Retailer Ollie's Bargain Outlet Holdings, Inc. [OLLI] recently drew the SEC’s attention when the company said it would eliminate all of its critical accounting estimates.
The SEC requires companies to make critical accounting disclosures when a firm must make judgement calls about income estimates and other assumptions that could materially affect the firm’s financial statements if those judgment calls are incorrect or need to be updated.
In our Critical Accounting Review published in November 2018, we warned our readers that although Ollie's past disclosures were consistent with industry peers, in 2018 Ollie’s eliminated all of its critical accounting estimates, saying the disclosure was no longer needed. Here is what we wrote:
Ollie’s removal of the inventory critical accounting estimate disclosure reduced financial statements users’ understanding of the company’s inventory policy. Prior to its removal, Ollie’s critical accounting estimate disclosure enhanced the company’s significant accounting policy disclosure by explaining how the company applies the retail inventory method, and how the company estimates and records shrinkage and permanent markdowns of inventory designated for clearance.
Prior to this shift, Ollie’s disclosed goodwill and intangible assets, impairment of long-lived assets, income taxes, inventories, revenue recognition and stock-based compensation as critical accounting estimates from 2015 to 2017.
As a retailer, Ollie’s accounts for its inventory using the retail inventory method (RIM) on a first-in, first-out (FIFO) basis. The value of Ollie’s inventory includes the cost of merchandise, transportation, distribution and storage. The firm makes estimates of potential shrinkage rates and markdowns of inventory.
By eliminating the company’s inventory disclosure, Ollie’s made it more difficult to understand the company’s policy for shrinkage and permanent markdowns, something the company cited as risk factor before. This is significant since inventory comprised 70% of its tangible assets as of February 3, 2018.
Ollie’s had modified some critical accounting estimates before, such as changes made to their revenue recognition disclosure over the past few years. However, those changes did not reduce the usefulness or understandability of the company’s revenue recognition policy.
The following table shows common critical accounting estimates from Ollie’s peers. As you can see, goodwill, impairment of assets, income taxes, insurances/self-insurance and inventories are the most common disclosures.
In August 2018, the SEC issued comment letters to Ollie’s, requesting clarification about removing all the critical accounting policies and estimates. The conversation spanned over seven letters and took 74 days to resolve. This was much longer than the average four letters and 45 days for most SEC conversations. While it is not uncommon for the SEC to issue comment letters referencing critical accounting estimate disclosures, since 2008 the percentage of companies receiving these letters has significantly decreased – from a peak of 27.5% in 2009 to 7.9% in 2017.
In the initial comment letter, the SEC simply asked for clarification why Ollie’s believes none of their significant accounting policies or estimates meet the definition of critical policies or estimates. The SEC says critical accounting estimates are “material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change” and has “a material impact on financial condition or operating performance.”
Based on these SEC phrases, Ollie’s said:
It does not believe that its significant accounting policies and estimates for the periods presented in its Form 10-K involved the level of subjective analysis, judgment or uncertainty required to qualify as critical policies or estimates. For example, in assessing Goodwill and intangible assets, Ollie’s utilizes an assessment process with limited subjectivity that includes calculating the differential between the carrying amount of its sole reporting unit and Ollie’s market value, which has shown a market value in significant excess of carrying value.
In a September letter, the SEC pushed back on Ollie’s reply, emphasizing key words in its letter:
We have read your response to comment 1 and are still unclear how you determined that you do not have critical accounting policies or estimates.
Citing Ollie’s 10-K disclosure about inventory, the SEC points out in the letter that Ollie’s uses shrinkage and markdowns estimates to calculate ending inventory, estimates which could significantly impact the ending inventory valuation at cost and the resulting gross margin.
Please explain to us in greater detail how you determined that each of these accounting policies do not involve estimates and assumptions that could have a material impact on your financial condition and operating performance and on the comparability of such reported information over different reporting periods.
In part, for its response, Ollie’s said the company has “evolved and grown significantly since its initial public offering… certain assumptions and estimates relating to its accounting policies now have reduced elements of management subjectivity or uncertainty. Therefore … Ollie’s eliminated its critical accounting policies and estimates for that period.”
The SEC didn’t agree and pushed back harder, requiring Ollie’s to add at least some disclosures. In its third comment letter, the SEC said in part, again, emphasizing key words:
Although you indicate that certain assumptions and estimates relating to your accounting policies more recently have reduced elements of management subjectivity or uncertainty, these assumptions and estimates appear susceptible to change and the resulting change(S) could materially impact your financial statements in the future. Accordingly, please revise future filings to include, at a minimum, critical accounting policies for inventory and goodwill and intangible asset impairment. We note that these items represent approximately 90% of your total assets as of fiscal year-end 2017.
In response, Ollie’s said “it will revise its future Form 10-K filings to include, at minimum, disclosure of critical accounting policies for inventory and goodwill and intangible asset impairment.”
This is not the first comment letter for Ollie's, nor is it the first SEC attempt to request more transparency about inventories. In a June 22, 2015 letter, the Company responded to the SEC’s questions regarding critical accounting estimates for inventory shrinkage, which indicates the agency believes this disclosure was material.
Please tell us in detail how accurate your permanent markdown estimates have been and what impact permanent markdowns had on your results of operations for the historical financial statement periods presented.
The Company acknowledges the Staff’s comment and respectfully advises the Staff that, as noted in its accounting policies, the Company utilizes the retail inventory method to determine inventory cost. As part of the retail inventory method, the Company recognizes permanent markdowns on a timely basis within the perpetual inventory system based upon the assessment of management for specific inventory items that will require permanent markdowns in retail price due to limited circumstances, such as seasonal merchandise or end-of-season clearances. The Company has not experienced any material inventory write-downs or impairments that would indicate that historical permanent markdowns were not reasonable estimates. The level of permanent markdowns recognized on a retail basis for each of the historical periods presented has not been material relative to total net sales, with permanent markdowns as a percentage of net sales at 1.0% and 0.8% for fiscal years 2014 and 2013, respectively. The level of permanent markdowns has also been consistent from year to year and as a result permanent markdowns have not had any material impact on the trends or comparability between reporting periods.
Also, tell us how many times your inventory turned over for each period presented in your financial statements.
Since Ollie’s eliminated its revenue recognition disclosure and tried to reduce critical accounting estimates disclosure, it seems that the retailer is trying to eliminate redundant and immaterial disclosure, but in its latest move made the company’s policy for shrinkage and permanent markdowns less transparent. Ollie’s is not the only company that has tried to reduce repetitive disclosure. Critical accounting estimates are typically discussed in two sections – MD&A and footnotes. For example, Zebra Technologies Corp. [ZBRA] and SPLUNK INC [SPLK] also omit critical accounting estimates disclosure in the MD&A section. Unlike Ollie’s that does not discuss critical accounting estimates anywhere in the filing, both Zebra Technologies and SPLUNK INC discuss critical estimates in the footnotes and make reference to the footnote disclosure in the MD&A section.
Ollie’s is also not the only company to drop critical accounting estimates between annual filings. However, in a comparison of the last three annual filings for Ollie’s and 20 peers, only two companies had more than four changes to their disclosed critical accounting estimates – Ollie’s and Dollar Tree [DLTR].
As noted above in its correspondence with the SEC, what sets Ollie’s apart is that they state “We do not believe that any of our significant accounting policies or estimates meet the definition of critical policies or estimates based upon our interpretation of the guidance provided by the SEC.”
There are a few conclusions analysts and investors can draw from Ollie’s. First, companies need to know where their disclosure stands in comparison to their peers. Second, eliminating material disclosures can reduce transparency into a company’s risk factors. Third, eliminating all disclosures makes it much more likely a company will invite regulatory scrutiny.
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