Tuesday, February 26, 2008

Overstock.com and Patrick Byrne: Phony Accounting and False and Misleading Disclosures - Revenues

In a previous blog post entitled, "Overstock.com and Patrick Byrne: Phony Accounting and False and Misleading Disclosures," I detailed how the Securities and Exchange Commission found that Overstock.com (NASDAQ: OSTK) had neglected to report its revenues in compliance with GAAP since its very first filings more than five years ago. In addition, in that blog post and two other previous blog posts (link here and here), I detailed how Overstock.com violated Securities and Exchange Commission Regulation G that governs the disclosure of non-GAAP financial measures. These two observations illustrate how Overstock.com continually cherry picks information it deems most favorable to the company, while omitting material disclosures that are important to investors. That would appear to be the primary reason that Overstock.com can't seem to keep its books in order.

Once again, Overstock has proved to be the story that keeps on giving. Every time I try to find the answer to one simple question, I am confronted by even more violations and inconsistencies. The latest evidence, analyzed in this blog post, indicates that the company has knowingly violated its own revenue recognition policies since at least 1999.

The SEC instructs Overstock.com to report its revenues in compliance with GAAP

In Overstock.com's recent press release disclosing the company's fourth quarter results, management made the following surprise disclosure:

Note regarding our Q4 and 2007 financial results:

From the company's inception through the third quarter of 2007, we have recorded revenue based on product ship date. In the fourth quarter of 2007, in response to an accounting comment from the staff of the SEC, we retrospectively changed our policy to recognize revenue based on estimated product delivery date. We have recorded the cumulative effect of this change in the fourth quarter of 2007.

Note: Bold print and italics added by me.

But Overstock.com's acknowledgment that "From the company's inception through the third quarter of 2007, we have recorded revenue based on product ship date" is only half the story. This misleading disclosure omits the fact that Overstock.com knowingly violated its own stated revenue recognition policies since at least 1999. In addition, contrary to the company’s stated policy, Overstock’s revenue accounting was in violation of Securities and Exchange Commission Staff Accounting Bulletin No. 101.

The latest discovery resulted when I decided to look back to the first publicly available financial reports issued by Overstock.com. In its first S-1 filed with the Securities and Exchange Commission on May 5, 2002, Overstock.com disclosed its revenue recognition policy which states in part:

For sales transactions, we comply with the provisions of Staff Accounting Bulletin 101 "Revenue Recognition" which states that revenue should be recognized when the following four revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) the product has been shipped and the customer takes ownership and assumes the risk of loss; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. We generally require payment by credit card at the point of sale. Any amounts received prior to when we ship the goods to customers are deferred.

Note: Bold print and italics added by me.

The key takeaway is that Overstock states above that it is in compliance with Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 (which went into effect in 1999). This revenue recognition policy was provided in financial statements reported in the company's S-1 from 1999, and has continued relatively unchanged ever since. Since 2004, the company has also claimed to be in compliance with the latest revenue recognition guidance from the SEC, Staff Accounting Bulletin No. 104. But, take a closer look at the highlighted disclosure:

(2) the product has been shipped and the customer takes ownership and assumes the risk of loss;

Note: Bold print and italics added by me.

Overstock.com asserts that, consistent with Staff Accounting Bulletins 101 and 104. that it recognizes revenue when "the product was shipped and the customer takes ownership and assumes risk of loss." However, as detailed below, the company deliberately failed to follow this stated revenue recognition policy, leading to a material departure from GAAP in every one of its SEC filings to date.

Patrick Byrne uses the “everyone else was doing it” excuse to explain why Overstock.com's revenue recognition policy was not in compliance with GAAP

During the fourth quarter fiscal year 2007 earnings conference call, Patrick Byrne used some more fancy footwork to try to avoid taking responsibility for the company’s latest accounting failure. This time the CEO claimed, more or less, that “everyone else was doing it, so we did too.” Of course, being the subject of an SEC inquiry, Byrne delivered a suitably lawyered up version of the story:

Let me explain real quickly, just when do you recognize a sale? Do you recognize it -- the convention has been and many – has been when you ship the product, in the case of when you ship things by UPS and FedEx, title does not actually change until the consumer receives it. At the beginning of our Company's history, we looked at it, and the difference was immaterial or small enough, and of course, we don't really know exactly when people receive their products in general or we did not eight years ago. Plus, as far as we could tell in the industry, everybody recorded at ship date. Amazon, according to their financial statements, recorded at ship date. So we chose the policy of recording at ship date. And one of the things that has happened in the last seven years is the information has gotten better where you can more feasibly look at when people receive their products. And more significant part of the industry has now migrated to recording at the date that things are received, even if it's an estimated date. And so we have put together, Dave has put together, the systems that can make that estimate, so it will have the effect of shifting two or three days of revenue.

Note: Bold print and italics added by me.

To make a long story short, the lawyered up version of the story is that, while the company was in violation, "we looked at it, and the difference was immaterial or small enough, and of course, we don't really know exactly when people receive their products in general or we did not eight years ago." The problem is, the lawyered up version of the story is still a significant problem according to SEC rules. Even if Overstock.com's departure from GAAP was "immaterial" by conventional percentage rules of thumb—which I don’t think it was, more on that later—under SAB No. 99, public companies are never permitted to make intentional immaterial departures from GAAP under any circumstances. Stated another way, if the GAAP departure was intentional, by definition it is unlawful.

Let's examine Securities and Exchange Commission Staff Accounting Bulletin No. 99

According to SEC Staff Accounting Bulletin 99, Overstock.com’s intentional GAAP violation cannot be ignored as immaterial:

2. Immaterial Misstatements That are Intentional

Facts: A registrant's management intentionally has made adjustments to various financial statement items in a manner inconsistent with GAAP. In each accounting period in which such actions were taken, none of the individual adjustments is by itself material, nor is the aggregate effect on the financial statements taken as a whole material for the period. The registrant's earnings "management" has been effected at the direction or acquiescence of management in the belief that any deviations from GAAP have been immaterial and that accordingly the accounting is permissible.

Question: In the staff's view, may a registrant make intentional immaterial misstatements in its financial statements?

Interpretive Response: No. In certain circumstances, intentional immaterial misstatements are unlawful.

Note: Bold print and italics added by me.

Therefore, the SEC's response to Byrne's explanation above is a flat out "No" and in certain circumstances even "intentional immaterial" departures from GAAP "are unlawful." But there’s more.

Was everyone else really doing it?

Naturally, I was skeptical when Patrick Byrne claimed, "Plus, as far as we could tell in the industry, everybody recorded at ship date. Amazon, according to their financial statements, recorded at ship date." Again, Byrne didn’t disappoint. After looking at Amazon’s financial statements, I found that Patrick Byrne’s comment was just another example of his half-true, materially misleading, doublespeak. According to Amazon's fiscal year 1999 10-K, issued after SAB No. 101 became effective:

The Company recognizes revenue from product sales, net of any promotional gift certificates, when the products are shipped to customers, which is also when title passes to customers.

Note: Bold print and italics added by me.

Note the subtlety. While revenue was recognized upon shipment, in the case of Amazon, title passed at the point of shipment. So Amazon met the standard.

This same disclosure appeared in Amazon's fiscal year 2002 10-K, the year that Overstock.com became a public company. For 2002, Amazon included the following revenue recognition disclosure:

Product sales, net of promotional discounts, rebates and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss upon our delivery to the carrier (commonly referred to as “F.O.B. Shipping Point”).

Note: Bold print and italics added by me.

And again, in Amazon's fiscal year 2006 10-K, the company included a similar revenue recognition disclosure:

Product sales and shipping revenues, net of promotional discounts, rebates, and return allowances, are recorded when the products are shipped and title passes to customers. Retail items sold to customers are made pursuant to sales contracts that generally provide for transfer of both title and risk of loss upon our delivery to the carrier.

Note: Bold print and italics added by me.

So, to summarize, Amazon has consistently reported revenue when title passes—unlike Overstock.com, which reported revenue prior to the passage of title.

My take is that Overstock.com would like to fool investors into believing that it was following Amazon's revenue recognition policy when in fact, a very careful readings shows that there is one very important difference. While both policies claim to record sales when their products are shipped, in the case of Overstock.com, title does not actually pass until customer receipt. That means Overstock.com is in violation of Staff Accounting Bulletins 101 and 104.

SAB No. 99 clearly states that GAAP takes precedence over industry practices

So maybe you think Overstock is arguing that industry practices should take precedence and allow them to record sales at the point of shipment. Well, regardless of the baloney spewing from the mouth of double talking Overstock.com CEO Patrick Byrne, SAB No. 99 also expressly prohibits the use of industry accounting practices when they are in conflict with GAAP:

GAAP Precedence Over Industry Practice

Some have argued to the staff that registrants should be permitted to follow an industry accounting practice even though that practice is inconsistent with authoritative accounting literature. This situation might occur if a practice is developed when there are few transactions and the accounting results are clearly inconsequential, and that practice never changes despite a subsequent growth in the number or materiality of such transactions. The staff disagrees with this argument. Authoritative literature takes precedence over industry practice that is contrary to GAAP.

Note: Bold print and italics added by me.

What about that claim of “immateriality”?

Another problem with Mr. Byrne’s latest round of excuses is that, as far as I can tell, he’s telling another half truth when he says that the practice lead to an immaterial departure from GAAP. The problem as I see it is that, because the company reported a series of small losses (and two small profits) up until the end of 2004, even a very small change in sales is likely to produce a material misstatement in one or more quarters. This problem is even more pronounced in the only two quarters that Overstock reported a small profit. SAB 99 provides several considerations that would "render material a quantitatively small mistatement of a financial statement item" such as revenues:

Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are -

  • whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate
  • whether the misstatement masks a change in earnings or other trends
  • whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise
  • whether the misstatement changes a loss into income or vice versa
  • whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability
  • whether the misstatement affects the registrant's compliance with regulatory requirements
  • whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements
  • whether the misstatement has the effect of increasing management's compensation – for example, by satisfying requirements for the award of bonuses or other forms of incentive compensation
  • whether the misstatement involves concealment of an unlawful transaction.

More misleading disclosures from Byrne and Company

In a previous blog item entitled, "Did Overstock.com's recent press release about Gradient violate Rule 10b-5?," I noted how Overstock.com has continued to make false and misleading disclosures when it suits the company's purposes. Well here we go again. In the case of the latest disclosure about Overstock’s noncompliance with revenue recognition rules, Byrne has once again violated Rule 10b-5.

To review part of my earlier post, recall that according to Securities and Exchange Commission Rule 10b-5:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

a. To employ any device, scheme, or artifice to defraud,

b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

Note: Bold print and italics added by me.

To summarize, whether a public company violates GAAP, Regulation G governing non-GAAP financial disclosures, or generally any federal securities law, it is the presentation of untrue information or the omission of material information that gives rise to fraud (as opposed to a technical violation, without consequence to the public) under the federal securities law. Therefore, if a public company issues any statement to the public, whether in a press release or an SEC filing, Rule 10b-5 mandates (DEMANDS) that the company include all material information in connection with the subject matter of the document.

According to the Securities and Exchange Commission:

Section 10(b) of the Exchange Act and Rule 10b-5 proscribe, among other things, misstatements of material fact made in connection with the purchase or sale of securities. Information is material if there is a substantial likelihood that its disclosure would be viewed by a reasonable investor as having significantly altered the total mix of information available.

Note: Bold print and italics added by me.

So, once gain, Byrne and Overstock proved to be the gift that keeps on giving. Overstock.com's deliberate noncompliance of its revenue recognition policies and disclosures, the explanations offered by the company in its fourth quarter fiscal year 2007 press release, and Patrick Byrne's double talking explanations during the fourth quarter earning conference call are all clear violations of Rule 10b-5.

To be continued....

Written by:

Sam E. Antar (former Crazy Eddie CFO and a convicted felon)

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