Krispy Kreme

[Miklos Vasarhelyi <miklosv@andromeda.rutgers.edu>]

Report Shows How
Krispy Kreme
Sweetened Results
Panel Says Doughnut Maker
Used 'Egregious' Practices,
Blames Ex-CEO, Directors

By MARK MAREMONT and RICK BROOKS 
Staff Reporters of THE WALL STREET JOURNAL
August 11, 2005; Page A1

Former executives at Krispy Kreme Doughnuts Inc. who oversaw its
rise from a regional chain to a highflying sensation used improper, even
"egregious," accounting to satisfy Wall Street's hunger for
growth, according to a sweeping internal report from the
company.

The report, which followed a 10-month investigation of the doughnut maker
by a special board committee, provided fresh details of how a team led by
former Chief Executive Scott A. Livengood fudged financial results during
the company's meteoric rise starting in the late 1990s. The report marked
the company's clearest account yet of its financial and governance
shortcomings, which first surfaced last year and led to the ouster of Mr.
Livengood and other senior executives.

After going public in 2000, Krispy Kreme sought to capitalize on Wall
Street's appetite for growth stocks at the end of the stock-market boom.
But the doughnut maker wasn't ready for prime time. The report, a 24-page
summary of which was made public in a regulatory filing yesterday, says
it lacked internal controls, didn't employ a general counsel for a
two-year period and hired three chief financial officers in four years --
including one who told the panel he wasn't comfortable in the
job.

"The Krispy Kreme story is one of a newly public company,
experiencing rapid growth, that failed to meet its accounting and
financial reporting obligations to its shareholders and the public,"
the report said.

Though the report stopped short of accusing former executives of outright
fraud, it included a strong condemnation of the former management team
led by Mr. Livengood, as well as the company's outside directors, noting
that senior managers "were profiting greatly" from questionable
accounting.

Indeed, the panel said Krispy Kreme's woes stemmed in part from a common
1990s-era practice: Setting earnings-per-share targets for Wall Street
analysts and then pushing to beat them by a penny. The panel noted that
executive bonuses were tied to exceeding those growth targets.
DOLLARS AND DOUGHNUTS

• Stock Chart: Sugary IPO to Ousted CEO1
 
REPORT SUMMARY

•

Read the summary2 of the committee's report.
 
•

Read excerpts3 from a press release on the report.
 

"While some may see the accounting errors...as relatively small in
magnitude, they were critical in a corporate culture driven by a narrowly
focused goal of exceeding projected earnings by a penny each
quarter," the report said.

Among other things, the panel slapped Mr. Livengood for what it said was
his abuse of corporate aircraft, reporting that in two years he racked up
at least $320,000 more in personal-flight costs than was permitted by the
board, while company filings hid the true costs from
shareholders.

It highlighted the company's decision to spend $500,000 to sponsor a
"storytelling festival" in the hometown of Mr. Livengood's
wife. Part of the money came from a "brand fund" paid for by
franchisees, some of whom have criticized the spending as a waste of
money for Mr. Livengood's personal benefit.

The panel also described several methods that it said were used to boost
results. For instance, it said Krispy Kreme improperly boosted profits by
shipping high-margin doughnut-making equipment to franchisees -- long
before they wanted or needed it.

Though the company would book revenue, some of that equipment would then
sit unused for months in trailers controlled by Krispy Kreme, and
franchisees didn't have to pay until it was actually installed, said one
person familiar with the probe's findings.

In another deal cited in the report, Krispy Kreme sold costly equipment
to a franchisee and booked it as revenue -- immediately before it bought
the same company for a price that was inflated by the cost of the
equipment.

The committee said it has turned over its full report, for which it said
it interviewed more than 100 people, to federal officials, who are
conducting criminal and civil investigations of Krispy Kreme's
accounting.

It also ordered a board shake-up, saying that a "substantial
majority" of new directors are needed. The board, it said, approved
big acquisitions based on little more than what it called
"back-of-the-envelope" calculations by executives, failed to
oversee management with "an appropriately skeptical eye," and
was "distracted" by the company's apparent success and Mr.
Livengood's charisma.

The panel didn't directly tie Mr. Livengood to any particular accounting
maneuver, but criticized him for setting aggressive growth targets and
being "too focused on meeting and exceeding" Wall Street
expectations, while disregarding "essential requirements of public
company stewardship." Mr. Livengood remained a consultant after
being forced out in January, but yesterday the panel said it cut off the
former CEO's monthly pay and medical benefits in May after he stopped
cooperating with its probe.

Mr. Livengood declined to comment yesterday. An attorney who is
representing him, F. Joseph Warin, said he and his client were
"pleased" that the committee had finished its work and that
"the report specifically stated that no employee said that they
participated in or were directed to manage earnings."

He added, "We strongly disagree with the subjective speculation of
the report. Mr. Livengood devoted his heart and soul to Krispy
Kreme."

Besides blaming Mr. Livengood, the panel singled out John W. Tate, the
company's former chief operating officer. The panel said Mr. Tate
"appears to have been directly involved in inappropriate efforts to
increase or accelerate the recognition of revenue."

Mr. Tate resigned in August 2004 and is now executive vice president and
chief operating officer at Restoration Hardware Inc., a retailer in Corte
Madera, Calif. David Siegel, a Los Angeles attorney who represents Mr.
Tate, said the former chief operating officer "denies any
wrongdoing."

The report marks an ugly postscript to the career of Mr. Livengood, who
started at Krispy Kreme as a personnel trainee and became its CEO in
1998. As CEO, he recounted that while growing up not far from the
company's Winston-Salem, N.C., headquarters, he was such a fan that he
ordered a plate of chocolate-covered, cream-filled Krispy Kremes for his
16th birthday. At his 2002 wedding, he served a cake made of 720
doughnuts.

It is also a blow for Krispy Kreme itself. Founded in 1937, the chain had
fewer than 100 stores in 1996 when it opened its first Manhattan store,
which helped catapult its glazed doughnuts to cult status and fuel rapid
growth. Today it has 420 stores in 45 U.S. states and five other
countries and sells doughnuts in thousands of supermarkets, convenience
stores, truck stops and other locations.

The panel's findings show that recent reforms intended to clean up
business practices haven't penetrated all executive suites and
boardrooms. The bulk of the accounting problems at Krispy Kreme occurred
after passage of the 2002 Sarbanes-Oxley Act, which was intended to
strengthen corporate governance.

But Charles Mulford, an accounting professor at Georgia Institute of
Technology in Atlanta, said the special committee's sharp criticism of
Messrs. Livengood and Tate and its move to reshape the board reflected a
new push by companies "to build a wall between themselves and former
officers" who allegedly use aggressive accounting.

"They're doing it to preserve as much shareholder value as possible,
but also to try to mitigate possible penalties from regulators," Mr.
Mulford said.

New management led by turnaround specialist Stephen F. Cooper has been
struggling to fix Krispy Kreme amid tumbling sales and signs of
franchisee financial distress. The company hasn't filed any financial
reports in nearly a year, and is unlikely to file its restated financials
for at least several more months.

As a result of the probe, Krispy Kreme said yesterday it would have to
restate its results downward back to before it first went public in 2000,
slicing an estimated $25.6 million from pretax profits over the years. Of
that, $22.2 million would be backed out of pretax profits from fiscal
year 2001 through fiscal 2005's third quarter, which ended last October,
about 9% of the $241.9 million in pretax profits originally reported over
that period.

Krispy Kreme shares, which hit a high of $49.37 in August 2003, rose 15
cents, or 2.1%, to close at $7.30 in 4 p.m. New York Stock Exchange
trading.

The company faces numerous lawsuits, including a shareholder lawsuit
claiming that it overpaid for franchises and misrepresented its sales
slowdown. In an unusual move, the board's special committee said it
"will not seek the dismissal of claims asserted" in shareholder
suits against Messrs. Livengood, Tate and another former executive,
citing "serious concerns about their discharge of their management
duties."

Some shareholders burned by the problems at Krispy Kreme said they hope
the boardroom changes pushed by the special committee will help the
company turn itself around. "I think this will have a sobering
effect on those who are left," said Don Hodges, co-manager of Hodges
Fund, a mutual fund in Dallas, which took a loss on its stake in the
doughnut maker but started buying shares again in March. "They've
got a great name that's known all across the country. It's a shame they
drug it through the mud."

The special committee probe was led by two outside directors who joined
the board late last year, Michael Sutton and Lizanne Thomas. Mr. Sutton
is a former chief accountant of the Securities and Exchange Commission.
Ms. Thomas is a partner in the Atlanta office of law firm Jones Day.
Attorneys from the law firm of Weil Gotshal & Manges LLP served as
outside counsel to the committee.

Write to Mark Maremont at
mark.maremont@wsj.com
4 and Rick Brooks at
rick.brooks@wsj.com5

Miklos A. Vasarhelyi
KPMG Professor of AIS
Rutgers University
Director Rutgers Accounting Research Center
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