Friday, March 14, 2008

Is BIDZ.com Reporting Inventory in Compliance with GAAP?

A close study of BIDZ.com's (NASDAQ: BIDZ) inventory disclosures in its recent 10-K report for fiscal year 2007 raises a question if company is in compliance with GAAP in valuing inventories. Let's carefully review BIDZ.com inventory disclosure:

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 equal to the difference between the cost of inventory and the average selling price that is lower than cost of inventory that is held for less than one year. In addition, for the years ended December 31, 2006 and 2007 we recorded reserves for obsolete and slow moving inventory of 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 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.

Inventory held less than one year

In the case of BIDZ.com, as detailed above, the company discloses that "We record reserves against our inventory equal to the difference between the cost of inventory and the average selling price that is lower than cost for inventory that is held for less than one year." The company's inventory disclosure for inventory held less than one year does not seem to be in compliance with GAAP. BIDZ.com cannot use the "difference between the cost of inventory and the average selling price" in valuing its inventory. Average selling price is not net realizable value, since it does not deduct the cost of completion and disposal of inventory. Therefore, in this specific case, inventory may be overstated. Even if BIDZ.com were to use net realizable value, the company could only use such a measure if the current replacement cost of inventory is greater than its net realizable value.

Inventory held more than one year

As detailed above, BIDZ.com discloses that "In addition, for the years ended December 31, 2006 and 2007 we recorded reserves for obsolete and slow moving inventory of 100% of the value of inventory held for more than one year." Here too, the company's inventory disclosure does not seem to be in compliance with GAAP. The lowest amount that inventory can be valued at is net realizable value (estimated selling price less cost of completion and disposal) minus normal profit margins. It seems that BIDZ.com's method of valuing inventory over one year old is arbitrarily based on the amount of time that the inventory is held, rather than the application of GAAP. Unless such inventory cannot be sold under any and all circumstances, BIDZ.com cannot "record reserves of 100% of the cost of inventory held more than one year." Therefore, in this specific case, inventory may be understated.

Securities and Exchange Commission Staff Accounting Bulletin No. 99

According to Securities and Exchange Commission Staff Accounting Bulletin No. 99, a public company cannot make "adjustments to various financial statement items in a manner inconsistent with GAAP." See below:

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, BIDZ.com cannot depart from GAAP in its financial reports even if the effect of non-compliance with GAAP is immaterial.

Written by:

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

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