By James Davey and Kate Holton
LONDON (Reuters) - Accounting mistakes in supplier contracts forced Tesco to suspend its UK boss along with three other senior executives and cut its profit outlook for the third time in two months, dealing another major blow to the world's No. 3 retailer.
People familiar with the matter said the company had been overly ambitious when predicting the sales of products in its UK food business. This in turn reduced the cash rebates Tesco receives from suppliers who pay out when certain volumes are achieved.
They also said Tesco had mis-reported in its accounts the costs of "waste", which is out of date food, and "shrinkage", which is stolen or unaccounted for product.
A profit warning on Aug. 29, three days before its new chief executive Dave Lewis joined, had overstated expected first half profit by 250 million pounds ($408.50 million) or 23 percent.
The news sent shares in the group down 12 percent to an 11-year low after Tesco said it had called in its lawyers and new accountants to investigate the error in its UK food business. Along with the UK managing director Chris Bush, three other senior executives were suspended.
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The accounting issue draws attention to Tesco's lack of a group finance director, with Lewis, who succeeded the ousted Phil Clarke as CEO, the only executive director on the board of Britain's biggest private sector employer.
Tesco's error was discovered by a "commercial manager", Lewis told reporters, who informed the firm's legal counsel on Friday when he discovered it during preparations for the forthcoming first half results.
Lewis declined to name the individual and said it was too early to say if the issue involved fraud. Tesco's interim results have now been pushed back from Oct. 1 to Oct. 23.
"This is something completely out of the ordinary. Never mind the (Tesco) finance function - the auditors didn't catch it," said chairman Richard Broadbent, who told reporters he would not be resigning because he wanted to be "part of the solution" to the firm's problems.
PwC [PWC.UL], Tesco's auditor since 1983, declined to comment.
In its 2013-2014 report it highlighted commercial income as an "area of focus" due to "the risk of manipulation" in accounting for deals. Tesco's audit committee responded then that it believed it had appropriate management controls.
Lewis said on Monday that commercial income covered all transactions between Tesco and its suppliers. PwC's report defines it more narrowly - as promotional monies, discounts and rebates receivable from suppliers.
"Such an announcement is not the stuff of a well operated FTSE-100 organisation," said Shore Capital analyst Clive Black.
"AN ILLUSION"
The retailer currently has no full-time chief financial officer after Laurie McIlwee quit in April. Although his official leaving date is Oct. 3 he has been working only sporadically and his replacement Alan Stewart, formerly of Marks & Spencer does not start until Dec. 1. [ID:nL6N0PL300]
Analysts also questioned the board's scrutiny of the profit warning and numbers put out by Tesco on Aug. 29, asking why that process had not revealed this latest issue.
That alert had forecast trading profit - or underlying profit - for the six months ending Aug. 23 to be in the region of 1.1 billion pounds. The new forecast of 850 million pounds means group trading profit has nearly halved from the 1.6 billion pounds Tesco recorded in the comparable period last year.
Cantor Fitzgerald analyst Mike Dennis said he had questioned last year how Tesco was supporting a 5.2 percent UK trading margin with falling sales and rising costs, drawing attention to a note he published in October entitled: "It's just an illusion."
Analysts at HSBC said the announcement raised the spectre that there could be more issues across the group, and said the possibility of a rescue rights issue could no longer be ignored.
With Tesco in its weakest position in years, it could even become a takeover target.
STEP ASIDE
With a market valuation of nearly 17 billion pounds and over 500,000 employees, Tesco ranks third behind France's Carrefour and U.S. giant Wal-Mart in annual sales.
It had been the darling of the sector during two decades of uninterrupted earnings growth until it lost UK market share to fast-growing German discounters Aldi and Lidl as well as upmarket rivals Waitrose [JLP.UL] and Marks & Spencer . Under Clarke it issued three profit warnings in two and a half years and saw its share price drop to decade-lows.
Lewis said four Tesco employees had been "asked to step aside" while the investigation proceeded but had not been disciplined.
He declined to name them. However a source with knowledge of the situation named them as UK managing director Chris Bush, UK finance director Carl Rogberg, commercial director John Scouler and food sourcing director Matt Simister.
Lewis declined to comment on Bush, a Tesco veteran of 32-years, but said Robin Terrell, the firm's multi-channel director, had stepped in to lead the UK business, Bush's role.
"We have uncovered a serious issue and have responded accordingly. The chairman and I have acted quickly to establish a comprehensive independent investigation," said Lewis, adding he would take "decisive action" when the results of the investigation were known.
Tesco is working to establish the extent of the issues and the impact they might have on its full-year profit, he added.
"The early indication is that (250 million pounds) number is more to do with timing in the first half/second half than anything else," said Lewis.
Tesco investor Niall Dineen, a portfolio manager at AGF International Advisors, questioned whether Lewis was "kitchen sinking" - getting all the negatives to investors in one go.
Tesco has appointed a new adviser Deloitte to undertake an independent and comprehensive review of the issues, working closely with Freshfields, its external legal advisers.
Bernstein analyst Bruno Monteyne said the bringing in of Freshfields "implies there is potential foul play, beyond simple account stretching."
UK business secretary Vince Cable said the Financial Reporting Council (FRC), the body that oversees corporate behaviour, could be called in to investigate Tesco if it transpires that "serious malpractice" had taken place.
Tesco shares closed down 11.6 percent at 203 pence. Shares in UK rivals Sainsbury's and Morrisons both fell almost 2 percent and investors also marked Tesco's credit wider.
Agency Fitch placed Tesco on ratings watch negative.
(1 US dollar = 0.6120 British pound)
(additional reporting by Clara Ferreira Marques, Nishant Kumar and Simon Jessop; editing by Sophie Walker and Janet McBride)