Is Green Mountain Coffee’s Management Team Milking Shareholders For Every Last Penny?

In an interview last Monday with veteran investigative reporter and best-selling author Gary Weiss, I described how executives at Green Mountain Coffee Roasters (NASDAQ:GMCR) apparently received higher bonuses in 2011 because computations for annual cash incentive rewards did not take into legal and accounting expenses relating to an ongoing Securities and Exchange Commission probe into its financial reporting and class action litigation alleging securities fraud. Those executives are already indemnified for legal fees to defend themselves in any S.E.C. investigation and class action lawsuit.

It’s equivalent to management double dipping into corporate coffers at the expense of shareholders. While the company has the burden of paying for the ongoing S.E.C. probe and management’s legal defense in class action lawsuits, their bonuses don’t take into account such costs. It’s like tossing a coin and if it lands on heads, management wins, or if it lands on tails, investors still loose.

In addition, the cash incentive plan does not factor in acquisition-related expenses and the cost of amortizing identifiable intangible assets related to those acquisitions. Therefore, management is encouraged to overpay for acquisitions since such costs are not included in calculating annual cash incentive rewards, while they are still borne by the company. The executives running Green Mountain Coffee seem to be milking the company for every last penny they can get in compensation.

Background

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its revenue accounting practices and relationship with a certain fulfillment vendor eight days earlier. On that same day, the company reported that it discovered an accounting error involving its K-Cup margin percentages during the preparation of its financial report for the period ended September 25, 2010. Within days, class action lawsuits were filed against the company and certain officers alleging securities fraud.

On November 19, 2010, Green Mountain disclosed that it found four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to the period ended June 26, 2010 to correct its errors and conceded that there were material weaknesses in internal controls.

Since then, this blog has detailed ongoing accounting rule violations by the company. Its so-called restated numbers still don’t appear to add up. More recently, money manager David Einhorn has uncovered serious improprieties at the company.

2011 cash incentive rewards plan

On January 17, 2012, Green Mountain Coffee’s preliminary proxy statement revealed details of its “annual incentive awards” paid for key executives (page 18):

We use these two metrics to determine the amount of annual incentive awards earned. For fiscal 2011, these results translated into an achievement of 122% of the bonus targets set for the year, with net sales for fiscal 2011 of $2.7 billion exceeding the prior year’s target by 9% and non-GAAP operating income of $428 million exceeding the prior year’s target by nearly 14%. The Compensation Committee set these targets at challenging levels that it believed would incentivize the executives to perform at the highest levels. [Emphasis added.]

Furthermore, the company disclosed (see page 26):

Consistent with prior years, the Compensation Committee again chose challenging net sales and non-GAAP operating income (as defined in the GAAP to non-GAAP Reconciliation of Consolidated Statements of Operations table as set fourth [spelled incorrectly] in Exhibit 99.1 on the Company’s current report on Form 8-K filed November 9, 2011.) targets as the financial targets against which to measure any annual incentive compensation payable to the named executive officers. Under the Company’s annual incentive plan for fiscal 2011, for any payout to have occurred, the Company’s net sales and non-GAAP operating income had to have been at least equal to the “threshold” amounts as set forth below. At the “threshold,” 20% of an individual’s target bonus opportunity would have been paid. If the Company’s net sales and non-GAAP operating income met the “target” level as set forth below for fiscal 2011, then 100% of the individual’s target opportunity would have been paid. Finally, if the Company’s net sales and non-GAAP operating income for fiscal 2011 had reached the “maximum” levels, as set forth below, then, all else being equal, 150% of the individual’s target bonus opportunity would have been paid. The amounts below are in thousands.

For fiscal 2011, the Compensation Committee set the target percent of base salary for each of our named executive officers to be consistent with the Company’s compensation philosophy and the competitive marketplace data, which are shown below. In addition, the table also shows the target and maximum annual incentive opportunity and the actual annual cash incentive paid to the named executive officers as a result of the Company’s achievement of 122% of the financial goals set by the Compensation Committee at the beginning of the fiscal year. [Emphasis added.]

The company was able to pay higher bonuses to its executives in part because its non-GAAP operating income of $428,693 for the fiscal year ended September 24, 2011 exceeded the $376,100 target set for that year. According to Exhibit 99.1 of the 8-K report referenced in the proxy statement detailed above, non-GAAP operating income excluded legal and accounting expenses related to the S.E.C. inquiry and pending litigation which increased non-GAAP operating income by $7.9 million to $428 million. Therefore, executive bonuses were higher because such costs do not count in computing their annual incentive rewards. See below. (Click on image to enlarge.):

The company’s incentive compensation calculation ignores the cost it incurred due to management incompetence, negligence, and possibly fraud. The company had to restate its financial reports from the beginning to 2007 to June 26, 2010 due to inadequate internal controls and material accounting errors and it now faces on ongoing S.E.C. probe and class action lawsuits.

Chief Executive Officer Lawrence Blanford and Chief Financial Officer Frances Rathke received 18.8% and 15.4% respective raises in base compensation despite signing inaccurate Sarbanes-Oxley certifications claiming that adequate internal controls existed from 2007 to 2010. Their raises were bigger than raises received by other executive officers who did not sign such certifications. So far, no key executive has been held accountable for the company’s financial reporting and legal troubles. See below. (Click on image to enlarge.):

Furthermore, the 2011 cash incentive plan did not take into account acquisition-related expenses and the amortization of identifiable intangibles from those acquisitions. The cash incentive plan encourages management to overpay for acquired companies, since such costs resulting from acquisitions are not included in the calculation of their annual rewards.

Under the 2010 cash incentive plan, the amortization of identifiable intangibles was included in the calculation of cash incentive rewards, unlike the current 2011 plan. Therefore, the 2011 plan was apparently richer for executives than in 2010 because it did not factor in certain costs that were used to calculate annual incentive rewards in the prior year. That contradicts its disclosure that the plan was "Consistent with prior years...." (See Proxy page 26.)

On a lighter note, Green Mountain Coffee’s high-paid executives and high-priced lawyers are advised to use a spell-checker before preparing reports such as the latest proxy statement detailed above. On page 26, they misspelled “forth” as “fourth” in language describing the incentive compensation plan. My Microsoft Word spell-checker was able to flag that error right away.

Written by:

Sam E. Antar

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. Furthermore, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not own any Green Mountain Coffee Roasters securities long or short.

Overstock.com Facing Dismal Fourth Quarter Numbers?

Yesterday, Overstock.com (NASDAQ:OSTK) disclosed that it was forced to pay off its existing obligations under a Master Lease Agreement with U.S. Bank to avoid an anticipated default under its covenants on December 31, 2011. So far, Overstock.com has lost $16 million in the first nine months of the year compared to only a $1.1 million loss during the previous year's nine month period. The termination of the Master Lease Agreement by Overstock.com to avoid a pending default appears to confirm that it will report dismal fourth quarter 2011 numbers.

According to the 8-K report filed with the Securities and Exchange Commission after the market closed on December 28, 2011:

On December 27, 2011 Overstock.com, Inc. (the “Company”) and U.S. Bancorp Equipment Finance, Inc. — Technology Finance Group (“Lessor”), agreed to terminate a Master Lease Agreement, dated September 17, 2010 (“Master Lease Agreement”) and all related schedules. The Company paid approximately $20.1 million to Lessor in connection with the amendment and agreement to terminate the Master Lease Agreement, including approximately $1.2 million in prepayment premiums. The aggregate amount the Company paid to amend the Master Lease Agreement and terminate the schedules associated with the Master Lease Agreement was less than the amount the Company would have been required to pay over the scheduled life of the Master Lease Agreement and all related schedules. By this transaction, the Master Lease Agreement was first amended to eliminate all financial covenants, effective immediately. Lessor also committed to convey to the Company all of the equipment and other assets covered by the Master Lease Agreement for no additional consideration.

The Company amended the Master Lease Agreement in order to eliminate the total fixed charge coverage ratio covenant under the Master Lease Agreement. As disclosed in the Company’s Form 10-Q for the quarter ended September 30, 2011, based on the Company’s results for the first three quarters of 2011, management considered it likely at that time that the Company would be out of compliance with the Master Lease Agreement’s total fixed charge coverage ratio covenant at December 31, 2011. In order to avoid a covenant violation, the Company amended the Master Lease Agreement to eliminate the financial covenants.

Lessor is an affiliate of U.S. Bank National Association (the “Bank”). The Company has a $20 million cash-secured credit facility with the Bank. The Bank or its affiliates have also provided other commercial services to the Company from time to time. [Emphasis added.]

Overstock.com tried to spin its termination of the Master Lease Agreement as positive news by claiming that the amount paid to US Bank was “was less than the amount the Company would have been required to pay over the scheduled life of the Master Lease Agreement and all related schedules." However, the company apparently agreed to pay the full obligation of $18.9 million that was due under the Master Lease Agreement as of December 31, 2011 plus applicable taxes and a stiff $1.2 million prepayment penalty. It was unable to restructure its Master Lease Agreement and obtain less stringent terms from U.S Bank.

As of September 30, 2011, OSTK owed US Bank $20.329 million under the Master Lease Agreement. $1.428 million of that amount was payable during the quarter ending December 31, 2011. (See Quarter Ended September 30, 2011 10-Q report page 17). Therefore, Overstock.com would have owed US Bank $18.901 million as of December 31, 2011 ($20.329 million less $1.428 million). The prepayment penalty amounts to approximately 6% of Overstock.com's obligation to U.S. Bank under the Master Lease Agreement as of December 31, 2011. That prepayment penalty will be reflected as charge to its otherwise expected dismal fourth quarter financial results. Furthermore, the company will have to take additional depreciation charges in future periods since it will take title to the equipment and other assets covered under the Master Lease Agreement.

Liquidity problems

As of September 30, 2011, Overstock.com reported that it had only $18.4 million in working capital. However, the company would have reported a mere $1.4 million of net working capital (current assets minus current liabilities) had it not played a shell game and window dressed its balance sheet during the third quarter.

On September 21, 2011, Overstock.com borrowed $17 million under a separate Financing Agreement (line of credit) with U.S. Bank and used $7.5 million of internal cash to redeem $24.5 million of convertible debt before its December 1, 2011 due date (10-Q report page 16 and 33). The convertible debt was classified on the company's balance sheet as a current liability. The $17 million that it borrowed under its Financing Agreement (line of credit) is a long term debt (noncurrent liability) because payment is due on December 31, 2012 (10-Q report page 42). Had Overstock.com not borrowed that $17 million from U.S. Bank to redeem its convertible debentures before the end of the third quarter (September 30, 2011), it would have ended the quarter with a mere $1.4 million in working capital (current assets less current liabilities). In any case, its balance sheet window dressing is temporary, since the $17 million it borrowed will become a current liability by the end of the first quarter of 2012 (March 31, 2012) which is traditionally a weak quarter for the company.

As of December 31, 2011, $12.959 million of Overstock.com's $18.901 million obligation under the Master Lease Agreement would have been classified as a long term liability. Since the company paid $20.1 million, including a $1.2 million prepayment penalty to terminate the Agreement, its working capital was apparently depleted by another $7.1 million ($20.1 million less $12.959 million).

In December 9, 2011, Overstock.com filed a shelf registration statement with the Securities and Exchange Commission that would allow it to sell up to $200 million of its debt securities, common stock, warrants and other securities. It appears likely that Overstock.com will need to do some sort of equity related offering in the first quarter of 2012 to stay afloat and avoid further liquidity problems. Such an offering will likely significantly dilute the value of existing common shares. (See Davian Letter "Overstock.com is Overstocked.")

On December 14, 2011, the company unloaded millions of dollars of excess inventory in a public auction and generated a mere $150,000 in cash, just pennies on the dollar.

Other issues

Patrick Byrne

Overstock.com also has to contend with an ongoing investigation by the Securities and Exchange Commission into securities law violations after this blog exposed it fabricating its earnings numbers. So far, every single financial report issued from its inception in 1999 to the third quarter of 2009 had to be restated up to three times due to violations of Generally Accepted Accounting Principles.

The company is being sued by District Attorneys from seven California District Attorneys who are alleging consumer fraud. They are seeking at least $15 million of restitution, fines, penalties, and cost reimbursements from the company for allegedly defrauding consumers. The Judge in that case had to compel an uncooperative Overstock.com to turn over information to the California District Attorneys.

Earlier in the year, Google penalized Overstock.com because it improperly gamed its search algorithm to boost its search rankings.

In October 2011, Overstock.com CEO Patrick Byrne, his hedge fund High Plains Investments LLC, Deep Capture LLC, and Mark Mitchell, a writer for Deep Capture, were sued in a Canadian court for defamation. Deep Capture LLC is an affiliate of Overstock.com and its website was used to promote Byrne's delusional conspiracy theories and libel company critics.

Latest deceptions

Back in January 2011, Overstock.com changed its name to O.co and directed its customers to use the O.co domain. As late as September 30, 2011, Patrick Byrne claimed in a press release that, "Our customers associate 'O' with Overstock.com, which made the transition to O.co seamless."

However, in the third quarter ended September 30, 2011, Overstock.com reported a $7.8 million loss compared to a $3.4 million loss in the previous year's quarter. Revenues during that quarter had declined by 2% to $239.7 million from $245.4 million dollars in the previous year. The company revealed that, "We also believe that our current efforts to rebrand ourselves from Overstock.com to O.co may have contributed to the decline in revenue." (See 10-Q page 33). Apparently, Overstock.com's transition to O.co was not as "seamless" as previously claimed by Byrne at the end of that same quarter. During a conference call with analysts, Patrick Byrne now admitted that customers found the transition was "confusing."

Jonathan Johnson

On November 14, 2011, Ad Age reported that the company's president, Jonathan Johnson also backpedaled on remarks made by Byrne at the end of its third quarter:

The online retailer's president, Jonathan Johnson, said it is stepping back from the O.co name "for now," though not abandoning it outright...."

Confused? So were customers. Mr. Johnson said customers responded well to the O.co advertising, but after watching the spots, "a good portion" of those who sought out the website went to O.com, instead of O.co. (O.com is one of the off-the-market single letter domain names still held by ICANN.)

"We were going too fast and people were confused, which told us we didn't do a good job," Mr. Johnson said.

Marketing Magazine put Overstock.com's rebranding efforts at the top of its list of 2011 marketing blunders.

Worst customer service in 2011

Just yesterday, the Huffington Post reported that, “The site with the dubious honor of proffering the worst customer service in 2011 was Overstock.com, those ubiquitous merchants of discounted furniture, clothes and home furnishing.”

Byrne sold shares before decline

Yesterday, Overstock.com common stock closed at $7.77 per share. Back on May 20 to May 24, 2010, Patrick Byrne's 100% controlled High Plains Investments LLC dumped 140,000 company shares at an average price of $22.11 per share and collected over $3 million in proceeds. Despite Byrne's optimistic forecasts, the company surprised investors and failed to meet analysts' consensus earnings expectations in the quarter ended June 30, 2010. Since the time Byrne has sold his stock, Overstock.com’s shares have dropped about 65% in market value and its market capitalization has dropped approximately $330 million.

Written by,

Sam E. Antar

Recommended Reading

Seeking Alpha: Green Mountain Coffee Roasters Surpasses Overstock.com As Worst Stock of 2011, By Gary Weiss

Davian Letter: Overstock.com continued....

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 white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

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. My past sins are unforgivable.

I do not own any Overstock.com securities long or short.

Green Mountain Coffee Roasters: Where are the missing beans?

Just about every time I take a look at financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I found troubling discrepancies in its numbers. In the past, I’ve described how certain so-called restated numbers which purportedly corrected accounting errors in its Timothy’s subsidiary don’t appear to add up. Now, I’ve found even more puzzling numbers which raise more questions of whether its restatements of financial reports were actually correct.

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its revenue accounting practices and relationship with a certain fulfillment vendor eight days earlier. On that same day, the company coincidently reported that it discovered an accounting error involving its K-Cup margin percentages during the preparation of its financial report for the period ended September 25, 2010. On November 19, 2010, Green Mountain disclosed that it found four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to the period ended June 26, 2010 to correct its errors and conceded that there were material weaknesses in internal controls.

On December 9, 2010, Green Mountain Coffee issued its 10-K report for the year ended September 25, 2010. That 10-K report included details of its restatements for various periods. For example, the company reported the following restated segment numbers for the quarter ended March 27, 2010 (See page F-64 and click on image to enlarge):

Future financial reports issued in the following fiscal year 2011 should reflect those same restated numbers. They don't. Furthermore, the revision of the restated numbers don’t seem to add up.

In the quarter ended March 26, 2011 10-Q report, showed the following restated segment numbers for the previous year’s thirteen week period ended March 27, 2010 (See page 14 and click on image to enlarge):

In the above 10-Q report, Green Mountain Coffee reduced the depreciation and amortization amount for the SCBU unit to $6.388 from the restated $8.062 million amount in the previous 10-K report. It increased the depreciation and amortization amount for the Corporate unit to $1.674 million from the restated $0 amount in the previous 10-K report. In other words, the company shifted $1.674 million of depreciation and amortization from its SCBU unit to its Corporate unit.

However, there were no changes income before taxes reported in any segment. Furthermore, there were no changes in any other income statement line items for its segments or in intercompany eliminations affecting those income statement line items. There were revisions in certain balance sheet line items. However, those balance sheet item revisions don’t explain why income before taxes were not changed in the SCBU unit or corporate unit. Therefore, if the company reduced depreciation and amortization expense in the SCBU segment and increased it in the corporate segment, its income before taxes should have increased in the SCBU segment and decreased in the corporate segment. I didn’t. The same issue continues to appear in subsequent 10-Q reports and even the annual audited 10-K report for fiscal year 2011.

Tracy Coenen, author of several forensic accounting books, once told me, "If a company cannot complete a simple task such as correctly adding or subtracting numbers, investors cannot trust anything in their financial reports." Historical numbers are supposed to be consistent from report to report, and the totals must be correct. At Green Mountain Coffee we continue to find the opposite - inconsistent historical numbers and numbers that don't add up.

Can anyone at Green Mountain Coffee explain the missing beans? Does the company add fudge to its coffee?

Written by,

Sam E. Antar

Recommended reading

Forbes: Some Advice for MF Global Employees - Start Cooperating With The Feds! by Walter Pavlo

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. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not own any Green Mountain Coffee Roasters securities long or short.

Did j2 Global Communications Fumble in Accounting?

Last week, I suggested that j2 Global Communications Inc. (NASDAQ:JCOM) could have misinterpreted certain accounting rules and that it should consider restating its financial reports issued in 2010. My analysis was based on a report issued by independent research firm Gradient Analytics and an examination of accounting rules and company disclosures. This blog post will examine how j2 Global has attempted to downplay certain problems in its financial reporting and provide even more compelling reasons for the company to consider restating its financial reports.

Background

Up to 2010, j2 Global apparently estimated the remaining life under its annual contracts with eFax customers to compute its deferred revenues, revenues, and earnings. In the first quarter 2011 10-Q report j2 Global disclosed that it upgraded its accounting systems and started using the actual useful life under its annual contracts with eFax customers to compute those numbers:

In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax subscribers. As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers. As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenue of $10.3 million with an equal offset to revenues. This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended 03/31/11 by $0.17 and $0.16, respectively. [Bold/underline added for emphasis.]

The determination of the actual remaining life of an annual service contract involves a simple computation. For example, assume a company has a December 31 year-end. On November 1, a customer purchases an annual contract with an advance payment of $120. The company earns $10 per month under the annual contract ($120 divided by 12). At year-end, the company reports $20 of revenue to reflect income earned during November and December. In addition, it reports a deferred revenue liability of $100 to reflect the unearned income for the remaining 10 months under the contract. It’s not rocket science. Apparently, j2 Global’s accounting systems could not make such a computation, so the company estimated the number. It turns out that its estimates were significantly incorrect.

In the first quarter of 2011 j2 Global upgraded its accounting systems and was now able to calculate the actual remaining life under its annual service contracts with eFax customers. In that quarter, the company recorded a one-time cumulative adjustment to increase deferred revenues by $10.3 million, decrease in revenues by $10.3 million, and decrease net income by $7.6 million to accurately reflect its actual remaining service obligations under annual contracts with eFax customers.

Cumulative one-time adjustments in current periods relate to numbers reported in prior periods. Therefore, the company apparently understated its deferred revenue liability and overstated both revenue and net income reported in 2010 because it was unable to accurately measure the remaining life of annual service contracts with eFax customers. j2 Global claimed that those adjustments stemmed from a “change in estimate” under accounting rules. Therefore, it could use a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods.

Last week, independent research firm Gradient Analytics issued a report that questioned whether j2 Global appropriately treated those adjustments as a change in estimate. Based on its examination of the j2 Global’s financial disclosures, applicable accounting rules, and limited feedback from the company, Gradient reported that “…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results.” If those adjustments were considered an accounting error rather than a change in estimate, a restatement of j2 Global’s 2010 financial reports may be warranted if such errors are considered material under accounting rules.

Earlier company disclosures

For years, j2 Global warned investors about potential "failures or errors" in its billing systems. For example, in the 2010 10-K report issued just months before it made those one-time adjustments, the company disclosed:

We are in the process of upgrading our current billing systems to meet the needs of our growing subscriber base. Any failures or errors in our billing systems or procedures or resulting from any upgrades to our billing systems or procedures could impair our ability to properly bill our current customers or attract and service new customers, and thereby could materially and adversely affect our business and financial results. [Emphasis added.]

If there were no “failures or errors” in j2 Global’s billing systems, logically there would have been no one-time adjustments in the first quarter of 2011 to correct an understatement of deferred revenue liabilities and overstatement of revenues and net income reported in 2010. However, when the accounting adjustments came as warned, the company did not admit to any foul ups. In its first quarter 2011 10-Q report, it tried to put a good face on the issue. The company said it upgraded its systems and started using actual numbers for the remaining life of annual contracts to eFax customers. It's like an army general who doesn't want to admit retreat and brags about advancing to the rear.

SingerLewak LLP signed off on j2 Global's 2010 audit and internal controls on February 25, 2011, 56 days into the first quarter of 2011 (See 10-K report page 62). The close timing of the sign off by the auditors and the subsequent report of one-time adjustments raises concerns about the quality of their audit work and internal control environment at j2 Global.

Gradient raised similar concerns in its report:

Our research identified a number of troubling issues that point to a potentially weak audit-and-control environment. For example, the company’s disclosure of a $10.3 million one-time-target to revenue and offsetting increase in deferred revenue appears unusual in our view, and may be indicative of an error in in JCOM’s revenue reporting. In addition, we are concerned by management’s decision to omit disclosures relating to acquired revenues since 2010. We have further concern regarding PCAOB reports on the work of JCOM’s external auditor SingerLewak (hired in 2007) and a 2006-2007 internal investigation into incorrect stock-option-grant dates between 1999 and 2005.

A recent Public Company Accounting Oversight Board (PCAOB) inspection report issued on April 29, 2011, cited SingerLewak for various audit deficiencies, including "the failure to perform sufficient procedures related to the testing of revenue." The PCAOB report did not identify the company involved in that audit.

j2 Global attempts to play down significance of one-time adjustments

On May 5, 2011, CFO Kathy Griggs sought to downplay the significance of its one-time adjustments during the first quarter 2011 earnings call with investors and analysts:

The difference relates to a change in estimate implemented in Q1 2011 regarding our remaining service obligations to annual eFax subscribers. As a result of systems upgrades we are now basing the estimates on the actual remaining service obligations to these customers. As a result of this change we recorded a one-time noncash increase to our balance of deferred revenues of $10.3 million with an equal offset to revenues. This change is insignificant considering that our prior estimation techniques have been in place for over thirteen years, a period of which we reported over $1.6 billion in revenues cumulatively. [Emphasis added.]

The so-called first quarter 2011 “change in estimate” related to annual eFax subscribers. Logically, those one-time adjustments can only relate to revenues reported in 2010, not the entire thirteen year period. The adjustments increased deferred revenue liabilities by $10.3 million, decreased revenues by $10.3 million, and decreased net income by $7.6 million. Griggs used thirteen years of cumulative revenues amounting to $1.6 billion to make an inappropriate comparison to the $10.3 million revenue adjustment. She should have compared the $10.3 million revenue adjustment to $255.4 million of revenues reported in 2010.

Kathy Griggs tried to explain the significance of its one-time adjustments purely in terms as a percentage of cumulative revenues. That was wrong, too. Relatively insignificant misstatements in reporting revenues can have a significant effect on reported growth trends in revenues and earnings. Furthermore, relatively small revenue misstatements can hide a company’s failure to meet or beat analyst’s consensus earnings forecasts. Whether you call it a change in estimate or an accounting error, relatively small misstatements of revenues can have a significant impact on a company’s reported financial performance.

Was it a change in estimate or an accounting error?

Last week, Gradient Analytics examined j2 Global's first quarter 2011 10-Q report and questioned whether j2 Global had appropriately treated those adjustments as a change in estimate:

…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results. The distinction between a change in estimate and a correction of an error is important in that it may have implications for an evaluation of the effectiveness of internal controls.

Under U.S. GAAP, a change in accounting estimate occurs when new information or additional experience causes a company to change its estimate of an amount that is subject to uncertainty, such as future warranty obligations or the useful life of an asset. In contrast, errors result from mathematical mistakes in applying accounting principles or oversight, or misuse of facts that existed when preparing financial statements. In the case of JCOM, if the remaining service obligation for eFax customers can be determined with certainty, as is implied by the disclosure in the firm’s 10-Q it would appear to us to be a result of oversight of facts existing at the time of financial statement preparation. That is, the disclosure appears to indicate that the company’s internal control systems were not able to determine the remaining service obligation, despite the fact that the remaining service obligation was important both to revenue recognition and to customers who depend on accurate billing on their accounts and accurate tracking of remaining services they are owed. Furthermore, if the firm’s legacy system could not properly identify or track the underlying facts and figures required to properly value deferred revenue, as implied by the disclosure in the Q1 2011 10Q, it would appear to indicate a deficiency in internal control before Q1 2011.

In order to gain more clarity on this issue, we contacted the company on several occasions before publication. The first response we received was from investor relations (IR) representative Laura Hinson, who stated that the “systems upgrade permitted an accurate measurement of the remaining useful life of an annual customer and therefore permitted a more accurate measurement of the remaining useful life of an annual customer and therefore a more accurate picture of the amount of deferred revenue.” We followed up with a question asking why the company determined that the situation should be treated as a change in estimate, rather than the correction of an error. However, the company declined to answer our follow-up question. [Emphasis added.]

I'll try to explain the situation involving j2 Global's accounting issues in simple terms. A person could not count the fingers on his right hand without a calculator. He looked at his right hand and estimated that he had four fingers. After that person bought a calculator, he realized that there are actually five fingers on this right hand instead of four.

Is the one finger adjustment a change in estimate or an error under accounting rules? In such a case, the actual amount of fingers already existed, was not subject to uncertainty, and did not come about because of new information. Therefore, the adjustment should not be a change in estimate under accounting rules. The person made a mathematical error. The miscounting of fingers arose from an oversight or misuse of facts at the time they were counted. If he couldn't count his fingers, he should have used a calculator to count them. Therefore, the adjustment should be considered an accounting error. The same logic appears to apply to adjustments made by j2 Global to deferred revenues, revenues, and net income.

Gradient's concerns seem well-founded. If we are to accept j2 Global's rationale that its adjustments were a change in estimate, any public company that does not have adequate internal controls in place to report correct numbers can avoid reporting an accounting error when it turns out that previously reported numbers were incorrect.

j2 Global treated its adjustments of overstatements of deferred liabilities and understatement of revenue and earnings as a “change in estimate” under accounting rules. That allowed it to make a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods. If j2 Global had considered those adjustments as stemming from a material accounting error it would have been required to restate its previously affected financial reports rather than make a one-time adjustment.

Furthermore, it's troubling that j2 Global apparently stopped responding to Gradient as it made further inquiries about the change in estimate. Why clam up? The company did find time to comment about other aspects of Gradient's report to CNBC Senior Stock Commentator Herb Greenberg (Video link to "Herb Alert" on CNBC).

Materiality

If we assume that j2 Global’s adjustments to deferred revenue, revenue, and net income stemmed from an accounting error instead of a change in estimate, the next step is to determine if the misstatement was material in affected previous reporting reports. According to Securities and Exchange Commission Staff Accounting Bulletin No. 99 (SAB No. 99) some of the measures used to determine if accounting error is material are: “whether the misstatement masks a change in earnings or other trends” and “whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.” If a misstatement causes a company to report an increase in revenues rather than properly report a decrease in revenues or if a misstatement hides a failure to match or beat analyst’s estimates, it is considered material and previously issued financial reports must be restated.

In the third quarter of 2010, j2 Global’s revenues increased by a mere $977,000 to $62.778 million compared to $61.801 million in the previous year’s third quarter. Its earnings per share matched the previous year’s comparable numbers – no growth. RTT News reported that j2 Global beat earnings beat analyst’s estimates by just $0.01 per share in both the third quarter and second quarter of 2010.

The understatement of deferred revenues and overstatement of revenues and earnings by j2 Global could have caused the company to report higher revenues and earnings per share in the third quarter of 2010 instead of lower revenues and earnings when compared to 2009's third quarter. In addition, they could have caused the company to beat analyst's estimates for third quarter and possibly the second quarter of 2010, too. Therefore, based on the size of the one-time adjustments it is possible there was a material misstatement of j2 Global’s financial performance in 2010.

Other items

In its recent 8-K report for the third quarter of 2011, j2 Global presented a full non-GAAP income statement and reconciled it side-by-side with its GAAP numbers. According to S.E.C. Regulation G Compliance and Disclosure Interpretations, the company cannot present a full non-GAAP income statement. See below:

Question 102.10

Question: Is it appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP measures to the most directly comparable GAAP measures?

Answer: Generally, no. Presenting a full non-GAAP income statement may attach undue prominence to the non-GAAP information. [Jan. 11, 2010].

The company should change its future non-GAAP presentations to comply with S.E.C rules.

Closing comments

Whether or not there was a change in estimate or an accounting error, j2 Global needs to be more transparent with investors about its financial reporting issues. Mistakes happen. Best to be forthright about them early and move on, than to downplay them and create further investor uncertainty.

Written by,

Sam E. Antar

Update:

J2 Global Communications Trying to Hide Accounting Errors by Tracy Coenen

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. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

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. My past sins are unforgivable.

I do not own any securities in j2 Global Communications, long or short. I am an eFax subscriber. In the past, I have permitted Sabrient Systems LLC, which owns Gradient Analytics, to republish certain of my blog posts as a professional courtesy. I have never received any compensation from either Sabrient or Gradient and have no financial relationship with either firm.