Assessment of Krispy Kreme Doughnuts Incorporation

Subject: Assessment of Krispy Kreme Doughnuts Incorporation
1.1 History and Products of Krispy Kreme Doughnuts Incorporation
Krispy Kreme was founded by Vernon Rudolph in Marshall County and originally commenced with a doughnut method, a pack of cigarettes and a dream.  Even though from its creation the firm has frequently encountered business hardships due to economic and competitive conditions, they still manage to enter the market and build a good reputation.  Indeed in 1949 a laboratory was created in order to enhance product originality and quality (Arai J. et al. 2004).

Krispy Kreme is a leading corporation engaged in the wholesaling and retailing of high quality doughnuts.  From its inception in 1937 to date the organization have always strived to provide a variety of doughnuts to meet all the wants of its target clients.  Presently over 20 varieties are being marketed.  A number of beverage programs, like different kinds of coffee, where introduced in the product range of the company to complement the original good marketed.  The principal main distribution channels through which sales revenue is generated are the Company Stores, Franchise Fees and a number of supply chains attained through vertical integration (Securities Information, p 3-4).
The firm’s premises are both a manufacturing plant as well as retail outlets, on which on-premises company sales are generated.  Management has also developed a number of distribution channels, like convenience stores, groceries and more, through which off-premises company sales are attained (Securities Information, p 3).
Long ago the organization has noted a key managerial technique in which they can think globally and act locally.  In this respect a number of franchising agreements had been set in order to widen the market of the firm and enhance the revenue growth.  A vertical integration of supply chains was also carried out, managed under KK Supply Chains.  KK Supply Chain originate sales revenue from sale of doughnut mixes, equipment and coffee to franchisees and attains both the firm and the aforesaid franchisees via product knowledge and technical proficiency, together with appropriate control on critical production and distribution processes (Securities Information, p 4). Read about open access good example
1.1.1        Principle Officers of Krispy Kreme Doughnuts
The main officers of the organization are (Securities Information, p 124):
·          James H. Morgan – Chairperson of board of directors
·          Daryl G. Brewster – Chief Executive Officer
·          Michael C. Phalen – Chief Financial Officer
·          Douglas R. Muir – Chief Accounting Officer
·          Charles A. Blixt – Director
·          Robert S. McCoy Jr. – Director
·          Andrew J. Schindler – Director
1.2 Audit Risks
There are a number of audit risks that ought to be considered before accepting this client.  These are explained in the sub-sections below.
1.2.1 Adhering to Relevant Legislations
The products marketed by Krispy Kreme Doughnuts Incorporation are subject to food product regulation.  For instance product weight, packaging, content and other factors are periodically investigated to ensure compliance.  It has been noted that presently the corporation is subject to governmental investigations for a number of incidents.  For example,   on 12th May 2004, the claimant alleged that between August 2003 and May 2004 the organization conducted certain activities in violation of sections 10(b) and 20(a) of the Exchange Act and legal proceedings commenced on such case (Securities Information, p 27).
Due to the aforementioned investigations the issue of contingent liabilities comes into force.   The auditor is required to increase the audit tests on contingencies in order to control the detection risk (ACCA Paper 6, 2000, p 335).  Apart from involving additional work, there is the risk that something remains undetected that can materially affect the truth and fairness of the financial statements. In fact the organization frequently incurs litigation costs arising from such incidents as portrayed in the past two years income statements of the firm.
1.2.2 Reliance on Franchisees
The sales revenue of the organization relies heavily on the franchisees, who are independent contractors and do not comprise employees of Krispy Kreme Doughnuts Incorporation.  Disputes that may arise with these entities may lead to a significant negative effect on the financial health of the company (Securities Information, p 19).  Therefore a risk element present in this area is that the firm’s profitability is vulnerable to such negotiations plus legal proceedings may occur directing to contingent liabilities. Read about Doughnut Industry
1.2.3 Sales generated from Company Stores
The highest proportion of sales generated by the company arises from the corporation’s stores.  In 2006, it amounted to 73% of the total sales revenue.  A section of this sales category is generated from in-house retail outlets in the firm’s premises.  In this division the majority of the sales made from clients comprise cash sales.  As a result a high amount of sales will be on cash leading greater scope to understatement of sales and/or theft of cash (U.S. Government Accountability Office).  Therefore a high inherent risk on sales will arise due to the nature of the transaction.
1.2.4 Industry and Market Risk
The market in which the organization operates is very dynamic and subject to client’s tastes and preferences, which are susceptible to change.  The continuous movement for dietary and health preferences is also influencing the type of doughnuts that the organization ought to focus on.  Such changes in the product mix can significantly influence the sources of income and the profit elements of the firm.  Indeed presently doubts about the ability of Krispy Kreme Incorporation to get back on her feet from the worrying losses is in doubt (Hogan M. 2006). As a result, the applicability of analytical procedures on the income statement would diminish necessitating during the audit fieldwork necessitating more detailed substantive tests on such area (Jiambalvo J, 2001, p 99).
1.2.5 The Management of Krispy Kreme Doughnuts Incorporation
The firm’s executive management holds considerable reputation and experience in the business area the organization is employed in (Gogoi P. 2006).  Concern about internal control procedures shown by management, reveal for instance that a good control environment exists sustained by managers.  Thus the risk of fraud induced from top management is remote and there is a high probability of appropriate cooperation from such parties with the audit team.  This is a very positive feature on this client.
1.3 Financial Health of Krispy Kreme Doughnuts Incorporation
Krispy Kreme Doughnuts Incorporation financial health is presently very weak as portrayed by the accounting ratios measured in Exhibit A.  The firm is facing losses, together with negative net current assets.
Further amplification of these categories reveals that even though negative profits, the efficiency of management in generating lower losses from the resources employed in the organization improved by a reduction in the return on capital employed of 29.67%.  The losses generated from every $100 of sales also decreased by 15.83% indicating better control on costs.  In addition, the gross profit margin shows that if proper cost exercises are conducted, the firm can attain profits, since a good 15.57% gross profit margin is derived from every $100 sales (Weetman P. 2003, p 365-366).
A slight development in the financial position occurred by a small improvement in the ability of the current assets to cover the current liabilities.  The most liquid assets also improved as shown by the Quick Ratio (Lewis R. et al 1996, p 382-383).  This may be the result from better working capital management, such as a decrease in the time taken to collect money from trade debtors.  However, the net current assets are still negative revealing that the current assets of the firm are not capable to cover all the current liabilities, which is a serious issue.
The capital structure of the organization comprises one of a low-geared company.  This means that the ratio of debt is in a lower proportion than equity.  Low-geared companies are considered as less risky corporations due to lower interest commitments.  Yet the ability of the firm to cover interest expenses out of profits is critical because the enterprise is operating at a loss (Weetman P. 2003, p 369).  It is imperative that profitability further improves in order to recover the stability of the organization as it happened from 2005 to 2006.
Overall the company’s financial health is improving as shown by the time series analysis conducted in Exhibit B.  However there are still significant doubts on the company’s going concern, because if an adverse unexpected business factor happens, the firm may face bankruptcy.  This is a serious audit issue, because important features of the financial statements upon which we conduct our audit opinion will be the going concern assumption of the organization (ACCA Paper 6, 2000, p 104).
1.4 Recommendation of Client Evaluated
The audit risk evaluation of Krispy Kreme Doughnuts Incorporation revealed the following positive and negative features:
Positive Features
Negative Factors
Executive management of the company holds a good reputation.
High reliance on Franchisees.
Risk of understatement of sales and cash.
High market risk.
Weak financial health.
In view of the audit risks mentioned in the table above one can note that the issues of the organization are significant and substantial audit work needs to be carried out by the auditor in order to minimize the overall audit risk.  However at this stage, we cannot fully ascertain the value of the audit risk of Krispy Kreme Incorporation’s audit.  For instance we have not yet conducted a preliminary review of the internal controls of the firm through discussions with management on such matter (ACCA Paper 6, 2000, p 130).  This hinders us from providing an accurate value of the control risk.
Substantial information was gathered for the other uncontrollable risk, commonly known as inherent risk.  Indeed with respect to such factor we can provide a reliable assessment.  However, it is also necessary to conduct discussions with management with respect to the audit to obtain a better understanding of their willingness and value provided to the intended audit.
An overall estimate that can be provided from the information gathered on the audit risk elements is portrayed below:
Overall Audit Risk:
Inherent Risk (High) x Control Risk (Medium) x Detection Risk (Low)
The detection risk is considered high because it is the only variable that can be influenced by the auditor.  If the other risks are assessed a high figure, then it is imperative that the auditor increases the amount of substantive procedures in order to minimize the risk that a substantive test will not detect a material error or misstatement (ACCA Paper 6, 2000, p 97).  In this respect, we should not reject the audit of Krispy Kreme Incorporation solely on grounds of high inherent risk.  We ought to evaluate the overall audit by considering factors such as availability of time during the audit and other risk factors.  For example, control risk appears to be moderate, thus compensating for a lower overall audit risk.  At this stage, I suggest that further investigation and discussions should be carried out in order to obtain more information on the audit and thus be capable to take a decision based on more concrete evidence.
Exhibit A – Determination of Accounting Ratios
Profitability
Liquidity
Stability
Exhibit B – Time Series Analysis
References:
AAT Unit 17 Interactive Text (2004).  Implementing Auditing Procedures. New York:  BPP Publishing Limited.
ACCA Paper 6 Study Text (2000). The Audit Framework International Stream. Fourth Edition. New York: BPP Publishing Limited.
Arai J.; Shay W.; Robinson F. (2004). Krispy Kreme Doughnut Corporation Records, American History (on line). Available from: http://americanhistory.si.edu/archives/d7594.htm (Accessed 26th April 2007).
Gogoi P. (2006). A Taste for Tim Hortons?, Businessweek.com (on line). Available from: http://www.businessweek.com/investor/content/mar2006/pi20060321_777334.htm (Accessed 26th April 2007).
Hogan M. (2006). Can Krispy Kreme Rise Again?, Businessweek.com (on line). Available from: http://www.businessweek.com/investor/content/mar2006/pi20060307_732175.htm?campaign_id=nws_insdr_mar10&link_position=link7 (Accessed 26th April 2007).
Jiambalvo J.; Kennedy J. (2001). Analytical Procedures and Audit Planning Decisions, Journal of Accountancy, Vol. 191, Issue 2.
Lewis R.; Pendrill D. (1996). Advanced Financial Accounting. Fifth Edition. London: Pitman Publishing.
Securities Information. Krispy Kreme Doughnuts Incorporation (on line). Available from: http://www.secinfo.com/d14qfp.uUm.htm (Accessed 26th April 2007).
U.S. Government Accountability Office. Field Work Standards for Performance Audits (on line). Available from: http://www.gao.gov/govaud/ybhtml/doc6.html (Accessed 26th April 2007).
Weetman P. (2003). Financial and Management Accounting. Third Edition. England: Pearson Education Limited.