KKD » Topics » Critical Accounting Policies

These excerpts taken from the KKD 10-K filed Apr 17, 2008.

Critical Accounting Policies

     The Company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements that have been prepared in accordance with GAAP. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures, including disclosures of contingencies and uncertainties. GAAP provides the framework from which to make these estimates, assumptions and disclosures. The Company chooses accounting policies within GAAP that management believes are appropriate to accurately and fairly report the Company’s operating results and financial position in a consistent manner. Management regularly assesses these policies in light of changes in facts and circumstances and discusses the selection of accounting policies and significant accounting judgments with the audit committee of the Board of Directors. The Company believes that application of the following accounting policies involves judgments and estimates that are among the more significant used in the preparation of the financial statements, and that an understanding of these policies is important to understanding the Company’s financial condition and results of operations.

   Allowance for Doubtful Accounts

     Accounts receivable arise primarily from royalties earned on sales by the Company’s franchisees, sales by KK Supply Chain to our franchisees of equipment, mix and other supplies necessary to operate a Krispy Kreme store, as well as from off-premises sales by company stores to convenience and grocery stores and other customers. During the three years in the period ended February 3, 2008, some of the Company’s franchisees experienced financial difficulties or for other reasons did not comply with the normal payment terms for settlement of amounts due to the Company. The Company has recorded provisions for doubtful accounts related to its accounts receivable, including receivables from franchisees, in amounts which management believes are sufficient to provide for losses estimated to be sustained on realization of these receivables. Such estimates inherently involve uncertainties and assessments of the outcome of future events, and changes in facts and circumstances may result in adjustments to the provision for doubtful accounts.

53


   Goodwill and Identifiable Intangible Assets

     FAS 142, “Goodwill and Other Intangible Assets” (“FAS 142”), addresses the accounting and reporting of goodwill and other intangible assets subsequent to their acquisition. FAS 142 requires intangible assets with definite lives to be amortized over their estimated useful lives, while those with indefinite lives and goodwill are not subject to amortization but must be tested annually for impairment, or more frequently if events and circumstances indicate potential impairment.

     For intangible assets with indefinite lives, the Company performs the annual test for impairment as of December 31. The impairment test involves determining the fair values of the reporting units to which goodwill is assigned and comparing those fair values to the reporting units’ carrying values, including goodwill. To determine fair value for each reporting unit, the Company uses the fair value of the cash flows that the reporting unit can be expected to generate in the future. This valuation method requires management to project revenues, operating expenses, working capital investment, capital spending and cash flows for the reporting units over a multiyear period, as well as determine the weighted average cost of capital to be used as a discount rate. Significant management judgment is involved in preparing these estimates. Changes in projections or estimates could significantly change the estimated fair value of reporting units and affect the recorded balances of goodwill. In addition, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, future operating results and the balances of goodwill in the future could be affected by impairment charges. Impairment analyses of goodwill in fiscal 2008, 2007 and 2006 resulted in impairment charges of approximately $4.6 million, $1.1 million and $3.5 million, respectively. As of February 3, 2008, the remaining goodwill had a carrying value of $23.5 million, all of which was associated with the Franchise segment.

   Asset Impairment

     When an asset group (typically a store) is identified as underperforming or when a decision is made to abandon an asset group or to close a store, the Company makes an assessment of the potential impairment of the related assets. The assessment is based upon a comparison of the carrying amount of the assets, primarily property and equipment, to the estimated undiscounted cash flows expected to be generated from those assets. To estimate cash flows, management projects the net cash flows anticipated from continuing operation of the asset group or store until its closing or abandonment, as well as cash flows, if any, anticipated from disposal of the related assets. If the carrying amount of the assets exceeds the sum of the undiscounted cash flows, the Company records an impairment charge in an amount equal to the excess of the carrying value of the assets over their estimated fair value.

     Determining undiscounted cash flows and the fair value of an asset group involves estimating future cash flows, revenues, operating expenses and disposal values. The projections of these amounts represent management’s best estimates at the time of the review. If different cash flows had been estimated, property and equipment balances and related impairment charges could have been affected. Further, if management uses different assumptions or estimates in the future or if conditions exist in future periods that are different than those anticipated, future operating results could be affected. In fiscal 2008, 2007 and 2006, the Company recorded impairment charges related to long-lived assets totaling approximately $56.0 million, $9.4 million and $49.7, respectively. Additional impairment charges may be necessary in future years.

   Insurance

     The Company is subject to workers’ compensation, vehicle and general liability claims. The Company is self-insured for the cost of all workers’ compensation, vehicle and general liability claims up to the amount of stop-loss insurance coverage purchased by the Company from commercial insurance carriers. The Company maintains accruals for the estimated cost of claims, without regard to the effects of stop-loss coverage, using actuarial methods which evaluate known open and incurred but not reported claims and consider historical loss development experience. In addition, the Company records receivables from the insurance carriers for claims amounts estimated to be recovered under the stop-loss insurance policies when these amounts are estimable and probable of collection. The Company estimates such stop-loss receivables using the same actuarial methods used to establish the related

54


claims accruals, and taking into account the amount of risk transferred to the carriers under the stop-loss policies. Many estimates and assumptions are involved in estimating future claims, and differences between future events and prior estimates and assumptions could affect future operating results and result in adjustments to these loss accruals and related insurance receivables.

   Income Taxes

     The Company recognizes deferred tax assets and liabilities based upon management’s expectation of the future tax consequences of temporary differences between the income tax and financial reporting bases of assets and liabilities. Deferred tax liabilities generally represent tax expense recognized for which payment has been deferred, or expenses which already have been deducted in the Company’s tax return but which have not yet been recognized as an expense in the consolidated financial statements. Deferred tax assets generally represent tax deductions or credits that will be reflected in future tax returns for which the Company has already recorded a tax benefit in its consolidated financial statements. The Company establishes valuation allowances for deferred income tax assets as required under FAS 109, “Accounting for Income Taxes.” At February 3, 2008, the Company has recorded a valuation allowance against deferred income tax assets of $177.0 million, representing the total amount of such assets in excess of the Company’s deferred income tax liabilities. The valuation allowance was recorded because management was unable to conclude, in light of the cumulative losses realized by the Company, that realization of the net deferred income tax asset was more likely than not. The determination of income tax expense and the related balance sheet accounts, including valuation allowances for deferred income tax assets, requires management to make estimates and assumptions regarding future events, including future operating results and the outcome of tax-related contingencies. If future events are different from those assumed or anticipated, the amount of income tax assets and liabilities, including valuation allowances for deferred income tax assets, could be materially affected.

   Guarantee Liabilities

     The Company has guaranteed a portion of loan and lease obligations of certain franchisees in which the Company owns an interest. The Company assesses the likelihood of making any payments under the guarantees and records liabilities for the present value of anticipated payments when the Company believes that an obligation to perform under the guarantees is probable. No liabilities for the guarantees were recorded at the time they were issued because the Company believed the value of the guarantees was immaterial. As of February 3, 2008, the Company has recorded liabilities of approximately $3.4 million related to such guarantees, which totaled approximately $17.5 million at that date. Assessing the probability of future guarantee payments involves estimates and assumptions regarding future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated, the amounts estimated to be paid pursuant to such guarantees could change, and additional provisions to record such liabilities could be required.

   Investments in Franchisees

     The Company has investments in certain Equity Method Franchisees. While the Company believes that the recorded amounts of such investments are realizable, these franchisees typically do not have an extensive operating history, and the value of the Company’s investments in the franchisees cannot be verified by reference to quoted market prices. The Company’s assessment of the realizability of these investments involves assumptions concerning future events, including the future operating results of the franchisees. If future events are different from those assumed or anticipated by the Company, the assessment of realizability of the recorded investments in these entities could change, and impairment provisions related to these investments could be required. As of February 3, 2008, the Company’s investment in Equity Method Franchisees was approximately $2.0 million.

   Stock-Based Compensation

     In fiscal 2007 the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” which requires that stock awards, including stock options, granted to employees and which ultimately vest be recognized as compensation expense based on their fair value at the grant date. Because

55


options granted to employees differ from options on the Company’s common shares traded in the financial markets, the Company cannot determine the fair value of options granted to employees based on observed market prices. Accordingly, the Company estimates the fair value of stock options subject only to service conditions using the Black-Scholes option valuation model, which requires inputs including interest rates, expected dividends, volatility measures and employee exercise behavior patterns. Some of the inputs the Company uses are not market-observable and must be estimated. The fair value of stock options which contain market conditions as well as service conditions is estimated using Monte Carlo simulation techniques. In addition, the Company must estimate the number of awards which ultimately will vest, and periodically adjust such estimates to reflect actual vesting events. Use of different estimates and assumptions would produce different option values, which in turn would affect the amount of compensation expense recognized.

     The Black-Scholes model is capable of considering the specific features included in the options granted to the Company’s employees that are subject only to service conditions. However, there are other models which could be used to estimate their fair value, and techniques other than Monte Carlo simulation could be used to estimate the value of stock options which are subject to both service and market conditions. If the Company were to use different models, the option values would differ despite using the same inputs. Accordingly, using different assumptions coupled with using different valuation models could have a significant impact on the fair value of employee stock options.

   Recent Accounting Pronouncements

     The Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” during first quarter of fiscal 2008 as described in Note 1 to the consolidated financial statements appearing elsewhere herein.

     In March 2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. FAS 161 is effective for the Company in fiscal 2010.

     In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. FAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value. Management does not intend to adopt any fair value measurement options permitted by FAS 159 and, accordingly, does not expect FAS 159 to have any effect on the Company’s financial position or results of operations.

     In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“FAS 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. As a result of FAS 157, there is now a common definition of fair value to be used throughout GAAP, which is expected to make the measurement of fair value more consistent and comparable. The Company must adopt FAS 157 in fiscal 2009. Management does not expect adoption of FAS 157 to have a material effect on the Company’s financial position or results of operations.

56


Critical Accounting
Policies


     The
Company’s discussion and analysis of its financial condition and results of
operations is based upon its financial statements that have been prepared in
accordance with GAAP. The preparation of financial statements in accordance with
GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenues and expenses and related
disclosures, including disclosures of contingencies and uncertainties. GAAP
provides the framework from which to make these estimates, assumptions and
disclosures. The Company chooses accounting policies within GAAP that management
believes are appropriate to accurately and fairly report the Company’s operating
results and financial position in a consistent manner. Management regularly
assesses these policies in light of changes in facts and circumstances and
discusses the selection of accounting policies and significant accounting
judgments with the audit committee of the Board of Directors. The Company
believes that application of the following accounting policies involves
judgments and estimates that are among the more significant used in the
preparation of the financial statements, and that an understanding of these
policies is important to understanding the Company’s financial condition and
results of operations.


   Allowance for Doubtful
Accounts


     Accounts
receivable arise primarily from royalties earned on sales by the Company’s
franchisees, sales by KK Supply Chain to our franchisees of equipment, mix and
other supplies necessary to operate a Krispy Kreme store, as well as from
off-premises sales by company stores to convenience and grocery stores and other
customers. During the three years in the period ended February 3, 2008, some of
the Company’s franchisees experienced financial difficulties or for other
reasons did not comply with the normal payment terms for settlement of amounts
due to the Company. The Company has recorded provisions for doubtful accounts
related to its accounts receivable, including receivables from franchisees, in
amounts which management believes are sufficient to provide for losses estimated
to be sustained on realization of these receivables. Such estimates inherently
involve uncertainties and assessments of the outcome of future events, and
changes in facts and circumstances may result in adjustments to the provision
for doubtful accounts.


53





   Goodwill and Identifiable Intangible
Assets


     FAS 142,
“Goodwill and Other Intangible Assets” (“FAS 142”), addresses the accounting and
reporting of goodwill and other intangible assets subsequent to their
acquisition. FAS 142 requires intangible assets with definite lives to be
amortized over their estimated useful lives, while those with indefinite lives
and goodwill are not subject to amortization but must be tested annually for
impairment, or more frequently if events and circumstances indicate potential
impairment.


     For
intangible assets with indefinite lives, the Company performs the annual test
for impairment as of December 31. The impairment test involves determining the
fair values of the reporting units to which goodwill is assigned and comparing
those fair values to the reporting units’ carrying values, including goodwill.
To determine fair value for each reporting unit, the Company uses the fair value
of the cash flows that the reporting unit can be expected to generate in the
future. This valuation method requires management to project revenues, operating
expenses, working capital investment, capital spending and cash flows for the
reporting units over a multiyear period, as well as determine the weighted
average cost of capital to be used as a discount rate. Significant management
judgment is involved in preparing these estimates. Changes in projections or
estimates could significantly change the estimated fair value of reporting units
and affect the recorded balances of goodwill. In addition, if management uses
different assumptions or estimates in the future or if conditions exist in
future periods that are different than those anticipated, future operating
results and the balances of goodwill in the future could be affected by
impairment charges. Impairment analyses of goodwill in fiscal 2008, 2007 and
2006 resulted in impairment charges of approximately $4.6 million, $1.1 million
and $3.5 million, respectively. As of February 3, 2008, the remaining goodwill
had a carrying value of $23.5 million, all of which was associated with the
Franchise segment.


   Asset Impairment


     When an
asset group (typically a store) is identified as underperforming or when a
decision is made to abandon an asset group or to close a store, the Company
makes an assessment of the potential impairment of the related assets. The
assessment is based upon a comparison of the carrying amount of the assets,
primarily property and equipment, to the estimated undiscounted cash flows
expected to be generated from those assets. To estimate cash flows, management
projects the net cash flows anticipated from continuing operation of the asset
group or store until its closing or abandonment, as well as cash flows, if any,
anticipated from disposal of the related assets. If the carrying amount of the
assets exceeds the sum of the undiscounted cash flows, the Company records an
impairment charge in an amount equal to the excess of the carrying value of the
assets over their estimated fair value.


     Determining
undiscounted cash flows and the fair value of an asset group involves estimating
future cash flows, revenues, operating expenses and disposal values. The
projections of these amounts represent management’s best estimates at the time
of the review. If different cash flows had been estimated, property and
equipment balances and related impairment charges could have been affected.
Further, if management uses different assumptions or estimates in the future or
if conditions exist in future periods that are different than those anticipated,
future operating results could be affected. In fiscal 2008, 2007 and 2006, the
Company recorded impairment charges related to long-lived assets totaling
approximately $56.0 million, $9.4 million and $49.7, respectively. Additional
impairment charges may be necessary in future years.


   Insurance


     The Company
is subject to workers’ compensation, vehicle and general liability claims. The
Company is self-insured for the cost of all workers’ compensation, vehicle and
general liability claims up to the amount of stop-loss insurance coverage
purchased by the Company from commercial insurance carriers. The Company
maintains accruals for the estimated cost of claims, without regard to the
effects of stop-loss coverage, using actuarial methods which evaluate known open
and incurred but not reported claims and consider historical loss development
experience. In addition, the Company records receivables from the insurance
carriers for claims amounts estimated to be recovered under the stop-loss
insurance policies when these amounts are estimable and probable of collection.
The Company estimates such stop-loss receivables using the same actuarial
methods used to establish the related


54





claims accruals, and taking into account
the amount of risk transferred to the carriers under the stop-loss policies.
Many estimates and assumptions are involved in estimating future claims, and
differences between future events and prior estimates and assumptions could
affect future operating results and result in adjustments to these loss accruals
and related insurance receivables.


   Income Taxes


     The Company
recognizes deferred tax assets and liabilities based upon management’s
expectation of the future tax consequences of temporary differences between the
income tax and financial reporting bases of assets and liabilities. Deferred tax
liabilities generally represent tax expense recognized for which payment has
been deferred, or expenses which already have been deducted in the Company’s tax
return but which have not yet been recognized as an expense in the consolidated
financial statements. Deferred tax assets generally represent tax deductions or
credits that will be reflected in future tax returns for which the Company has
already recorded a tax benefit in its consolidated financial statements. The
Company establishes valuation allowances for deferred income tax assets as
required under FAS 109, “Accounting for Income Taxes.” At February 3, 2008, the
Company has recorded a valuation allowance against deferred income tax assets of
$177.0 million, representing the total amount of such assets in excess of the
Company’s deferred income tax liabilities. The valuation allowance was recorded
because management was unable to conclude, in light of the cumulative losses
realized by the Company, that realization of the net deferred income tax asset
was more likely than not. The determination of income tax expense and the
related balance sheet accounts, including valuation allowances for deferred
income tax assets, requires management to make estimates and assumptions
regarding future events, including future operating results and the outcome of
tax-related contingencies. If future events are different from those assumed or
anticipated, the amount of income tax assets and liabilities, including
valuation allowances for deferred income tax assets, could be materially
affected.


   Guarantee Liabilities


     The Company
has guaranteed a portion of loan and lease obligations of certain franchisees in
which the Company owns an interest. The Company assesses the likelihood of
making any payments under the guarantees and records liabilities for the present
value of anticipated payments when the Company believes that an obligation to
perform under the guarantees is probable. No liabilities for the guarantees were
recorded at the time they were issued because the Company believed the value of
the guarantees was immaterial. As of February 3, 2008, the Company has recorded
liabilities of approximately $3.4 million related to such guarantees, which
totaled approximately $17.5 million at that date. Assessing the probability of
future guarantee payments involves estimates and assumptions regarding future
events, including the future operating results of the franchisees. If future
events are different from those assumed or anticipated, the amounts estimated to
be paid pursuant to such guarantees could change, and additional provisions to
record such liabilities could be required.


   Investments in Franchisees


     The Company
has investments in certain Equity Method Franchisees. While the Company believes
that the recorded amounts of such investments are realizable, these franchisees
typically do not have an extensive operating history, and the value of the
Company’s investments in the franchisees cannot be verified by reference to
quoted market prices. The Company’s assessment of the realizability of these
investments involves assumptions concerning future events, including the future
operating results of the franchisees. If future events are different from those
assumed or anticipated by the Company, the assessment of realizability of the
recorded investments in these entities could change, and impairment provisions
related to these investments could be required. As of February 3, 2008, the
Company’s investment in Equity Method Franchisees was approximately $2.0
million.


   Stock-Based Compensation


     In fiscal
2007 the Company adopted Statement of Financial Accounting Standards No. 123
(revised 2004), “Share-Based Payment,” which requires that stock awards,
including stock options, granted to employees and which ultimately vest be
recognized as compensation expense based on their fair value at the grant date.
Because


55





options granted to employees differ from
options on the Company’s common shares traded in the financial markets, the
Company cannot determine the fair value of options granted to employees based on
observed market prices. Accordingly, the Company estimates the fair value of
stock options subject only to service conditions using the Black-Scholes option
valuation model, which requires inputs including interest rates, expected
dividends, volatility measures and employee exercise behavior patterns. Some of
the inputs the Company uses are not market-observable and must be estimated. The
fair value of stock options which contain market conditions as well as service
conditions is estimated using Monte Carlo simulation techniques. In addition,
the Company must estimate the number of awards which ultimately will vest, and
periodically adjust such estimates to reflect actual vesting events. Use of
different estimates and assumptions would produce different option values, which
in turn would affect the amount of compensation expense recognized.


     The
Black-Scholes model is capable of considering the specific features included in
the options granted to the Company’s employees that are subject only to service
conditions. However, there are other models which could be used to estimate
their fair value, and techniques other than Monte Carlo simulation could be used
to estimate the value of stock options which are subject to both service and
market conditions. If the Company were to use different models, the option
values would differ despite using the same inputs. Accordingly, using different
assumptions coupled with using different valuation models could have a
significant impact on the fair value of employee stock options.


   Recent Accounting
Pronouncements


     The Company
adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48,
“Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement
No. 109” during first quarter of fiscal 2008 as described in Note 1 to the
consolidated financial statements appearing elsewhere herein.


     In March
2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative
Instruments and Hedging Activities” (“FAS 161”). The new standard is intended to
improve financial reporting about derivative instruments and hedging activities
by requiring enhanced disclosures to enable investors to better understand their
effects on an entity’s financial position, financial performance, and cash
flows. FAS 161 is effective for the Company in fiscal 2010.


     In February
2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities, including an amendment of FASB Statement No.
115” (“FAS 159”). FAS 159 permits entities to choose to measure many financial
instruments and certain other items at fair value that are not currently
required to be measured at fair value. Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings. FAS 159
does not affect any existing accounting literature that requires certain assets
and liabilities to be carried at fair value. Management does not intend to adopt
any fair value measurement options permitted by FAS 159 and, accordingly, does
not expect FAS 159 to have any effect on the Company’s financial position or
results of operations.


     In September
2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“FAS 157”),
which addresses how companies should measure fair value when they are required
to use a fair value measure for recognition or disclosure purposes under GAAP.
As a result of FAS 157, there is now a common definition of fair value to be
used throughout GAAP, which is expected to make the measurement of fair value
more consistent and comparable. The Company must adopt FAS 157 in fiscal 2009.
Management does not expect adoption of FAS 157 to have a material effect on the
Company’s financial position or results of operations.


56





EXCERPTS ON THIS PAGE:

10-K (2 sections)
Apr 17, 2008
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