Accounting Ethics
Case 8-5
Kreme Doughnuts Krispy, 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 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
in return for the franchisee 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 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 negotiations, Krispy Kreme demanded payment of a “management fee” inconsideration 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 Liven good 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 Liven good 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, and13a-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 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. On March 4, 2009, the SEC reached agreement with three former top Krispy Kreme officials, including one-time chair, CEO, and president Scott Liven good. Liven good, former COO John Tate, and CFO Randy Cass evens all agreed to pay more than $783,000 for violating accounting laws and fraud in connection with their management of the company. Liven good 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. Cass evens was found in violation of fraud, reporting provisions, record keeping, internal controls, and false certification rules. Liven good’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 Cass evens 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
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.
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 provided independent audit services and rendered audit opinions on Krispy Kreme’s FY2003 and FY2004financial statements. The firm also provided significant consulting, tax, and due diligence services. Specifically provided consulting services for employee benefit audits; business acquisitions; accounting consultations including on joint ventures; tax compliance services; tax advice and planning services; services for a cost segregation study prepared by PwC; and actuarial services in connection with the company’s insurance plans. Of the total fees received during this period, 66 percent (FY2003) and 61 percent (FY2004) were for non audit services. The lawsuit alleged that PwC was highly motivated not to allow any auditing disagreements with Krispy Kreme management to interfere with its non audit 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 company’s 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: 2 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 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 omitting to state material facts necessary to make Krispy Kreme’s financial statements not misleading. The company wound up restating its statements for the FY2003 through FY2004 period.
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.
2 Evaluate the corporate governance at Krispy Kreme during its financial statement fraud including management’s stewardship responsibility to owners
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.
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.
In each of round-trip transactions, Krispy Kreme paid money to franchisee with an understanding that franchisee would pay the money back to Krispy Kreme in a pre-arranged manner that it would allow Krispy Kreme for recording additional pre-tax net income with amount roughly equal to funds originally paid to franchisee. This circular approach for revenue recognition violates rule that revenue should it be recognized when it is actually realized or realizable & when it is earned. Round-trip transactions of Krispy Kreme do not meet second criteria of the revenue recognition. It was not earned until franchisee paid money back to Krispy Kreme.
2. Internal investigation report criticized company’s board of director, it said was “overly the deferential in its relationship with the Livengood & it failed to adequately oversee managemens decisions.” Report stated that, every employee /franchisee which was interviewed repeatedly & firmly denied deliberately scheming for distorting earnings or being ordered for doing so. Report used with carefully nuanced language to hint at possibility for willful cooking of the books. Where were internal controls, internal auditors, and audit committee / tip hotline to aid in a preventing ethical lapses? Thus, corporate governance at Krispy Kreme would be considered as weak during the period of FY 2003 and 2004.
For fiscal year 2002 & 2003, Krispy Kreme paid an incentive bonuses to its top levelexecutives. Bonuses were paid when the quarterly EPS exceeded by at least one cent of Wall Street expectations or at the time of issued, Krispy Kreme’s quarterly guidance. These incentive plan weakens corporate governance further.
The management’s stewardship responsibility to the owners embodies responsible planning & management of resources. The Management stewardship theory assumes that the managers will act as the responsible stewards over assets they control. In case of Krispy Kreme, Livengood, Tate & Casstevens did not act for responsible stewards. Had they all acted as the responsible stewards, they would not have committed for fraud nor manipulated earning for triggering bonus payments. They have acted out of the self-interest and it is not in interests of shareholders & other stakeholders thereby violating the fiduciary duties.
3.
Auditor has the responsibility for planing and perform the audit for detecting material misstatement whether due to an error or fraud. Auditor relies on the professional skepticism in identifying the material weaknesses in an internal controls & misstatements in financial statements. Due care is requires that auditor should obtain with sufficient competent evidential matter for properly evaluating whether fraud exists or the material misstatements have been made in financial statements. Based on audit risk assessment, auditor should develop programs and an audit procedures for obtaining reasonable assurance that all the significant errors and fraud have been identified.
Whenever if auditor has determined that there is evidence that any fraud may exist, such matter should be brought to attention of appropriate level of the management. Fraud wich causes material misstatement of financial statements must be reported directly to audit committee or board of the directors. Financial statements must be corrected retroactively & correct procedures used going forward.
4.
First round-trip transaction inflated purchase of franchise so that seller would buy an equipment from Krispy Kreme; Krispy Kreme had treated a purchase of equipment as an ordinary income. Information in case does not disclose whether an equipment was ever delivered to seller or if it was just sham transaction to for increaseing Krispy Kreme’s income. (Why would the seller need Krispy Kreme equipment, if he had sold franchise back to Krispy Kreme?)
Second round-trip transaction had inflated a purchase price in return for receiving the litigation or a disputed settlement; this would not considered as franchise fee or an income.
In third round-trip transaction, purchase price was inflated for covering a management fee. Here management fee could correctly be considered as continuing franchise fee under SFAS No. 45. However, here Krispy Kreme collected one time management fee for a month prior to the sell of franchise. Thus, this fee might not qualify as continuing franchise fee & it was not initial franchise fee because it was at termination of franchise by seller.
