The ongoing federal inquiry into how Under Armour Inc. reported its earnings around 2016 shows how the government targets accounting practices involving the way in which companies record their sales.
Under Armour broached the topic of the investigation during its third-quarter earnings call earlier this month, saying it was cooperating with the U.S. Securities and Exchange Commission and the U.S. Department of Justice for more than two years. The company acknowledged the investigation amidst reporting by the Wall Street Journal about its apparent practice of moving revenues from one quarter to another, and of potentially encouraging retail customers to accept earlier shipments.
The company has insisted in its public statements so far that its reporting practices are kosher, saying in a statement Friday that “we firmly believe that our disclosures and our accounting practices have been entirely appropriate.”
The legality of certain earnings reporting practices might sometimes be ambiguous. But from the government’s perspective, the questions for Under Armour, and public companies relying on sales, often boil down to: did the company misstate its earnings or leave out information and, if so, were those misstatements or omissions material — that is, did they affect investors’ decision-making — and also, whether it was done knowingly, said David Slovick, a partner at Barnes & Thornburg LLP, and a former senior enforcement attorney at the SEC and the Commodity Futures Trading Commission.
“The important word here and touchstone is materiality; that means, is the conduct material to investors, that is, would it affect their decision to buy or sell stock?” he said. “You can imagine that one way it could be is if huge numbers of sales were recorded in the wrong period, but again, the question is, ‘Was it material?’”
These types of so-called earnings or revenue recognition practices are a common area of focus for the SEC. In its annual whistleblower program report to Congress Friday, the SEC said the most common types of complaints by internal corporate whistleblowers involved “corporate disclosures and financials,” which accounted for roughly a fifth of such complaints in fiscal year 2019.
Investigators typically scrutinize whether companies are improperly bringing forward future revenues into current quarters in order to inflate their current revenues and make sales appear robust to investors, said Matthew Stock, director of the whistleblower rewards practice at Zuckerman Law, who is also a certified public accountant.
The opposite practice of setting up so-called “cookie jar” reserves may also be problematic, he said. That involves moving the current quarter’s revenue to the future, in violation of the U.S. Generally accepted accounting principles, a standard overseen by the nonprofit Financial Accounting Standards Board.
“Revenue can only be recognized when it is earned,” Stock said.
The SEC and DOJ typically view accounting misconduct through the lens of the Securities Exchange Act of 1934, and the Securities Act of 1993. But the broad provisions under those laws that target deceptive practices don’t necessarily specify which accounting practices are and are not acceptable, legal experts said.
That allows for discretion on the government’s part, and offers room for a company’s attorneys to argue that the company’s practices were appropriate, said Joan MacLeod Heminway, professor at the University of Tennessee, Knoxville, College of Law.
“There’s pressure by the public market on companies to show good earnings, so to the extent people feel they can do that lawfully, they do,” Heminway said. “But sometimes they cross the line into unlawful conduct.”