978-0077862213 Chapter 5 Case Krispy Kreme Doughnuts

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Case 5-5

Krispy Kreme Doughnuts, Inc.

On March 4, 2009, the SEC reached an agreement with Krispy Kreme Doughnuts, Inc., and issued a cease-

and-desist order to settle charges that the company fraudulently inflated or otherwise misrepresented its

earnings for the fourth quarter of its FY 2003, and each quarter of FY 2004. By its improper accounting,

Krispy Kreme avoided lowering its earnings guidance and improperly reported earnings per share (EPS) for

that time period earnings per share; these amounts exceeded its previously announced EPS guidance by 1

cent.

The primary transactions described in this case are “round-trip” transactions. In each case, Krispy Kreme

paid money to a franchise with the understanding that the franchise would pay the money back to Krispy

Kreme in a prearranged manner that would allow the company to record additional pretax income in an

amount roughly equal to the funds originally paid to the franchisee.

There were three round-trip transactions cited in the SEC consent agreement. The first occurred in June

2003, which was during the second quarter of FY 2004. In connection with the reacquisition of a franchise

in Texas, Krispy Kreme increased the price it paid for the franchise by $800,000 (i.e., from $65,000,000 to

$65,800,000) in return for the franchise purchasing from Krispy Kreme certain doughnut-making

equipment. On the day of the closing, Krispy Kreme debited the franchise’s bank account for $744,000,

which was the aggregate list price of the equipment. The additional revenue boosted Krispy Kreme’s

quarterly net income by approximately $365,000 after taxes.

The second transaction occurred at the end of October 2003, four days from the closing of Krispy Kreme’s

third quarter of FY 2004, in connection with the reacquisition of a franchise in Michigan. Krispy Kreme

agreed to increase the price it paid for the franchise by $535,463, and recorded the transaction on its books

and records as if it had been reimbursed for two amounts that had been in dispute with the Michigan

franchise. This overstated Krispy Kreme’s net income in the third quarter by approximately $310,000 after

taxes.

The third transaction occurred in January 2004, in the fourth quarter of FY 2004. It involved the

reacquisition of the remaining interests in a franchise in California. Krispy Kreme owned a majority

interest in the California franchise and, beginning on or about October 2003, initiated negotiations with the

remaining interest holders for acquisition of their interests. During the negotiations, Krispy Kreme

demanded payment of a “management fee” in consideration of Krispy Kreme’s handling of the

management duties since October 2003. Krispy Kreme proposed that the former franchise manager receive

a distribution from his capital account, which he could then pay back to Krispy Kreme as a management

fee. No adjustment was made to the purchase price for his interest in the California franchise to reflect this

distribution. As a result, the former franchise manager received the full value for his franchise interest,

including his capital account, plus an additional amount provided that he paid back that amount as the

management fee. Krispy Kreme, acting through the California franchise, made a distribution to the former

franchise manager in the amount of $597,415, which was immediately transferred back to Krispy Kreme as

payment of the management fee. The company booked this fee, thereby overstating net income in the fourth

quarter by approximately $361,000.

Additional accounting irregularities were unearthed in testimony by a former sales manager at a Krispy

Kreme outlet in Ohio, who said a regional manager ordered that retail store customers be sent double orders

on the last Friday and Saturday of FY 2004, explaining “that Krispy Kreme wanted to boost the sales for

the fiscal year in order to meet Wall Street projections.” The witness said the manager explained that the

doughnuts would be returned for credit the following week – once FY 2005 was under way. Apparently, it

was common practice foe Krispy Kreme to accelerate shipments at year end to inflate revenues by stuffing

the channels with extra product, a practice known as “channel stuffing.”

Some could argue that Krispy Kreme auditors — Price-Waterhouse-Coopers (PwC) — should have noticed a

pattern of large shipments at the end of the year with corresponding credits the following fiscal year during

the course of their audit. Typical audit procedures would be to confirm with Krispy Kreme’s customers their

purchases. In addition, monthly variations analysis should have led someone to question the spike in

doughnut shipments at fiscal year end. However, PwC did not report such irregularities or modify its audit

report.

In May 2005, Krispy Kreme disclosed disappointing earnings for the first quarter of FY 2005 and lowered

its future earnings guidance. Subsequently, as a result of the transactions already described, as well as the

discovery of other accounting errors, on January 4, 2005, Krispy Kreme announced that it would restate its

financial statements for 2003 and 2004. The restatement reduced net income for those years by $2,420,000

and $8,524,000, respectively.

In August 2005, a special committee of the company’s board issued a report to the SEC following an

internal investigation of the fraud at Krispy Kreme. The report states that every Krispy Kreme employee or

franchisee who was interviewed “repeatedly and firmly” denied deliberately scheming to distort the

company’s earnings or being given orders to do so; yet, in carefully nuanced language, the Krispy Kreme

investigators hinted at the possibility of a willful cooking of the books. “The number, nature and timing of

the accounting errors strongly suggest that they resulted from an intent to manage earnings,” the report

said. “Further, CEO Scott Livengood and COO John Tate failed to establish proper financial controls and

the company’s earnings may have been manipulated to please Wall Street.” The committee also criticized

the company’s board of directors, which it said was “overly deferential in its relationship with Livengood

and failed to adequately oversee management decisions.”

Krispy Kreme materially misstated its earnings in its financial statements filed with the SEC between the

fourth quarter of FY 2003 and the fourth quarter of FY 2004. In each of these quarters, Krispy Kreme

falsely reported that it had achieved earnings equal to its EPS guidance plus 1 cent in the fourth quarter of

FY 2003 through the third quarter of FY 2004 or, in the case of the fourth quarter of FY 2004, earnings that

met its EPS guidance.

The SEC cited Krispy Kreme for violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1,

and 13a-13 thereunder, which require every issuer of a security registered pursuant to Section 12 of the

Exchange Act to file with the commission all the necessary information to make the financial statements

not misleading. The company was also sanctioned for its failure to keep books, records, and accounts that,

in reasonable detail, accurately and fairly reflect their transactions and dispositions of their assets. Finally,

Krispy Kreme was cited for failing to devise and maintain a system of internal accounting controls

sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation

of financial statements in accordance with GAAP.

On March 4, 2009, the SEC reached agreement with three former top Krispy Kreme officials, including

one-time chair, CEO, and president Scott Livengood. Livengood, former COO John Tate, and Randy

Casstevens, the CFO, all agreed to pay more than $783,000 for violating accounting laws and fraud in

connection with their management of the company.

Livengood was found in violation of fraud, reporting provisions, and false certifications regulations. Tate

was found in violation of fraud, reporting provisions, record keeping, and internal controls rules.

Casstevens was found in violation of fraud, reporting provisions, record keeping, internal controls, and

false certifications rules. Livengood’s settlement required him to pay about $542,000, which included

$467,000 of what the SEC considered as the “disgorgement of ill-gotten gains and prejudgment interest”

and $75,000 in civil penalties. Tate’s settlement required him to return $96,549 and pay $50,000 in civil

penalties, while Casstevens had to return $68,964 and pay $25,000 in civil penalties. Krispy Kreme was not

required to pay a civil penalty because of its cooperation with the SEC in the case.

VIDEO LINK: http://video.cnbc.com/gallery/?video=3000168961

Questions

1. Why did the round-trip transactions engaged in by Krispy Kreme and its franchisees violate

revenue recognition rules? How should they have been recorded under GAAP?

In each of the round-trip transactions, Krispy Kreme paid money to the franchisee with the understanding

that the franchisee would pay the money back to Krispy Kreme in a pre-arranged manner that would allow

Krispy Kreme to record additional pre-tax net income in an amount roughly equal to the funds originally

2. Evaluate the corporate governance at Krispy Kreme during its financial statement fraud including

management’s stewardship responsibility to owners.

The internal investigation report criticized the company’s board of directors, which it said was “overly

deferential in its relationship with Livengood and failed to adequately oversee management decisions.” The

report stated the every employee or franchisee that was interviewed repeatedly and firmly denied

deliberately scheming to distort the earnings or being ordered to do so. The report used carefully nuanced

For fiscal years 2002 and 2003, Krispy Kreme paid incentive bonuses to its top executives. The bonuses

Management’s stewardship responsibility to owners embodies the responsible planning and management of

resources. Management stewardship theory assumes that managers will act as responsible stewards over the

assets they control. In the case of Krispy Kreme, Livengood, Tate and Casstevens did not act of responsible

3. Krispy Kreme had materially misstated its financial results in an effort to manage its earnings.

Subsequently after the fraud was detected, the company restated its net income for 2003 and 2004.

What are an auditor’s responsibilities to detect material misstatements in the financial statements?

What should an auditor do after discovering material accounting irregularities? In other words, how

should an auditor correct for the fact that in the current year it was discovered that a previous years’

financial statements were materially misstated?

The auditor has a responsibility to plan and perform the audit to detect material misstatement whether due

to error or fraud. The auditor relies on professional skepticism in identifying material weaknesses in

internal controls and misstatements in the financial statements. Due care requires that the auditor should

Whenever the auditor has determined that there is evidence that fraud may exist, the matter should be

brought to the attention of the appropriate level of management. Fraud that causes a material misstatement

Optional Question

4. Prime accounting issues with respect to accounting for franchise activities include how to recognize

revenue on the individual sale of franchise territories and on the transactions that arise in connection

with the continuing relationship between the franchisor and franchisee. The Krispy Kreme case

describes three transactions between the company and its franchisees that created false earnings.

Review FAS No. 45, Accounting for Franchise Fee Revenue, and explain specifically how Krispy

Kreme’s transactions violated SFAS 45. (See www.fasb.org/pdf/fas45.pdf.)

The first round-trip transaction inflated the purchase of a franchise so that the seller would buy equipment

from Krispy Kreme; Krispy Kreme treated the purchase of the equipment as ordinary income. The

information in the case does not disclose whether the equipment was ever delivered to the seller or if it was

just a sham transaction to increase Krispy Kreme’s income. (Why would the seller need Krispy Kreme

equipment, if he had sold the franchise back to Krispy Kreme?) The second round-trip transaction inflated