Picking up the pieces after Tesco's stock affair

Tesco's revelation last week that it had improperly booked more than £250m of profits is clearly a nightmare for the UK food retailer's investors, who have seen their shares slump by more than a quarter since they first got wind of its accounting problems last month.

But the scandal - which has seen the suspension of eight senior executives - raises bigger issues about governance. Until a whistleblower appeared last month, investors had no reason to believe anything was amiss with the company's accounts. Now they know that not only is a substantial chunk of this year's profit a fiction; but the same also applies to last year, too.

Supermarkets have complex relationships with their suppliers and these can add a degree of subjectivity to profits. Branded suppliers offer discounts that are often linked to sales targets or promotional activity. In deciding when and whether to recognise the profits they make on these sales, managers do sometimes take a view on how many products they are likely to sell in a given period, and what promotional costs are associated with them. This can affect the level of discount that is applied and assumptions about the income generated.

But none of this is any excuse for Tesco's behaviour. The company appears to have been unduly and persistently optimistic in its judgments, routinely bringing forward sales and pushing back costs.

This at least seems to be the view of the accountants Deloitte. In a report commissioned by the board, it noted that the way discounts were accounted for contravened Tesco's own accounting policies. Deloitte also said the practice had occurred in earlier reporting periods and that the sums pulled forward grew period by period.

It is too early to say exactly what has happened. The affair is the subject of two investigations. Yet it does raise serious questions about the role of Tesco's auditor and the company's board. PwC signed off the accounts just months before the problem came to light. It did so in spite of specifically noting the "risk of manipulation" inherent in the estimates of commercial income, a big determinant of profit. But PwC was apparently persuaded by Tesco's audit committee that nothing was wrong.

This highlights the flaw in a bedrock of British corporate governance - the requirement either to "comply or explain". PwC arguably fulfilled the rule by flagging its concern to the company and the directors fulfilled theirs by considering the issue and dismissing it. Yet collectively the outcome was that investors were seriously misled.

That this could have happened will again raise questions about the independence of auditors and their willingness to challenge longstanding clients from whom they receive considerable income. PwC has been Tesco's auditor since 1983. Last year the retailer paid the accounting firm just over £10m for its audit services and a further £3.6m for consultancy work.

The scandal also lays bare a further weakness in the UK's system of self-regulation. The integrity of Tesco's accounts ultimately depended on the skill of its non-executive directors. Yet until the scandal broke none of them had any relevant retail expertise.

The Financial Conduct Authority must now scrutinise what has happened. It should consider the extent to which the problem was caused by the regulatory system and the cosy relationships between auditor and client. Tesco is not some small-cap stock but the world's second-biggest retailer. Drawing a line under this affair requires more than a brief tut and a ritual sacrifice.

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