Green Mountain Coffee Roasters: Calling a Bean, a Bean

Written by: Sam E. Antar with Ilene, Editor of Phil's Stock World

Green Mountain Coffee Roasters (NASDAQ: GMCR) is currently under the scrutiny of the Securities and Exchange Commission (SEC) and is facing numerous class action lawsuits alleging securities fraud. In particular, plaintiffs are alleging false and misleading disclosures in violation of federal securities laws.

One troubling issue is that when Green Mountain initially disclosed an accounting error concerning its K-Cup margin percentages, it claimed that the error was “immaterial.” Material and immaterial errors are treated differently.  If an accounting error is immaterial, a public company is required to correct it by making a one-time cumulative adjustment to earnings in the latest quarter. If an accounting error is material, a public company is required to notify investors that its previous financial reports cannot be relied on and that it will restate its affected financial reports to correct that error.

Background

On Monday, September 20, 2010, the SEC notified Green Mountain Coffee Roasters that it was conducting an informal inquiry. It requested information concerning “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” Eight days later, on September 28, 2010, Green Mountain surprised investors by disclosing news of the SEC inquiry in an 8-K filing. In that 8-K report, Green Mountain also disclosed that it discovered an "immaterial accounting error" affecting financial reports issued from 2007 to June 26, 2010:

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit. Management discovered that the gross margin percentage used to eliminate the inter-company markup resulted in a lower margin applied to the Keurig ending inventory balance effectively overstating consolidated inventory and understating cost of sales. Management determined that the accounting error arose during fiscal 2007 and analyzed the quantitative impact from that point forward to June 26, 2010.

As of June 26, 2010, there is a cumulative $7.6 million overstatement of pre-tax income. Net of tax, the cumulative error resulted in a $4.4 million overstatement of net income or a $0.03 cumulative impact on earnings per share.

After evaluating the quantitative and qualitative aspects of the error in accordance with applicable accounting literature, including Staff Accounting Bulletins published by the SEC, the Company, with the participation of the audit committee of the Board of Directors, has determined that the correction in the margin calculation represents a correction of an error in accordance with Accounting Standards Codification 250 Accounting Changes and Error Corrections, that the correction was not material to the fiscal years and the respective quarters ended 2007, 2008 and 2009 and that the Company anticipates that the correction will not be material to fiscal year 2010 and the respective quarters of fiscal 2010. As a result, the Company anticipates the cumulative amount of the accounting correction will be made in the quarter ended September 25, 2010. [emphasis added.]

Thus, Green Mountain claimed that its K-Cup margin error was “immaterial” and said it would correct that error by making a cumulative adjustment to earnings. If the error had been material, the company would have been required to 1) disclose that its previously issued financial reports cannot be relied upon and 2) restate its financial reports to correct that error.

On Friday on November 19, 2010, Green Mountain disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income. These errors plus the K-Cup margin error resulted in a total overstatement of $10.1 million in pre-tax income. This time, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

Green Mountain did not identify any specific accounting error as "material" and it marginalized the errors by using carefully crafted language:

The effects on certain reported periods are quantitatively significant, and the impact of the individual errors will be disclosed in more detail in the Company’s restated financial statements.

The adjustments necessary to correct the errors will have no effect on reported cash flow from operations, and are not expected to have a material impact on the balance sheet. [emphasis added.]

Under SEC Staff Accounting Bulletin No. 99, accounting errors are material when they meet certain quantitative or qualitative criteria such as causing the "financial statements taken as a whole" to be "materially misstated" or "materially misleading." Whether or not accounting errors have a material impact on the balance sheet is not by itself a test for materiality in determining whether it is necessary to disclose the errors and restate results.

Timing

Green Mountain waited until November 19, 2010 to inform investors that it was going to restate its financial reports.

Let’s go back to September 28, 2010, when Green Mountain disclosed its K-Cup margin error which caused “a cumulative $7.6 million overstatement of pre-tax income” from 2007 to June 26, 2010. Because the company claimed that its K-Cup margin error was “immaterial,” it was not required to restate its previously issued financial reports to correct that error. Instead, Green Mountain said it would make a one-time adjustment to earnings for the quarter ended September 26, 2010 to correct its K-Cup margin error. Green Mountain claimed that it evaluated “the quantitative and qualitative aspects of the error in accordance with applicable accounting literature, including Staff Accounting Bulletins published by the SEC….”

Material vs. Immaterial accounting errors

According to SEC Staff Accounting Bulletin No. 99:

Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are...  whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise….

In determining whether multiple misstatements cause the financial statements to be materially misstated, registrants and the auditors of their financial statements should consider each misstatement separately and the aggregate effect of all misstatements. [emphasis added]

Public companies must evaluate each accounting error both individually and together in determining materiality. The effects of an overstatement of income cannot be reduced by the effects of an understatement of income, in determining the materiality of the errors.

If Green Mountain’s K-Cup margin error “hides a failure to meet analysts' consensus expectations for the enterprise” in any previous reporting period from 2007 to June 2010 (whether in a quarterly or annual period) that error should be considered material. If Green Mountain’s K-Cup margin error caused it to overstate income and meet or exceed analysts’ consensus EPS forecasts, it should be considered a material accounting error under SAB No. 99. In such a case, Green Mountain’s claim that its K-Cup margin error was “immaterial” was arguably incorrect.

Was Green Mountain’s K-Cup margin error material or immaterial?

We would argue that Green Mountain’s K-Cup margin error was material because it overstated income and caused the company to meet analysts’ consensus earnings estimates for the quarter ended March 27, 2010.

On January 27, 2010, Green Mountain reported its first quarter financial results and provided the following initial guidance for its second quarter ending March 27, 2010:

Fully diluted GAAP earnings per share in the range of $0.56 to $0.61 per share. The fully diluted GAAP earnings per share estimates … exclude any one-time acquisition-related transaction expenses for the pending Diedrich acquisition above the amount incurred in the first quarter of fiscal 2010. [emphasis added]

Green Mountain excluded “any one-time acquisition-related transaction expenses for the pending Diedrich acquisition” from its earnings guidance to analysts. Analysts revised their earnings estimates to adjust for the acquisition-related transaction expenses.

On April 28, 2010, Green Mountain reported its financial results for the quarter ended March 27, 2010.

According to Generally Accepted Accounting Principles (GAAP), net income for the second quarter of fiscal 2010 totaled $24.7 million or $0.54 per fully diluted share. …the Company incurred approximately $5.0 million, or $0.06 per diluted share, of transaction expenses related to the pending Diedrich Coffee, Inc. (“Diedrich”) acquisition…. Excluding the transaction-related expenses, non-GAAP net income for the second quarter of fiscal 2010 increased 114% to $27.8 million, or $0.60 per diluted share, from $13.0 million, or $0.33 per diluted share, in the second quarter of fiscal 2009. [emphasis added]

Green Mountain reported $0.54 fully diluted earnings per share. Excluding “one-time acquisition-related transaction expenses” fully diluted earnings per share was $0.60, meeting consensus analysts’ estimates for the quarter ended March 27, 2010. Its matching estimates of $0.60 was relayed by the financial news.

BusinessWeek reported:

Also on Wednesday, Green Mountain said it earned $24.7 million, or 54 cents per share, on revenue of $324.9 million. Excluding costs related to a recent acquisition and other items, Green Mountain earned 60 cents per share, matching analyst estimates.

In addition, RTT news reported:

Excluding items, net income more than doubled to $27.8 million from $13 million, while earnings per share increased to $0.60 from $0.33 in the prior-year quarter. On average, 10 analysts polled by Thomson Reuters expected the company to earn $0.60 per share for the quarter. Analysts' estimates typically exclude special items.

On December 9, 2010, Green Mountain Coffee issued its 2010 10-K report and provided additional details about its accounting errors and their affect on previous reporting periods. This additional information allows us to surmise the magnitude of the original error disclosed on September 28th. Until Green Mountain issued its 10-K report, there was insufficient information for an outsider to calculate the impact of the K-Cup margin error on quarterly earnings due to insufficient information in previous filings (September 28 8-K report and November 19 8-K report).

The company originally reported net income of $24.7 million for the quarter ended March 27, 2010. Considering information contained in Green Mountain’s 10-K report, two accounting errors under the category “Inter-Company Elimination Adjustments” reduced its net income by $1.378 million.

(Note: On May 18, 2010, Green Mountain had a three-for-one stock split and subsequent financial reports reflect that split in earnings per share computations. Therefore, diluted earnings per share for the quarter ended March 27, 2010 were adjusted from $0.54 as originally reported to $0.18 before the effects of any accounting errors. We are using the numbers prior to the split for ease in making comparisons.)

Green Mountain’s “Inter-Company Elimination Adjustments” came from two accounting errors:

(1) The K-Cup margin error originally reported by Green Mountain in its September 28, 2010 8-K report:

A $7.4 million overstatement of pre-tax income ($4.5 million after tax), cumulative over the restated periods, due to the K-Cup® portion pack inventory adjustment error previously reported in the Company’s Form 8-K filed on September 28, 2010. This error is the result of applying an incorrect standard cost to intercompany K-Cup portion pack inventory balances in consolidation. This error resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales. Rather than correcting the cumulative amount of the error in the quarter ended September 25, 2010, as disclosed in the September 28, 2010 Form 8-K, the effect of this error has been recorded in the applicable restated periods. [emphasis added]

(2) An accounting error due to “applying an incorrect standard cost to intercompany brewer inventory balances,” reported in Green Mountain’s November 19, 2010 8-K report:

A $0.7 million overstatement of pre-tax income ($0.4 million after tax), cumulative over the restated periods, due to applying an incorrect standard cost to intercompany brewer inventory balances in consolidation. This error was identified during the preparation of the fiscal year 2010 financial statements and resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales. [emphasis added]

Both of the above accounting errors reduced Green Mountain’s previously reported net income of $24.7 million for the quarter ended March 27, 2010 by $1.378 million. Unfortunately, Green Mountain did not provide information about how each of those individual “Inter-Company Elimination Adjustments” separately impacted earnings for each reporting period.

Calculating the impact of the K-Cup margin error on earnings for the quarter ended March 27, 2010

Green Mountain disclosed that its K-Cup margin error resulted in a:

…$7.4 million overstatement of pre-tax income ($4.5 million after tax), cumulative over the restated periods ….

The brewer standard cost accounting error resulted in a:

…$0.7 million overstatement of pre-tax income ($0.4 million after tax), cumulative over the restated periods….

Therefore, about 92% of the “inter-company elimination adjustments” from 2007 to 2010 resulted from the K-Cup margin error ($4.5 million after tax divided by $4.9 million after tax).

For purposes of illustration, let’s assume that 92% or about $1.267 million of the $1.378 million adjustment to net income for the quarter ended March 27, 2010 came from the K-Cup margin error. In this case, the K-Cup margin error added $0.03 per share to its earnings (pre-stock split) and Green Mountain would have reported $0.57 diluted earnings per share excluding “one-time acquisition-related transaction expenses.” This would have caused it to miss estimates, as analysts were looking for $0.60 per share (pre-stock split).

In any case, the entire brewer standard cost error (from 2007 to 2010) amounted to a mere $0.4 million after tax. If we assume the entire error occurred exclusively in the quarter ended March 27, 2010, then $0.978 million (total inter-company elimination adjustments of $1.378 million minus brewer standard cost error of $0.4 million) of the adjustment to earnings in that quarter came from the K-Cup margin error. In this case, if Green Mountain had properly computed its K-Cup margin percentages, it would have reported $0.58 diluted earnings per share excluding “one-time acquisition-related transaction expenses” compared to consensus analysts’ estimates of $0.60 per share (pre-stock split).

Based on the analysis above, Green Mountain’s assertion that the K-Cup margin error was “immaterial” in its September 28, 2010 8-K report appears to be wishful thinking. According to SEC Staff Accounting Bulletin No. 99, “Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are...  whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise….” The K-Cup margin error caused Green Mountain to overstate income and meet analysts’ consensus expectations for earnings in the quarter ended March 27, 2010.

Green Mountain claims that it properly evaluated “the quantitative and qualitative aspects of the error in accordance… Staff Accounting Bulletins published by the SEC.” It would be interesting to know how its management came to that conclusion. While outsiders could not have performed these calculations until Green Mountains 10-K was released on December 9, 2010, presumably, Green Mountain would have had the information on September 28, 2010.

Closing comment

Arguably, Green Mountain should have identified the K-Cup margin error as a material accounting error in its September 28, 2010 8-K report, and it should have informed investors that its previous financial reports could not be relied on.  Under SEC rules, a material accounting error is required to be disclosed on Form 8-K within four business days. It wasn’t until November 19, 2010 that Green Mountain disclosed that its financial reports could not be relied upon by investors and that it would restate its earnings reports issued from 2007 to 2010 to correct accounting errors.

Disclaimer:  This article represents the opinions and analysis of Sam E. Antar, and not the opinions of Phil's Stock World and its employees, agents and affiliates.  Posting of the article does not represent an endorsement.


Ilene's disclosure

Ilene is the editor of Phil’s Stock World, a fellow Seeking Alpha contributor.  She does not own any Green Mountain Coffee Roasters securities, long or short.

Sam's Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.