April 23, 2007

The Lightest Shade of Truth: Earnings Manipulation at Krispy Kreme and Beyond

Each financial quarter, public companies are required by the SEC to publish their latest financial statements in accordance with GAAP (generally accepted accounting principals). At the bottom of their income statement, companies must calculate their most recent earnings on a per share basis. Months prior to earnings announcements, financial analysts from across the industry have already calculated an expected earnings per share for most public companies.

Usually, when companies announce higher earnings than expected their market stock prices immediately increase as a result of further anticipation that the company will continue to perform better than expected. On the flip side, when earnings are below what was expected their stock prices immediately reflect investors’ loss of confidence. When Whole Foods announced a once cent shortfall of earnings in the first quarter of 2006 their stock dropped 9.4% in one day; this is despite the fact Whole Foods reported a 26% increase in earnings and a 22% increase in sales from the prior year. As a consequence, some companies feel inclined to do whatever they can to artificially boost their earnings and keep their market value of equity from dropping. The Chamber of Commerce has recognized the incentives that companies have to “cook the books” to meet Wall Street expectations, and has begun to encourage public companies to refrain from issuing quarterly earnings guidance reports.

On May 25, 2004, The Wall Street Journal published the first story criticizing Krispy Kreme’s accounting practices. In 2003, Krispy Kreme purchased a struggling seven-store Michigan franchise. As a stipulation of the deal, the franchise owner would pay Krispy Kreme the accrued interest on past due loans upon completion of the repurchase. The company recorded this as interest income, an immediate source of revenue; however, the company booked the purchase cost of the franchise as an intangible asset, which was not amortized.

Most franchise repurchases in the food and beverage industry take into account that most of the cost associated with repurchasing a franchise is associated with property, plant, and equipment. The standard practice for filing these is to amortize the cost of these assets over several years. These amortization costs are deducted from revenues and result in a lower net income for the period. Although Krispy Kreme reported earnings that failed to meet Wall Street expectations, without the amortization costs their reported net income was misleading and inaccurate.

Krispy Kreme kept investors in the dark about other things as well. The failing franchise owner was allowed to remain employed at the company after the deal, but shortly after, that executive left and was paid an additional $5 million in severance pay. Krispy Kreme also recorded this expense in the unamortized asset category as reacquired franchise rights. The New York Times reported that, “these failures led or contributed to accounting errors – substantially all of which had the effect of increasing EPS (earning per share).”

On January 4, 2005, after starkly denying any wrongdoing, the Krispy Kreme board of directors announced that the company’s previously-issued financial statements for the fiscal year ended February 2004 would be restated to “correct certain errors”. The board determined that the adjustment to be made, which principally related to the company’s accounting for the acquisitions of certain franchisees, would reduce pre-tax income for 2004 by $6.2 million to $8.1 million. The company will also restate its financials for the first and second quarters of 2005.

Krispy Kreme is not the first to mislead investors with accounting practices that inflate earnings, nor will they be the last. All managers of public companies should be aware that their responsibilities to shareholders are more than just an ever increasing share value. Managers are also responsible for giving investors the most accurate picture of their companies’ financial health. Despite the consequences for reporting earnings below analyst expectations, it is not only the right thing to do but it also is the best for the company. It’s probably reasonable to assume that Krispy Kreme would rather have taken a 10% loss like Whole Foods for reporting low earnings, than the 80% market value loss and the negative attention that they received for their accounting practices. In this case, it may be better to be conservative in accounting practices than risk misleading investors and triggering an investigation by the SEC.

Although companies are responsible for their accounting practices and decisions, perhaps there is also a flaw in the system as suggested by the Chamber of Commerce. Analysts estimate earnings expectations in order to aid investors in analyzing the financial health of the company, but these estimates are estimates and offer room for error and interpretation. These expectations also provide companies with an incentive to manage their books since there are obvious repercussions for failing to meet market expectations. Whole Foods was punished by investors despite sales and earnings growth that most companies would be proud of. Krispy Kreme and others have collapsed under pressure in order to meet Wall Streets expectations. Are these expected earnings estimates creating more harm to investors though inaccuracy and incentives to shade the truth than they are creating a tool that investors can use to make wise decisions? Perhaps it’s best that investors do their own digging into financial statements and not Wall Street analysts.