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Wednesday, March 4, 2009

SEC Finds Krispy Kreme Misstated Earnings in 2003-04

The SEC issued an Order Instituting Administrative Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order (Order) against Krispy Kreme Doughnuts, Inc. (Krispy Kreme). The Order finds that Krispy Kreme materially misstated its earnings in its financial statements filed with the Commission between the fourth quarter of fiscal 2003 and the fourth quarter of fiscal 2004. In each of these periods, Krispy Kreme falsely reported earnings per share (EPS) equal to its EPS guidance plus one cent in the fourth quarter of fiscal 2003 through the third quarter of fiscal 2004 or, in the case of the fourth quarter of fiscal 2004, earnings that met its EPS guidance.

Specifically, Krispy Kreme improperly accounted for its incentive compensation plan for senior executive officers (Incentive Plan) and for three round-trip transactions in connection with the acquisition of company franchises. Krispy Kreme's accounting for the Incentive Plan operated as a de facto reserve accounting mechanism which virtually guaranteed that reported quarterly EPS would equal Krispy Kreme's quarterly guidance plus $0.01. For example, in the second and third quarters of fiscal 2004, Krispy Kreme reversed previously accrued incentive compensation expenses, which increased after-tax earnings by $569,999 and $499,999 respectively. By effecting the reversals, Krispy Kreme increased its earnings for each quarter and reported EPS that equaled its previously announced EPS guidance plus $0.01.

In the second, third and fourth quarters of fiscal 2004, Krispy Kreme engaged in round-trip transactions in connection with the reacquisition of a franchise. In each transaction, Krispy Kreme paid money to the franchise, the franchise paid the money back to Krispy Kreme in a pre-arranged manner and Krispy Kreme recorded additional pre-tax net income in an amount roughly equal to the funds originally paid to the franchise. The first round-trip transaction occurred in June 2003, in connection with the reacquisition of a franchise in Texas. Krispy Kreme increased the price it paid for the franchise by $800,000 in return for the franchise purchasing from Krispy Kreme certain doughnut making equipment at the request of Krispy Kreme. At closing, Krispy Kreme paid the additional amount to the franchise and then debited the franchise's bank account for the equipment. This additional revenue boosted Krispy Kreme's net income for the second quarter by approximately $365,000 after taxes. The second round-trip transaction occurred in October 2003, in connection with the reacquisition of a franchise in Michigan. Krispy Kreme increased the price it paid for the franchise in an amount that represented the approximate total of two disputed amounts that Krispy Kreme claimed it was owed by the Michigan franchise. When the reacquisition closed, Krispy Kreme recorded the transaction as if it had been reimbursed for the two disputed amounts and overstated its net income in the third quarter by approximately $310,000 after taxes. The third round-trip transaction occurred in January 2004, in connection with Krispy Kreme's reacquisition of the ownership interest of the manager of a franchise in California. A few days before the closing, Krispy Kreme provided the former franchise manager with funds that he immediately transferred back to Krispy Kreme as payment of a management fee. Krispy Kreme booked this fee as income, thereby overstating Krispy Kreme's net income in the fourth quarter by approximately $361,000.

Based on the above, pursuant to Section 21C of the Exchange Act, Krispy Kreme was Ordered to cease and desist from committing or causing violations and future violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13, promulgated thereunder. Krispy Kreme consented to the issuance of the Order without admitting or denying the findings in the Order.

In a related proceeding, the SEC issued an Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order (Order) against Sherry J. Polonsky. The Order finds that Polonsky, the former Senior Vice President of Finance for Krispy Kreme Doughnuts, Inc., caused Krispy Kreme to record improperly two round-trip transactions in connection with the acquisition of Company franchises located in Michigan and California in the third and fourth quarters of Krispy Kreme's 2004 fiscal year. In both transactions, Krispy Kreme paid money to the franchisee with the understanding that the franchisee would pay the money back to Krispy Kreme. In each instance, Krispy Kreme recognized additional income in an amount roughly equal to the funds that were paid back to it. As a result, Krispy Kreme filed annual, quarterly, and current reports with the Commission that contained misstated financial results, failed to have books and records that accurately and fairly reflected its transactions and disposition of assets, and failed to devise and maintain internal accounting controls sufficient to provide reasonable assurances that its accounts were accurately stated in accordance with generally accepted accounting principles.

Based on the above, Polonsky was ordered to cease and desist from causing any violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11, and 13a-13 thereunder. Polonsky consented to the issuance of the Order without admitting or denying the findings in the Order.

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