Victoria plc’s audit nightmare

FT Alphaville’s favourite Aim-quoted carpet roll-up, Victoria plc, appeared to publish a rosy set of audited annual results earlier this month.

For those who are not familiar with one of the London junior market’s more madcap mid-caps, Victoria is an over 120-year old carpet maker based in Worcester, which underwent a drastic transformation in 2012. That’s when Geoff Wilding, a former investment banker from New Zealand, took the helm as executive chairman and spearheaded an acquisition spree of over 20 flooring companies around the globe.

Wilding, who has a penchant for quoting Warren Buffett in his missives to shareholders, is a polarising figure. Supporters include the likes of Koch Industries, the sprawling US conglomerate, which has poured hundreds of millions of dollars into both Victoria’s common and preferred equity in recent years.

Sceptics and short sellers, meanwhile, have tended to point to oddities surrounding Victoria’s acquisitions and the arguably patchy business record of Wilding, who has cashed out a literal boatload of money from share sales over the years.

On September 14, Victoria seemingly proved the doubters wrong, however, announcing audited annual results that affirmed that it had reported “record underlying revenue and Ebitda” in the year ending April 1 2023.

The company also excitedly told investors that the total volume of flooring it sold exceeded the equivalent of “more than 29,500 football fields” for the first time. Wilding was so ebullient that he not only quoted Buffett’s longtime business partner Charlie Munger, but also Winston Churchill.

The stock market applauded, sending Victoria’s share price up as much as 10 per cent in the initial afterglow.

But those who actually bothered to read beyond those heady headline achievements soon noticed that Victoria had not actually received a completely clean bill of health from its auditor. Instead, Grant Thornton had handed down a qualified audit opinion.

This was because Victoria imposed a limitation of scope on its auditor, effectively stopping it from completing one aspect of its audit, which the company explained as follows (emphasis added):

LIMITATION OF SCOPE

In the year ended 1 April 2023 UK subsidiary, Hanover Flooring Limited (“HFL”), a small regional distributor in Yorkshire, had revenue of £18.7m (2022: £23.4m), statutory loss before tax of £1.2m (2022:  loss £0.9m), underlying profit before tax of £3.9m (2022: £5.8m) and net liabilities of £0.4m (2022: net assets of £0.7m). For reference, the level of materiality set by our auditor Grant Thornton for work performed on HFL for FY23 is £2.4m and £6.0m for the entire Group audit.

Victoria plc acquired the trade, inventory and debtors of Hanover Carpets (“HCP”) from a UK partnership on 26 January 2021, with one of the partners joining the group as managing director of HFL.

As is usual in these types of acquisitions, customers, despite instructions otherwise, continued to remit receipts for sales into the bank account of the seller (the bank account was not acquired by HFL and continued to be used by the partnership’s other businesses). These receipts (£5.2m since acquisition, more than 70% between January and June 2021 but including £0.3m in FY23) were periodically transferred to HFL.  HCP also made payments on behalf of HFL of £0.4m in FY21 from this bank account between January and June 2021. The opening and activation of a bank account for HFL was delayed until March 2021 due to Covid-19 lockdowns.

This arrangement was specifically anticipated in the Asset Purchase Agreement as we were not acquiring the bank account but it was brought to our attention in June 2023 that a small number of customers were still remitting payments into it (c.£0.002 million in the previous three months). This matter was reviewed by executive management and in discussion with the Board it was decided to appoint an external professional services firm (Big Four Accounting Firm) to assist in performing a number of procedures to confirm the completeness of amounts owing to HFL from HCP and the adequacy of accounting records. 

The interim outcome of the work undertaken has confirmed that since 26 January 2021:

(a)  £0.4m due to HFL by HCP was offset from the latest deferred consideration payment;

(b)  £0.1m of HFL customer receipts in FY23 (and £1.2m since January 2021) cannot be reconciled to individual product invoices due to a lack of detailed records in relation to those payments. (It is important to understand Victoria has received the payments, it is solely that customer receipts were applied to customer receivable balance without regard for specific invoices being paid); and

(c)  a number of instances of potential non-compliance with High Value Dealer regulations (MLR 2017) in HFL since the date of acquisition. Once identified we immediately stopped all cash handling until appropriate controls could be put in place, have advised the relevant regulatory authorities and, with the benefit of appropriate legal advice, have made a provision for the expected fine.

Under the terms of the Asset Purchase Agreement we have the legal right to retain any or all of the contingent consideration (of which £8.0 million remains to be paid) to cover any negative financial effect should there be one. We will continue to perform procedures on the completeness of amounts owed to HFL from HCP ahead of the final deferred consideration payment. Therefore, we do not anticipate any financial impact on Victoria from any of the above matters.

There have been some deficiencies in the control environment in this minor subsidiary and it has not maintained adequate and complete accounting records for the purposes of demonstrating how individual customer receipts were applied to individual invoices in the debtors’ ledger. Consequently, we allocated additional experienced finance resources to this subsidiary who are putting appropriate controls in place to ensure adequate accounting records will be maintained.

We have reviewed other similar acquisitions in the group and did not identify these deficiencies in their control environments or record keeping.

We believe, based on the extensive work carried out with the support of professional advisors, that due to inadequate books and records in certain areas, any further audit procedures by Grant Thornton will not provide them with sufficient and appropriate evidence to satisfy their concerns and therefore we took the decision to impose a limitation of scope on the auditor’s work and requested them to stop their work in respect of HFL.

As a result, Grant Thornton have not been able to complete their audit work on HFL in support of the Group audit for the year ended 1 April 2023. Grant Thornton have had to modify their audit opinion in respect of our decision to impose a limitation of scope in this area.

It doesn’t make for cheery reading, particularly if you’re aware that the benign-sounding initialism “MLR” stands for “money laundering regulations”.

But there is no mention of fraud, at least. And the amounts of problematic transactions in the reporting period are small, seemingly below the £2.4mn materiality threshold Victoria states that Grant Thornton set for its Hanover subsidiary.

Readers could have fairly concluded: “not great, but not material”.

The problem was that Victoria did not actually publish its annual report alongside the summary. It was not immediately possible to actually read Grant Thornton’s verdict straight from the horse’s mouth.

The delayed annual report has now finally emerged. Just over a week later, Victoria published it in full on Friday evening, just as most of us were winding down for the weekend.

And, as you might have guessed by now, Grant Thornton’s description of the issues at Victoria’s Yorkshire subsidiary Hanover is a little gnarlier (again, emphasis added):

BASIS FOR QUALIFIED OPINION

We selected some non-significant components, including Hanover Flooring Limited (‘Hanover’), to incorporate unpredictability into our audit approach. Despite Hanover’s relative contribution to the group, we also considered external market factors; and identified risk factors of fraud (as specified in ISA (UK) 240 The auditor’s responsibilities relating to fraud in an audit of financial statements) in respect of the revenue, cash and payroll cycles.

In the course of our audit work, we identified potential irregularities in respect of certain transactions within Hanover. This included that:

• after the acquisition of trade and assets which form Hanover in January 2021 customers continued to pay into the seller’s (pre-acquisition) bank account and the seller made a number of payments on behalf of Hanover. Management identified £5.2m of receipts (2023: £0.3m, 2022: £2.8m, 2021: £2.1m) and £0.4m of payments (2023: £0.0m, 2022: £0.0m, 2021: £0.4m) relating to Hanover since January 2021. One of the sellers of the trade and assets acquired by Hanover is the managing director of Hanover. Management have explained to us that this account is used for various activities and includes a significant number of transactions not relating to Hanover;

• significant volumes of cash sales and an ageing accounts receivable profile were identified, which is not in line with the rest of the Group;

• inadequate accounting records were retained; and

• instances of non-compliance with High Value Dealer regulations (Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017) were noted.

We raised our concerns with management who together with external advisors performed further work to understand the nature of these transactions and, where relevant, to attempt to reconcile them to Hanover’s records. Management have set out a description of the work they have performed on pages 29-30.

In responding to the identified and potential irregularities, we performed the following audit procedures:

• enhanced procedures in relation to the risk factors in respect of Hanover’s revenue, debtors, bank, cash and wages;

• inspected the reports prepared by experts engaged by management to understand and seek to reconcile the activity in the bank account operated by Hanover’s managing director. We engaged our own internal forensic expert to support our audit by gaining an understanding of and challenging the work performed by management’s expert;

• obtained and read legal letters from the Group’s legal representatives on a number of matters. We liaised with our internal legal experts in regard to certain matters;

• performed additional procedures over the remainder of the Group to address the risk of similar potential irregularities taking place, including obtaining confirmations from our component auditors;

• consideration of management’s disclosures in the Annual Report and financial statements.

This work, and the procedures we have performed in response, has not adequately addressed our concerns. We sought to obtain further evidence but were unable to do so because management imposed a limitation of our scope. We requested that the Board remove management’s limitation, which they did not. Because of their view that our proposed procedures are unlikely to generate further or better-quality evidence to address our concerns, the Board has prevented us from undertaking further work in the area.

Whilst we set component materiality at £2.4m for Hanover, we have concluded that these matters are qualitatively and quantitatively material to the Group financial statements.

We were therefore unable to reduce the risk of material fraud or error to an acceptable level and obtain sufficient and appropriate audit evidence for all Hanover balances (net liabilities of £0.4m, 2022: net assets of £0.7m) and transactions (including revenue, loss before taxation and underlying profit before taxation of £18.7m (2022:£23.4m), £1.2m (2022: £0.9m) and £3.9m (2022: £5.8m) respectively) and cannot conclude whether any irregularities have or have not taken place, other than those disclosed by management on pages 29-30.

Consequently, in respect of Hanover we were unable to determine whether any adjustments to these amounts or disclosures are necessary and whether there have been any breaches of applicable laws or regulations, other than those disclosed by management on pages 29-30.

We conducted our audit in accordance with International Standards on Auditing (UK) (ISAs (UK)) and applicable law. Our responsibilities under those standards are further described in the ‘Auditor’s responsibilities for the audit of the financial statements’ section of our report. We are independent of the Group and the parent company in accordance with the ethical requirements that are relevant to our audit of the financial statements in the UK, including the FRC’s Ethical Standard as applied to listed entities, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion.

Yikes.

Grant Thornton is clear that, whatever the materiality threshold, the issues are “qualitatively and quantitatively material” to Victoria’s financial statements. The audit firm also drops in the f-word pretty quickly and concludes that there is an unacceptable risk of material fraud. This puts a question mark over the audit of all of Hanover’s outstanding balances.

When it comes to breaches of money-laundering regulation, Grant Thornton does not opt for Victoria’s qualified phrase “potential non-compliance”. It is simply “non-compliance” and, furthermore, the auditor was also unable to determine whether there have been breaches of other laws or regulations.

Perhaps the biggest bombshell: Grant Thornton reveals that it asked Victoria’s board to remove the limitation of scope that management imposed and the board refused.

It is a lot to take in. Particularly for Peel Hunt, one of Victoria’s corporate brokers. The UK brokerage firm’s equity research team published this BUY recommendation on the day the company published its summary of its annual report, noting there had been “no change to numbers” that Victoria trailed last month. Peel Hunt did not see fit to mention the qualified audit.

FTAV asked Victoria for comment on the matter and we received the following statement:

There is no wrong-doing at Hanover and nor are the auditors alleging this. Hanover’s issue was predominantly one of having heightened financial risk due to inadequate accounting records — a situation that is regularly found when smaller businesses are acquired as their standard of financial controls and record keeping often don’t match the high levels we have across the rest of the Group. Not surprisingly, we’ve identified the issues, allocated additional finance resources, and are putting appropriate controls in place and the issue is not ongoing. However, it is essential to note that the amounts involved are immaterial as Hanover as a whole represents less than 1.25% of our total revenues and the sums for which inadequate records existed were less than 0.08% of our revenues.

We have obligations to both shareholders and bondholders to publish our audited accounts within a certain timeframe and the Board concluded that further work and delay on this immaterial matter would not generate any additional evidence beyond what was already known. We are confident there is no wrong-doing, we are putting additional financial controls in place at this subsidiary and are assured that these accounts give a true and fair view of the Company, as stated by the auditor.