2. Summary of significant accounting policies
The Company’s fiscal year is the 52 or 53 weeks ending on the Saturday closest to January 31. The Company’s fiscal years ended February 3, 2018 (fiscal 2017), January 28, 2017 (fiscal 2016), and January 30, 2016 (fiscal 2015) were 53, 52, and 52 week years, respectively.
The Company’s consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts, transactions, and unrealized profit were eliminated in consolidation.
Use of estimates
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the accounting period. Actual results could differ from those estimates.
Cash and cash equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with maturities of three months or less from the date of purchase. Cash equivalents include amounts due from third-party credit card receivables because such amounts generally convert to cash within one to three days with little or no default risk.
The Company determines the balance sheet classification of its investments at the time of purchase and evaluates the classification at each balance sheet date. Money market funds, certificates of deposit, and time deposits with maturities of greater than three months but no more than twelve months are carried at cost, which approximates fair value and are recorded in the Consolidated Balance Sheets in Short-term investments (see Note 9, “Investments”).
Receivables consist principally of amounts due from vendors and landlord construction allowances earned but not yet received. These receivables are computed based on provisions of the vendor and lease agreements in place and the Company’s completed performance. The Company’s vendors are producers of consumer products and landlords. The Company does not require collateral on its receivables and does not accrue interest. Credit risk with respect to receivables is limited due to the diversity of vendors and landlords comprising the Company’s vendor base. The Company performs ongoing credit evaluations of its vendors and evaluates the collectability of its receivables based on the length of time the receivable is past due and historical experience. The receivable for vendor allowances was $78,238 and $59,553 as of February 3, 2018 and January 28, 2017, respectively, and the receivable for landlord allowances was $12,729 and $23,186 as of February 3, 2018 and January 28, 2017, respectively. The allowance for doubtful receivables totaled $1,371 and $2,079 as of February 3, 2018 and January 28, 2017, respectively.
Merchandise inventories are stated at the lower of cost or market. Cost is determined using the weighted-average cost method and includes costs incurred to purchase and distribute goods. Inventory cost also includes vendor allowances related to co-op advertising, markdowns, and volume discounts. The Company maintains reserves for lower of cost or market and shrinkage.
Fair value of financial instruments
The carrying value of cash and cash equivalents, accounts receivable, and accounts payable approximates their estimated fair values due to the short maturities of these instruments. The Company had no outstanding debt as of February 3, 2018 and January 28, 2017.
Property and equipment
The Company’s property and equipment are stated at cost, net of accumulated depreciation and amortization. Maintenance and repairs are charged to operating expense as incurred. The Company’s assets are depreciated or amortized using the straight-line method over the shorter of their estimated useful lives or the expected lease term as follows:
Equipment and fixtures
3 to 10 years
Electronic equipment and software
3 to 5 years
The Company capitalizes costs incurred during the application development stage in developing or purchasing internal use software. These costs are amortized over the estimated useful life of the software.
The Company periodically evaluates whether changes have occurred that would require revision of the remaining useful life of equipment and leasehold improvements or render them not recoverable. If such circumstances arise, the Company uses an estimate of the undiscounted sum of expected future operating cash flows during their holding period to determine whether the long-lived assets are impaired. If the aggregate undiscounted cash flows are less than the carrying amount of the assets, the resulting impairment charges to be recorded are calculated based on the excess of the carrying value of the assets over the fair value of such assets, with the fair value determined based on an estimate of discounted future cash flows. No significant impairment charges were recognized in fiscal 2017, fiscal 2016, or fiscal 2015. Impairment charges are included in selling, general and administrative (SG&A) expenses in the consolidated statements of income.
Customer loyalty program
The Company’s loyalty rewards program, Ultamate Rewards, is a points-based program. Ultamate Rewards enables customers to earn points based on their purchases. Points earned by members are valid for at least one year and may be redeemed on any product the Company sells. The Company accrues the cost of anticipated redemptions related to this program at the time of the initial purchase based on historical experience. The accrued liability related to this loyalty program at February 3, 2018 and January 28, 2017 was $42,219 and $30,244, respectively. The cost of this program, which was $106,598, $77,145, and $54,464 in fiscal 2017, 2016, and 2015, respectively, is included in cost of sales in the consolidated statements of income.
During 2016, the Company entered into certain agreements (the Agreements) with third parties to provide guests with private label and/or co-branded credit cards (collectively, the Credit Cards). The private label credit card can be used at any store location and online and the co-branded credit card can be used anywhere the co-branded card is accepted. A third-party financing company is the sole owner of the accounts and underwrites the credit issued under the Credit Card programs.
The Company receives payments and reimbursements of expenses in accordance with the Agreements and based on usage of the Credit Cards. The Company recognizes income for such cash receipts when the amounts are fixed or determinable and collectability is reasonably assured, which is generally the time at which the actual usage of the Credit Cards or specified transaction occurs. A majority of the funds received are recorded as a reduction of SG&A expenses, and the remaining portion is recognized as a reduction to cost of sales in the consolidated statements of income.
Loyalty members earn points through purchases at Ulta Beauty and anywhere the co-branded credit card is accepted. Consistent with the current accounting for the customer loyalty program, the Company accrues the cost of anticipated redemptions of points at the time of the initial purchase and costs are included in cost of sales in the consolidated statements of income. Other administrative costs related to the Credit Card programs, including payroll, marketing expenses, and other direct costs, are included in SG&A in the consolidated statements of income.
Many of the Company’s operating leases contain predetermined fixed increases of the minimum rental rate during the lease. For these leases, the Company recognizes the related rental expense on a straight-line basis over the expected lease term and records the difference between the amounts charged to expense and the rent paid as deferred rent. The lease term commences on the earlier of the date when the Company becomes legally obligated for rent payments or the date the Company takes possession of the leased space.
As part of many lease agreements, the Company receives construction allowances from landlords for tenant improvements. These leasehold improvements made by the Company are capitalized and amortized over the shorter of the lease term or 10 years. The construction allowances are recorded as deferred rent and amortized on a straight-line basis over the lease term as a reduction of rent expense.
Net sales include retail store and e-commerce merchandise sales as well as salon service revenue. Revenue from merchandise sales at retail stores is recognized at the time of sale, net of estimated returns. The Company provides refunds for product returns within 60 days from the original purchase date. Salon service revenue is recognized when services are rendered. Salon service revenue amounted to $277,361, $241,105, and $209,249 in fiscal 2017, 2016, and 2015, respectively. E-commerce sales are recognized based on delivery of merchandise to the customer. E-commerce revenue amounted to $568,736, $345,342, and $221,077 in fiscal 2017, 2016, and 2015, respectively. Company coupons and other incentives are recorded as a reduction of net sales. State sales taxes are presented on a net basis as the Company considers itself a pass-through conduit for collecting and remitting state sales tax.
The Company’s gift card sales are deferred and recognized in net sales when the gift card is redeemed for product or services. The Company’s gift cards do not expire and do not include service fees that decrease customer balances. The Company has maintained Company-specific, historical data related to its large pool of similar gift card transactions sold and redeemed over a significant time frame. The Company recognizes gift card breakage to the extent there is no requirement for remitting balances to governmental agencies under unclaimed property laws. Gift card breakage is recognized over the same performance period, and in the same proportion, that the Company’s data has demonstrated that gift cards are redeemed. Gift card breakage was $7,783, $5,335, and $3,728 in fiscal 2017, 2016, and 2015, respectively, and is recorded as a decrease in SG&A expenses in the consolidated statements of income. Deferred gift card revenue was $63,139 and $46,268 at February 3, 2018 and January 28, 2017, respectively, and is included in accrued liabilities on the consolidated balance sheets.
The Company receives allowances from vendors in the normal course of business including advertising and markdown allowances, purchase volume discounts and rebates, reimbursement for defective merchandise, and certain selling and display expenses. Substantially all vendor allowances are recorded as a reduction of the vendor’s product cost and are recognized in cost of sales as the product is sold.
Advertising expense consists principally of direct mail catalogs, newspaper inserts, television, radio, and digital advertising. The Company expenses the costs related to its advertising in the period the related promotional event occurs. Total advertising costs, exclusive of incentives from vendors and start-up advertising expense, amounted to $259,423, $212,714, and $187,158 in fiscal 2017, 2016, and 2015, respectively. Advertising expense as a percentage of sales was 4.4%, 4.4%, and 4.8% in fiscal 2017, 2016, and 2015, respectively. Prepaid advertising costs included in prepaid expenses and other current assets on the consolidated balance sheets were $12,811 and $9,901 as of February 3, 2018 and January 28, 2017, respectively.
Non-capital expenditures incurred prior to the grand opening of a new, remodeled, or relocated store are expensed as incurred.
Cost of sales
Cost of sales includes the cost of merchandise sold (retail store and e-commerce), including a majority of vendor allowances, which are treated as a reduction of merchandise costs; distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities, and insurance; shipping and handling costs; store occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, licenses, and cleaning expenses; salon payroll and benefits; customer loyalty program expense; and shrink and inventory valuation reserves.
Selling, general and administrative expenses
SG&A expenses includes payroll, bonus, and benefit costs for retail and corporate employees; advertising and marketing costs; credit card program incentives; gift card breakage; occupancy costs related to our corporate office facilities; public company expense including Sarbanes-Oxley Act of 2002 compliance expenses; stock-based compensation expense; depreciation and amortization for all assets except those related to our retail store and distribution operations, which are included in cost of sales; and legal, finance, information systems and other corporate overhead costs.
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities used for financial reporting purposes and the amounts used for income tax purposes. The amounts reported were derived using the enacted tax rates in effect for the year the differences are expected to reverse.
Income tax benefits related to uncertain tax positions are recognized only when it is more likely than not that the tax position will be sustained on examination by the taxing authorities. The determination is based on the technical merits of the position and presumes that each uncertain tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. Penalties and interest related to unrecognized tax positions are recorded in income tax expense in the consolidated statements of income.
Share-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized on a straight-line basis over the requisite service period for awards expected to vest. The Company recorded stock compensation expense of $24,399, $19,340, and $15,594 in fiscal 2017, 2016, and 2015, respectively (see Note 10, “Share-based awards”).
The Company has insurance programs with third party insurers for employee health, workers compensation, and general liability, among others, to limit the Company’s liability exposure. The insurance programs are premium based and include retentions, deductibles, and stop loss coverage. Current stop loss coverage per claim is $350 for employee health claims, $100 for general liability claims, and $250 for workers compensation claims. The Company makes collateral and premium payments during the plan year and accrues expenses in the event additional premium is due from the Company based on actual claim results.
Net income per common share
Basic net income per common share is computed by dividing income available to common stockholders by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per common share includes dilutive common stock equivalents, using the treasury stock method (see Note 11, “Net income per common share”).
Recent accounting pronouncements not yet adopted
Revenue Recognition from Contracts with Customers
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014‑09, Revenue from Contracts with Customers, issued as a new Topic, Accounting Standards Codification Topic 606 (ASU 2014‑09). The new revenue recognition standard provides a five-step analysis of transactions to determine when and how revenue is recognized. The core principle is that the Company will recognize revenue when the transfer of promised goods or services to customers occurs in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The standard also calls for additional disclosures around the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In August 2015, the FASB issued ASU 2015‑14 Revenue from Contracts with Customers (Topic 606), which delayed the effective date of ASU 2014‑09 by one year. With the deferral, the revenue recognition standard is effective for annual reporting periods beginning after December 15, 2017, including interim reporting periods, with early adoption permitted. This standard and subsequent amendments allow for either full retrospective or modified retrospective adoption.
The Company will adopt the new standard effective February 4, 2018 using the modified retrospective method applied to all contracts as of that date. ASU 2014‑09 will impact the recognition timing or classification of revenues and expenses for the loyalty program (by using the deferred revenue method instead of the incremental cost method), private label credit card and co-branded credit card programs (by recognizing amounts earned under the programs as revenue instead of as a reduction of SG&A expenses), gift card breakage (by including breakage within net sales instead of SG&A expenses under the proportional model), sales refund reserve (by grossing up the balance sheet to record a refund obligation and right of return asset instead of recognizing revenue net of returns), and e-commerce operations (by recognizing revenue upon shipment, when control of the merchandise transfers to the customer, instead of upon receipt by the customer).
The adoption of ASU 2014-09 will not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. Upon adoption, the Company will recognize the cumulative effect of adopting this standard as an adjustment to the opening balance of retained earnings. Prior periods will not be retrospectively adjusted. The Company expects this adjustment will decrease the fiscal 2018 opening balance of retained earnings by $15,000 to $20,000, which is primarily related to the change in accounting for the loyalty program from the incremental cost method to the deferred revenue method as required by this standard.
In February 2016, the FASB issued ASU 2016‑02, Leases (Topic 842). This standard will change the way all leases of one year or more are treated. Under this guidance, lessees will be required to capitalize virtually all leases on the balance sheet as a right-of-use asset and recognize an associated financing lease liability or capital lease liability. The right-of-use asset represents the lessee’s right to use, or control the use of, a specified asset for the specified lease term. The lease liability represents the lessee’s obligation to make lease payments arising from the lease, measured on a discounted basis. Based on certain characteristics, leases are classified as financing leases or operating leases. Financing lease liabilities, those that contain provisions similar to capitalized leases, are amortized like capital leases under current GAAP as amortization expense and interest expense in the statement of operations. Operating lease liabilities are amortized on a straight-line basis over the life of the lease as lease expense in the statement of operations. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, and have the option to use certain relief. ASU 2016‑02 is effective for public companies for annual reporting periods beginning after December 15, 2018, including interim reporting periods. Early adoption is permitted.
The Company will adopt the new standard in fiscal 2019. The Company’s ability to adopt depends on system readiness, including software procured from third-party providers, and completing an analysis of information necessary to quantify the financial statement impact. The Company formed a project team to review the current accounting policies and practices and assess the effect of the standard on the consolidated financial statements. The team completed a preliminary assessment of the potential impact of adopting ASU 2016‑02 on the consolidated financial statements. The adoption of ASU 2016‑02 will have a material impact on the Company’s consolidated financial position, but the Company is not able to quantify the difference at this time. The Company does not believe adoption of this standard will have a material impact on the Company’s consolidated results of operations or cash flows.
Liabilities – Extinguishments of Liabilities
In March 2016, the FASB issued ASU 2016‑04, Liabilities – Extinguishments of Liabilities (Subtopic 405‑20): Recognition of Breakage for Certain Prepaid Stored – Value Products. This update entitles a company to derecognize amounts related to expected breakage to the extent that it is probable a significant reversal of the recognized breakage amount will not subsequently occur. ASU 2016-04 is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted. The adoption of ASU 2016-04 is not expected to have a material impact on the Company’s consolidated financial position, results of operations, or cash flows.
Recently adopted accounting pronouncements
Compensation – Stock Compensation
In March 2016, the FASB issued ASU 2016‑09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This guidance changed how companies account for certain aspects of share-based payments to employees. Companies have to recognize all income tax effects of awards in the income statement when the awards vest or are settled, and additional paid-in capital pools were eliminated. The guidance on employer’s accounting for an employee’s use of shares to satisfy the employer’s statutory income tax withholding obligation and for forfeitures changed, and two practical expedients for non-public entities were added. ASU 2016‑09 was effective for annual and interim reporting periods beginning after December 15, 2016.
The Company adopted the new guidance prospectively in the first quarter of fiscal 2017. The adoption resulted in a decrease in the provision for income taxes of $10,024 in fiscal 2017 due to the recognition of excess tax benefits for options exercised and the vesting of equity awards. The extent of excess tax benefits or deficiencies is subject to variation in the Company’s stock price and timing/extent of restricted stock units vesting and employee stock option exercises. Additionally, the consolidated statements of cash flows now present such tax benefits or deficiencies as an operating activity on a prospective basis. Based on the adoption methodology applied, the statement of cash flows classification of prior periods has not been adjusted. As allowed under the new guidance, the Company did not change its accounting principles relative to elements of this standard and continued its existing practice of estimating the number of awards that will be forfeited.
Statement of Cash Flows
In August 2016, the FASB issued ASU 2016‑15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force). ASU 2016‑15 provides classification guidance on certain cash receipts and cash payments, including, but not limited to, debt prepayment costs, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of bank-owned life insurance policies, and distributions received from equity method investees. The adoption of ASU 2016‑15 requires a retrospective transition method applied to each period presented. ASU 2016-15 is effective for annual periods and interim periods beginning after December 15, 2017, and early adoption is permitted. The Company early adopted the new guidance, retrospectively, in the fourth quarter of fiscal 2017, and its adoption had no material impact on the Company’s consolidated financial position, results of operation, or cash flows.
In November 2016, the FASB issued ASU 2016‑18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the Emerging Issues Task Force), which amends ASU Topic 230. ASU 2016‑18 requires entities to show the changes in the total of cash, cash equivalents, restricted cash, and restricted cash equivalents in the statement of cash flows. As a result, entities will no longer be required to present transfers between cash and cash equivalents and restricted cash and restricted cash equivalents in the statement of cash flows. When cash, cash equivalents, restricted cash, and restricted cash equivalents are presented in more than one line item on the balance sheet, the new guidance requires a reconciliation of the totals in the statement of cash flows to the related captions in the balance sheet. Entities will also have to disclose the nature of their restricted cash and restricted cash equivalent balances. ASU 2016-18 is effective for fiscal years beginning after December 15, 2017 and interim periods within those years and early adoption is permitted. Entities are required to apply the guidance retrospectively. The Company early adopted the new guidance, retrospectively, in the fourth quarter of fiscal 2017, and its adoption had no material impact on the Company’s consolidated financial position, results of operations, or cash flows.
Compensation – Stock Compensation: Scope of Modification Accounting
In May 2017, the FASB issued ASU 2017‑09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, which provides clarification on when modification accounting should be used for changes to the terms or conditions of a share-based payment award. This ASU does not change the accounting for modifications but clarifies that modification accounting guidance should only be applied if there is a change to the value, vesting conditions, or award classification and would not be required if the changes are considered non-substantive. ASU 2017-09 is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years, and early adoption is permitted. The Company early adopted this standard in the fourth quarter of fiscal 2017, and its adoption had no impact on the Company’s consolidated financial position, results of operations, or cash flows.