Accounting 557 Assignment 1
Student EAS
Professor Alfred Greenfield
Strayer University
27 October 2013

Many organizations have been in the news over the past few years due to accounting ethical breaches that have affected their customers, employees, and the general public. I searched the Internet to locate a story in the news that depicts an accounting ethical breach. I selected Krispy Kreme. I enjoy their hot donuts and was curious to learn more about how they played with the numbers. For some reason I always want to dig into the trickery behind the manipulation of financial statements.
When we get right down to it playing games is what happens. Someone comes along and they think they know something the rest of us are too dumb to know. They think they are special and that God bestowed upon them special powers to get away with something no one else has been able to get away with in the entire history of mankind. I am intrigued with the thought process behind the faces of these people who think they have what it takes to trick the rest of us. I can only think of a few words; hubris, vanity, ego, arrogance and delusional. I do not believe it is truly possible to ever get away with anything. No man has a good enough memory to be a successful liar.
Given the corporate ethical breaches in recent times, I will assess whether or not I believe that the current business and regulatory environment is more conducive to ethical behavior. I will say up front that as I start this paper I do not believe anything has improved in America or in the world ethically speaking. I say this with confidence but not with pride. After all we are all human and we all have a sin nature. I do not care if a person tells me they do not believe in God or if they tell me they do believe in God. Research has proven conclusively that all of us cheat. We essentially weigh everything based upon a simple cost-benefit analysis and then decide if the rewards are worth the risk of being caught and the possible punishment.
We will review recent ethical breaches from a business and government standpoint. We should keep in mind that the U.S. government is the world’s biggest employer. However, to be fair we must remind ourselves that we are no better than the businesses and government agencies that lie, steal and cheat. When we judge others we must also judge ourselves. We are all the same when it comes to the human propensity to lie, steal and cheat if we think we can get away without being discovered.
In America we care about ethics. We care about what is right and what is wrong. The United States was formed based upon Christian ethics and principals summed up in the Golden Rule advocated by Jesus Christ. While corporations and governments are technically “people” they are rarely treated as harshly as private citizens when the rules are broken. When corporations, including government entities, have committed unethical acts, historically they have never been held to the same level of accountability as we are held as individuals. It can be argued further that people receive the greatest punishments when caught. Businesses receive a lesser punishment and governments are rarely held accountable at all for their transgressions and incompetency. What is the reason for this triple standard?
If you are a cynical sort then maybe you want to believe unethical malfeasance is overlooked because of the contributions politicians receive. I am also cynical but the reason many organizations (business & government) go unpunished, or under punished, is more complicated. What would happen if every organization involved in wrong doing was dissolved and destroyed like Arthur Anderson was following the collapse of Enron in 2002? What if the IRS, the EPA, the Bureau of Indian Affairs were all shut down because of their past abuses of power and failure to properly track and administer the funds entrusted to them?
Whatever the reason for the triple standard between punishing people crime, punishing corporate crime, and punishing government crime, we should start by asking if the U.S. government really cares about non-violent crime. Even though we have very strict regulations on everything from money laundering to banking transparency, banks like Standard Chartered and Barclays have took hits for corporate crimes. Bribery allegations, fines and settlements have hurt businesses such as Siemens, KBR, and Alcatel-Lucent.
We need to understand that when company officials, or government officials achieve power over others, there will be some who will abuse the trust they have been given. Internal controls and locks only keep honest people honest. People run corporations and the government. People will skirt the law if the potential for gain appears to be great and the risk of being caught appears small. Human activity, businesses and government included, is based upon capital allocation and a risk-reward analysis; if the profits to be gained from cheating outweigh the probability-adjusted consequences of being caught and punished, then it makes sense to go for it.
Professor Dan Arielly is the James B. Duke Professor of Psychology and Behavioral Economics at Duke University, with appointments at the Fuqua School of Business, the Center for Cognitive Neuroscience, the Department of Economics, and the School of Medicine. The professor has extensively studied and researched the human nature behind dishonesty. We all behave dishonestly at work and at home; you and I included. So if research proves that we all have a propensity to cheat and be somewhat criminal, then I believe it is crucially important that we understand how dishonesty operates. Doing this will help us figure out ways to contain and control the propensity to behave dishonestly.
Let us consider the drug companies who have been fined. Pfizer, Lilly and Johnson & Johnson have all paid billions in fines for not properly marketing certain drugs per FDA guidelines. Are these evil companies simply out to make money and the world be damned? Or is it a little more complicated than that? Could part of the problem be that our government (FDA) is overly zealous (excessively controlling) and the regulations for complying overly burdensome and bureaucratically excessive? I do not doubt it.
Government organizations should not be exempted from being competent and treating all with dignity and respect. But when we discuss corporate ethics we must also factor in the impact government policies and regulations have upon all of us. The government is not innocent and above reproach. The bigger government grows the more uncoordinated, incompetent, and unaccountable government becomes; historical fact.
Given the nature of government organizations showing little empathy for the businesses and individuals they effect with excessive and burdensome legislation it is understandable that the government could find lots of opportunities for fining virtually all of us. One of the top three reasons many small businesses go out of business is due to the excessive and burdensome costs and confusion resulting from government policies and rules. Now we have the so-called “Affordable” Care Act being incompetently implemented and taking over 20% of the U.S. economy. All of us, members of Congress and the president exempted, will be subject to IRS fines, penalties and possible jail time for noncompliance.
Let’s look at the fines and settlements that banks have had to pay for money laundering and for other violations. These fines represent a small percentage of the money made from the actions that resulted in sanctions and fines. So let’s think about this and use an illustration. If you go to work and steal $100 and the police catch you what should the penalty be? What if they base the fine on what you stole and the officer takes you to the judge and the judge tells you that you owe $10 for stealing $100. You pay the court the $10 and they release you with the remaining $90 in your pocket.
Absurd yes but a good analogy none the less for white collar crime. This highlights the relationship between the government and white collar crime. Government has not shown they are serious about curbing white collar crime. The government waits for a fire (a catastrophe like Enron or the HUD caused housing disaster) and then they wring their hands and demand meetings and promise to get to the bottom of the matter. Or the president goes on television and claims everything is a phony scandal. Sometimes emotional legislation gets passed and everyone goes back to sleep until the next calamity occurs; corporate or governmental.
There have been relatively few cases of imprisonment for corporate and government wrong doers. There has been no jail time in the BP Deepwater Horizon accident. In the Enron fiasco the CEO, Kenneth Lay, the COO, Jeff Skilling, and the CFO, Andrew Fastow, all received token prison sentences considering the financial devastation they directly orchestrated upon thousands of innocent employees and investors. And absolutely no one at HUD, Fannie Mae and Freddie Mac was called to task for bad policies that pressured banks to make bad loans that ultimately led to the housing disaster.
Had an individual saboteur caused the BP or Union Carbide Bhopal disaster, I think that the person would sit in jail for quite some time; but when it's a faceless company or a government beauraucracy, it's just a fine, a consent decree or perhaps a showy appearance before suitably grim-faced Congressmen and then back to business. As a result, there will be always be a next scandal.
As long as we have a reactionary approach to ethical violations and betrayal of trust in positions of power and authority we will continue playing this merry-go-round. If it's cheaper to just pay a fine than change a profitable corporate practice, why would a company change, why would the government change (especially with the peer pressure and collective deniability that goes with a corporate and government structure)?
The case for going easy on corporate and government wrong doing is deeply entrenched. Is there an argument for giving preferential treatment to corporations and government officials, as opposed to private citizens, when it comes to violations of the law? Perhaps so. Effectively killing a business or government organization, a large one at any rate, will harm hundreds or thousands of employees and workers, many of whom likely had no knowledge of, or part in, the wrongdoing. Why can’t we simply enforce stiff prison sentences with a zero tolerance policy similar to other crime categories like drug trafficking, etc?
Bringing down a major business reduces the country's potential tax receipts, to say nothing of the potentially far-reaching impact to suppliers, clients and other related parties who also likely had no part in the original illegal act. In the same way that jailing a criminal's family punishes the innocent, severely punishing a drug company, bank, or government agency would very likely produce a ripple effect that punishes many other innocent companies and people.
All of this said, it doesn't excuse a failure to more aggressively target corporate and government executives. If FINRA has been given the power to banish stockbrokers and broker/dealer executives from the securities industry, why couldn't the Department of Justice get similar authority to suspend or banish industry executives and prosecute government officials? Of course, to date the DOJ has shown little inclination to police its own under Holder (the DEA’s Fast and Furious operation, HUD, the HHS, and the IRS indiscretions all got a free pass). Likewise, I suspect that corporate and government behavior would start to change if a few drug, energy, financial, or government executives ended up sitting in a cell.
The case should be made for harsher corporate and government punishment. If there's a case to be made for going easier on company and government officials, there's also a case for going even harder on them. It seems fundamentally unfair to strictly enforce individual responsibility, but give a pass to corporate/government officials’ responsibilities. Otherwise, you can reach a pretty antisocial conclusion that crime is OK, so long as there are enough criminals acting together. Likewise, I believe separate legal systems and processes for corporations, government entities and people can reinforce classism; the bigger, richer and more powerful you are, the more likely you are to receive special treatment. Although I believe this has been the status quo; way things have always been, it's still bad as a matter of policy.
It's also well worth noting that corporate and government wrongdoing can inflict serious harm. BP's Gulf of Mexico accident hurt a lot of people in a variety of industries (including tourism, fishing and energy), improperly-marketed drugs can lead directly to serious side-effects (or at least wasted money), and then there was HUD, Fannie Mae and Freddie Mac that dictated the irresponsible lending practices of commercial and investment banks during the housing boom ultimately making home loans to hundreds of thousands (if not millions) of Americans who should not have qualified.
Clearly, the current philosophy regarding corporate and government executive punishment has not been sufficient to discourage wrong actions - bribery, pollution, favoritism, and illegal marketing cases continue to crop up year after year. At a minimum, it seems there's an argument to be made that punishments need to, at least, be increased to a point where there are lasting economic consequences of serious bad behavior.
What is the bottom line? At a minimum, a rule of law is important within any civilization and bad things happen when certain groups in a society get preferential treatment. Currently corporate and government officials appear to be above the law in so many cases. The IRS can’t account for $60 million in lost funds. The HHS is spending over $500 million on a website that does not function and they had three years to have the website ready.
By no means should the Department of Justice or federal government look to decimate the Fortune 500. Nor should we close down many of the government departments that have proven incompetent and irresponsible in both the management of billions of taxpayer dollars and the implementation of legislation that hurts more than it helps.
At the same time, the government ought to realize that any organization (corporate or governmental) will get the behavior it incentivizes. If company and government leaders can knowingly break laws, get caught and still profit (on balance) from it, they will continue to do so. At a minimum, perhaps it is time for the legal system to hold senior executives, board members, and government officials to a higher standard of behavior. If they have the right to hire and fire thousands, approve multi-billion dollar mergers/funding projects and collect large pay packages, it doesn't seem exactly unfair to also make them more accountable for what happens on their watch.
Based on my research, I will describe the Krispy Kreme organization, the accounting ethical breach and the impact to the organization related to the ethical breach. The former CEO and COO at Krispy Kreme Doughnuts Inc. who oversaw its rise from a regional chain to a highflying sensation used improper accounting after the company went public in the 1990s. They did this to satisfy Wall Street's pressure for positive earnings growth, according to an internal report from the company.
The report followed a 10-month investigation of Krispy Kreme by a special board committee. The internal report provided details of how a team led by former CEO Scott A. Livengood fudged financial results starting in the late 1990s. The report marked the company's clearest account yet of its financial and governance shortcomings and led to the retirement of Mr. Livengood, the resignation of the COO, and the termination of others.
After going public in 2000, Krispy Kreme tried to capitalize on Wall Street's appetite for growth stocks but the company wasn't ready. The report, a 24-page summary of which was made public in a regulatory filing, says Krispy Kreme lacked proper 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. Having a high turnover for the CFO position tells me as an accountant that the CFOs were leaving because they did not like what they observed regarding the Krispy Kreme accounting operations.
The report alleged that the former executives were profiting greatly from questionable accounting. The report did not directly allege that the CEO and COO committed fraud. The report did include a strong condemnation of the management. And the management is always led by the CEO and COO as well as the CFO. In the case of Krispy Kreme the CEO and the COO were running the show.
For reasons that are unclear the CFO was not directly involved in the accounting manipulations. Four CFOs had come and gone and we can only guess that they had been either uncooperative with the accounting manipulations being implemented by the CEO and COO or they elected to move on once they realized that accounting games were being played. The report makes it very clear that the accounting manipulations were the fault of the CEO Mr. Livengood, and the Krispy Kreme outside directors. It was confirmed and disclosed that the senior management had improperly profited from the accounting games from their bonuses.
On April 5, 2000, the corporation went public at $21 per share. The stock reached what would be its all-time high of $50 in August 2003, a gain of 235 percent in less than three years. For the fiscal year ended in February 2004, the company reported sales of $665.6 million and operating profits of $94.7 million from almost 400 stores (including international locations). The market initially considered the company as having "solid fundamentals, adding stores at a rapid clip and showing steadily increasing sales and earnings." Since then it had lost 75-80% of its value by 2005, amid earnings declines, as well as an SEC investigation over the company's alleged improper accounting practices.
Because of the SEC investigation into the improper accounting practices, Krispy Kreme lost up to 80% of its stock value! Who paid the price for that devaluation? Stockholders paid the price. The CEO and other senior management had already received their bonuses. The panel concluded something very important regarding the reasons why the senior management failed in their stewardship duties and responsibilities at Krispy Kreme. The panel said that the Krispy Kreme accounting problems stemmed in part from a common 1990s-era practice or mindset. Senior management of companies publicly traded were pressured to surpass the earnings-per-share targets or goals set by Wall Street analysts. CEOs often had their bonuses tied to exceeding those growth objectives.
In May 2004, the company missed quarterly estimates for the first time and suffered its first loss as a public company. We should not view the Krispy Kreme accounting games and manipulations as insignificant. In a corporate culture driven by a narrowly focused goal of exceeding projected earnings by even a penny a quarter the stage was set for weak executives to allow for accounting gimmicks, games, and manipulations. And this is exactly what occurred at Krispy Kreme under the noses of the senior management, the outside board of directors, the auditors and the SEC.
Determine how the organizational ethical issue was detected and how management failed to create an ethical environment. Management failed to create an ethical environment by failing to model ethics. The CEO Mr. Livengood was discovered to have abused his use of Krispy Kreme corporate aircraft. In a period of two years he racked up at least $320,000 more in personal-flight costs than was permitted by the board of directors. What was also an ethical lapse the company filings hid the true costs from shareholders.
Furthermore, it was revealed that the company decided to spend $500,000 to sponsor a "storytelling festival" in the hometown of the CEO’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 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 CEO Mr. Livengood's charisma.
The panel didn't directly tie CEO 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."
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.
Analyze the accounts impacted and / or accounting guidelines violated and the resulting impact to the business operation. 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.
Krispy Kreme installed new management amid tumbling sales and signs of franchisee financial distress. The company also had to issue restated financials. As a result of the probe, Krispy Kreme had 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, about 9% of the $241.9 million in pretax profits originally reported over that period.
The company faces numerous lawsuits, including a shareholder lawsuit claiming that it overpaid for franchises and misrepresented its sales slowdown.
As a CFO, recommend which measures could have been taken to prevent this ethical breach and how each measure should be implemented in the future. As a CFO I would recommend to the management team a review all internal controls. I would recommend having the financial statements reviewed to be sure GAAP was being consistently implemented and followed. I would review the relationships between the CEO, COO and other top management and the board of directors and the audit firm. It would be important that everyone on board maintained their perspective and independence. I would request for a training program that would educate the management regarding the cost of failing to enforce and safeguard the new internal controls. I would review all members of the accounting department from the controller on down. I would be looking for any weaknesses that would benefit from additional employee training.
References and sources:
Ariely, Dan (2012). The (Honest) Truth About Dishonesty (1st Edition). Harper Collins Publishers.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2012). Financial Accounting (8th Edition ed.). Hoboken, NJ: John Wiley & Sons, Inc. http://www.investopedia.com/financial-edge/0412/4-reasons-why-you-love-to-hate-big-businesses.aspx http://businessethicsmemo.blogspot.com/2007/04/lightest-shade-of-truth-earnings.html http://www.oxforddictionaries.com/us/definition/american_english/bureaucratic http://www.cashflowanalytics.com/news.php?articleID=89 http://www.businessweek.com/stories/2006-09-12/krispy-kreme-still-no-sugar-coatingbusinessweek-business-news-stock-market-and-financial-advice http://www.nasdaq.com/symbol/kkd/financials?query=balance-sheet http://www.nasdaq.com/symbol/kkd/financials?query=income-statement http://www.nasdaq.com/symbol/kkd/financials?query=cash-flow
http://www.nasdaq.com/symbol/kkd/financials?query=ratios