nder Armour may have gone too far to boost its sales growth. The company recently received a Wells Notice, which means the SEC intends to bring charges against Under Armour for violating securities laws.
The issue dates back to 2016, when Under Armour’s strong sales began to falter. The company had 26 consecutive quarters of 20% sales growth, but the bankruptcy of a major customer (Sports Authority) put the streak in jeopardy.
And this is where we get into the accounting problems.
When Under Armour realized it wasn’t going to hit its sales target at the end of a quarter, it would pressure customers to buy more product. They didn’t need more product, but Under Armour pressured them to take delivery anyway. As an incentive, Under Armour offered customers steep discounts and told them they could return anything they didn’t sell the next quarter. According to the Wall Street Journal, “truckloads of unopened boxes would come back.”
To see if this was true, I pulled Under Armour’s annual report (10-K) for each of the past 8 years. I focused on an account called “reserves for returns, allowances, markdowns, and discounts,” which is a contra-revenue account (a reduction in revenue) that Under Armour estimates at the time of a sale. Here’s how Under Armour describes its policy:
“We record reductions to revenue at the time of the transaction for estimated customer returns, allowances, markdowns and discounts. We base these estimates on historical rates of customer returns and allowances…”
In short, if Under Armour sells $100,000 of product today, and it assumes that 2% of this product will ultimately be returned or result in a discount, it would record $100,000 of gross sales but $2,000 for the reserve account; net sales would therefore be $98,000.
If Under Armour did indeed start pressuring customers to take early delivery of product around 2016, we should see the reserve account increasing at a faster rate than sales around that time. And in fact gross sales (sales before subtracting the reserve account) increased by 22.5% in 2016 while the reserve account increased by 54.71%. The following year, gross sales increased by just 5.1% while the reserve account increased by 68.67%.
The reserve account was increasing a lot faster than sales.
You can also see the change by looking at the reserve account as a percentage of gross sales.
This graph shows that the percentage of sales expected to be returned or marked down began increasing in 2014, before rising dramatically in 2016 and 2017.
If you’re wondering why the percentage of returns declined in 2019, bear in mind that the SEC had begun investigating Under Armour by that point in time.
We don’t have all the facts since the SEC hasn’t filed its legal complaint yet, but the financials are consistent with the story that several Under Armour executives told the Wall Street Journal about the companying stealing sales from future quarters by pressuring customers to accept more product than they needed.
There’s nothing wrong with applying a little pressure to make a sale, but if you know the customer doesn’t want the product and that they’re going to return it anyway, it’s not really a sale. At best, it’s a sale for a future quarter that you are trying to record in the present quarter.
And that is a violation of GAAP.
Under Armour’s CFO stepped down after the company’s 20% sales growth streak came to an end, and the company went through three CFO’s in just two years (another red flag). Under Armour made the news when its executives were caught using company credit cards at a gentleman’s club. Thus, I’m very curious to see what kind of accounting shenanigans the company may have been up to.