Bake it till you make it: How Patisserie Valerie created fictitious revenues

As auditors are getting ready for the upcoming busy season or even already started, it is always good to reflect on past fraud cases. This helps us to remain vigilant towards fraud and non-compliance red flags. Typically we are so busy with getting the audit done, there is a risk that we overlook or miss red flags. Thus, to help us with the vigilance, lets reflect on the demise of Patisserie Valerie, a once-prominent UK patisserie chain. This case also serves as a stark reminder of the consequences of fraudulent activities not being detected.

While the Patisserie Valerie fraud is case from the archives, it does provide many relevant lessons for controllers working on the year-end close and auditor moving into the busy season. In particular, the report of the Financial Reporting Council (“FRC”) explains the fraud scheme in detail and show us how Patisserie Valerie did it. The FRC is the authority for statutory audit in the UK an operates the Audit Enforcement Procedure (“AEP”). The AEP sets out the rules and procedure for the investigation, prosecution and sanctioning of breaches by audit firms in the UK.

This article is not meant to reiterate the audit failures, but rather explores how Patisserie Valerie created fictitious revenues. Its aim is to empower those entrusted with governance, auditors, and other professionals to identify the subtle red flags indicative of financial shenanigans.

Background Patisserie Valerie

Patisserie Valerie used to be a well-known UK patisserie chain that, at its peak, had a network of shops and cafes renowned for their pastries and desserts. Founded in 1926, the chain gained popularity for its commitment to high-quality, freshly made confections. Patisserie Valerie was celebrated for its elegant ambiance, offering customers a sophisticated environment to indulge in a variety of artisanal pastries, cakes and other culinary delights. This all came crashing down when in 2018 a financial scandal revealed an extensive financial reporting fraud.

The fraud scheme

The book “Financial Shenanigans” by Howard Schilit is a great read for people interested forensic accounting. Schilit, decribes various modus operandi which organisations use to creatively ‘improve their financial health’. The book categorises various types of accounting gimmicks, from earnings manipulation to cash flow tricks. It provides readers with a framework to spot and understand such deceptive practices. With respect to earning management, the book describes seven categories:

• recording revenue too soon;
• recording bogus revenue;
• boosting income using one-time or unsustainable activities;
• shifting current expenses to a later period;
• employing other techniques to hide expenses or losses;
• shifting current income to a later period; and
• shifting future expenses to the current period.

Patisserie Valerie applied various of such techniques to artificially improve the financial health of the organisation. However, the primary modus operandi was the creation of fictitious revenue. For this purpose, Patisserie Valerie used a mix of the earning management schemes noted above. Lets zoom in on Patisserie Valerie earning management scheme to learn how they did it.

Creating revenue; a piece of cake

Patisserie Valerie’s revenue was made up of ‘retail revenue’, which originated from (1) restaurant, takeaway and online sales, and (2) ‘wholesale sales’ or ‘voucher sales’. The latter sales were the result of arrangements with third party companies. These voucher sales came from partnerships with three companies (let’s call them ‘Company A’, ‘Company B’ and ‘Company C’) and concerned the selling of vouchers for certain Patisserie Valerie products or experiences such as afternoon teas. Despite Patisserie Valerie’s auditor recognising risks associated with these vouchers and devising audit procedures for different revenue streams, the FRC report indicates that these procedures were not executed. Consequently, critical red flags went unnoticed and were not subsequently investigated.

Furthermore, Patisserie Valerie voucher revenues were significantly larger at year-end compared to the rest of the year. The FRC report details the voucher sales per month and at the end of the financial years FY2015, FY2016 and FY2017, see table below. The table shows that a large portion of the voucher sales was recorded at year-end: 41% in FY2015; 67% in FY2016; and 49% in FY2017. The FRC report also states that the auditor “...did not stand back and consider the trading patterns of wholesale revenues…“. The question here is whether it makes sense that such portions of sales take place at year-end?

We believe that ‘standing back and considering patterns‘ is an important step in any audit. This is the moment where auditors can put their ‘professional critical attitude’ into practice. This is the moment in which they should ask themselves: does this make sense? what is the business rationale? And use these questions for inquiries with management. We believe that auditors should train themselves and their teams to ‘stand back’ and take time and space to reflect. This is also an excellent moment to team up with fraud specialists who are trained to naturally observe from a distance how a fraudster would behave. Of course, this does not take away from the fact that in hindsight, everything is easier.

The FRC report further zooms in on these unusual patterns and provides various examples of large receipts at year-end. Some of the receipts are explained by Patisserie Valerie as receipts “…from a processor of credit card payments…” and “…that the processor had delayed these payments due to an issue with their receipts.” Furthermore, the FRC report describes various red flags in the underlying documentation that should have supported the voucher sales. For example: “There were numerous “red flags” including the fact that they cover 13 months when they should cover only 12 and that for the final five items listed, the invoices are dated 2 October 2017, indicating that they might have related to FY18. Another “red flag” was that these five receipts comprise 54% of all revenue apparently received from Company A in FY17.”

In addition to the fictitious revenue, Patisserie Valerie engaged in inflating cash balances and misclassifying specific fixed asset additions, but these are subjects for future blogs. The malpractices at Patisserie Valerie offer valuable lessons. While the problems may appear glaring, financial manipulations can be subtler and more sophisticated. Always ask yourself, does it make sense?

Lessons learned

Lesson 1: Transactions around year-end should be highly scrutinised, especially if they result in meeting budgets or other targets. One important lesson from the Patisserie Valerie scandal is the importance of scrutinising transactions at year-end, especially large, unusual or one-off transactions. Fraudulent activities often happen towards the culmination of the end of the fiscal year or reporting period. Auditors need to pay special attention to the timing of transactions, especially those clustered around year-end, as this can be indicative of potential manipulations aimed at presenting a rosier financial picture.

Lesson 2: Assess various types of revenue streams and corresponding risk. Revenue streams can vary, each carrying its own risk. Patisserie Valerie’s downfall emphasised the necessity of assessing various types of revenue comprehensively. Auditors must adopt a holistic approach, recognising the distinct risks associated with the different revenue streams. This broader perspective allows for different audit approaches that address the specific nuances and challenges presented by each revenue category.

Lesson 3: Journal entry testing is one of most powerful tools, do it with care. Journal entries are the basis of a organisation’s financial records, and the Patisserie Valerie case underscores the importance of thorough journal entry testing. Auditors should carefully think through the selection of the journal entries to be test and delve into the details, ensuring that entries are not only accurate but also properly authorised. And, do not easily except explanations by management. Meticulously examine the supporting documentation behind these entries, and investigate(!) discrepancies and irregularities.

Lesson 4: Scrutinise explanations and inconsistencies, the devil is in the details. Explanations provided by management can be smokes and mirrors. Auditors need to scrutinise these explanations meticulously, digging into the details and investigate inconsistencies. The Patisserie Valerie scheme teaches us that accepting explanations at face value without robust verification can lead to overlooking red flags. A diligent and critical examination of the narrative is essential for uncovering the truth.

Lesson 5: Always ask yourself, does it make sense? The final and perhaps most crucial lesson revolves around questioning the business rationale. In the Patisserie Valerie case, the reported revenue at year-end raised eyebrows, challenging the conventional expectations for a bakery business. Auditors must develop a keen sense of skepticism, consistently asking, “Does it make sense?” Unusual patterns in transactions and behaviour, especially those deviating from industry norms, should trigger further investigation. This probing approach helps auditors unearth potential financial irregularities that may otherwise remain concealed.

In essence, the Patisserie Valerie fraud serves as a useful reminder for auditors to be vigilant, adopting a skeptical approach to auditing and a relentless pursuit of understanding the business rationale. When you encounter inconsistencies in this busy season, think of the lessons from the Patisserie Valerie case!

Curiosity Leads, Amazement Follows – Continue reading the Green Hyena