Financial Statements & Audit Risk

1.    Introduction – Operating Activities of Tesco

Tesco PLC is one of the top listed companies in the London Stock Exchange that has encountered various audit related problems in the year 2023 (Palmer, 2005).

(a) Profit making in conditions of high inflation

(b) High operating cost and concerns of tightening operating margins.

Audit Risk Factors for Tesco include:

1. Revenue Recognition: Due different sales outlets results that may significantly affect the figures of financial statements of Tesco.
2. Inventory Valuation and Cost Management: Strategy to transfer inflation to consumers and the cost of merchandise sold entails evaluations of audits on inventory valuation.
3. Cyber security and Data – Customer base using digital gift vouchers and will strong IT controls at TESCO.
4. Regulatory Compliance: Rules of data protection, accuracy of the financial information concerning these new divisions such as digital media advertising.

2.    Materiality

a)    Concept of Materiality in IFRS and ISAs

IAS 1 regulates materiality in the presentation of financial statements where material information is that without which the understanding of the financial statements by users of such statements for making economic decisions would be compromised (De Cristofaro, 2021). ISA 320 deals with materiality in planning and performing an audit. It measures the level of a misstatement that would reasonably be considered to influence the user of financial statements. Materiality, in the hands of auditors, concerns the degree to which an item or amount presented in an organization’s financial statements is likely to affect the decisions of the users and hence deserves special consideration (Jaafar Abdulhussein, 2024)

b)   Relationship between Materiality and Audit Risk

Audit risk is the risk that the auditor expresses an unqualified opinion because of the existence of a material incorrectly stated. It is possible to state that, following the principle of materiality, auditors can identify the specific areas in the statement of financial position that contain errors that, if undetected, will cause a material misstatement. (Bernardi & Pincus, 1996)

c)    Calculating Materiality for Tesco Using Common Benchmarks

d)   5 Material Items in Tesco’s Financial Statements

• Revenue of £66.7 billion demonstrates the extent of this giant’s market tapped and the market consumers it serves. This makes revenue a key indicator among all key performance indicators among stakeholders.
• Operating Profit of £ 1.7 billion. The company’s operating Profit gives insight into the efficiency of operations and management of costs within operations before taxation and interest expenses are factored in.
• Total Assets £46.9 billion. The magnitude of this figure speaks volumes about Tesco’s financial strength and potential for asset utilization for growth.
• Net Debt of £10.3 billion is material because it affects cash flow and interest costs, changing investors’ solvency and liquidity perceptions.
• Dividend Payouts of £250m. This metric is material to shareholders, especially those who depend on dividend receipts as their source of income.

3.    Risk & Response

a)    Definition of Inherent Risk According to ISAs

Inherent risk is defined in the International Standards on Auditing (ISA 315) as the risk that an assertion that relates to a financial statement element is likely to contain a misstatement that will be material, where there are no controls that relate to the particular assertion. Examples of factors include complexity, subjectivity, unusual transactions, economic & industry factors & susceptibility to fraud (Bernardi & Pincus, 1996)

b)   High Inherent Risk Items in Tesco’s 2023 Financial Statements

• Inventory Valuation of £2.8 billion. Misstatements as inventory is very volatile and vulnerable to write-down if market price or demand drops.
• Goodwill and Intangible Assets of £5.4 billion: The value of Goodwill is based on estimates and expectations of the future behavior of the market price and economic indicators, and will likely undergo impairment assessments.
• Revenue Recognition of £68.2 billion: Sales services, numerous promotional discounts, and potential revenue recognition issues contribute to revenue recognition consternation because of IFRS 15.
• Lease Obligations of £10.2 billion. Tesco has long-term commitments that must be measured accurately, and lease discounts must be determined. There can be some inaccuracies in the evaluations in case the predictions regarding lease renewals or options for their termination will change.
• Provisions and Contingent Liabilities are high-risk items that significantly affect the estimation; at times, Tesco might be the recipient due to regulatory issues or client claims.

c)    Auditor’s Response to High-Inherent Risk Items

• Auditors would perform gross counts of inventory, compare the previous year’s inventory turnover, and also perform some analytical procedures on the inventory valuation model used by Tesco (TAYLOR, 2000).
• Auditors would review Goodwill as the company tested for impairment. They would examine the various assumptions related to future cash flows, the rate of growth, and discount rates.
• Auditors would test specific via Cut-off testing & Analytical review techniques, having rebates, discounts, refunds, and promotions for completeness to substantive test revenue and make sure that it is recognized correctly per the IFRS 15 provision.
• Auditors would check lease contracts to ensure lease term estimates are accurate and the discount rate applied to the liabilities.
• For provisions, auditors would evaluate the appropriateness of Tesco’s assumptions used in legal or restructuring provisions. They would also assess whether or not the company’s provisioning criteria and sensitivity analysis were appropriate.

4.    Corporate Governance

a)    Practices at Tesco: A Critical Evaluation

Board Composition and Leadership

• The company has an independent non-executive chairperson and a CEO, and separating the Chairperson’s roles reflects good corporate governance practice.
• Independent non-executive directors comprise more than half of the board, ensuring adequate oversight (TAYLOR, 2000).
• Some board members have been on the board for a long time and thus might need to bring more innovative perspectives.

Risk Management & Internal Controls

• The constitution of an independent Audit Committee is based on recommendations on appropriate compliance.
• The evaluations of internal controls at least semi-yearly allow for confirmation that the company has systems for managing financial & operational risks.
• The Audit Committee is chaired by an independent non-executive director and ensures the integrity of financial statements.

Shareholders’ Communications and Public Relations

• Tesco encourages active shareholders’ participation through its Annual General Meeting, which is held together with regular reports on business management.
• Detail disclosure of Tesco’s ESG activities also ensures commitment to reporting, which is crucial to shareholders today.
• Tesco improved its approach to shareholder engagement, especially in relation to executive pay, by disclosing its remuneration policies. However, some of its shareholders have had issues with executive remuneration and performance, thus damaging the firm’s reputation (Chen et al., 2020).
• While the board is diverse, some critics have highlighted that the tenure of certain board members could lead to a need for more fresh perspectives. There is always a risk of over-boarding them as this might make them too defensive to effect changes.

b)   Impact of Governance Practices on Audit Risk

Board Structure and Oversight

Tesco management is overseen by an appropriate board structure through independent directors, a separate CEO, and the Chairperson, thereby minimizing audit risk. However, there is a possibility that such directors will become less effective in monitoring management (Turley & Zaman, 2004).

Internal Control in Risk Management

Despite positive improvements in internal control at Tesco, past accounting scandals, including the 2014 scandal, persist. Professionals would probably expect auditors to evaluate internal control risk, especially regarding financial reporting and fraud. However, some loopholes in such improvement could lead to an increase in audit risk, particularly in areas that involve complicated issues like financial instruments or stocks.

Transparency and Disclosure

Audit risk could be even heightened if there is any disparity between reported financial data and actual performance, mostly in areas such as executive remuneration and stock option expenses, where auditors may be required to verify that remuneration has been properly reflected on the financial statements (Cassell et al., 2012).

5.    References

Bernardi, R.A. and Pincus, K.V. (1996) ‘The relationship between materiality thresholds and judgments of fraud risk,’ Managerial Finance, 22(9), pp. 1–15. doi:10.1108/eb018578.

Cassell, C.A. et al. (2012) ‘The effect of corporate governance on auditor-client realignments,’ AUDITING: A Journal of Practice & Theory, 31(2), pp. 167–188. doi:10.2308/ajpt-10240.

Chen, H. et al. (2020) ‘Internal controls, risk management, and cash holdings,’ Journal of Corporate Finance, 64, p. 101695. doi:10.1016/j.jcorpfin.2020.101695.

De Cristofaro, T. (2021) ‘Materiality,’ Encyclopedia of Sustainable Management, pp. 1–11. doi:10.1007/978-3-030-02006-4_170-2.

Jaafar Abdulhussein, H.A. (2024) ‘The Auditor’s responsibility is to apply the concept of materiality by the standard (ISA.320) in determining analytical audit procedures to reduce audit risks’, Technium Business and Management, 7, pp. 98–110. doi:10.47577/business.v7i.10787.

Palmer, M. (2005) ‘Retail multinational learning: A case study of Tesco,’ International Journal of Retail & Distribution Management, 33(1), pp. 23–48. doi:10.1108/09590550510577110.

TAYLOR, M.H. (2000) ‘The effects of Industry Specialization on Auditors’ Inherent Risk Assessments and confidence judgments*,’ Contemporary Accounting Research, 17(4), pp. 693–712. doi:10.1506/3ldh-av52-0f4w-h4bb.

Turley, S. and Zaman, M. (2004) ‘The corporate governance effects of audit committees’, Journal of Management and Governance, 8(3), pp. 305–332. doi:10.1007/s10997-004-1110-5.