Wednesday, February 04, 2009

Overstock.com and CEO Patrick Byrne Violate Accounting Rules in Q4 2008 Financial Report

Latest GAAP Violations by Overstock.com in Q4 2008 Financial Report Improperly Turn a Loss into a Profit

Last Friday, Overstock.com (NASDAQ: OSTK) reported a fourth quarter 2008 net profit of $1 million dollars. CEO Patrick Byrne proudly told investors, "After a tough three years, returning to GAAP profitability is a relief." However, Overstock.com's "returning to GAAP profitability" was simply accomplished by the company violating GAAP through its failure to restate prior period financial reports effected by a certain accounting error. Had Overstock.com properly followed acounting rules, it would have reported an $800,000 loss instead of a $1 million profit.

During the Q4 2008 earnings call, the new Overstock.com CFO Steve Chesnut, who recently replaced David Chidester, told investors:
Gross profit dollars were $43.6 million, a 6% decrease. This included a one-time gain of $1.8 million relating to payments from partners who were under-billed earlier in the year.
Note: Bold print and italics added by me.
That "one-time gain of $1.8 million" referred to above by CFO Steve Chesnut was actually an improper one-time cumulative adjustment of an accounting error.

According to Statement of Financial Accounting Standards No. 154 and SEC Staff Accounting Bulletin No. 99, Overstock.com should have restated all prior accounting periods, rather than use a "one-time gain" to correct its accounting errors "relating to payments from partners who were under-billed earlier in the year."

Under GAAP, we are required to use an accrual basis of accounting. Income is recognized when it is earned and not when it is later billed or when amounts are collected. The “one-time gain of $1.8 million relating to payments from partners who were under-billed earlier in the year” was earned before Q4 2008 and should have been recognized in prior periods. Since the accounting error is material under SAB No. 99, Overstock.com is required to restate prior period financial reports under SFAS No. 154 and cannot use a “one-time gain” to correct its error.

As a result of violating SFAS No. 154 and SAB No. 99, Overstock.com improperly reported a Q4 2008 net profit of $1 million, instead of an $800,000 net loss.

According to SFAS No. 154 paragraph 25:
Any error in the financial statements of a prior period discovered subsequent to their issuance shall be reported as a prior-period adjustment by restating the prior-period financial statements.
Note: Bold print and italics added by me.
Among the criteria that SAB No. 99 uses to define a material accounting error that requires a restatement of prior period financial reports are:
• 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
Overstock.com’s accounting error met in all three materiality criteria above and the company should have restated its prior financial reports, rather than use a one-time gain to correct its accounting error in Q4 2008. See below.


Whether the material misstatement masks a change in earnings and other trends

Overstock.com has never reported a profitable year and has reported only three profitable quarters (Q4 2002, Q4 2004, and Q4 2008), since its inception. Prior to Q4 2008, Overstock.com’s last reported profitable quarter was four years earlier, in Q4 2004. If Overstock.com had properly restated its prior financial reports, rather than improperly report a one-time gain of $1.8 million from correcting its under-billing of fulfillment partners in prior periods, the company would have reported an $800,000 loss in Q4 2008, instead of a $1 million profit.

Therefore, Overstock.com clearly changed its trend of 15 consecutive reported quarterly losses by improperly using a one-time gain of $1.8 million to correct its accounting error in Q4 2008. The company’s treatment of its accounting error as a one-time gain “masks a change in earnings and other trends” and is considered a material accounting error under SAB No. 99. Therefore, Overstock.com should have restated its financial reports as required under SFAS No. 154.

Whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise

The mean analysts’ consensus expectations for Overstock.com’s Q4 2008 financial results were negative $.03 earnings per share. Overstock.com reported $.04 positive earnings per share because of the $1.8 million one-time gain it improperly reported from correcting its under-billing of fulfillment partners in prior periods.

Without that $1.8 million one-time gain, Overstock.com’s earnings per share would have been reported at negative $.04 earnings per share, compared to analysts’ consensus expectations of negative $.03 earnings per share.

Therefore, Overstock.com’s accounting error was material under SAB No. 99, since it “hides a failure to meet analysts’ consensus expectations” and we have another reason why Overstock.com should have restated its financial reports as required under SFAS No. 154.


Whether a misstatement changes a loss into income or vice versa

As I detailed above, Overstock.com reported a Q4 2008 profit of $1 million instead of a loss of $800,000 because the company improperly used a one-time gain of $1.8 million to correct its under-billing of fulfillment partners in prior periods. Clearly, Overstock.com’s accounting error is material, since it changes a properly reported net loss into an improperly reported net profit.

Overstock.com’s more recent violations of Generally Accepted Accounting Principles (GAAP) and SEC rules should come as no surprise readers of my blog. What should be surprising is the SEC’s failure to take enforcement action against the company and its management.

Written by,

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


Disclosure:

I am not long or short Overstock.com securities.

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