Note 1 — Accounting Policies

Krispy Kreme Doughnuts, Inc. (“KKDI”) and its subsidiaries (collectively, the “Company”) are engaged in the sale of doughnuts and complementary products through Company-owned stores. We also license the Krispy Kreme business model and certain of our intellectual property to franchisees in the United States and over 25 other countries around the world, and derive revenue from franchise and development fees and royalties from those franchisees. Additionally, we sell doughnut mixes, other ingredients and supplies and doughnut-making equipment to franchisees.

Significant Accounting Policies

We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The significant accounting policies followed by us in preparing the accompanying consolidated financial statements are as follows:

BASIS OF CONSOLIDATION. The financial statements include the accounts of KKDI and its subsidiaries. Investments in entities over which we have the ability to exercise significant influence but which we do not control, and whose financial statements are not otherwise required to be consolidated, are accounted for using the equity method.

CHANGE IN PRESENTATION. In the first quarter of fiscal 2016, we changed the presentation of the Consolidated Statement of Income and segment financial information. Pre-opening costs related to Company Stores; gains and losses on commodity derivatives, net and gain on refranchisings, net of business acquisition charges are now separate line items on the Consolidated Statement of Income and are no longer in the respective business segments' operating income in Note 2. Such changes were made to provide more clarity and visibility to our operations and to conform to new management reporting. We furnished a Current Report on Form 8-K on June 10, 2015 providing the Consolidated Statement of Income and segment financial information for the quarterly and annual periods in fiscal 2014 and fiscal 2015 conformed to the fiscal 2016 presentation. We have made no changes to our reportable segments. These presentation changes had no impact on our consolidated operating income or consolidated net income.

REVENUE RECOGNITION. Revenue is recognized when there is a contract or other arrangement of sale; the sales price is fixed or determinable; title and the risks of ownership have been transferred to the customer; and collection of the receivable is reasonably assured. A summary of the revenue recognition policies for our business segments is as follows:

Company Stores revenue is derived from the sale of doughnuts and complementary products to on-premises and consumer packaged goods (“CPG”) customers. Revenue is recognized at the time of delivery for on-premises sales. For CPG sales, revenue is recognized either at the time of delivery, net of provisions for estimated product returns, or, with respect to those CPG customers that take title to products purchased from us at the time those products are sold by the CPG customer to consumers, simultaneously with such consumer purchases.

Domestic and International Franchise revenue is derived from development and initial franchise fees relating to new store openings and ongoing royalties charged to franchisees based on their sales. Development and franchise fees are recognized when the store is opened, at which time we have performed substantially all of the initial services we are required to provide and we have determined that the earnings process is complete. Development fees are related to initial services such as training and assisting with store setup and are therefore deferred until store opening and recorded within current and noncurrent liabilities as deferred development fee revenue until that time (See Notes 10 and 12). Royalties are recognized in income as underlying franchisee sales occur unless there is significant uncertainty concerning the collectibility of such revenues, in which case royalty revenues are recognized when received. Revenues related to licensing certain Company-owned trademarks to domestic third parties other than franchisees are included in the Domestic Franchise segment.

KK Supply Chain revenue is derived from the sale of doughnut mix, other ingredients and supplies and doughnut-making equipment. Revenues for the sale of doughnut mix and supplies are recognized upon delivery to the customer or, in the case of franchisees located outside North America, when the goods are loaded on the transport vessel at the U.S. port. Revenue for equipment sales and installation associated with new store openings is recognized at the store opening date. Revenue for equipment sales not associated with new store openings is recognized when the equipment is installed if we are responsible for the installation, and otherwise upon shipment of the equipment.

FISCAL YEAR. Our fiscal year ends on the Sunday closest to January 31, which periodically results in a 53-week year. Fiscal 2016, 2015 and 2014 each contained 52 weeks.

CASH AND CASH EQUIVALENTS. We consider cash on hand, demand deposits in banks and all highly liquid debt instruments with an original maturity of three months or less to be cash and cash equivalents.

ALLOWANCE FOR DOUBTFUL ACCOUNTS. We maintain allowances for doubtful accounts related to our 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 allowance for doubtful accounts.

INVENTORIES. Inventories are recorded at the lower of cost or market, with cost determined using the first-in, first-out method.

PROPERTY AND EQUIPMENT. Depreciation of property and equipment is provided using the straight-line method over the assets' estimated useful lives, which are as follows: buildings — 5 to 35 years; machinery and equipment — 3 to 15 years; computer software — 3 to 10 years; and leasehold improvements — 5 to 20 years.

REACQUIRED FRANCHISE RIGHTS. Franchise rights reacquired in connection with business combinations are valued based on the present value of the cash flows of the acquired business and are amortized on a straight-line basis from the acquisition date through the expiration date of the terminated franchise agreement.

GOODWILL. Goodwill represents the excess of the purchase price over the value of identifiable net assets acquired in business combinations. Goodwill has an indefinite life and is not amortized, but is tested for impairment annually or more frequently if events or circumstances indicate the carrying amount of the asset may be impaired. Such impairment testing is performed for each reporting unit to which goodwill has been assigned.

LEGAL COSTS. Legal costs associated with litigation and other loss contingencies are charged to expense as services are rendered.

ASSET IMPAIRMENT. We assess asset groups for potential impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. The assessment is based upon a comparison of the carrying amount of the asset group, consisting primarily of property and equipment, to the estimated undiscounted cash flows expected to be generated from the asset group. 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, we record an impairment charge in an amount equal to the excess of the carrying value of the assets over their estimated fair value.

EARNINGS PER SHARE. The computation of basic earnings per share is based on the weighted average number of common shares outstanding during the period. The computation of diluted earnings per share reflects the additional common shares that would have been outstanding if dilutive potential common shares had been issued, computed using the treasury stock method. Such potential common shares consist of shares issuable upon the exercise of stock options and the vesting of currently unvested shares of restricted stock units.

The following table sets forth amounts used in the computation of basic and diluted earnings per share:

	Year Ended
	January 31,		February 1,		February 2,
	2016		2015		2014
	(In thousands)

Numerator: net income	$	32,398	$	30,060	$	34,256
Denominator:
Basic earnings per share - weighted average shares
outstanding		65,221		66,360		67,261
Effect of dilutive securities:
Stock options		1,435		2,037		2,998
Restricted stock units		251		532		795
Diluted earnings per share - weighted average shares
outstanding plus dilutive potential common shares		66,907		68,929		71,054

Stock options with respect to 308,000, 257,000 and 301,000 shares for fiscal 2016, 2015 and 2014, respectively, as well as 285,000 and 57,000 unvested restricted stock units for fiscal 2016 and 2015, respectively, have been excluded from the computation of the number of shares used to compute diluted earnings per share because their inclusion would be antidilutive. There were no antidilutive unvested shares of restricted stock units in fiscal 2014.

SHARE-BASED COMPENSATION. We measure and recognize compensation expense for share-based payment awards by charging the fair value of each award at its grant date to earnings over the service period necessary for each award to vest.

MARKETING AND BRAND PROMOTION. Costs associated with our products, including advertising and other brand promotional activities, are expensed as incurred, and were approximately $10.3 million, $9.8 million and $8.2 million in fiscal 2016, 2015 and 2014, respectively.

CONCENTRATION OF CREDIT RISK. Financial instruments that subject us to credit risk consist principally of receivables from CPG customers and franchisees, guarantees of certain franchisee leases and, in prior years, guarantees of certain indebtedness of franchisees. CPG receivables are primarily from grocer/mass merchants and convenience stores. We maintain allowances for doubtful accounts which we believe are sufficient to provide for losses which may be sustained on realization of these receivables. In fiscal 2016, 2015 and 2014, no customer accounted for more than 10% of Company Stores segment revenues. The two largest CPG customers collectively accounted for approximately 15%, 16% and 17% of Company Stores segment revenues in fiscal 2016, 2015 and 2014, respectively. The two CPG customers with the largest trade receivables balances collectively accounted for approximately 28% and 24% of total CPG customer receivables at January 31, 2016 and February 1, 2015, respectively.

We also evaluate the recoverability of receivables from our franchisees and maintain allowances for doubtful accounts which management believes are sufficient to provide for losses which may be sustained on realization of these receivables. In addition, we evaluate the likelihood of potential payments by us under lease guarantees and record estimated liabilities for payments we consider probable.

SELF-INSURANCE RISKS AND RECEIVABLES FROM INSURERS. We are subject to workers' compensation, vehicle and general liability claims. We are 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 us from commercial insurance carriers. We maintain 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, we record 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. We estimate such stop-loss receivables using the same actuarial methods used to establish the related claims accruals, and taking into account the amount of risk transferred to the carriers under the stop-loss policies. The stop-loss policies provide coverage for claims in excess of retained self-insurance risks, which are determined on a claim-by-claim basis.

We recorded favorable adjustments to our self-insurance claims liabilities related to prior years of approximately $440,000, $1.7 million and $1.1 million in fiscal 2016, 2015 and 2014, respectively. Such adjustments represent changes in estimates of the ultimate cost of incurred claims.

We provide health and medical benefits to eligible employees, and purchase stop-loss insurance from commercial insurance carriers which pays covered medical costs in excess of a specified annual amount incurred by each claimant.

DERIVATIVE FINANCIAL INSTRUMENTS AND DERIVATIVE COMMODITY INSTRUMENTS. We reflect derivative financial instruments, which typically consist of interest rate derivatives and commodity futures contracts and options on such contracts, in the consolidated balance sheet at their fair value. The difference between the cost, if any, and the fair value of the interest rate derivatives is reflected in income unless the derivative instrument qualifies as a cash flow hedge and is effective in offsetting future cash flows of the underlying hedged item, in which case such amount is reflected in other comprehensive income. The difference between the cost, if any, and the fair value of commodity derivatives is reflected in earnings because we have not designated any of these instruments as cash flow hedges.

USE OF ESTIMATES. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results will differ from these estimates, and the differences could be material.

Recent Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, “Leases”, which requires lessees to present right-of-use assets and lease liabilities on the balance sheet for all leases with terms longer than 12 months. The guidance is to be applied using a modified retrospective approach at the beginning of the earliest comparative period in the financial statements and is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We are evaluating the impact that adoption of this guidance will have on our consolidated financial statements.

In November 2015, the FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes”, which eliminates the current requirement for companies to present deferred tax liabilities and assets as current and non-current in a classified balance sheet. Instead, companies will be required to classify all deferred tax assets and liabilities as non-current. This guidance is effective for annual and interim periods beginning after December 15, 2016 and early adoption is permitted. We adopted this accounting guidance retrospectively in the fourth quarter of fiscal 2016. The consolidated balance sheet at February 1, 2015 includes a reclassification of $23.2 million from the previously reported current deferred income tax assets to noncurrent deferred income tax assets.

In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory”, which changes guidance for subsequent measurement of inventory from the lower of cost or market to the lower of cost and net realizable value. This update is effective for annual and interim periods beginning after December 15, 2016 and early adoption is permitted. We do not expect the adoption of this guidance to have an impact on our consolidated financial statements.

In April 2015, the FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs.” This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. In August 2015, the FASB issued ASU 2015-15, “Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements.” This guidance states that given the absence of authoritative guidance within ASU 2015-03 for debt issuance costs related to the line-of-credit arrangements, the SEC staff would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the costs ratably over the term of the arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit. As all of our debt issuance costs are related to line-of-credit arrangements and are currently classified as assets, this update will not have any impact on our consolidated financial statements.

In April 2015, the FASB issued ASU 2015-05, “Customer's Accounting for Fees Paid in a Cloud Computing Arrangement”, which provides guidance about whether a cloud computing arrangement includes a software license. ASU 2015-05 is effective for annual and interim periods beginning after December 15, 2015. We do not expect the adoption of this guidance to have an impact on our consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers”, to clarify the principles used to recognize revenue for all entities. This guidance was deferred by ASU 2015-14, issued by the FASB in August 2015, and is now effective for fiscal years beginning on or after December 15, 2017 including interim periods within those fiscal years. Early adoption is permitted as of the original effective date. We are evaluating the impact that adoption of this guidance will have on our consolidated financial statements.