What might be driving the criminal investigation at Under Armour?
I asked five experts to use the company's profile and financial filings to try to answer this question
What might be behind civil and criminal investigations of accounting irregularities at sporting goods retailer Under Armour Inc.?
Under Armour still isn’t saying much.
The company did confirm civil and criminal probes by the U.S. Department of Justice and the Securities and Exchange Commission after they were reported by the Wall Street Journal on November 4. It also documented that confirmation immediately in a filing with the SEC, disclosing that it has been responding to requests for documents and information from both the SEC and DOJ since July of 2017 regarding “certain of the company’s accounting practices and related disclosures.”
Under Armour’s filing said the company continued to believe its accounting practices and related disclosures were appropriate and that it did not intend to comment further on the status of the investigations “except to the extent required by law.”
But the WSJ was not the first to warn of undisclosed investigations at Under Armour. John Gavin at Probes Reporter has been saying it since 2017.
Now some ex-employees are talking.
A more recent WSJ story quotes anonymous ex-employees who say Under Armour “scrambled to meet aggressive sales targets, borrowing business from future quarters to mask slowing demand in 2016 for its athletic apparel.”
The second report 10 days later on November 14 by the same Wall Street Journal reporters, who cover the Justice Department, paints a little better picture. The company, it says, allegedly shifted sales from one quarter to another to appear healthier, and allegedly inflated sales numbers in some of the periods.
The reporters quote former executives in sales, logistics, merchandising and finance describing pressure put on retailers to take products early and efforts to book sales in the final days of a quarter by “redirecting” merchandise intended for its factory stores to off-price chains.
The original WSJ story also highlighted that Under Armour has had three chief financial officers from 2016 to the present.
Chip Molloy, a former PetSmart Inc. executive, took over in early 2016 from Brad Dickerson, who had served as CFO since 2008 and left the company in February 2016. Molloy only spent a year, leaving suddenly in February 2017. Under Armour said at the time Molloy left for unspecified personal reasons.
The WSJ said that investigators are looking into financial results for the end of 2016 and also into Molloy’s time with the company. Molloy, who is a board of directors member at private fashion company Torrid and is chairman of the audit committee at publicly-traded Sprouts Farmers Market, did not respond to my request for comment.
Under Armour told the WSJ after its most recent story, “Our management and board of directors have extensively reviewed this matter over the past two and a half years, and we continue to believe that our accounting practices and related disclosures have been appropriate.”
What do the experts say?
The WSJ asked “analysts and accounting experts” about the issues described by the anonymous ex-employees and the anonymous analysts and experts, “agree the end-of-quarter maneuvers described by these executives are generally permitted under accounting rules.”
That didn’t sound right to me so I asked five experts of my own what kinds of accounting issues could drive two investigations that reportedly focus on revenue recognition.
In particular, I asked my experts to look at Under Armour’s business model and the company’s financial filings to see what might point to the reason for the more serious criminal investigation.
An Under Armour spokesman told me he did not have any further comment beyond the company’s statement.
Here’s what my experts said:
Tom Gorman, a lawyer with Dorsey & Whitney, former SEC enforcement attorney, publisher of the securities blog SEC Actions:
“SEC financial fraud cases where there are parallel criminal investigations are typically the more aggressive ones where there is a repeated pattern of, for example, manipulating revenue recognition by techniques such as shifting sales from one quarter to the next, pre-mature revenue recognition or channel stuffing.”
This would be particularly true, Gorman told me, when those techniques are coupled with efforts to minimize expenses, which creates a clear pattern of intentional conduct that could become the predicate of a criminal securities violation.
Nerissa Brown, associate professor of accountancy at the University of Illinois:
Brown, whose academic research focuses on revenue recognition issues, told me that Under Armour ramped up its reliance on non-standard financial metrics when its string of earnings growth broke at the end of 2016. Until the fourth quarter of 2016, Under Armour was one of the top retail industry growth stocks, recording more than 20 quarters of double-digit revenue growth.
Then the company started to have repeated earnings misses.
Beginning in 2017, Under Armour started reporting adjusted gross margin and three adjusted earnings metrics that stripped out charges related to their restructuring efforts.
“My research shows that firms lean on non-GAAP disclosures when they can no longer achieve consecutive earnings growth the old-fashioned GAAP way,” Brown told me.
In Under Armour’s February 2017 annual report, the company disclosed a positive change in estimate of $48 million related to a reversal of a compensation accrual. The unusual nature of the change in accounting estimate prompted the SEC to issue a comment letter requesting clarification about the circumstances surrounding the adjustment.
The company responded that the reversal was related to executive compensation that was not going to be earned based on the 2016 results:
Lynn Turner, former SEC Chief Accountant:
Turner, a frequent expert witness for investors and the government when they sue audit firms, told me it’s possible the DOJ is looking at revenue-shifting via a bill-and-hold scheme related to Under Armour’s international manufacturing partners, or perhaps a channel stuffing scheme with one or more third-party distributors or retailers.
“Extended payment terms may be a form of vendor financing, which may raise questions as to whether sales are actually consignment sales,” Turner told me.
Consignment sales occur when companies ship product but allow customers to pay when the product is sold to the retail customer. The vendor can also give a full right of return of any unsold product.
In a bill-and-hold scheme, the seller records the related revenue even though the goods have not yet been shipped to the ultimate buyer, but instead are sitting at an intermediate distribution location.
In a channel stuffing scheme, a company sends retailers and distributors more products than they would ordinarily purchase or reasonably be able to sell to the public, and then books those as sales in the current quarter or year. Sometimes the company may explicitly promise a right to return unsold product or stretches out the payment period to make up for the over-shipment.
Channel stuffing allows a company to inflates its sales right before a reporting period, such as the end of a fiscal quarter or fiscal year, to make its financial results look better.
That’s what the former Under Armour executives seem to be describing, although the WSJ doesn’t call the well-known accounting manipulation techniques by their common names.
According to the WSJ, “Former employees described efforts in 2016 to sustain the 20% quarterly growth rate, even as retailers failed to sell some of the company’s sweatshirts, T-shirts and other apparel. ‘It was a pretty common practice to pull forward orders from the month after the quarter to ship within the quarter in order to hit the number or close the gap,’ a former sales executive said. When retailers declined to take products before their requested ship date, Under Armour sometimes adjusted the terms of the contract to offer a discount or extend the period in which retailers could pay for the products, this former executive and other employees said.”
The investigations may be taking a while, Turner told me, because the DOJ is having trouble getting documentation from Under Armour manufacturing partners outside the U.S.
Under Armour said in its most recent annual report for 2018 that substantially all of its manufacturers are located outside the United States. In 2016, about 60% of its apparel and accessories products were manufactured in Jordan, Vietnam, China and Malaysia.
In Latin American countries other than Mexico, Chile, Colombia and Argentina, the company distributes its products through independent distributors that are sourced primarily through an international distribution hub in Panama.
At the end of 2016, Under Armour said in its filings with the SEC that it had seen an increase in net cash outflows as a result of a significant increase in inventory in-transit and a decrease in spend for inventory due to early deliveries of product “to meet key seasonal floor set dates in the prior period.”
The company had also seen an increase in accounts receivable “due to the timing of shipments and a higher proportion of sales to our international customers with longer payment terms compared to the prior year.”
The company disclosed in its most recent 10-K, “If we determine actual or expected returns or allowances are significantly higher or lower than the reserves we established, we would record a reduction or increase, as appropriate, to net sales in the period in which we make the determination.”
A revision in the sales returns and allowances account estimate could also shift revenue recognition from one period to another because it is a contra-revenue account — one where, under GAAP, the amount can be used to adjust revenue from a gross to a net amount for directly-related expenses.
Large write-offs for sales, returns and allowances could also signal that products were billed to the distributor but put on hold for delivery to the retail customer. Or it could also suggest that inventory was stuffed into the distribution channel to make the numbers one period and taken back the following period, then had to be written-off because the inventory was now obsolete.
Write-offs increased significantly during the three years from 2016 to 2018, according to Under Armour’s last annual report for 2018. Total write-offs against revenue went from $130.8 million in 2016, to $215.9 million in 2017, to up to $301.9 million in 2018.
J. Edward Ketz, associate professor of accounting, Pennsylvania State University:
Ketz, one of the original “Grumpy Old Accountants” that uncovered a revenue recognition issue at Groupon back in 2011, said the DOJ may be looking at a type of fraud called front-loading. Sunbeam used an income front-loading scheme in the 1990s.
The Sunbeam case, from the late 90’s, is a textbook example of bill-and-hold and channel-stuffing strategies used to fraudulently recognize revenue. Sunbeam failed to disclose that it offered discounts and other inducements to customers to sell merchandise immediately that otherwise would have been sold in later periods.
Those tactics threatened to depress Sunbeam’s future results. Companies must disclose the impact of granting extended payment terms to customers that may result in a longer collection period for accounts receivable and, thus, slower cash flow from operations, and the company’s liquidity.
That possibility came to Ketz when he looked at Under Armour’s “days sales outstanding,” a measure of how long it takes a company to collect what’s owed from customers. He saw a recent significant increase in DSO. It’s been increasing at a steady pace from about 25 days at the beginning of 2016 to 58 days as of the end of the second quarter of 2019.
Joseph Schroeder, assistant professor of accounting, Indiana University:
Actual examples like Sunbeam, as well as recent research on the subject, show that companies can be tempted to artificially to increase operating income by shifting core operating expenses to non-operating expenses.
Schroeder, whose research focuses on how companies manipulate results to improve the perception of performance and enhance executive compensation, also referenced Sunbeam.
“Restructuring charges present ample opportunity for management to improperly characterize operating expenses into one-time only restructuring charges,” according to Schroeder.
For example, Sunbeam’s former CEO, “Chainsaw Al” Dunlap, was brought in to turn around the company, but instead directed that millions of dollars of expenses for 1997 should be wrongly charged in 1996, front-loading the company’s write-off for his reorganization efforts. The SEC said the front-loading strategy created ‘’cookie jar’’ reserves, which could be used to create fake profits in 1997.
Sunbeam also unreasonably reduced the value of its inventory, according to the SEC’s enforcement action, so it could record large profits when the goods were later sold.
“Prior academic research demonstrates that restructuring costs is one account management may use to manage earnings,” said Schroeder. “It’s important to know what’s in those restructuring charges because they present an opportunity for earnings management both for financial reporting and executive compensation purposes.
“To the extent companies shift core expenses to the non-routine restructuring charge, they can give the illusion to their investors that these expenses are not going to re-occur,” Schroeder told MarketWatch.
Under Armour’s board approved a 2017 restructuring plan that recognized approximately $100.4 million of pre-tax charges and restructuring-related goodwill impairment charges of about $28.7 million for its Connected Fitness business.
In 2017 net revenue grew by 3.1% to $4.98 billion compared to 2016, but operating income according to the accounting standards all public companies are required to use, Generally Accepted Accounting Principles, was down year-over-year. In each case the results were below the targets required under the company’s 2017 annual cash incentive plan.
As a result, no awards were paid under the plan.
However, the company said in its proxy that “given the efforts of our executives throughout the year, particularly in implementing our restructuring plan and other strategic initiatives” its compensation committee awarded limited cash bonuses to some executives other than CEO Kevin Plank. The bonuses ranged from 10% to 30% of the target level of bonus the executives were otherwise eligible for under the plan.
On February 9, 2018, the board approved an additional restructuring plan and said about $110 million to $130 million of pre-tax restructuring and related charges were expected to be incurred during fiscal 2018.
To ensure an exception to the plan would not be necessary in 2018, the company’s compensation committee created a non-GAAP metric to calculate an adjusted operating income figure that would disregard any restructuring charges. By the time 2018 was over, the company had actually recognized $203.9 million of pre-tax charges in connection with its 2018 restructuring plan, much more than originally budgeted.
GAAP operating income for 2018, which reflected the cost of the restructuring activities, was a loss of $25 million. After adding back the restructuring expenses, the adjusted operating income was now a positive $179 million. That number was well above the target set forth under Under Armour’s 2018 annual cash incentive plan.
“As a result, we achieved between the target and stretch financial targets under the plan,” the company announced in the proxy.
Under Armour’s auditor, PricewaterhouseCoopers LLP, gave the company a clean audit opinion with no qualifications for 2018. The PwC partner leading the Under Armour audit is Deanna Marie Byrne, who is also responsible for leading the audit on West Pharmaceuticals, according to data publicly available from the audit regulator. Byrne was new on the account in 2018, succeeding PwC’s Russell David Moore.
A PwC spokeswoman said the firm could not comment due to client confidentiality constraints.