A few weeks ago Patisserie Valerie (PV), a chain of upmarket purveyor of cakes, pastries and coffees made a shock announcement. They had been “notified of potentially fraudulent, accounting irregularities” in their accounts.
What followed was a tumult of activity. The company’s shares were suspended on AIM (the Alternative Investment Market); the CFO was first suspended, then arrested; the Serious Fraud Office (SFO) announced an investigation; the company said it would fall into administration without immediate capital injection; a controversial share issue backed by the minority shareholder was declared; ‘secret’ overdrafts were discovered; and an enormous cash shortfall found. All in the space of a few days!
This is a bitter blow for the AIM. PV was one of, sadly few, darlings on the troubled market which has seen more scandals than success stories. Particularly so with PV, given its solid growth, strong accounts and successful story of a long established Brit business come good. [The listed entity is Patisserie Holdings Plc, which I will refer to, for ease, as Patisserie Valerie/PV.]
Besides, PV is a pretty simple business. It sells cakes to people in shops and sometimes on the internet. But mainly in shops. How can it all go so wrong?
First, some accounting basics (I promise this is actually basic).
Accounts can be summarised by the ‘accounting equation’: Assets – Liabilities = Equity
In normal person words: the company is worth (equity) what it owns (assets) less what it owes (liabilities). This is found in the Balance Sheet.
A company becomes more valuable as it owns more stuff than it owes. It does that by making profits. The ‘profits equation’ is: Revenues – Expenses = Profit. This is found in the Income Statement.
Finally, the accounts translate how those profits (or losses!) become cash. The change in cash = change in cash from operations (doing stuff) + change in cash from investing (buying stuff) + change in cash from financing (borrowing stuff). This is found in the Cash Flow Statement.
Moving forward, we can see the ways that a company can fraudulently manipulate its accounts. It does so by playing around with one of the elements in each of our three equations:
|Overstate revenues||Overstate profits|
|Overstate assets||Overstate equity|
|Manipulate cash||Overstate translation of profits into cash|
There are many ways to do these various manipulations. We looked at some of these when we reviewed Carillion (particularly overstating revenues, overstating assets). We’ll use this framework to try to piece together what may have happened at Patisserie Valerie.
[This post was, I hope, accurate as at 23 October 2018, when it was written. I may choose to update or not update this post based on future events. Mainly that is dependent on whether I can be bothered or not.]
What Patisserie Value have said
In its 12 October 2018 regulatory filing the company said:
Following the initial investigation, the Directors can confirm that the Group has net debt of approximately £9.8 million. Historical statements on the cash position of the Company were mis-stated and subject to fraudulent activity and accounting irregularities as set out in the announcement of the Company on 10 October 2018. This activity and the irregularities are, in the Directors view, also likely to have affected the historical financial statements of the Company. The Directors estimate that based on current run rate information available, annual revenue and EBITDA, before exceptional one off costs, for the year ending 30 September 2019 could be approximately £120 million and £12 million, respectively.
For reference, here is the financial performance of the company over the past few years, plus the consensus forecasts.
The company guidance for 2019 is stark: a 12% drop in revenues, a 61%(!) drop in EBITDA.
Worst of all, rather than having over £21 million of cash (in the latest audited accounts), the company had negative £10 million! How did all that cash vanish?
We’re towards the end of the cold hard facts (as at the time of writing). At this point, we’ve got to put our idea caps on and try to think about ways this could have happened.
One possibility is that there was a one-off transaction that went horrifically wrong. Perhaps a hedge or derivative arrangement or some such. However, this seems unlikely given the company’s statements and the sheer size of the ‘black hole’.
The other possibility, therefore, is a long-term manipulation of the accounts. Let us use our five manipulations above to generate some ideas.
On first view, this seems like a difficult one to do. A customer walks into the shop, buys a cake, pays by card and walks out. The EPoS (Electronic Point of Sale) system records the transaction, sends it all to head office. The manager will do the cash reconciliation at the end of the day. It seems very difficult to manipulate these sales (unless it was done in an outrageously brazen way that the auditors should have spotted…)
However, there is one potential clue. As I mentioned in my Carillion piece, it’s important to look out for what words management/auditors change year on year. Compare the 2017 and 2016 revenue notes on voucher sales (emphasis mine):
Revenue from voucher sales is recognised at point of redemption at the face value of the voucher. Revenue from un-redeemed vouchers is recognised on expiration of the voucher. Any commissions and charges payable to agencies are recognised as costs of sales.
Revenue from voucher sales is recognised at point of redemption at the face value of the voucher. Any commissions and charges payable to agencies are recognised as costs of sales.
In 2015 there was no note (that might be because PV didn’t sell vouchers back then). Comparing 2016 to 2017, the 2017 note is more prudent (and I’d argue more appropriate). This suggests that PV may have recorded revenue from vouchers before they were entitled to it. I couldn’t find any information on what percentage of sales vouchers made up, but googling “Patisserie Valerie vouchers” comes up with a deluge of offers (don’t do this if you’re hungry and/or like cakes, lest you be tempted).
This is important for two reasons. Firstly, an expired voucher is pure profit – you get the money from selling the voucher but with none of the costs (and a lot of people forget to redeem vouchers!). Secondly, vouchers are a great cash wheeze. You get cash up front, but the cash costs come later (when you hand the goods over to the customer). This is why they have always been a popular staple of retail stores.
The forecast drop in revenues is not huge (£16m in 2019 on £136m revenue). It could be down to the company having to ‘circle the wagons’ and get things running properly. But it’s a possibility for overstating revenues.
Again, on the face of it, this would seem a challenge. The company takes raw ingredients, pays somebody to turn them into a delicious cake and then sells it. It would appear difficult to significantly manipulate those costs.
However, there is a significant way in which expenses can be understated for a retail company like PV. That is by capitalising, and not expensing, the costs of opening shops. I’ll give an example to explain. Say you buy a chair for your shop that costs £10. That chair is an asset because you can use it for five years (until it breaks) and you get value out of it in each of those years. So when you buy it, you don’t expense the whole £10. Instead, each year, for five years, you expense £2 (£10/5) as the value of the chair diminishes. Now, let’s use an example of fliers for a new shop opening. They also cost £10, but once the shop opens you throw them away. The £10 should be expensed in full on purchase.
Those fliers are pre-opening costs. Accounting standards prevent you from capitalising them. Pre-opening costs can be significant. Especially for companies that are rapidly growing the number of stores. PV had 100 shops in 2013, nearly 200 in 2018. So they would have been spending a lot of money setting up those shops.
Therefore, tight financial management is required. A company engages with a Quantity Surveyor (QS) to price up the costs of fitting out a new shop. For companies like PV, you often find that lots of shops are ‘identikit’. They all look and feel the same (ever gone to a Pret?). That’s deliberate for two reasons: first, it reinforces the brand and second, it means shop-to-shop fit-outs are very similar in terms of costs and rolling-out.
In that respect, it would seem like a challenge to fraudulently book expenses as assets (fliers as chairs). But it could be possible if there were insufficient controls in place. For example, a lack of oversight on those accounting judgements, or not checking capitalised costs back to the QS’s work. It would be an area where I would expect the auditors to focus significant time to make sure judgement was appropriate.
Another area could be the manipulation of rent/lease costs. Principally, booking rental costs too early or too late or not recognising lease premiums (an upfront lease cost). That said, those costs should all tie back to specific contracts. These are easily verified. Again, something the auditors should have done.
Overstating assets / understating liabilities
Now we turn to the elephant in the room, the cash. It seems simple – you either have £20m in your bank account or you don’t! Here, my readers, I’m completely stumped. It might seem facetious to say this: cash shouldn’t just disappear. Now I’m not the smartest egg in the box (according to Mrs YFG), but I see nothing in the accounts to suggest even the slightest whiff something was up. Even with the benefit of hindsight.
Cash is the easiest and most important thing for the auditors to verify. [INSERT OBLIGATORY ‘CASH IS KING’ STATEMENT]. The auditors write to the bank asking for the bank statements for the company, the bank sends them to the auditor. In fact, it’s even easier these days. It’s usually, or should be, done all automatically through document sharing systems). The company should have no involvement in the process.
So what the hell happened? I can think of three possibilities (and to absolutely clarify, I can only speculate here. I’m not saying this is what happened):
- A fraudulent actor at the company provided incorrect information to the auditors
- The auditors didn’t do the bank reconciliation properly
- The banks didn’t provide all the relevant information
Taking the first possibility. This would require the person committing the fraud to manipulate the general ledger (the list of all transactions) to cover their tracks. This is possible through the posting of ‘journals’. These are manual adjustments to transactions used to correct errors or to post transactions in a form ready to use to prepare the accounts. However, journals should be posted by one person and authorised by another (called segregation of duties). That’s so that any one person can’t manipulate the accounts (Nick Leeson). Likewise, any journals in high-risk areas (movements between accruals, expense/capitalisation (see above), large cash movements) – should get flagged.
The forensic accountants (some poor sod) will currently be going through the ledger, identifying postings that look suspect and tracing them through the accounts to see what manipulation was going on.
It’s almost as simple as this.
The company says: “I’ve got £20m of cash, my bankers are HSBC.”
Auditor: “HSBC, does the company have £20m of cash in their bank account with you?”
It’s a yes or no answer really (like: “Will you marry me?”). Making the presumption that the answer is yes (don’t make such a presumption if you are proposing) the next thing you do is reconcile the movements in the bank account statements to the accounting system.
At this point, any manipulation in the ledger should be spotted. Transactions in the bank statement won’t line up with the accounts. Or there’ll be a bunch of suspicious manual entries. At its simplest, the bank statement (assuming there actually was cash there) might have a transaction showing £5m paid in. It has to come from somewhere! Analysing that transaction you would eventually find the source of the money (a ‘secret overdraft‘, I don’t know why I keep using that term, I don’t like it) or a black hole (Parmalat).
The Company’s bank was HSBC and had been for many years. According to the accounts, the company had a £4m facility with the bank which had been unused since 2014. It seems inexplicable that the bank would arrange a separate overdraft facility for the company, without its apparent knowledge (interview with Executive Chairman, Mr Luke Johnson in the Times).
Firstly, if I was HSBC I’d ask: why do you need an overdraft when you already have this longstanding unused facility?
Secondly, it is inexplicable that a single person could authorise opening a bank account for a company. As far as I’m aware, though I’m often wrong about many things according to my wife (mainly, who’s turn it is to empty the bins), banks require the approval of at least two signatories. One of them is usually the CEO. Likewise, banks usually also require the board of directors to approve a lending facility. I mean, this isn’t Denmark for goodness sake!
Finally, the company showed no borrowings (zero) on its balance sheet. Did the banks (HSBC and Barclays) at no point check on the accounts of the company they had loaned millions of pounds to? Maybe they’d ask: Hold on! where have you accounted for the money we’ve lent to you?
Safe to say, I have no satisfactory answers. Only questions and confusion (much like the rest of my life).
Cash flow manipulation
Again, I see very few ‘clues’ in the accounts.
A potential oddity is that the company only received £8,000 interest on c.£20m of cash (a whopping 0.04% interest rate). That said, bank rates do suck at the moment and Marcus wasn’t about back then.
Another potential clue is that the company acquired £8.7m of Property Plant & Equipment (PPE) from opening 20 stores but made only £105k from disposals of PPE despite closing 5 stores during the year. But there are many valid reasons why that could be the case (re-use of equipment, closed stores being old with little valuable stuff left etc.)
You can tell I’m really clutching at straws here.
There are two other very troubling issues that are worth touching on. First, an HMRC tax winding-up petition. Second, the issue of equity options to senior management.
HMRC on a wind-up
The genesis of this whole debacle appears to have started from when the operating subsidiary (Stonebeach Limited) realised it was subject to a winding-up petition from HMRC for an unpaid tax bill of £1.14m. It is, of course, odd that a company which apparently had £20m of cash couldn’t pay a £1m tax bill. But that’s the tip of the iceberg.
In UK company law, if a company hasn’t paid money it owes you, you can petition to the High Court to wind the company up and get what you’re owed.
Now HMRC doesn’t usually do that as a first step. First, they might write some nice letters to you (“Hey, you know that money you owe us. Well, I’ve got an expensive month coming up, Tarquin has his horse riding lessons you know. It’d be super-nice if you could, maybe, pay us“). Then maybe some more threatening ones (“Please pay us. Otherwise, I’m gonna ask you give me back my back catalogue of Genesis vinyls”). Then possibly a letter saying: “Oi. Pay us or else“. It’s possible you might miss all those letters. Unlikely, but possible.
Then HMRC will seek a winding up petition. They send a hand-delivered letter to the company saying: “See you in court“. This is almost always delivered to the company Secretary (in the case of PV, Mr Chris Marsh, also the CFO, the guy that was arrested). They also have to put a notice in a publication called the Gazette. That way, you should definitely know that you’re subject to a winding-up petition. Unless of course, the company Secretary forgot about the really important letter he was just given. Or the random person who it was delivered to (this shouldn’t happen, but might) thought: “Meh, this court demand can’t be that important. I’ll put it in the bin.”
The petition was filed on 14 September 2018. The Petition was advertised in the Gazette on 5 October 2018. Apparently, the company didn’t realise it was subject to the winding up petition until 10 October 2018. Sorry to be flippant, but that doesn’t really make sense.
Another alarm bell is that on 5 October 2018, somebody sold a lot of shares. Courtesy of Jim Armitage in the Evening Standard:
Amid the flurry of extraordinary announcements last week was one in which the company said it had just discovered a winding-up order against its principal trading subsidiary, Stonebeach. The company said it knew nothing of the action, even though it was advertised in the London Gazette on October 5.
The firm may not have been aware but it looks like somebody else was: records for that day show 1.5 million shares in the company were traded with a value of about £6.5 million. On a typical day only 200,000 shares change hands.
Either the seller got lucky or they knew the score.
Most of the trading that day was done through the Irish broker Goodbody and house broker Canaccord. Did they smell any rats, or serve any Suspicious Transaction Reports?
Now, I’m a little less ‘conspiracy theory’ than Jim. That’s because, you can set up an alert to know when a company is subject to a notice in the Gazette (and yes, a company should have somebody set up such an alert ‘just in case’). Maybe a smart cookie did just that.
However, did the company’s broker, Canaccord, not think to contact the company and ask: What’s going on? Why is somebody selling all these shares?
I promise we’re nearing the end (well done if you’ve made it this far, there’s cake at the end, I promise). PV had, as is quite common, an equity option plan through a “Long-Term Incentive Plan” (LTIP). Basically, if the company does really well, the company issues a bunch of options to its senior managers as a bonus. They can then sell them, give them away, even sing “we’re in the money“. According to the 2017 accounts, under the LTIP, CEO Mr Paul May held 1,000,000 options and CFO Mr Chris Marsh 666,666, all with an exercise price of 170p. As of September 2017, none had been exercised. In February 2018, those options were exercised by both Mr May and Mr Marsh who both sold all the issued shares. So far, so good.
But then in July 2018, PV issued another 1,000,000 shares to Mr May and 666,666 to Mr Marsh “following the exercise of share options under the LTIP”. These were at a different exercise price of 316p. Again, they sold all the issued shares.
This second set of options are nowhere to be found in the accounts. Likewise, I couldn’t find anywhere where such a new issue of options had been disclosed. The FT has asked the company, the auditors and the brokers about this issue but they have been stonewalled.
Something has clearly gone terribly wrong at Patisserie Valerie. We’ve been left with a lot of questions and not a lot of answers. I’d go as far to say that it is commendable how fast Mr Johnson has reacted to the crisis. Although, the planned equity raise is not without its critics. I suspect many of the forensic accountants have been burning the wick at both ends (poor sods). However, that doesn’t excuse what appear to be some inexcusable oversights on the part of the Company. There are also big questions to ask of the auditors, banks and brokers. On 1 November 2018, the Company will convene a General Meeting to discuss the rights issue and provide a trading update. I suspect we will be waiting much longer to find out the whole picture of what went down.
All the best,
Young FI Guy
(p.s. That cake I promised… The cake is a lie.)
Literally the day after posting this, Patisserie Valerie provided two important updates. First, that the winding up petition has been dismissed by the court. Second, to clarify the LTIP options. Apparently, the 1,000,000 shares issued in July 2018 to Mr May and the 666,666 to Mr Marsh were granted in 2015. A further set of 1,000,000 and 666,666 options were also granted in 2016. All these options were granted under the LTIP scheme. However, this was not set out in the audited financial statements. PV states: “The Company¸ as part of the ongoing investigation, is seeking to understand why the grant of options relating to 2015 and 2016 have not been appropriately disclosed and accounted for in its financial statements.”
Today’s EGM vote passed the controversial placing with 99% backing the motion. Management apparently provided no trading update or further information. Very unsatisfactory.