The Future of Cake Shops and Auditors

31 January 2019

Patisserie Valerie recently followed many other High Street names into administration. Questions are now being asked not only about the viability of this type of business model, but also about the quality of management and the apparent lack of reliable scrutiny of public companies.

A loss of uniqueness

Can a small business with a unique offering be successfully scaled up?

Patisserie Valerie is a typical example. I did not have the good fortune ever to visit the original cake shop, established in Frith Street, London in 1926, nor the one which replaced it in Old Compton Street and which remained its only outlet for most of its history. However, when Risk Capital Partners acquired a majority stake in 2006 there were only eight shops, all of which retained their faux Belgian charm, as I found when I visited one about 10 years ago. It was, however, with some surprise that I stumbled on another last year in a motorway service area. By this time the old world atmosphere and sophistication had given way to the noisy bustle and brash décor which typifies motorway food counters. Valerie, whose name by then adorned 191 outlets (cake shops would be a misnomer) had obviously lost her way.

A piece of cake

It now appears that few appreciated to what extent Valerie had gone off course, not even the directors. Let’s consider how difficult it might be to understand such a business and what might be required of management to monitor its performance. Well, it’s a cake shop. The mark-up on ingredients has to be substantial, the staff are not highly paid, and the overheads are totally predictable. Customers pay as they leave so no bad debts or slow payers. What could possibly go wrong? Monthly reports would quickly identify underperforming branches. It should be (pardon the pun) a piece of cake.

It is reported, however, that the directors were unaware that in September last year HMRC had issued a winding-up petition to one of the subsidiary companies for unpaid tax of £1 million. That warning shot having gone unheeded, the company continued to have problems paying its suppliers, until eventually it was discovered that although the balance sheet showed £28m in the bank there were in fact bank borrowings of £10m. So the directors were ignorant of what has been described as ‘a black hole’ of £38m. Fraud is suspected, and the former finance director has been arrested and released on bail.

A flawed model?

So what went wrong? Speculation is rife but this very common business model consists of acquiring a well-respected small business, using venture capital to scale it up rapidly, floating it on the Stock Market and then disposing of a large proportion of the share capital for a substantial gain. Those involved in this type of venture are serial entrepreneurs, and they use the proceeds of one deal to leverage the next, and so on. What they often lack is both an in-depth knowledge of and a passion for the business in question.

Furthermore, it is becoming obvious that the market for cake and coffee shops is saturated; combine this factor with the general decline of our high streets, and you have a recipe for converting a small profitable niche business into an overgrown loss maker.

Who checks directors’ competence?

Setting aside the implications for the hospitality and retail sectors generally, very serious questions arise regarding the scrutiny of the UK’s large businesses. The public would perhaps not be too concerned that the investment banks have halved their spending on analysts since the financial crisis, so the conduct and performance of public quoted companies are much less frequently examined on behalf of investors. However, they do become agitated when businesses close and jobs are lost (in this case 900 so far and a further 2,800 in jeopardy). They might ask what can be done to ensure that directors are competent to run their businesses.

Auditors in the spotlight

The public, although they know little about auditing, nevertheless are entitled to question the value of an audit when it fails to identify an ailing company. As always it is the bad cases that grab the headlines whereas there is no doubt that the majority of audits are carried out diligently and effectively. In this case, however, Patisserie Valerie reported to the Stock Exchange that forensic accountants had found “thousands of false entries in the company’s ledgers”. The insolvency practitioners who now control the company have allegedly advised prospective buyers that the last three years’ accounts cannot be relied upon. Perhaps most embarrassingly, according to the Times newspaper, the Financial Reporting Council, which is currently investigating both the conduct of the directors and the work of the auditors, as part of a random sample actually reviewed the auditors’ work on the 2017 accounts.

Perhaps we auditors should be thankful that the attention of Parliament is engaged elsewhere. If not, and given the current populist attitude towards experts in general, I think we would be hearing clamours for auditors to be replaced by government officials. As it stands, we have the veiled threat issued by Rachel Reeves, MP, chair of the Business, Energy and Industrial Strategy Committee that, “we are already looking into the future of auditing in the UK.” There is no doubt that auditing is going to change, and so probably is the role played by the big four audit firms. I doubt that companies would be keen to have their affairs scrutinised annually by Government inspectors, but to avoid this, the auditing profession is going to have to up its game and also increase awareness of its role in public life. How much more satisfying would it have been if the headlines had read “Auditors discover £40m black hole – 3,700 jobs saved”?

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