On March 4, 2009, the SEC reached an agreement with Krispy Kreme Doughnuts, Inc., and issued a cease-anddesist 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. 2 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 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 FY2004. In connection with the reacquisition of a franchise in Texas, Krispy Kreme increased the price that it paid for the franchise by $800,000 (i.e., from $65,000,000 to $65,800,000) in return for the franchisee purchasing from Krispy Kreme certain doughnutmaking 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 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 franchis 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 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 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 FY2004, explaining "that Krispy Kreme wanted to boost the sales for the fiscal year in order to meet Wall Street projections." 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 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-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 May 2005, Krispy Kreme disclosed disappointing earnings for the first quarter of FY2005 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 FY2003 and the fourth quarter of FY2004. 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 FY2003 through the third quarter of FY2004 or, in the case of the fourth quarter of FY2004, 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 onetime chair, CEO, and president Scott Livengood. Livengood, former COO John Tate, and CFO Randy Casstevens 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 certification regulations. Tate was found in violation of fraud, reporting provisions, recordkeeping, and internal controls rules. Casstevens was found in violation of fraud, reporting provisions, recordkeeping, 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 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 itself was not required to pay a civil penalty because of its cooperation with the SEC in the case.
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?
2. Evaluate the corporate governance at Krispy Kreme during its financial statement fraud including management's stewardship responsibility to owners.
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?