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Impact Of Material Misstatement On Profitability - A Case Study Of Tesco

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Question:

Describe about the Impact of Material Misstatement on Profitability for A Case Study of Tesco.

 

Answer:

Introduction:

Background of the company:

Tesco Plc is the leading food retailer of Britain and this is the third largest in the world. Since the open its first store in 1929 in London, the company has been started pioneering many new innovations. For instance, Tesco has developed many new store concepts including Tesco Metro. The concept behind this innovation is meeting the needs of local shoppers in the form of city centre stores. A key ingredient to the growth of Tesco is the use of well-targeted own-label brands including the up-market “Finest” and low-price “value” labels. In the recent time, Tesco has successfully generated sales more than £700 million along with ensuring profits of more than £35 million (Tesco.com 2016). However, many of the financial researchers criticized the company for the presence of the risk of material accounting misstatement in the financial statement of the company. In the year of 2013-2014, the profit was overstated by around £250m and faced four suspensions of four executives.

Problem statement:

The preparation of the financial statement in a company is generally done by internal accountants, who are working under the advocacy of the management of the organization. This involves the intrinsic risks of management to be able to influence to the statement of the company, resulting financial irregularities or misstatement in them (Bhattacharjee et al., 2015). In several cases in the recent time, companies faced allegations due to aggressive misstatements found exceeds the overall materiality level which is the results of the misleading financial records. For instance, the profit of Tesco had been artificially inflated by £250m (Tesco.com 2016). In the case, the payments from suppliers were being non-booked and the costs of business were being overestimated for showing reduced profits for tax benefits (Chambers, 2013). The fact has learnt a lot of importance in necessary incorporation of all material facts while recording the financial records by several companies.

Rationale of the research topic

Unfortunately, several companies have allegedly involved in several kinds of irregular financial practices and represent the untrue picture to their investors. This is a critical concern for them for functioning efficiently in the capital markets. According to Wright (2016), managers of firms often misstated their statements of financials for ensuring short-term profitability. However, a missing comprehensive database of financial misstatements leads reduced returns of investors in the long term period and results investment debacle. Researcher implies that the accounting misstatement is the main cause for damaged reputations of the organization (Lobo & Zhao, 2013). Hence, the discussion about the recent practice of accounting misstatements will highlight the associated risks. This may guide managers, financial advisers and internal accountants to develop business understanding, risk assessment and internal control. The chosen discussion will further help to plan a successful audit at the end of the financial record of the organization.

Scope of the Review

In this discussion, the researcher will explore the causes behind the misstatement of the accounting records along with identifying risks. Under the principle of the “Internal Standard of Auditing 315”, the research will understand the difference between the amounts, segregation, presentation or disclosure which is required for any item to be in accordance with the applicable framework of the statement of financial. To uncover the all immaterial facts and financial irregularities from the financial report of the firm, specifically in case of Tesco, will be the main purpose of the review of the literature along with addressing its effects on profitability of the business. 

Literature Review:

Concept of Misstatement of materiality in Accounting:

The concept of materiality is the principle in accounting which needs to be regarded and disclosed properly while maintaining the financial records properly. According to Lennox & Li, (2014)  materiality implies particularly the level of detail appropriate for several reports of financial and the significance of errors such as expenses related to the reporting , revenues, equities, liabilities and assets in unsuitable accounts or reporting them for inappropriate period of reporting.

In ISA 315, the term “misstatement” is not clearly defined. However, the financial misstatement identified during the audit indicated in ISA 450 that “a difference between the amount, classification, presentation or disclosure of a reporting financial statement item and the amount, classification, presentation or disclosure that is required for the item to be in accordance with the applicable financial reporting framework”.        It is mentioned by the regulatory bodies of the accounting that the practice of “irregularities” or “misstatements” can be the cause of “fraud or error”. On the contrary, many times misstatement arises while the financial analysts, auditors find differences between the figures which are reporting at the end of the reporting period and what is likely to be reported in order for the financial statements to be fairly viewed (Eilifsen & Messier Jr, 2014). The misstatement in accounting can be factual when a clear violation of a requirement of the reporting standards takes place by a reporting entity. Tesco’s overstated accounting statements of £250m are the perfect example of the unsustainable estimation technique or the practice of inappropriate policies of accounting (Chambers, 2013). The lack of internal control over the management and the clear knowledge about the materiality are the fundamental reasons of the accounting misstatement. IFRS has made an effort for developing a single set of high quality and the globally acceptable standards of the financial reporting.

In determining the relevance of the financial information, firms need to disclose all necessary information at the end of the financial period (Hribar et al., 2014). Before disclosing the material facts, a reporting entity needs to clearly address omission and irregularities in reports of accounting and in business case analysis (Li & Ma, 2015). For example, the statement of income is beneficial for stockholders, management and the board of directors for assessing the profitability while taking judgmental decisions about investing, managing and evaluating financial and management performance of the company (Blankley et al., 2014). Therefore, the sensitiveness of the material misstatement holds a lot of significance of maintaining the accounting consistency of the financial records of the reporting entities to being considered as the global entity. In short, the concept of materiality is a recognized, structured accounting convention. However, accounting practitioners are often gets confusion with the presence of “historical costs convention”. A lot of disparity takes place of the reporting entity are followed “historical” perspective because it recorded at the price prevailing when the financial transactions are made and the costs of the assets are valued at the cost of the original. According to Glover et al., (2015) the “historical costs” are generally calculated and approved objectivity with a bit of uncertainty. On the contrary, the accounting practitioners have taken more subjective consideration while measuring and valued for the purpose of maintaining the authenticity for the accounting purposed. Here all subjective judgmental decisions shall be taken by accountant, auditors, and people from management as well as the board of directors and management (Skaife et al., 2013). Here the common interest is making profitability and thus an appropriate accounting statements needs to be recorded at the end of the reporting period. 

 

Risk associated in material misstated by firms:

Tesco, the biggest super chain market of Britain has been go down into financial crisis when four executives of the organization found guilty and discovered its artificial inflated account by £250m. The forensic accountants and lawyers had been found that the company cleaned off the value of the account of more than £2bn from their financial books of account. This had been one of the biggest incidents of material misstatement in the recent times. The business misleadingly boosted their profitability by showing £250m in the initial six months of the fiscal year of 2013-14. With the falsification of account, the company had lose the market hold in the local market because most of the shareholders deprived from getting the adequate returns and later anticipated to make half of the estimated profits due to sudden financial crisis. The seriousness of the fact got wider when the profit figure fall further along with the share prices by 11.5 percent to the eleven years low. This piece of reality has clearly indicated that the misstated financial statements are directly impacts on the profitability. The firm’s reputation is simultaneously be halted due to such inappropriate presentation by the reporting entities like Tesco in the year of 2014. Therefore, it is important to assess the risk of “material misstatement” to avoid such financial irregularities.

Without the sufficient knowledge about the audited entity, it is impossible to assess appropriately the risk of the “material misstatement” (Chan et al., 2012). ISA 315 stated that auditor normally obtained five aspects while auditing the statements of the financial of reporting entities. Firstly, the accounting statements are vouched considering the relevant industry, regulatory and other relevant factors externally which are applicable under the framework of the financial reporting. Secondly, the auditors need to assess the nature of the entity including its operations, the structure of the ownership along with its governance (Brazel et al., 2016). Thirdly, it is important to study the approach and the application of the policies of accounting. Fourthly, the objectives and strategies of the entity are the important factors to assess. This will help to observe the associated risks that may result in risks of “material misstatement”. Fifthly, the internal approach of measurement of the accountant of the company and the financial performance of the entity needs to be considered by the regulatory bodies or auditor of the company at the preparation of the financial report.

To be implied an effective risk assessment strategy, it is an important requirement as per IAS 315 that the auditors need to be obtained knowledge about the “internal control” relevant to the audit. According to Asare & Wright, (2016), this is the vital step in the assessment of the “material risks” because an audit risk needs to be controlled if it is not prevented on the basis of the internal control. On the contrary, the mechanism of the internal control can be considered an effective tool for assessing “material misstatement” if each of the following items documented by thee auditor properly:

  • The environmental control mechanism
  • The procedure of the risk assessment
  • The financial process of the business, relevant to the reporting aspects and communication
  • The control activities practiced by the entity
  • The monitoring activities

Based on these entire framework, the “material misstatements” will be assessed by an effective internal control processes. However it is a matter of fact that the capability of the particular auditor’s risk assessment approach is completely a individual professional approach.

Impact of material misstatement on profitability:

In a small reporting entity, the documentation on internal control is likely to be a simple compare to the large entity. Here the operation related to the purchase and sales needs to be documented for reducing the “material misstatement” that can be raised due to the lack of control in that  place (Chan et al., 2012). Though the profitability of the smaller organization may be limited but the specific risks are definitely associated with this company such as the scope of the management override, the restricted scope of the classification of duty and the lack of control of the authorization. All these factors of material misstatement are directly impacts on the profitability.

Conclusion

Based on the above literature review this can be concluded that the misstated facts of the statements of the financial can be restricted or prevented by an effective application of the internal control mechanism along with the sound application of the guidelines provided by the IAS 315. Under the IFRS rules, all reporting entities are must focus on the nuisance of the documentation. Here the procedures of risk assessment should be incorporate inquiries of management and other individuals, observations and so on. The discussion of the research topic clearly stated that misstated statements practiced by the organization may be intentionally or unintentionally. Tesco’s overstated profit figure is the perfect example of the intentional approach of the “material misstatement”. To restrict all these practice, the reporting entities must follow an effective internal control within their organization. 

 

References:

Asare, S. K., & Wright, A. M. (2016). Inferring remediation and operational risk from material weakness disclosures. Behavioral Research in Accounting.

Bhattacharjee, S., Maletta, M. J., & Moreno, K. K. (2015). The Role of Account Subjectivity and Risk of Material Misstatement on Auditors' Internal Audit Reliance Judgments. Accounting Horizons, 30(2), 225-238.

Blankley, A. I., Hurtt, D. N., & MacGregor, J. E. (2014). The relationship between audit report lags and future restatements. Auditing: A Journal of Practice & Theory, 33(2), 27-57.

Brazel, J. F., Jackson, S. B., Schaeffer, T. J., & Stewart, B. W. (2016). The Outcome Effect and Professional Skepticism. The Accounting Review.

Chambers, D. (2013). Overstating the Satisfaction of Lawyers. Law & Social Inquiry, 39(2), 313-333.

Chan, L. H., Chen, K. C., Chen, T. Y., & Yu, Y. (2012). The effects of firm-initiated clawback provisions on earnings quality and auditor behavior. Journal of Accounting and Economics, 54(2), 180-196.

Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.

Glover, S. M., Hansen, J. C., & Seidel, T. A. (2015). The effect of deadline imposed time pressure on audit quality. Available at SSRN 2561713.

Hribar, P., Kravet, T., & Wilson, R. (2014). A new measure of accounting quality. Review of Accounting Studies, 19(1), 506-538.

Lennox, C., & Li, B. (2014). Accounting misstatements following lawsuits against auditors. Journal of Accounting and Economics, 57(1), 58-75.

Li, B., & Ma, C. (2015). Can Audit Fees Inhibit Accounting Misstatements? Moderating Effects of Auditor Reputation from Chinese Experience. Moderating Effects of Auditor Reputation from Chinese Experience (January 27, 2015).

Lobo, G. J., & Zhao, Y. (2013). Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), 1385-1412.

Skaife, H. A., Veenman, D., & Wangerin, D. (2013). Internal control over financial reporting and managerial rent extraction: Evidence from the profitability of insider trading. Journal of Accounting and Economics, 55(1), 91-110.

Tesco | Online Groceries, Homeware, Electricals & Clothing. (2016). Tesco.com. Retrieved 7 October 2016, from https://www.tesco.com

Wright, W. F. (2016). Client business models, process business risks and the risk of material misstatement of revenue. Accounting, Organizations and Society, 48, 43-55.

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