The announcement that Tesco is to be investigated by the UK's serious fraud office has once again shone a light on murky accounting practices in the corporate world.

Tesco shares have nose-dived since it admitted it had overstated profits by £263 million (€337 million). The full facts will not emerge for some time, with British fraud investigations typically taking years to complete.

However, investors already know questionable accounting practices have been going on for some time, Tesco confirming that £118 million of the profits overstatement related to the first six months of this year, with £145 million pertaining to previous years. Additionally, they know Tesco was overstating profits through the early recognition of revenue and the delayed recognition of costs.

Common problem

Earnings management

is an age-old and common corporate practice. A 2012 survey of 169 chief financial officers (CFOs) found that, in any given period, one in five firms will “manage earnings to misrepresent economic performance”. As one CFO told researchers: “We were going to get a $1.50 EPS (earnings per share) number and you could report anywhere from a $1.45 to a $1.55, and so you sit around and have the discussion saying, ‘Well, where do we want the number to be within that range?’

“We talk about estimates: do we recognise this in this quarter? Is there some liability that can be triggered that hasn’t been triggered yet or has it really been triggered yet? Do we really have enough information to write this down?”

The reasons for such behaviour are unsurprising: to protect against “adverse career consequences” and to influence share prices and their own pay packets. Few CFOs supported fair-value accounting, the survey revealed.

Clearly, a casual attitude towards accounting practices exists in some circles. Indeed, to former General Electric (GE) chief executive Jack Welch, earnings management was something to be celebrated. In his autobiography, Welch related how GE managers responded to the case of a rogue trader who lost $350 million at Kidder Peabody, GE's investment banking subsidiary.

“The response of our business leaders to the crisis was typical of the GE culture”, he wrote, approvingly. “Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap. Some said they could find an extra $10m, $20m, and even $30m from their businesses to offset the surprise.”

This was in “dramatic contrast” to the Kidder employees, who are portrayed as unhelpful, individualistic complainers. “The two cultures and their differences never stood out so clearly in my mind,” he wrote. That readers might view the response of GE managers as questionable or even crooked does not dawn on Welch.

GE is a textbook case of how creative accounting can remain under the radar for many years. GE became the most valuable company in the world under Welch, its market value increasing 40-fold over his 20-year stewardship. Quarterly earnings beats were the norm, GE meeting or beating estimates in every quarter from 1995 through 2004. However, following a four-year investigation, GE settled accounting fraud charges with the US securities and exchange commission (SEC) in 2009. Its shares have more than halved since 2000’s all-time high.

Dell case

Similar allegations of earnings management have been levelled at computer giant Dell, which paid a $100 million fine in 2010 to settle allegations of false accounting. The SEC charged Dell with another common accounting trick, that of cookie-jar accounting.

Such cases involve the delayed recognition of revenue, creating a reserve fund that can be dipped into to cover up weak quarters. Were it not for this tactic, the SEC alleged, Dell would have missed earnings estimates in every quarter between 2002 and 2006.

Dell has also been cited as a possible practitioner of quadrophobia, another common accounting trick. Research indicates companies often nudge their EPS numbers by a tenth of a cent. Upping the EPS number from, say, 9.4 cents to 9.5 cents allows companies to round up to 10 cents.

The least common post-decimal point number to appear in quarterly results is the number 4, with numbers 2 and 3 also infrequent.

This quadrophobia is most likely to be found in results close to analysts’ expectations and in expensive companies. Persistent offenders are more likely to restate earnings and to be sued for fraud. As for Dell, it didn’t report earnings ending in .4 on a single occasion between 1988 and 2006, the odds of which are an estimated 2,500 to 1.

Orphan months

On other occasions, losses never make it into official accounts due to the issue of

orphan months

caused by a company moving from a fiscal year to a calendar year accounting system. For example, Goldman Sachs’s 2008 fiscal year ended in November but it switched to a calendar-based system in 2009, leaving December 2008 as an orphan month that did not belong to any fiscal quarter. Only a few eagle-eyed commentators noticed that large write-offs – pretax losses of $1.3 billion – were reported for December 2008.

These orphan months are not covered by analysts, and not reported in computerised financial databases. As one study noted, many investors are “unaware that an episode of a firm’s history is missing”. Between 1993 and 2008, it found, almost half of US firms analysed changed their fiscal year.

Such firms tended to report lower income in the missing months, it said, and were usually more likely to meet or beat earnings targets in the subsequent quarter.

Reforms

What can be done? In April, the European Parliament mandated that public companies put their audits out for tender every 10 years and ensure their auditor be changed at least every 20 years.

That will ensure the lengthy relationships of old – Barclays has been audited by PricewaterhouseCoopers (PwC) since 1896, while the same firm has audited Marks & Spencer accounts since 1926 – become a thing of the past.

Additionally, from 2018, banks must provision earlier for souring loans. That will ensure there will be no repeat of 2008, when banks in Ireland continued to report healthy profits even as the economic environment disintegrated.

However, most of the practices referred to in this piece are legal, and there will always be legitimate doubt over how best to account for various items.

Meanwhile, the continued focus on short-term quarterly results, and the linking of executive pay to share prices, means there remains an obvious incentive to bend the rules. Nor is it encouraging that many corporate executives seem to view earnings management as acceptable and even laudable.

There are myriad ways in which executives can massage the figures. Many are obscure; others, as in Tesco’s case, are more common.

Although some bemoan that the army of analysts covering Tesco failed to spot the warning signs, this is not entirely true – last year, Cantor Fitzgerald published notes warning Tesco was overstating its profits by some £200 million. Additionally, Tesco’s auditor, PwC, warned in May of the “risk of manipulation”.

Nevertheless, the problem remained under the radar, with Tesco shareholders such as Warren Buffett remaining unaware of what was really going on.

If the oracle of Omaha can’t spot the warning signs, what hope is there for ordinary investors?