What should investors do about potential fraud at Patisserie Valerie?

I was shocked, as no doubt were many, by the admission on Wednesday morning of “significant, and potentially fraudulent, accounting irregularities and therefore a potential material mis-statement of the company’s accounts” from Patisserie Holdings(LSE: CAKE), the owner of the Patisserie Valerie café chain and other brands.

My only recent encounter was a cycling lunch stop at a Patisserie Valerie, which opened my eyes to the firm as an investment candidate. Actually, though their food was undoubtedly good, the first thing my eyes did after opening was water on seeing the prices — even £2.50 just for a bottle of soft drink that has a usual retail price of £1.

That experience made me understand my colleague Roland Head’s comments on the company’s “high profit margins and strong cash generation.” With the café packed, I could see how the cash was rolling in — and I do like to understand where a company’s profit is coming from, not just by reading the numbers in the accounts. I very much agreed with Roland’s assessment.

Accounting irregularities

But now, the company says that the potentially fraudulent accounting irregularities which were brought to its attention on Tuesday have “significantly impacted the company’s cash position and may lead to a material change in its overall financial position.”

The shares, traded on the Alternative Investment Market (AIM), have been suspended temporarily. But what does this tell investors, and what should we do?

It reminds me of my good fortune in once attending a lecture by Terry Smith, author of “Accounting for Growth“. That book lifted the lid on some of the accounting frauds that were taking place in the 80s and 90s, including the Polly Peck and British and Commonwealth collapses — both members of the FTSE 100 at the time.

Thankfully Mr Smith’s endeavours helped tighten the accounting rules governing the FTSE indices, but we’re still seeing “accounting irregularities” today. It’s only last year that we saw BT Group taking a £225m hit over its Italian accounting scandal, but the hardest market for us to get our heads around is AIM.

AIM risk

AIM has significantly less stringent accounting rules than the main London Stock Exchange indices, intended to help smaller companies get off the ground without facing the same expensive red tape as bigger and more established firms. I think that’s a valuable ambition, but I do firmly believe that trusting in its standards for investors wanting to avoid this kind of calamity carries significant risk.

A recent example is Quindell, which faced an accounting controversy and was forced to restate its accounts — turning claimed profits into losses. The company went on to rename itself Watchstone Group after selling most of its assets to Australia-based Slater & Gordon, but is still the subject of a Serious Fraud Office investigation (and legal action by Slater & Gordon).

Diversification

When accounting irregularities occur, shareholders are left carrying the can — when we buy a share of a company, we take on responsibility for that company’s actions and it can be very hard to get anything back should we suffer a loss through fraudulent practices.

My only answer is to diversify. Diversifying hedges you against all sorts of things that can go wrong with individual investments, not just possible fraudulent accounting. And I do hope any Patisserie Holdings investors reading this are well diversified.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended Patisserie Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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