Back Margin audits - Now it's your turn.

Accountancy watchdog to focus on suppliers after Tesco profits scandal.

According to The Guardian, the Financial Reporting Council (FRC) will make retailers’ relationships with their suppliers a priority due to ‘increasingly complex arrangements’ in their inspections in 2015/16. The FRC will “pay particular attention to the audit of revenue recognition and complex supplier arrangements” at food, drink and consumer goods manufacturers, as well as retailers. They plan to check a significant number of audits - of the 140 checks planned - in these sectors.

More details of scope and process are given in the FRC latest Annual Report published today, and for convenience we have highlighted key sections below, but best point your finance colleagues at the original document, here.

As indicated, this is about Back Margin definitions and how suppliers and retailers account for payments made to retailers. 

We believe that we are headed towards further clarity, meaning that payments to retailers will eventually be measured more accurately, paid retrospectively - in arrears - and based upon results achieved vs. agreed KPIs, in order to comply with strict auditing standards and process.

Action for suppliers:

• Identify and clarify all of the ways in which you remunerate the customer
• Reassess the 'buckets', clarify the definitions, measurement process and ensure the customer agrees...
• Focus on Tesco's three permitted buckets (scale discounts, rewards for display and payments re product re-calls) that will probably  become 'standards' eventually, as SFO, FRC and GCA investigations begin to report findings
• Think through internal processes re proposal, objectives, agreement (you and the customer), timing and payment (if in any doubt about the eventual accounting rigour involved, check with your production colleagues re their capital requisition process...)
• Whilst your company will hopefully escape an FRC inspection in 2015/16, auditors will obviously be increasingly conscious of the risks involved and will be more than likely operating to the above standards anyway...

The FRS Annual Report (extracts)
Section 2-4 Page 7 refers to
...Given the focus in recent months in respect of complex supplier arrangements, food, drink and consumer goods manufacturers and retailers have been designated as a priority sector for our 2015/16 inspections and a significant number of audits we plan to inspect will be from those business sectors. These inspections will pay particular attention to the extent to which the audit team has challenged and corroborated the appropriateness of how complex supplier arrangements are accounted for. Corporate Reporting Review (CRR) as part of their programme of reviews of financial statements will also be giving priority to the reporting of these arrangements. We also plan to inspect a number of first year audits to assess the extent to which changes in auditors have an impact on audit quality.

In early 2015 we engaged external consultants to undertake an extensive review of our inspection activities and how these can promote continuous improvements in audit quality. The outcome of this review will be incorporated in the FRC’s Strategy for 2016/19.

Analysis of inspection findings: Section 3-5, page 16 Future Inspections: Section 7-2, page 32: ... planning to inspect around 140 audits.... The priority sectors for 2015/16 are insurance; food, drink and consumer goods manufacturers and retailers... Our inspections will pay particular attention to the audit of revenue recognition and complex supplier arrangements.

Appendix A, page 36 Inspection Process
Our inspections comprise a review of the firms’ policies and procedures supporting audit quality and a review of the quality of selected audits of listed and other major public interest entities that fall within the scope of independent inspection, as determined each year. 

Scope in Appendix B

Joining the commercial income dots: moving to full disclosure?

Given the latest news of Asda slashing prices to maintain/increase its position of 5% less than the other mults, knowing that any growth in flatline has to come at the expense of direct competition, coupled with Tesco’s ending of their 32 year relationship with auditors PwC, itself a reminder that the SFO are at work investigating how Tesco’s £263m profit overstatement was caused in part by how retailers book trade investment, all adds up to a need for retailers to disclose the contribution made by commercial income to their final results.

Indeed the recent criticism of Sainsbury’s for not following Tesco and Morrisons lead in making these disclosures, with little sympathy for protestations of ‘commercial sensitivity’, means that the SFO will probably conclude that disclosure will be mandatory...

However, better if all retailers anticipate legal developments and make these disclosures on a voluntary basis.

This leaves Asda, which, being US-owned, and ultimately subject to a changing tax regime where issues of global taxation will drive more open reporting at local level, will inevitably conform re disclosure of commercial income in the UK.

The rest of the trade will probably fall in line to avoid possible raising of their profile at the SFO…

Auditing will become more precise, in terms of accounting for, and booking of, such revenues.

This means that stakeholders will need to anticipate that all CI ‘buckets’ will be defined more precisely, have clearer objectives, appropriate KPIs and will be measured with more precision. In other words, we are headed towards payment in arrears, based on actual boxes sold…

Time for suppliers and retailers to anticipate the obvious and start accounting now…

Sainsbury's - Elephant-management in the main aisle...

With a less than expected fall in its third quarter, and confirmation of their convenience and quality credentials, there are many things right about Sainsbury’s.

Bearing in mind that the reported results reflect the whole of Sainsbury’s business, NAMs will have already compared their brands’ performance to check fair shares at category level.

However, in order to optimise opportunities, it is necessary for NAMs to go beyond Mike Coupe’s understated warning that "The outlook for the remainder of the financial year is set to remain challenging…” and explore possible issues and implications, ideally ahead of the competition.

Essentially, Sainsbury’s have to be considering the following:

Space redundancy
Like the other multiples, Sainsbury’s are probably occupying retail space that is 20% in excess of need, especially out-of-town. This means they will close and sell off some low-profit outlets. (See impact here )

However, this leaves some outlets that are too big for purpose in terms of the company’s current offering. These require re-engineering in terms of possibly franchising redundant space for complementary categories that might benefit from Sainsbury’s pulling power.

Meanwhile, there are instore theatre opportunities for suppliers in appropriate categories, providing that the resulting numbers exceed current-use performance…

Commercial Income
With Tesco re-negotiating its supplier contracts (see yesterday’s KamBlog below) it is likely that other multiples will have to follow suit.

This could mean that significant amounts of supplier trade investment will transfer into front margin, with a strong possibility (as you know, in current retail, only yesterday is certain!) that this will result in price-cuts sufficient to neutralise the discounters….

Whilst Sainsbury’s will probably edge upmarket to optimise their strengths at Waitrose end of the field, they will need to keep one foot firmly in mass retail and follow Tesco…

Meanwhile, the multiples and their suppliers need to re-assess their use of trade investment /commercial income as per the UK Financial Reporting Council (FRC) warning (see details).

Hopefully, proactive management of these two elephants will leave some time to deal with other distractions like food price deflation, flat-line demand and increasingly savvy consumers…

Tesco Supplier Contracts - a ‘back to front’ move in trade relationships?

On Thursday, Tesco is expected to announce that it is making major changes in supplier contracts by shifting its emphasis from back-margin to front-margin.

In practice, this has to mean that commercial income (trade investment) will be translated into sales-based reward, and presumably negotiated into trade margin and volume discounts. Given the sums involved, with trade investment running at 20% of their sales for many suppliers, and average trade margins at 25% of a retailer’s net sales, it is imperative that suppliers enter these re-negotiations, well prepared.

In effect, this means that a supplier has to be very clear about the actual cost to the business of each element of the supplier trade investment package, the purpose, the KPIs and the terms of compliance. Converting these sums into the incremental retail sales (ex VAT) that they represent, based on the retailer’s current net margin, will help in adding value in negotiation.

More importantly, it will remind the NAM that any transfer into front-margin has to be linked with appropriate levels of incremental sales.

In other words, as front-margin currently consists of a mix of the retailer’s trade margin and unconditional volume discounts (!) it is vital that any additional volume-based discounts should be made conditional upon specific initiatives hitting pre-agreed KPI targets, and paid in arrears – a reward for additional effort by the retail-partner, the original purpose of trade investment.

If Tesco manages to make this fundamental change in their supplier relationships, and unless suppliers are able to tie the incentives to specific in-store initiatives, it is probable that much of the monies will transfer into price support.

This means that other multiples will have to follow suit, or risk loss of market share.

Time for a fundamental re-assessment of the TOTAL support package your brand needs in making itself available to the consumer?

Coles ordered to pay $11.2m in penalties, legal fees for mistreating suppliers

According to reports in ABC Au News, the ACCC said the supermarket giant had set up the Active Retail Collaboration (ARC) program to make 200 small suppliers pay rebates to boost the company's profits. Details of specific charges here.

Even more importantly, the court used the word ‘unconscionable’ to describe Coles behaviour.
Unconscionable conduct is generally understood to mean conduct which is so harsh that it goes against good conscience. 

Under the Australian Consumer Law, businesses must not engage in unconscionable conduct, when dealing with other businesses or their customers, following a Federal Court decision to uphold an Australian Competition and Consumer Commission (ACCC) settlement over supplier mistreatment.

The ACCC used its compulsory information gathering powers, forcing suppliers and Coles to provide information about the claims.
.
Why this is serious
There are a number of factors an Au court will consider when assessing whether conduct in relation to the selling or supplying of goods and services to a customer, or to the supplying or acquiring of goods or services to or from a business, is unconscionable.

These include:
- the relative bargaining strength of the parties
- whether any conditions were imposed on the weaker party that were not reasonably necessary to protect the legitimate interests of the stronger party
- whether the weaker party could understand the documentation used
- the use of undue influence, pressure or unfair tactics by the stronger party
- the requirements of applicable industry codes
- the willingness of the stronger party to negotiate
- the extent to which the parties acted in good faith.

This is not an exhaustive list and it should be noted that the court may also consider any other factor it thinks relevant.

The key idea is that the Au authorities are using legislation and language that will guarantee the wide publication of the details in consumer media, in terms of criticism of retailers for abuse of power, especially with regard to small suppliers.

Application to the UK
Despite a distance of 10,500 miles, the case has to set important precedents for UK authorities….

Apart from the obvious pointers for strengthening UK rules, the case clearly demonstrates the ‘teeth’ that have been given to Au competition authorities, meaning that UK will have re-assess all current supplier-retailer practices in anticipation of eventual application here.

The Tesco SFO investigation will provide a platform and act as a catalyst in defining and accelerating appropriate change in the UK.

The problem for UK retailers is that the combination of 45+ days credit, trade investment of 20+% of purchases, deductions of 5+% and price-cutting currently result in Net Profit margins of approximately 3%, meaning that retailers will be unable roll-back any of these sources of income without diluting their profits…

It remains to be seen how early in 2015 the pace of equivalent change will begin to accelerate in the UK…

See here for guidance on How to avoid becoming a victim of unconscionable conduct, How to avoid engaging in unconscionable conduct, Penalties and remedies, and links to appropriate Au law.

Abolishing Trade Investment by suppliers - the impact on brands

News that Tesco is allegedly planning to dismantle the system of using Commercial Income, or Trade Investment, as a source of cash from suppliers raises a number of issues for NAMs and competing retailers.

What does it mean financially?

Conclusions:

• Supplier cannot afford additional investment (in fact the calculation shows why so many suppliers are struggling profit-wise)
• Retailers are not going to surrender Trade Investment & Deductions as sources of income
• Retailers may try to negotiate Trade Investment into Margin, thus removing the issue of how it is booked in the business
• Trade Investment may be absorbed into retail running costs and price-cutting, with less available for in-store customer incentives
• Eventually, additionally funding may be requested in order to 'create a bit of excitement' in-store....

Still ok with your trade agreements for 2015?
(Why not substitute your brand's % in the above calculation and see what it is costing you to be onshelf...?)

UK accounting watchdog warns retailers after Tesco scandal

Britain's Financial Reporting Council (FRC), which polices accountants and is examining how Tesco's error came about, said on Monday that the boards of all retailers and suppliers should provide investors with sufficient information on their accounting policies, especially Commercial Income (i.e. Trade investment).

This is particularly important for NAMs as the watchdog said it would focus on this area when it comes to reviewing audits for 2014 that will be published in 2015.

The FRC said there was no single accounting standard for such disclosures and there is an "absence of well-known industry norms", meaning that auditors have to resort to judgement in most cases.

Given the 20+ ‘buckets’ that suppliers use for trade funding, it might be useful if NAMs simplified and segregated their funding.

‘Supply and Demand’ rewards could provide a useful basis for clarification.  In other words, classifying elements of commercial income as either facilitating supply economies, or optimising consumer demand, might help, but still leaves complexity....

Supply rewards could include:
- Central assortment & listing
- Timely and committed forecasts
- EDI
- Central credit, settlement terms, and payment
- Returns/write-offs
- Deductions

Demand rewards could include:
- Listings
- 'Appropriate' range/assortment
- Category compliance: shelf space & level, fair-share facings
- Promotional compliance, price support, POS compliance, additional placements/displays
- Minimalising post-audit recoveries
- Sales achievement

It is likely that the SFO-Tesco outcome will result in new auditing procedures aimed at transparency, defensibility and like-with-like 'comparability' in dealing with Commercial Income in retail accounts.

Meanwhile, suppliers can anticipate the changes and possibly avoid major retrospective overhauling of their trade funding process, by taking action to clarify their trade funding process now, while others await the inevitable… 

Tesco aftermath: The options for other mults' NAMs?

Given yesterday’s surprises, and bearing in mind the degree of fall-out, despite the fact that precise causes still await the revelations of the FCA investigation, it is important that other mults’ NAMs anticipate the obvious and take action now.

Because of Tesco’s Commercial Income issue, compounded by structural changes in the market and how people shop, we are now embarking on an era of retailing simplicity as per the French formula: fewer complex promotions and big price cuts across the board.

For consumers this means lower prices, clearer promotions, demonstrable value for money, with the same transparency for auditors and the authorities, stripping out all non-essentials to reduce complexity and costs...

Back to the future of Commercial Income
This is a situation that 'just growed and growed', where the introduction of a 5% 'discretionary' trade fund gradually morphed into a trade investment budget in excess of 20% of a supplier's sales...yet retains many elements of a 'nodding through' process unsuited to the new post-Tesco climate of 'accountability'...

This all changed as of yesterday

This long-overdue investigation of Commercial Income practices will not stop at Tesco…

From an auditing point-of-view, from now on, think post-audit recovery, on steroids...
In other words, auditors and management of all major retailers will have to move to more focused assessment of all trade investment, examining actual transactions rather than accounting process, in order to satisfy any retrospective re-auditing and possibly legal assessment arising from the FCA examination.

For NAMs, acting now will help optimise new opportunities arising in the market

Action:

• Tighten up Commercial Income practices in anticipation of more aggressive auditing in anticipation of fall-out from the Tesco issue. In practice this means revisiting your definitions and conditions ref Commercial Income and ensure their alignment with the customer and their accounting practices
• Avail of the opportunity to establish clearer and more transparent KPIs for all trade investment
• Push for a move to payment in arrears, based upon results achieved
• Above all, insist on fair share dealings in negotiated agreements - your customer needs you now, like never before...

Seems opportunistic on the part of suppliers?
Much of Tesco's issues are due to a massive imbalance of supplier-retailer power that has been allowed to build up over the years. The trade now needs and is ready for a seismic shift back to a situation where trading partners understand their roles, relative risk-levels, challenge one another and are ready to accept a reward-split that reflects relative levels of investment in the consumer-brand relationship.

In other words, think savvy consumer buying from savvy retailer, buying from savvy supplier, all based on 'fair is fair'.....

Over-cautious?
Do you really think that any auditing firm will be able to resist this golden opportunity to increase its fee income in the current climate?
         
A lot of extra work? 
Then think about the work involved if left unchecked until your customer drifts to the top of the radar screen....

NB. Tips for Tesco NAMs: Here 

Commercial Income fall-out: the open domain perspective?

The investigation of Tesco’s £250m overstatement issue by independent auditors and Tesco’s legal advisers has obviously impacted the share price and created considerable media coverage for a topic that is technically not in the open domain. The results of the review will need to be available to all, in order to attempt to reassure shareholders that the share price fall has ‘bottomed out’, corrective measures are in place and growth will be restored, under new management.

Any holding back in the interest of ‘commercial sensitivity’ will seem like a cover-up, resulting in shareholders acting with their feet…

In other words, all output is headed for the open domain.

Meanwhile shareholders, regulators, HMRC, retail competitors, media, suppliers and shoppers, await an explanation…

The issue is, what type of explanation will satisfy this diverse audience’s need for simplicity and clarity?

Any retrospective review of accounting procedure, with a combination of legal help and the benefit of hindsight, is bound to result in a call for unambiguous clarification of each element of Commercial Income.

‘Supply and Demand’ rewards could provide a useful basis for clarification.  In other words, classifying elements of commercial income as either facilitating supply economies, or optimising consumer demand, might help, but still leaves complexity....

Supply rewards could include:
- Central assortment & listing
- Timely and committed forecasts
- EDI
- Central credit, settlement terms, and payment
- Returns/write-offs
- Deductions

Demand rewards could include:
- Listings
- 'Appropriate' range/assortment
- Category compliance: shelf space & level, fair-share facings
- Promotional compliance, price support, POS compliance, additional placements/displays
- Post-audit recovery
- Sales achievement

It can be seen that, over the years, what was once a fairly simple buying and reselling process, with a retail margin to cover the effort, and sufficient free credit to bridge the gap between receipt of goods and payment by the shopper, has evolved into the complex package we now call Commercial Income.

All stakeholders will now insist upon clarification of each element, including the precise contribution that commercial income makes to a retailer's profits.

This will inevitably result in new auditing procedures aimed at transparency, defensibility and like-with-like 'comparability' in dealing with Commercial Income in retail accounts.

Moreover, as it is unlikely that all retailers will have evolved a uniform definition and treatment of commercial income, so any output from the Tesco exercise will soon result in the need for parallel reviews of other retailers’ accounts, in order to satisfy all stakeholders…

Meanwhile, suppliers could usefully prepare for the inevitable by reassessing each element of their offering in terms of purpose, cost, value and result, before the open domain demands an explanation…

Commercial Income - the driver for large space retailing?

                                                                                      Shopper-density map Herb Sorensen

The current controversy ref retailers’ advance booking of commercial income and its impact on profit forecasts will be the subject of increasing press coverage in the coming months, especially as other major retailers feel the need to reassess and explain how their procedures differ…

In the meantime, Shopper-scientist Herb Sorensen, in his work The Problem: "Parked" Capital, and his use of shopper-density maps of retail stores, questions retailers’ use of large space.

The above extract is an accurate map of the time shoppers spend in the store. All those blue, and especially the dark blue areas, represent what he calls ‘parked capital’, defined as money tied up in real estate and inventory.

The data and map above are relevant to both inefficient use of floor space capital, but are also directly related to the massive unmoving inventory on most stores' shelves.

Sorensen goes on to suggest that the building of larger and larger stores has been driven more by the desire to offer more inventory - requiring more space - on behalf of the brand suppliers, who are paying for the space and other marketing services, than consumer need.

In other words, large space is NOT needed to accommodate the demands of the crowds of shoppers.

If this is the case, then following the UK's ‘re-audit’ of Commercial Income, redundant space may not be the only casualty…

Hat-tip to Mike Anthony for the pointer

Retailers' Commercial Income - a cloudy window emerges for suppliers?

As the Tesco profit-overstatement issue builds, it would appear that advance booking of supplier investment will be challenged in terms of the degree of judgement involved and the resulting scope for interpretation…

The FT goes into the detail re the complexity involved in auditing retailer accounts that are based on high-volume, low-value transactions. This means that auditors tend to focus on the systems, controls and processes. 

The article also adds some gems re the audit-techniques used such as examining a sample of agreements between supplier and retailer for accuracy, and may even contact the supplier for validation…

This retrospective analysis of all commercial income, combined with the legal presence and potential shareholder class-action moves in the US, has to result in increasing clarification and classification of the monies paid by suppliers including:
- Rental of space
- Price support
- Promo-support
- Over-riders
- % split between commercial income and operating profit/sales
- And more…(think shopper-marketing, for starters…)

As the ‘revelations’ enter the public domain, other major retailers will need to explain how their systems and process are different/better, or suffer hits to their share prices… In the same way, brand owners will need to anticipate and defend their use of trade investment to ‘encourage’ consumer demand….

Clarifying the opportunity window
However, as the smoke begins to clear, the real opportunity for suppliers lies in the fact that a move to results-based reward, paid retrospectively, would solve many of the problems caused by advance booking  of commercial income. Measurement against clear and unambiguous KPIs would reduce the judgement-element, and booking of the income could be tied down to actual sales performance in given periods of the financial year, or a conservative estimate agreed and used where necessary…

The resulting issue for retailers would be the negative impact on cashflow of moving from payment-in-advance to after-the-event remuneration…

Here a courageous supplier might try to point out that credit periods were always intended to bridge the gap between supply of goods to the retailer and receipt of payment from the shopper.

However, with average credit periods at 40 days+ on supplies that can include best-selling SKUs being delivered daily, but an average stockturn in retail of 15 times p.a., i.e. 24 days stock, it could be said that there is already some surplus in the cashflow pipeline..

Or is supplier credit perhaps the next financial crisis ticking away in the background?