Krispy Kreme Dougnuts: Empty Calories or Empty Profits?
Case Study of the Impact of Sarbanes-Oxley Act ("SOX")

Krispy Kreme Doughnuts (KKD), a once high flying growth stock has been hampered as of late with shareholder lawsuits. When sales growth and earnings began to drop significantly in 2003, the company blamed its problems on the popularity of low-carbohydrate diets like Atkins and South Beach at the time. But the SEC began probing Krispy Kreme's accounting for franchise buybacks and is now facing shareholder lawsuits for inflating profits. Senior management officials allegedly knew of the problems, but continued to pad sales figures by doubling doughnut shipments to wholesale customers at the end of fiscal quarters, according to lawsuits.


Inflated Sales:

The suit alleges that between January 2003 and last May, when Krispy Kreme issued a profit warning, "the company issued false and misleading statements, including false financial results" and "repeatedly ratcheted upward its public quarterly and fiscal year revenue and earning projections ... all in the face of slowing sales and market saturation."

In addition, the lawsuit claims,CEO Scott Livengood, former COO officer John W. Tate and former CFO Randy S. Casstevens - "unloaded more than 475,000 shares of Krispy Kreme stock for proceeds of $19.8 million", while fully aware sales were declining since January 2003. The charges, leveled by two unidentified "confidential witnesses" who are former employees of the company, is included in a recent filing in the lawsuit.

According to one witness cited, Krispy Kreme double-shipped wholesale customer orders at the end of quarters on four separate occasions while the witness worked for the company.

Testimony by a former sales manager at a Krispy Kreme outlet in Ohio, said a regional manager ordered that retail store customers be sent double orders on the last Friday and Saturday of the 2004 fiscal year, 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 fiscal 2005 was under way.

The witness "understood that it was commonplace at Krispy Kreme to channel stuff in order to meet Wall Street expectations," according to the complaint.

Some could also 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 KKD's customers their purchases. In addition monthly variations analysis should have led someone to question the spike in doughnut shipments at fiscal year end.


Accounting Irregularities:

The SEC is investigating if Krispy Kreme used questionable methods to inflate profit when it bought back its Michigan franchise for $32.1 million last year. PWC refused to sign off on quarterly results. It was only after the firm retained the services of outside legal counsel to verify the methodology that Krispy Kreme was allowed to put the matter behind them. The outcome of the SEC investigation is still pending.

If PWC were not already under scrutiny for failing to detect inflated sales, PWC may have considered signing off on the accounting methodology based on immateriality. However, under SOX accountability and reporting requirements, Price WaterHouse had a profession and legal obligation to bring forth publicly, any irregularities immediately. When the smoke clears, expect Krispy Kreme to look for a new auditor in an attempt to appease shareholders.


Management Accountability:

Chief executive officer Scott Livengood "announced his retirement" at the age of 52 from Krispy Kreme Doughnuts Inc. (KKD) amid allegations of padded sales figures. Livengood was replaced as CEO by Stephen Cooper, a renowned industry turnaround specialist who most recently headed the Enron Corp. bankruptcy reorganization.

According to the company, Livengood will be paid $45,833 a month, the equivalent of his current base salary, for a six-month consulting term. Livengood's departure also triggers an option to purchase 330,125 shares of Krispy Kreme stock; he now has vested options to purchase more than 1.3 million shares.

In its latest SEC filing, the company said net income for the year could be reduced by as much as 7.6 percent.

Under SOX, senior management would still be liable for fraud for knowingly signing off on the financial results. In addition, I expect other senior management officials, particularly in Krispy Kreme's internal accounting division to depart in the coming months as management review should have been in place to question all the credits issued for the return of overshipments.

© 2005 Nelson Chin.

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