Krispy Kreme Case Study

Krispy Kreme fraudulently participated in a number of round-trip transactions in an effort to inflate their profits. In 2003 the company sold equipment to a franchise with the understanding that they would reimburse that location the cost of the equipment after the fiscal quarter was over. This inflated profits by $800,000 (Mintz 319).  Later in 2003, Krispy Kreme paid a franchise in Michigan more than half a million dollars more than originally agreed to increase profits for that quarter (319). Then, in 2004, Krispy Kreme charged a franchisee who was selling his location a “management fee” that was meant to be reimbursed to the company after the franchise was completely reabsorbed by corporate. They paid this franchisee for their location and then added additional money that was meant to be paid back as the agreed upon fee. This fee was recorded as income for the company, thereby inflating profits by $361,000 (319). This trend of round-trip trading was not only carried out by corporate management, however, but also individual franchise owners. An owner in Ohio told employees to send double shipments to their customers so that they could record sales knowing that the extra product would be returned after the end of the 2004 fiscal year (319).

All businesses are required to create internal control systems that help ensure accurate financial reporting (262). Krispy Kreme failed to follow these systems, allowing the fraud to be possible. The three occurrences of round-trip transactions should have never occurred in the first place since they were obviously carried out with the intention to commit fraud.  However, after the first two transactions occurred the company should have modified the previous fiscal year’s numbers or counted the returned profits as a loss. In the third instance of fraud, the company should have recorded the paid fee as a return because of overpayment rather than a fee. The money would have then been returned to the company instead of being counted as a payment, which then in turn inflated the profits.

Krispy Kreme is a franchise-run business. While there is corporate management, the majority of locations are run by private franchisees. The fraudulent acts uncovered during their audit were committed by both corporate and private management. The CEO, Scott Livengood, the COO, John Tate, and the CFO, Randy Casstevens, were all found guilty of fraud and other related charges (320). These members of management were responsible for reporting company sales to Wall Street, and, in turn, stockholders and owners. Unspecified management at the company recognized the issues and called for an internal investigation, which then led to an audit (320). These top-tiered members of management played an important role in the success and future of the company. If the company was not meeting its goals for the end of the fiscal year, it would be important for other members of the company to be aware of this so that they could come up with solutions to legally better the business. However, the chief officers hid the fact that the company was failing by using round-trip transactions. Instead of helping the company by honestly reporting profits, members of management lied in order to look better. As top-tiered members of management, these officers were given their positions because they were trusted to honestly report on the status of the company and help manage solutions for the company’s betterment. None of them fulfilled this role, and the lengths they took to cover up the company’s shortcomings could have potentially caused serious harm to corporate employees as well as franchises.

There are a number of steps that auditors should take after realizing there are materially misstated financial records. One of the auditors’ goals is to determine whether or not the material weaknesses are still present within the company. They are also responsible for evaluating whether or not the company had effective systems for financial reporting in place at the time of the supposed fraud (274). Auditors are also responsible for bringing possible fraud to the attention of the people within the company who are in charge of governance, and, in some cases, the SEC (274). Their correspondence should “describe the act, the circumstances of its occurrence, and the effect on the financial statements” (274). Ultimately, an auditor is not only responsible for looking at previous transactions to search for fraudulent activity, but also to ensure that the company has since modified its practices to prevent similar activity from happening again in the future.

The auditor must uphold certain guidelines while creating their report; that is, they must have reasonable assurance, materiality, and their report must be presented fairly (273-6).  The auditor is responsible for making sure that they have reasonably assessed the company’s finances. While they do not look at every single transaction performed by the company, they must assert that they looked at general transaction trends within the company to determine whether or not fraudulent activity occurred (273). Auditors must also use their discretion in materiality to determine whether or not financial statements have material misstatements in them. They are responsible for judging if they can reasonably assess the state of the company’s financial records as fraudulent or not based on a relatively small number of viewed transactions. The auditor must then present the information gathered fairly; that is, they must have used acceptable auditing standards and the results must be presented in an accurate, reasonable way (275).

In an auditing situation where it is discovered that the investigated company had material misstatements in previous fiscal years it is important for the auditor to check current financial procedures that are in place within the organization. Auditors are not only responsible for identifying fraud, but also ensuring that systems are in place to prevent similar acts of fraud from happening again. Similarly, they are responsible for investigating and reporting on what the causes of fraud were and what systems were responsible for allowing it to happen in the first place (283).

Krispy Kreme’s fraudulent activity came out of the franchisor-franchisee relationships that the company is built on. SFAS 45 dictates that some franchisors may sell things such as equipment to franchisees at no profit, and that when this kind of transaction takes place it should be recorded as receivables and payables as opposed to cost or profit (Kirk 16). However, in 2003 Krispy Kreme raised the price it paid for a franchised location in exchange for selling that location equipment. At the end of the fiscal year, Krispy Kreme charged that location for the price of the equipment, thereby counting the money they had paid themselves as profit. This exchange was in direct violation of the guidelines laid out by SFAS 45. Similarly, in 2003 Krispy Kreme increased the price it paid for a franchise by a significant amount of money and then recorded the increase as if the franchise had paid the company for two disputed charges, allowing them to inflate their profits. SFAS 45 states that franchise fees cannot be counted as revenue before all services as carried out (13). This was not the case, as the company counted the money it had spent on the franchise as reimbursement for disputed charges with that branch. Therefore, the money was falsely reported, and all services had not been performed since the dispute remained unsolved. In 2004 Krispy Kreme reacquired a franchise and charged them a management fee as part of the agreement, paying the management fee and then having it reimbursed to the company so it could be recorded as profit instead of a return. This violates SFAS 45, which states that revenue can be collected after the franchisor has performed all specified tasks, given the stipulation that all acts from both parties have been performed (5). This third case of fraud required a reimbursement after the terms of the reacquisition were settled, and the money taken here was used to inflate profits, thereby violating SFAS 45.

Works Cited

Kirk, Donald J. "FASB, Financial Accounting Standards Board." FAS 45. Financial Accounting Standards Board, 1981. Web. 31 Mar. 2017.

Mintz, Steven M., and Roselyn E. Morris. Ethical Obligations and Decision Making in Accounting. New York, NY: McGraw-Hill Education, 2017. Print.