Case 8-5 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 FY2003 and each quarter of
FY2004. By its improper accounting, Krispy Kreme avoided lowering its earnings guidance and
improperly reported earnings per share (EPS) for that time period; 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 franchisee with the understanding that the franchisee would pay
The second transaction occurred at the end of October 2003, four days from the closing of
Krispy Kreme’s third quarter of FY2004, in connection with the reacquisition of a franchise in
Michigan. Krispy Kreme agreed to increase the price that it paid for the franchise by $535,463,
and it 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 franchisee. 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 FY2004. 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 in or about October 2003, initiated
negotiations with the remaining interest holders for acquisition of their interests. During the
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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.
Some could argue that Krispy Kreme auditors—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 the end of the fiscal year. However, PwC did not
report such irregularities or modify its audit report.
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
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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 its
transactions and dispositions of its 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 were recorded as necessary to permit preparation of financial statements in
accordance with GAAP.
Livengood was found in violation of fraud, reporting provisions, and false certification
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 certification rules. Livengood’s settlement required him to
pay about $542,000, which included $467,000 of what the SEC considered as the “disgorgement
SEC Charges against PricewaterhouseCoopers
In a lawsuit brought on behalf of the Eastside Investors group against Krispy Kreme Doughnuts,
Inc., members of management, and PricewaterhouseCoopers, a variety of the fraud charges
leveled against the company were extended to the alleged deficient audit by PwC. These charges
were settled and reflect the following findings.
PwC provided independent audit services and rendered audit opinions on Krispy Kreme’s
FY2003 and FY2004 financial statements. The firm also provided significant consulting, tax, and
due diligence services. Specifically, PwC provided consulting services for employee benefit
audits; business acquisitions; accounting consultations including on joint ventures; tax
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franchisees; and (3) ignoring numerous red flags that indicated risks that should have been
factored into the audit and in questioning of management. These include:
• Unusually rapid growth, especially compared to other companies in the industry;
• Excessive concern by management to maintain or increase earnings and share prices;
• Domination of management by a single person or small group without compensating controls
Questions
1. Explain the dimensions of ethical leadership that did not exist in the Krispy Kreme case
both on the part of company management and PwC.
A good example of failed leadership at Krispy Kreme was the financial structuring of the
management fee payments to Krispy Kreme that were returned to franchisees but not until
Krispy Kreme used those fees to improperly bolster net income. The round-trip nature of the fees
should have led to an offset against earnings instead. Here are the relevant facts from the case.
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 would be made to the purchase price for his interest in
the California franchise to reflect this distribution. As a result, the former franchise
manager would receive the full value for his franchise interest, including his capital
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Here is the relevant material from the case.
PwC was charged with a variety of failures in conducting its audit of Krispy Kreme.
These include: (1) failure to obtain relevant evidential matter whether it appears to
corroborate or contradict the assertions in the financial statements; (2) failure to act on
The legal action against PwC referenced Rule 10b-5 of the Securities Exchange Act of 1934
in charging the firm with making untrue statements of material fact and omitting to state
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 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 language to hint at the possibility of a willful cooking of
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would not have committed fraud nor manipulated earning to trigger bonus payments. They acted
out of self-interest and not in the interests of the shareholders and other stakeholders thereby
violating their fiduciary duties. The inescapable conclusion is the “leaders” were inauthentic and
created an unhealthy ethical environment.
The SEC’s analysis of the Krispy Kreme case below goes beyond the facts in the case and may
be worth discussing with students.
1
In our judgment, Livengood as CEO and Tate as COO failed to
establish a management tone and environment that demanded accurate
accounting and financial reporting or to put in place controls,
appropriate management tone and environment and to put in place adequate
controls, procedures and resources. Although he came from outside the Company,
and had public company experience, Tate did not bring with him an emphasis on
It appears to us that Livengood was too focused on meeting and exceeding Wall
Street expectations and gave too little attention to establishing the appropriate
tone from the top. While setting an aggressive growth agenda, Livengood
disregarded essential requirements of public company stewardship: sufficient
internal controls and procedures for managing rapid growth and ensuring accurate
accounting and reporting, including senior management oversight, broad-based
internal communication and an adequate number of personnel with the requisite
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3. Do you believe PwC violated its independence obligation in its relationship with Krispy
Kreme and audit of its financial statements? What about other ethical requirements?
Explain.
The following excerpt from the case illustrates the compromise made by PwC with respect to its
independence.
PwC provided independent audit services and rendered audit opinions on Krispy Kreme’s
FY2003 and FY2004 financial statements. The firm also provided significant consulting,
tax, and due diligence services. Specifically, PwC provided consulting services for
employee benefit audits; business acquisitions; accounting consultations including on
One would think that earning 2/3 of its total fees from nonaudit services impairs independence in
appearance if not factual independence. Moreover, the scope of the nonaudit services lends itself
to compromising objectivity on the audit including advice on business acquisitions, joint
ventures, and the cost segregation study. The Sarbanes-Oxley Act prohibits some of the nonaudit
services provided to Krispy Kreme because of the independence requirement when auditing a
client.
As for other ethical requirements, PwC clearly did not exercise the level of care expected in an
audit such as for Krispy Kreme. The following excerpt from the text illustrates the firm’s
disregard for proper accounting for franchisee payments.
” The manager explained that the doughnuts would be returned for credit the following
week—once FY2005 was under way. Apparently, it was common practice for Krispy
4. Using the Fraud Triangle, analyze the incentives, motivations, and/or pressures that
existed and how management took advantage of its opportunities to commit the fraud.
Incentives/Pressures
The following are some of the signs that management of Krispy Kreme was motivated to push
the envelope with its accounting in order to manage earnings and make it appear that the
company was doing better than it really was.
• Unusually rapid growth, especially compared to other companies in the industry;
• Excessive concern by management to maintain or increase earnings and share prices;
• Unduly aggressive financial targets and expectations for operating personnel set by
management.
Opportunity
A key factor here was the domination of management by a single person or small group
without compensating controls such as effective oversight by the board of directors or audit
committee.
Rationalizations
Krispy Kreme management believed it had to get its earnings numbers up to meet Wall Street
projections and continue to show an increasing level of earnings at the company. The
following statement from the facts of the case reflects the pressure felt by firm management