Monday, March 31, 2008

BIDZ.com's Inventory Disclosures: More Questions

In two previous items in this blog (here and here), I examined BIDZ.com’s (NASDAQ:BIDZ) inventory disclosures and raised questions about the company’s compliance with GAAP in valuing inventories. In my latest blog post, I will examine some of BIDZ.com’s historical inventory disclosures. From fiscal year 2005 to 2007, it seems that while BIDZ.com’s piled on massive amounts of inventory and inventory turnover decreased (in other words merchandise stayed in BIDZ.com’s stockrooms for longer periods of time) the company switched to a less conservative method to value its inventory at the lower of cost or market. Both of the methods used by BIDZ.com to value its inventory at the lower of cost or market don't seem to be in compliance with GAAP and may violate Securities and Exchange Commission Staff Accounting Bulletin No. 99 which prohibits even immaterial departures from GAAP.

BIDZ.com’s Fiscal Year 2005 10-K inventory disclosures

In BIDZ.com’s 10-K for fiscal year 2005, the company made the following disclosure about the company’s inventory:

Inventories: Inventories consist of merchandise purchased for resale and are stated at the lower of first-in, first-out cost (FIFO) or market. We record reserves against our inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. We record reserves of 50% of the value of inventory held for more than six months and 100% of the value of inventory held for more than one year. If actual market conditions are less favorable than those projected by us, specific reserves or additional inventory write-downs may be required.

Note: Bold print and italics added by me.

Like other inventory disclosures that I have examined in my previous blog items, BIDZ.com’s inventory disclosure for its fiscal year 2005 10-K does not seem to be compliance with GAAP. As detailed above, BIDZ.com recorded “reserves of 50% of the value of inventory held for more than six months and 100% of the value of inventory held for more than one year.” It does not appear that BIDZ.com in the company's 2005 10-K used any of the three allowable measures under GAAP to value its inventory at the lower of cost or market: current replacement cost, net realizable value, or net realizable value less normal profit margins.

Why did all inventory held for six months suddenly lose half its value in a single day (from day 182 to 183)? Why did all inventory held by the company beyond one year suddenly lose its entire value in a single day (from day 365 to 366)? Does BIDZ.com really claim that a blanket reduction in value of 50% for all inventory held more than six months represents either current replacement cost, net realizable value, or net realizable value less normal profit margin? Unless inventory held more than one year is worthless crap and can in effect be tossed away in the garbage, the lowest allowable measure for determining market under GAAP is net realizable value less normal profit margins.

Inventory at the lower of cost or market under GAAP

BIDZ.com’s automatic reduction of inventory values by a fixed percentage of its original cost based on the number of days such inventory is held seems contrary to the requirements of Accounting Research Bulletin (ARB) No. 43 for valuing inventory at the lower of cost or market as detailed below. As I described in a previous blog post:

According to Accounting Research Bulletin (ARB) No. 43, inventory must be valued at the lower of cost or market value. Market means the current replacement cost of inventory. If the current replacement cost of inventory is greater than its net realizable value (estimated selling price less cost of completion and disposal), net realizable value is considered market. If the current replacement cost of inventory is less than its net realizable value minus normal profit margins, than net realizable value minus normal profit margins is considered market. Therefore, the upper limit of market is net realizable value and the lower limit of market is net realizable value minus normal profit margins. Lower of cost or market may be applied to each individual inventory item, the total of each major category of inventory, or the aggregate total of inventory.

In the fiscal year 2005 10-K disclosure above, BIDZ.com’s automatic reduction of the value of inventory held more than six months to 50% of its original cost basis and automatic reduction of the value of inventory held for more than one year to zero does not appear to be any one of the three appropriate measures of market (current replacement cost, net realizable value, or net realizable value less normal profit margins) as defined by ARB No. 43.

Next, let’s examine a certain BIDZ.com inventory disclosure in a Form S-1 Registration Statement issued after the 2005 K-1

On June 29, 2006, BIDZ.com filed an amendment to its Form S-1 Registration Statement and included the following disclosure about inventory levels and inventory turnover:

We attempt to reduce inventory obsolescence by managing the product offerings available for auction at any given time. However, as our inventory balances increase and inventory turnover decreases, we anticipate that our reserves for inventory obsolescence may increase.

Note: Bold print and italics added by me.

In BIDZ.com's S-1 Registration Statement disclosure above, the company warned investors that as the company’s “inventory balances increase and inventory turnover decreases,” future reserves against inventory may increase. However, as detailed below, BIDZ.com later changed its method of valuing inventory at the lower of cost or market to a less conservative method that resulted in the company recognizing less inventory reserves and higher gross profit margins in future accounting periods. In addition, both the prior method and new method of valuing inventory at the lower of cost or market used by BIDZ.com do not seem to be in compliance with GAAP.

BIDZ.com’s inventory disclosure for the second quarter of fiscal year 2006

According to BIDZ.com’s second quarter fiscal year 2006 10-Q, the company changed its method of valuing inventory at the lower of cost or market to a less conservative method which resulted in lower inventory reserves and higher gross margins as inventory levels piled up and inventory turnover was significantly decreasing:

Inventory Reserve

We record reserves against our inventory for lower of cost or market equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. Beginning from the three months ended June 30, 2006 we will only record reserves of 100% of the value of inventory held for more than one year and will no longer record reserves for 50% of the value of inventory held for between six months and one year. If the previous method of estimating reserves had been used, the inventory reserves would have been higher by $138,000.

Note: Bold print and italics added by me.

As detailed above, beginning in the second quarter of fiscal year 2006, BIDZ.com “will only record reserves of 100% of the value of inventory held for more than one year and will no longer record reserves for 50% of the value of inventory held for between six months and one year.” Previously BIDZ.com recorded “reserves of 50% of the value of inventory held for more than six months” and up to one year. The company continued to write-down the value of all inventory held more than one year to zero value. According to BIDZ.com’s 10-Q disclosure above, the company claimed that its change of method in valuing inventory at the lower of cost or market resulted in an immediate reduction of inventory reserves and an increase in gross profits of $138,000.

How did BIDZ.com determine estimated market value for inventory held less than one year beginning in the second quarter of fiscal year 2006? For a clue, we need to examine the company’s 10-K inventory disclosure for fiscal year 2006:

Inventories:

Inventories consist mainly of merchandise purchased for resale and are stated at the lower of first-in, first-out cost (FIFO) or market. We record reserves against our inventory for lower of cost or market equal to the difference between the cost of inventory and the average selling price. In addition, for the year ended December 31, 2006 we recorded reserves for obsolete and slow moving inventory of 100% of the value of inventory held for more than one year. For the year ended December 31, 2005, we recorded reserves of 50% of the value of inventory held for more than six months and 100% of the value of inventory held for more than one year. If actual market conditions are less favorable than those projected by us, specific reserves or additional inventory write-downs may be taken.

Note: Bold print and italics added by me.

According to BIDZ.com’s fiscal year 2006 K-1, above, the company recorded reserves against its inventory “for lower of cost or market equal to the difference between the cost of inventory and the average selling price.” If BIDZ.com used such a measure to determine report market in the second, third, and fourth quarter of fiscal year 2006, the company’s reported inventory does not seem to be in compliance with GAAP.

As I pointed out in my previous blog items examining BIDZ.com’s inventory disclosures, “average selling price” is not net realizable value (estimated selling price less costs of completion and disposal). Net realizable value can only be used as market value for inventory if it is less than the estimated replacement cost of such inventory and net realizable value is less than the cost basis of such inventory, too.

If we assume that BIDZ.com’s average selling price used by the company to value inventory at the lower of cost or market is less than its estimated replacement cost, than BIDZ.com is understating its inventory reserves and overstating its gross profits by not deducting the estimated costs of completion and disposal from its inventory values. If the current replacement cost of BIDZ.com’s inventory was less than its net realizable value but higher than its net realizable value less normal profit margins, than inventory reserves would be understated and gross profits would be overstated by an even greater amount: the difference between the average selling price used by BIDZ.com to value inventory at the lower of cost or market and its lower current replacement cost. Furthermore, if the current replacement cost of BIDZ.com's inventory is less than its net realizable value less normal profit margins than the company's inventory reserves would have been understated and gross profits overstated by a still higher amount: the difference between the average selling price used by BIDZ.com and the even lower net realizable value less normal profit margins. Therefore, neither BIDZ.com’s fiscal year 2005 10-K inventory disclosures, second quarter fiscal year 2006 10-Q inventory disclosures, nor its fiscal year 2006 10-K inventory disclosures appear to be in compliance with GAAP.

At a minimum, in the second quarter of fiscal year 2006, BIDZ.com chose a less conservative method to value its inventories at the lower of cost or market as inventory levels piled up and inventory turnover dramatically decreased. As detailed above, according to BIDZ.com’s inventory disclosure in its second quarter fiscal year 2006 10-Q, “If the previous method of estimating reserves had been used, the inventory reserves would have been higher by $138,000.” The key question is how much higher would inventory reserves have increased and gross profits decreased in the following quarters and fiscal years as BIDZ.com’s inventory levels substantially increased and inventory turns dramatically decreased, if the company had not changed its method of valuing inventories?

Selected data from BIDZ.com's financial statements

See the chart below:

Fiscal Year

2005

2006

2007

Cost of good sold (in thousands)

$71,257

$100,633

$132,683

Ending inventory, net of reserves (in thousands)

$15,921

$34,308

$56,686

Inventory turnover based on average inventory amount

5.35

4.00

2.92

Average days of inventory outstanding based on average inventory and cost of goods sold

68.26

91.09

125.16

Inventory reserves (in thousands)

$331

$461

$1,071

Inventory reserves as a percentage of gross inventory

2.04%

1.33%

1.85%

The average number of days that inventory remained in BIDZ.com’s stockrooms increased by about 23 days from 68.26 days at the end of 2005 (before the company’s change of method in estimating the market value of its inventory) to 91.09 days at the end of 2006 (after the company’s change of method in estimating the market value of its inventory) or about a 33% increase in the time it took the company to sell its inventory. However, the inventory reserves as a percentage of gross inventory dropped from 2.04% at the end of 2005 to 1.33% at the end of 2006 or a 34.8% reduction in relative inventory reserves. As detailed above, when BIDZ.com changed its method of valuing inventory at the lower of cost or market in the second quarter of fiscal year 2006, the company immediately recognized a $138,000 reduction in reserves and increase in gross profits. As BIDZ.com held on to its inventory about 33% longer at the end of 2006 compared to 2005, it is probable that inventory reserves would have been significantly higher had the company not changed its method of valuing inventory to a less conservative method in the second quarter of fiscal year 2006.

At the end of fiscal year 2007, the average number of days that inventory remained in BIDZ.com’s stockrooms was 125.16 days compared to 91.09 days at the end of fiscal year 2006 and 68.26 days at the end of fiscal year 2005. Therefore, at the end of fiscal year 2007 BIDZ.com held on to inventory almost twice as long as compared to fiscal year 2005 (125.16 days in 2007 versus only 68.26 days in 2005). However, at the end of fiscal year 2007 inventory reserves as a percentage of gross inventories was 1.85% compared to fiscal year 2005 at 2.04%. Therefore, while the average amount of time inventory remained in BIDZ.com’s stockrooms almost doubled from 68.26 days in 2005 to 125.16 days in 2007, the relative amount of inventory reserves declined by about 10% from 2.04% of gross inventory in 2005 to 1.85% of gross inventory in 2007.

As the number of average days (125.16 days) that inventory remained in BIDZ.com’s stockrooms in fiscal year 2007 got closer to more than six months (183 days), it is probable that a relatively larger portion of such inventory was held for more than six months compared to fiscal year 2005 when the average was only 68.26 days. Therefore, if BIDZ.com had continued to automatically write-down inventory held more than six months to 50% of its original cost basis, rather than use an amount “equal to the difference between the cost of inventory and the average selling price,” it is probable that the company’s inventory reserves would have been much higher at the end of fiscal year 2007. In any case, BIDZ.com's apparent use of “average selling price” rather than net realizable value for determining market resulted in lower reported inventory reserves and higher gross margins, too.

To be continued....

Written by,

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

1 comment:

GlennC said...

125 days to move inventory seems to suggest an **extremely** inefficient business to me. This smells fishy to me.

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