Lululemon Athletica Inc Accounting Theory

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Investor relations [7]

Conflict between management and shareholders

On June 11, 2015, Lululemon Athletica Inc. filed for Dennis Chip Wilson to sell his family’s stake in the yoga-wear maker. In recent years, there has been an increasingly fraught relationship between Mr. Wilson and the current management creating conflict. This conflict between Mr. Wilson and the board is largely over the company’s strategic direction and vision for the business and is usually referred to as agency costs. Shareholders typically wish for the company to be run in ways that increase shareholder value and management wish to grow a company in ways that maximize their personal power and wealth which may not be in the best interest of shareholders.

Adverse Selection

Another mitigating factor to the fraught relationship between Mr. Wilson and Lululemon Athletica Inc. is due to his is involvement and advising role with a rival retailer set up by his wife and son: this has become a concern for Lululemon Athletica. The information asymmetry that exists between Mr. Wilson and Lululemon Athletica contributes to the drop in stock price between June 9th 2015 and June 11th 2015: 68.72 to 66.07. The news of the file for Wilson to sell his family stake in Lululemon Athletica shows that stocks readily experience adverse selection in that buyers tend to (but don't always) know less about the stock than issuers in the primary market.

Diversifiable Risk

Investors will always be faced with unsystematic risk when investing in companies: diversifiable risk. Since investors are assumed to be rational and risk adverse, the news about the file made for Wilson to sell his family stake was a concern to some investors and caused this stock to be viewed as risky. This news is considered an unsystematic risk and through diversification, selling stocks, investors strive to smooth out this risky event in their portfolios. By smoothing out this event, the positive performance of other investments will neutralize the negative performance of others.

Evaluation of management performance

Elements of compensation[8]

1. Base salary

The base salary established for each of executive officers reflects their responsibilities, experience, historical performance and other discretionary factors deemed relevant by the Compensation Committee. In order to attract and retain qualified executives, base salaries are generally close to the market median of base salaries of same-sized companies in the industry.

2. Annual cash incentive

The annual cash performance bonuses are to compensate executive officers for achieving financial, operational and strategic goals and for achieving individual annual performance objectives. This can be highly variable from year to year.

Under the executive bonus plan, no payouts are provided to participants unless the company achieves a minimum level of annual operating income. The executive bonus plan is funded at maximum if this level of operating income is achieved and the Committee uses an objectively determined process to put a cap on the incentive, to reduce payouts from the maximum level. Payouts of achieving goals are weighted as below:

[pic 5]

3. Equity-based compensation

a. Performance-based restricted stock unit awards

Each performance-based restricted stock unit represents a right to receive one share of our common stock on a specified settlement date if the performance-based restricted stock unit vests as a result of our attainment of a performance goal during a performance period. Each performance-based restricted stock unit award specifies the threshold, target and maximum number of performance-based restricted stock units that will vest at certain performance levels.

b. Stock options

The stock option grants generally vest in four equal installments beginning on the first anniversary of the date of grant to encourage executive retention and to compensate the executive officers for their contribution over the long-term. Stock options only have value to the executive officers to the extent that, on the date they are exercised, the company's share price is higher than the exercise price. The options generally have a term of seven years.

Performance evaluation

1. Net income based

Under historical cost accounting, in reflecting the executive's’ performance, net income is low in sensitivity but relatively precise. Net income may not show management effort immediately due to recognition lag (i.e. advertising, capital expenditures, and earnings management). However, it is relatively unaffected by economy wide factors and other events unrelated to management effort. Providing full disclosure in the financial report may increase the sensitivity of net income.

From fiscal 2013 to 2014, net income increased by 9.47% and CEO compensation increased by 24.15%. Meanwhile, the total compensation (CEO, CFO, and the three most highly compensated officers) decreased by 5.40% due to the decrease in their gross margins of 3.8%[9].

2. Share price based

Under fair value accounting, as one of the tools to evaluate executives’ performance, share price is high in sensitivity (due to less recognition lag) but low in precision, due to its vulnerability to market-wide factors. Looking back to a 5 year period, the total executive compensation had been paid relatively to the ups and downs of the company’s share price.

[pic 6] (Executive Compensation, LULU)[10]

Control over Compensation risk

Annually, the Compensation Committee reviews the company’s compensation policies to determine whether any of their aspects encourage excessive or inappropriate risk-taking by the executive officers. The Compensation Committee reports its activities in this regard to the full board of directors and makes such recommendations to our board of directors with respect to the compensation policies as it may deem necessary or appropriate. Also, the Compensation Committee conducts a review of the peer group used for executive compensation comparisons to ensure all peer companies remain appropriate