On March 4, 2009, the SEC reached an agreement with Krispy Kreme Doughnuts, Incorporated, 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 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 doughnut-making equipment. On the day of the closing, Krispy Kreme debited the franchises bank account for $744,000, which was the aggregate list price of the equipment. The additional revenue boosted Krispy Kremes 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 Kremes 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 Kremes 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 negotiations, Krispy Kreme demanded payment of a management fee in consideration of Krispy Kremes 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 weekonce 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's auditorsPwCshould 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 Kremes 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 companys 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 companys 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 companys earnings may have been manipulated to please Wall Street. The committee also criticized the companys 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.

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 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, record-keeping, and internal controls rules. Casstevens was found in violation of fraud, reporting provisions, record-keeping, internal controls, and false certification rules. Livengoods 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. Tates 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.

SEC Charges against PricewaterhouseCoopers ²

In a lawsuit brought on behalf of the Eastside Investors group against Krispy Kreme Doughnuts, Incorporated, 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 Kremes FY2003 and FY2004 financial statements. The firm also provided significant consulting, tax, and due diligence services. Of the total fees received during this period, 66 percent (FY2003) and 61 percent (FY2004) were for nonaudit services. The lawsuit alleged that PwC was highly motivated not to allow any auditing disagreements with Krispy Kreme management to interfere with its nonaudit services.

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 violations of GAAP rules with respect to accounting for franchise rights and the companys relationship with its 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 such as effective oversight by the board of directors or audit committee;

unduly aggressive financial targets and expectations for operating personnel set by management; and

significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm.

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 failing to state material facts necessary to make Krispy Kremes financial statements not misleading. The company wound up restating its statements for the FY2003 through FY2004 period.

Describe the financial shenanigans used by Krispy Kreme. In this regard, is earnings management always a sign of failed leadership?