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A Painful Lesson in the Realities of Commercial Accounting Practice
On 22 September 2014, Tesco Stores Limited announced that it had overstated its expected profits for the half year to 23 August 2014 by some £250m. The headlines were immediate and predictable. Within hours the FT had reported, “Tesco in turmoil after profits overstatement” and the Daily Mail, honing in on the more dramatic aspects of the debacle, recorded “£2.1 billion wiped off shares”. An investigation by the SFO and the FCA was assured.
By April 2017, Tesco Stores had entered into a Deferred Prosecution Agreement (“DPA”) on the basis that there had been false accounting. In due course, the SFO commenced a criminal prosecution against Messrs Bush, Scouler and Rogberg and were no doubt confident of success against those senior executives.
Unfortunately, for the SFO, by 26 November 2018, the prosecution had collapsed following the trial judge’s decision to accede to a defence submission of no case to answer.
By 5 December 2018, following the SFO’s unsuccessful appeal against the trial judge’s ruling, that decision had been upheld by the Court of Appeal. This document is an analysis of the Court of Appeal’s judgment in R v Bush  EWCA 29 (Crim) and the accountancy considerations that caused so much difficulty for the SFO.
The Accountancy at the Core of the SFO’s Case
The issue at Tesco arose as a result of irregularities in the company’s accounts. Tesco explained this at the time of its initial public statement by saying that this was, “principally due to accelerated recognition of commercial income and delayed accrual of costs”.
The prosecution case was that the overstatement of expected profit had resulted from a practice of meeting impossibly high targets through the unlawful recognition of income in an accounting period prior to that in which it was earned and ought to have been recognised.
Paragraph 27 of the judgment neatly summarises the evidence that the SFO relied upon for this purpose:
i) An alleged company culture of bringing income forward into the “wrong” year;
ii) The identification of the large ‘hole’ in the figures when the alleged underlying fraud of the buyers came to light;
(iii) Evidence of one form of pull forward – multi-year deals. Under these, a supplier might pay Tesco a volume-based rebate for achieving sales targets. Witnesses gave evidence that the lump sum rebate payable under the contract was spread over the life of the contract, but the entire lump sums would be recognised as income earned by Tesco in year 1, when at least some of the income ought to have been apportioned over the lifespan of the contract. This practice would artificially inflate the profits recognized in year 1, whilst at the same time leaving a “hole” in the accounts of the following years of the contract and influencing the setting of targets for the following years.
It should be acknowledged that some of the bringing forward of income had been supported by false documentation presented to the Commercial Finance Department by Tesco’s buyers. There was, however, no evidence that the Commercial Finance Department had been aware of the falsity of that documentation at the relevant time and it followed that the SFO had to place some general reliance on the Finance Departments accounting treatments in the practice of pulling forward. What the SFO failed to appreciate was that those accounting treatments were not necessarily dishonest.
Mr. Soni was a prosecution witness and the head of the Commercial Finance Department of Tesco. His evidence was that he was not aware of any illegality and he was, as the trial judge characterised it, the accountancy “gate keeper”. The trial judge took the view that if Mr. Soni was unaware, there was likely to be no mechanism by which the defendants could have been aware.
The International Accounting Standards
Much of the overriding guidance for accountants is provided by what are known as the International Accounting Standards (“IAS”). The guidance for the recognition and measurement of revenue is published in IAS 18 and it will be clear that there is an element of accounting judgement in the booking of income.
Revenue is defined in IAS 18.7 as:
“The gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties and dividends)”
Measurement of Revenue
Revenue should be measured at the fair value of the consideration received or receivable. [IAS 18.9] An exchange for goods or services of a similar nature and value is not regarded as a transaction that generates revenue. However, exchanges for dissimilar items are regarded as generating revenue. [IAS 18.12]
If the inflow of cash or cash equivalents is deferred, the fair value of the consideration receivable is less than the nominal amount of cash and cash equivalents to be received, and discounting is appropriate. This would occur, for instance, if the seller is providing interest-free credit to the buyer or is charging a below-market rate of interest. Interest must be imputed based on market rates. [IAS 18.11]
Recognition of Revenue
Recognition, as defined in the IASB Framework, means incorporating an item that meets the definition of revenue in the income statement when it meets the following criteria:
it is probable that any future economic benefit associated with the item of revenue will flow to the entity, and
the amount of revenue can be measured with reliability
Sale of Goods
Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied: [IAS 18.14]
the seller has transferred to the buyer the significant risks and rewards of ownership
the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold
the amount of revenue can be measured reliably
it is probable that the economic benefits associated with the transaction will flow to the seller, and
the costs incurred or to be incurred in respect of the transaction can be measured reliably
The Submission of No Case
The defence relied upon the second limb of the test in Galbraith and submitted that a reasonable jury properly directed could not properly convict. The trial judge’s decision to accede to the submissions was as a result of what the Court of Appeal later characterised as a “logical fallacy” in the prosecution case.
When asked to set out the prosecution case on the knowledge and alleged dishonesty of the defendants, the prosecution asserted that it was their case that the defendants knew or ought to have known about the allegedly fraudulent accounting not because of what Mr. Soni was telling them, but because they were experienced working people. This was the inevitable, if unsatisfactory, position that the SFO found itself in because it could not impugn Mr. Soni’s integrity. It was unsatisfactory because “experienced working people” are not necessarily experts in commercial accounting treatments and, of course, rely on the expertise of people like Mr. Soni.
The trial judge considered that this was problematic. Firstly, the fact that the defendants were aware of the pull forward and profit issues did not equate with the use of false documentation. Secondly, it was plain from the evidence of other witnesses that the pulling forward was not thought to be the result of illegality or false accounting. The judge formed the view that although the defendants’ interviews might have shown an awareness of “Legacy issues”, the proper recognition of income was for the accountants.
The SFO’s Appeal
The Court of Appeal acknowledged that there were a variety of ways in which the recognition of income for accounting purposes might be accelerated or “pulled forward” into an earlier accounting period and that some of those would be perfectly legitimate. It also acknowledged that it was often a matter of accounting judgment as to when the economic benefit of a particular transaction accrues to one of the parties so as to entitle that party to treat the income as “earned” and book it in the accounts.
The issue of pulling income forward is far from straightforward. It can be done lawfully and properly (for example where the activity linked to the income is brought forward), it can be done lawfully but be unwise commercially; or it may be done unlawfully or via the use of false accounting. In many cases, how one characterises a particular transaction or accrual may depend very much on the judgment of the person booking the income. Booking income in complex deals requires accountancy expertise. In this case, although some of the ‘improperly recognised income’ was said to be based on the false documentation presented by the buyers, some of the ‘improperly recognised income’ was a ‘legacy issue’ resulting from booking legitimate income in the wrong period and some appears to have been based on accountancy judgements about which different practitioners may have different views.
The prosecution had contended that, as this was a circumstantial case, they had only to prove that a defendant was provided with information from which a fact can be inferred and there was, therefore, a sufficient case to go to the jury. The Court of Appeal quite properly disagreed. They concluded that it was unrealistic to adopt that approach where the information relied upon was provided by a person (Mr. Soni) who, with that same information, was not said to have the necessary knowledge.
The only sensible answer to the dilemma was for the prosecution to establish, by some means, that there was greater knowledge on the Defendants’ part. Given the extent of Mr Soni’s knowledge, that greater knowledge could only be knowledge of unlawfulness or false accounting and the difficulty with that was rather obvious.
Pursuant to section 67 of the Criminal Justice Act 2003, the Court of Appeal may not reverse a ruling on appeal by the Prosecution unless it is satisfied that the ruling was wrong in law, involved an error of law or principle; or was a ruling that it was not reasonable for the judge to have made. The Court of Appeal was not persuaded that there had been any error of principle and, as is plain from the judgment, concluded that the reasoning of Sir John Royce had been entirely sound.
This case serves as a stark reminder that dishonesty cannot be assumed in respect of accounting treatments that have been adopted for a commercial purpose. Commercial accounting practice is, unsurprisingly, complex and it is very often a matter of accounting judgement as to when the economic benefit of a particular transaction accrues. Tesco’s accounting treatments may have been flawed, but that was insufficient to establish dishonesty by the defendants. This article is not about the wisdom of Tesco’s decision to enter into a DPA, albeit that interesting questions arise following the collapse of the prosecution’s case  Managing Director of Tesco Stores Ltd (UK) and a member of the company’s executive committee Commercial Director of Food at Tesco Stores Ltd  Financial Director of Tesco Stores Ltd  R v Galbraith  2 ALL ER 1060. The two limbs derive from the judgment of Lord Lane CJ:
(1) If there is no evidence that the crime alleged has been committed by the defendant, there is no difficulty. The judge will of course stop the case.
(2) The difficulty arises where there is some evidence but it is of a tenuous character, for example because of inherent weakness or vagueness or because it is inconsistent with other evidence. (a) Where the judge comes to the conclusion that the Crown’s evidence, taken at its highest, is such that a jury properly directed could not properly convict on it, it is his duty, on a submission being made, to stop the case. (b) Where however the Crown’s evidence is such that its strength or weakness depends on the view to be taken of a witness’s reliability, or other matters which are generally speaking within the province of the jury and where on one possible view of the facts there is evidence on which a jury could properly come to the conclusion that the defendant is guilty, then the judge should allow the matter to be tried by the jury.”
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