Is Green Mountain Coffee Roasters Shuffling the Beans to Beat Earnings Expectations?

Note: Updated On June 6, 2011 here

On May 3, 2011, Green Mountain Coffee Roasters (NASDAQ: GMCR) beat analysts' earnings estimates by $0.10 per share for the thirteen-week period ended March 26, 2011. The next day, the stock price had risen to $11.91 per share to close at $75.98 per share, a staggering 18.5% increase over the previous day's closing stock price. CNBC Senior Stocks Commentator Herb Greenberg raised questions about the quality of Green Mountain Coffee's earnings because its provision for sales returns dropped $22 million in the thirteen-week period. He wanted to know if there was a certain adjustment to reserves ("a reversal") that helped Green Mountain Coffee beat analysts' earnings estimates. However, the company was not available to comment. It was too busy on a road show trying to sell more stock. Therefore, I will provide an analysis and some answers to questions below. (Video link to Herb Greenberg's comments.)

Provision for sales returns

During the thirteen-week period ended March 26, 2011, it was calculated that Green Mountain Coffee had a negative $22.259 million provision for sales returns. In its latest 10-Q report, Green Mountain Coffee disclosed that its provision for sales returns was $5.262 million for the twenty-six week period ending March 26, 2011, but the company did not disclose amounts for the thirteen-week period ended March 26, 2011. In its previous 10-Q report for the thirteen-week period ended December 25, 2010, Green Mountain Coffee disclosed that its provision for sales returns was $27.521 million. Therefore, the provision for sales returns for the thirteen-week period ended March 26, 2011 was a negative $22.259 million ($5.262 million minus $27.521 million). Note: The provision for sales returns can be found in the Statement of Cash Flows and see calculations below.

Why is a negative provision for sales returns an unusual occurrence

Under Generally Accepted Accounting Principles (GAAP), companies are required to set up reserves or allowances for product returns when customers have the right to return products back to the company. The provision for sales returns is supposed to reflect amounts that are added to the sales returns reserve for estimated future product returns. The accounting entry on the company's books increases the sales returns reserve and decreases revenues. Since revenues are decreased, earnings are decreased, too.

It is unusual for a company to have a negative provision for sales returns, since it is supposed to reflect amounts added, not subtracted from the sales returns reserve. A negative provision for sales returns increases earnings.

Reserves are depleted when the customer actually returns the product. However, the actual return of merchandise does not affect revenues or earnings, since the company previously reduced revenues when it made a provision for that sales return. The accounting entry on the company's books for the customer's return decreases the sales returns reserve and either increases liabilities (such as accounts payable) or decreases assets (such as accounts receivable).

Why a company could have a negative provision for sales returns

There are two reasons for a company to have a negative provision for sales returns. It may have overstated its sales returns reserve in the prior period and it is reversing the amount of the previous overstatement in the current period. Therefore, the company corrects that overstatement by increasing revenues and decreasing the sales returns reserve. The change of a previous estimate increases earnings in the current period, even though there is no improvement in operating performance.

The other reason for having a negative provision for sales returns has to do with illegal earnings management. For example, a company had an exceptionally good earnings report and beat analysts’ earnings estimates by $0.10 per share. It artificially increases its sales return reserve and thereby decreases its earnings by $0.05 per share. The company would still beat analysts’ earnings estimates by $0.05 per share instead of beating estimates by $0.10 per share. The company effectively created a "cookie jar" reserve, which is used to inflate future earnings.

Now, let’s say in the next quarter, the company's earnings fell below analysts' earnings expectations by $0.02 per share. Since the company overstated its reserve in the previous period, it then reduces the overstatement in the current period to beat analysts’ earnings estimates.

Another example of illegal earnings management is when a company understates its reserves in the current period to inflate earnings. Earnings management through the manipulation of reserves is a relatively easy fraud to commit because management could hide behind the excuse that it made good faith assumptions in computing its reserves.

Questions about earnings quality

Herb Greenberg wanted to know what caused Green Mountain Coffee to have a negative $22.259 million provision for sales returns in the thirteen-weeks ended March 26, 2011. Did the company make a reversal adjustment to its reserves? If the company made such an adjustment, did the increase in earnings help it beat analysts' earnings expectations for the thirteen-week period? He said, "This is all about earnings quality."

More red flags and some answers

I performed additional calculations below and found more red flags (Click on image to enlarge and see highlighted areas):

Note: In its fiscal year ended September 25, 2010 10-K report, Green Mountain Coffee reported separate balances for its sales returns allowance and allowance for doubtful accounts and provided a reconciliation of account balances (See page F-67). In its subsequent 10-Q reports, the company combined the balances of its sales returns allowance with allowances for doubtful accounts on its balance sheet and did not provide a reconciliation of account balances. Therefore, I traced the provision for sales returns in the Statement of Cash Flows (10-K report page F-8) to the reconciliation of reserve accounts (10-K report page F-67) to validate my assumptions and computations. In the above chart, I am assuming that Green Mountain Coffee is consistent in its presentation of provisions for sales returns in its subsequent 10-Q reports as required under GAAP and SEC rules.

As I detailed above, Green Mountain Coffee had a negative $22.259 million provision for sales returns for the thirteen-week period ended March 26, 2011. It’s usually a positive number. Deductions usually reflect the depletion of reserves and should be a negative number. However, in that same thirteen-week period it was a positive number and added $13.819 million to reserves, rather than reducing reserves. That is unusual, too. The fact that both numbers go opposite their normal direction is even more unusual.

The above data indicates that in the latest thirteen-week period ended March 26, 2011 Green Mountain Coffee apparently made an adjustment and reversed a significant amount of sales returns reserves from its previous reporting period. I'll make the presumption that the adjustment stemmed from an overstatement of reserves in the prior period and that it did not cause an understatement of reserves in the current period.

In any case, the reversal of the sales returns reserve made a significant contribution to Green Mountain Coffee's earnings during the latest period ended March 26, 2011. Since Green Mountain Coffee had a negative $22.259 million provision for sales returns, rather than a positive number, the adjustment of reserves probably added over $20 million in revenue to its latest quarter. However, I cannot determine its full impact on earnings.

When a reversal of a previous estimate of reserves in the current period helps a company beat analysts' earnings expectations it is considered material and should be disclosed. Green Mountain Coffee should show transparency to investors by responding to issues raised by Greenberg and explaining its accounting for reserves to clear up any concerns.

Now there are two SEC Divisions looking at Green Mountain Coffee's financial disclosures

On Monday, September 20, 2010, the SEC Enforcement Division 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.” According to Green Mountain Coffee’s 10-Q report for the quarter ended March 27, 2011, the SEC Division of Corporation Financial recently started a  review of Green Mountain Coffee’s acquisition accounting:

On May 2, 2011, the Company received a comment letter from the staff of the SEC requesting the Company to provide further detail regarding certain of the pro forma adjustments made in its presentation of its unaudited pro forma condensed combined statement of operations that illustrated the effects of its acquisitions of Van Houtte, Diedrich and Timothy’s. The unaudited pro forma condensed combined statement of operations information was included in the Company’s amendment to its Current Report on Form 8-K filed on December 17, 2010. Specifically, the staff of the SEC requested further details regarding the adjustments related to acquisition-related expenses and stock compensation expense in Note G, losses on derivatives in Note H and merger-related expenses in Note K. The Company intends to provide the requested additional information to the staff of the SEC in a timely manner.

Hopefully, the Division of Corporation Finance will expand the scope of its review and examine Green Mountain Coffee's accounting for reserves.

Shortly after the conclusion of the review, the SEC’s comment letters and the company’s responses to them will be available on the SEC’s EDGAR site (listed as "upload" and "corresp" respectively) and should provide an interesting peak into underlying assumptions for Green Mountain Coffee's financial disclosures.

Written by:

Sam E. Antar

Important Note: Updated On June 6, 2011 here

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 as an independent whistleblower. I teach about white-collar crime for government entities, 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.