The company that ate itself: How a lack of dough turned into a crisis for Krispy Kreme

At the Krispy Kreme shop in Washington's Dupont Circle yesterday morning a steady stream of customers were making their way inside to get their hands on the freshly cooked doughnuts. "I come here every morning for two of them," admitted a guilty-sounding Maneda Harrington, a 28-year-old accountant. "They're delicious."

At the Krispy Kreme shop in Washington's Dupont Circle yesterday morning a steady stream of customers were making their way inside to get their hands on the freshly cooked doughnuts. "I come here every morning for two of them," admitted a guilty-sounding Maneda Harrington, a 28-year-old accountant. "They're delicious."

To their fans, Krispy Kreme's sweet and airy doughnuts may still be the ultimate snack. But while there may be nothing wrong with its product, Krispy Kreme has found itself in unprecedented financial and legal problems less than two years after riding a tide of investor confidence and breathless publicity.

On Tuesday, the North Carolina-based company announced it was restating its earnings for the 2004 financial year, citing accounting errors. It said profits would have to be reduced by anywhere between six and eight per cent or $3.8m (£3m) to $4.9m. It also warned that it may have to default on almost $91m in loans. It shares immediately fell by 10 per cent as investors learned of the news.

But that is not all. A class-action lawsuit filed last month on behalf of hundreds of thousands of Krispy Kreme investors accused the company of issuing false statements about its earnings for more than a year and that the company even resorted to deliberately sending out double the number of doughnuts ordered by wholesalers in order to boost its sales. Three senior executives in the company were also accused of dumping 475,000 of their own shares for $19.8m profits in alleged insider trading.

If that was not enough, the company was also forced to admit that it was being formally investigated by the federal Securities and Exchange Commission (SEC).

What has gone wrong? Little more than a year ago Krispy Kreme, which was founded in 1933, had just opened its first British outlet in the Harrods food hall and was enjoying a wave of free publicity and product placement.

One could barely turn on the television, it seemed, without these doughnuts being plugged by either former President Bill Clinton, the cast of NYPD Blues, Madonna, Jim Carrey or Nicole Kidman. It was estimated that 7.5 million of them were being sold in the US every day.

Customers appeared mesmerised by the doughnuts as they watched them being cooked in the retro-fitted stores, placed on a moving conveyor belt and then soaked in a water fall of gooey, white sugar-glaze.

Indeed, between April 2000 when the company started public trading and August 2003, the company stock rose by some 625 per cent. While much of the US economy was in recession during this period, Krispy Kreme was the darling of investors. It appeared it could do no wrong.

Industry analysts say the company - whose founder Vernon Rudolph claimed to have obtained his doughnut recipe from a French chef in New Orleans - has suffered from two fac tors. One has been the growing obsession with low-carbohydrate diets such as Atkins, which hardly favours doughnuts that can pack up to 400 calories each.

The other problem may have been the company's too rapid expansion and saturation of the marketplace, something it achieved by making its doughnuts available at grocery stores. In a note to clients, analyst John Ivankoe of JP Morgan Securities, said this week: "There are many more questions than answers, especially given increased concerns regarding company liquidity."

Last May, the company posted its first losses since it went public and said it was cutting back on the number of stores it planned to open. At the time it blamed its difficulties on the growing popularity in low-carbohydrate diets.

But some allege the problems had existed long before then and that the company had been trying to hide that fact from investors. In the group lawsuit filed in December it was alleged that between January 2003 and May 2004 the company "issued false and misleading statements including false financial results [and] repeatedly ratcheted upward its public quarterly and fiscal year revenue and earning projections ... all in the face of slowing sales and market saturation".

According to the lawsuit, two witnesses had seen Krispy Kreme ship double the number of doughnuts ordered to boost sales. One witness, a former Krispy Kreme sales manager at a store in Ravenna, Ohio, said the regional manager ordered that customers be sent double orders on the last Friday and Saturday of the 2004 fiscal year because "Krispy Kreme wanted to boost the sales for the fiscal year in order to meet Wall Street projections". The extra doughnuts would be returned but go on the books of the 2005 fiscal year, the witness said.

Krispy Kreme yesterday failed to return calls seeking comment about both its restatement of earnings and the allegations of misconduct levelled at the company and its senior executives. Last month, when it missed a deadline for filing a quarterly report with the SEC, it said it was carrying out analysis "related to the accounting treatment of certain franchise matters in the company's third quarter".

In its most recent statement, on Tuesday, the firm said it had concluded that previously issued statements regarding its 2004 earning would have to be restated to "correct certain errors". It added: "Such statements should no longer be relied upon".