. London: Cengage Learning Deloitte. AS Plus. [Online] Available at: http://www.iasplus.com/ European Accounting Review, 2015, An international scholarly journal of the European Accounting Association Vol. 24(2). 2015 (Print) (Online) Available at http://www.tandfonline.com/toc/REAR20/current Financial Reporting Council, 2015, Improving the Quality of Reporting of Smaller Listed and AIM Quoted Companies Discussion paper on the FRC’s findings and proposals, pp. 1-41. (online) Available at https://www.frc.org.uk/Our-Work/Publications/FRC-Board/Consultation-Improving-the-Quality-of-Reporting-b-File.pdf/ Financial Times. [Online] Available at http://www.ft.com Griffin, P. A. & Wright, A. M., (Eds) 2014, Accounting Horizons, American Accounting Associations, Vol. 29(1), Pp. 1-244. Hargreaves, L., 2015, Financial Results Analysis for 5 Years (online) Available at http://www.hl.co.uk/shares/shares-search-results/t/tesco-plc-ordinary-5p/financial-statements-and-reports Institute of Chartered Accountants. [Online] Available at http://www.icaew.com/ International Financial Reporting Standards. [Online] available at http://www.ifrs.org/Pages/default.aspx Jones and Palmer, 2014, Next Annual Report and Accounts January 2014, Pp. 1-121 (online) Available at http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2014/Next%20AR2014%20web.pdf Next plc, 2013, Annual Report and Accounts January 2013, (online) Available at http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/latest-news/2013/ar2013.pdf SAGE, 2015, Accounting, Economics, Econometrics and Finance; Journal of Accounting, Auditing & Finance, Vol. 30(3). Taylor & Francis, 2015, Accounting and Business Research Vol. 45(3), (Print), 2159-4260 (Online) Available at http://www.tandfonline.com/toc/RABR20/current#.VYWJUfmqqko Tesco, 2015, Tesco PLC Annual Report and Financial Statements 2015 (Online) Available at http://www.tescoplc.com/files/pdf/reports/ar15/download_annual_report.pdf Shapland, M., May 28, 2015, Tesco Faces Legal Fight with Shareholders Seeking Compensation Over Profit Scandal, (online) Available at http://www.thisismoney.co.uk/money/news/article-3100867/Tesco-share-price-falls-readies-legal-fight-investors-seeking-compensation-profit-overstatement-scandal.html Read More