Toppled from the top – The risk of fraud

Fraud has become a significant issue for modern businesses, particularly with the development of new technology, which has made the facilitation of fraud much easier and detection far harder.

Regardless of its scale or complexity, fraud can have a devastating impact on businesses and their shareholders, leading to a loss of jobs, a devaluation of shares and ultimately insolvency.

This has been recently highlighted by the case of bakery Patisserie Valerie. Founded in 1926, the once small London bakery bloomed into a national institution with almost 200 stores in operation across the UK.

In the months since the story of its administration broke much has now become clearer about the mismanagement and allegations of accounting fraud at Patisserie Valerie, which ultimately left the once successful business with a £94 million black hole in its accounts.

Role of accountants to uncover fraud

In the wake of its collapse, the administrators, KPMG, revealed that the firm’s cash position had been overstated by £54 million, while its liabilities had been understated and the amount it was owed overstated to the tune of £17 million. To make matters worse there was a £23 million discrepancy in the way it had valued its assets.

However, the company hadn’t seemed like a sinking ship when it was valued at £450 million just months before it flagged up the potential fraud, which led to the administration that wiped out the value of the business.

Its former auditor Grant Thornton had given it a clean bill of health at the time, which gave investors in confidence the value of their shares. Following the administration, Grant Thornton said that it was not the role of accountants to uncover fraud.

Speaking to MPs back in January David Dunckley, chief executive of Grant Thornton, said: “We’re not looking for fraud, we’re not looking at the future, we’re not giving a statement that the accounts are correct. We are saying [the accounts are] reasonable, we are looking in the past and we are not set up to look for fraud.”

Dunkley was grilled by MPs for some time about the failure of Patisserie Valerie and their role as auditor but he reiterated: “If people are colluding and there is a sophisticated fraud, that may not be caught by normal audit procedures.”

Five arrests have since been made in relation to alleged accounting fraud and the individuals have been questioned following an investigation by the Serious Fraud Office (SFO), which worked in collaboration with the Hertfordshire, Leicestershire and Metropolitan police.

Amongst the people arrested was Chris Marsh, Patisserie Valerie’s former Chief Financial Officer (CFO). The SFO is yet to comment further on charge or actions it may take against those arrested.

Other watchdogs

In addition to the SFO, the case has attracted the attention of several other watchdogs, including the Financial Reporting Council (FRC), the Insolvency Service, the Aim market regulator and the HMRC fraud investigation service.

It has also led to further questions being raised about the effectiveness of the UK’s audit procedures and rules, with the likes of BDO and PwC both questioning whether change is needed.

In response, the FRC has issued a revised going concern standard, which requires auditors to challenge more robustly management’s assessment of going concern and thoroughly test the adequacy of the supporting evidence.

The FRC has also introduced a new reporting requirement for the auditor of listed and large private companies to provide a clear conclusion on whether management’s assessment is appropriate and a stand back requirement to consider all of the evidence obtained when the auditor draws its conclusions.

The Council has also launched an investigation into Grant Thornton’s handling of the audit of the financial statements of Patisserie Holdings for the years ended 30 September 2015, 2016 and 2017 under its audit enforcement procedure.

Alongside this, the FRC will investigate Chris Marsh, over the preparation and approval of Patisserie Holdings Plc’s financial statements and other financial information which had been provided by him.

Extreme cost-cutting

Patisserie Valerie was bought by an Irish private equity firm, Causeway Capital Partners (CCP) for £5 million after its collapse, in a move that helped to save around 2,000 jobs and has kept some outlets open.

Since acquiring the business, it has revealed the shocking state of the company it purchased, including an extreme approach to cost-cutting.

Measures used by the company before its administration included managers who stopped using butter in puff pastries, broken ovens, unpaid suppliers and an unrepaired leak in the roof at a key bakery site.

Dangers and devastating impact of fraud

While shareholders await more details that are likely to come from the SFO’s and FRC’s investigations, it seems clear from the work of the administrators that Patisserie Valerie had been mismanaged and its accounts overstated to elevate its share price artificially.

Many commentators have discussed how such a large company could get into such a state, how the warning signs could be missed and how auditors failed to flag up problems in the business or spot the fraudulent activity.

Unfortunately, for many of the staff and shareholders, the damage has already been done. This case, like many before it, has helped to highlight the dangers of fraud and the devastating impact that it can have on the lives of those affected by it.

It also demonstrates the enormous gap between the public perception of what an audit should achieve and reality.  An audit is significantly different from the type of focussed forensic accountancy investigation that has now been undertaken at Patisserie Valerie.  The former has the objective of giving “reasonable assurance” that financial statements are free from material errors arising from fraud, but an audit gives “no guarantee”.

Many commentators argue that the rules should be changed to place a greater onus on auditors to find fraud but this would inevitably increase the cost of an audit which would be at odds with the government’s stated aim to reduce the burden of bureaucracy and red tape on business.