Risk & Economy » Audit » The Secret FD: Black holes should be on CFO reading lists

AFTER decades of success, Tesco has hit the headlines for all the wrong reasons: declining footfall, aggressive competition, a failed international strategy, a £3bn rescue rights issue, dividend cuts, executive departures, horse meat, profit warnings and a 50% fall in its share price. That was not to be enough for a perfect storm, so it has confessed, worst of all, to a £250m accounting black hole.

Tesco is in eclectic company in terms of recent accounting scandals. Speedy Hire, the London Development Agency, the Ireland subsidiary of RSA and Essex Fire and Rescue Services have all suffered. Balfour Beatty issued five profit warnings, saw a 20% share price drop, and found a £75m black hole which resulted in Steve Marshall stepping down from his executive chair position.

Although we all know what an accounting black hole is, I was stumped in my pursuit of a definition. But I expect Ron Lutka’s book, Black holes in organisations, and paper, ‘Black holes in accounting’, are on every FD’s reading list.

The Tesco story contains a cocktail of worrying factors. CFO Laurie McIlwee had left, so had group FD Mike Iddon, and financial management fell to the beleaguered CEO Philip Clarke, himself in the exit lounge. Only after pressure from new CEO Dave Lewis was the incoming CFO Alan Stewart released early from M&S. The black hole was flagged up by a whistleblower who was allegedly ignored and the issue failed to gain traction. There are suggestions that managers felt pressure to use irregular accounting practices, to pressurise suppliers, and to encourage skewed virtues. Deloitte and Freshfields are investigating, and the company has said we must “await the findings before drawing any conclusions”.

At some point, some of us will have to face a potential black-hole problem. I experienced it twice, both in acquisition target companies.

One was a US public listed business, a market leader with a debt burden and a low share price. Pre-acquisition due diligence was constrained, but we took the risk and found out the truth only afterwards. They had capitalised development costs and other expenditure, recognised contract income too early, and provided employment contracts containing eye-watering change of control terms. We created a significant acquisition reserve, and integrated the business quickly, imposing our own processes and values from day one. The pitch to our shareholders had to be modified, and we needed to arrange additional lines of credit to accelerate the restructuring – with nobody to sue for the damage.

The second was a lucky escape for me, another acquisition target whose misdemeanours became apparent during the pre-acquisition stages when it missed a lending covenant. It turned out to be a small-cap public company that was propping up an onerous pension liability. It had over-borrowed to fund development projects that were unlikely to meet the market expectations on price or capability, and it had capitalised all development costs. When this was exposed, the share price collapsed. It did a debt-for-equity swap, put the pension fund into the government PPF scheme, and placed its businesses up for sale. We bought most of them at a fair – and significantly lower – price, and most of its staff remained employed.

In these cases I have to ask: where were the auditors, the board, the audit committee and the FD, especially in the US where blame culture and litigation are rife? The criminal penalty for a Sarbanes Oxley violation is on the same tariff as that of second-degree murder.

I accept that accounting is not a hard science, relying upon judgement and processes outside of finance. FDs are vulnerable to cultural misuse of these processes and systemic failures. We must be deeply embedded in the business to spot irregularities because it is only when these situations are far advanced that the warning signs appear. By then it may be too late.

Last month the Secret FD visited Liverpool University, not far from where John Lennon wrote the lyrics ‘4,000 holes in Blackburn Lancashire’, as part of the ‘Day in the Life’ album release