Monday, May 04, 2009

Overstock.com's First Quarter Financial Performance Aided by GAAP Violations

Updated

Overstock.com (NASDAQ: OSTK) and its management team led by its CEO and masquerading stock market reformer Patrick Byrne (pictured on right) continued its pattern of false and misleading disclosures and departures from Generally Accepted Accounting Principles (GAAP) in its latest Q1 2009 financial report.

In Q1 2009, Overstock.com reported a net loss of $2.1 million compared to $4.7 million in Q1 2008 and claimed an earnings improvement of $2.6 million. However, the company's reported $2.6 reduction in net losses was aided by a violation of GAAP (described in more detail below) that reduced losses by $1.9 million and buybacks of Senior Notes issued in 2004 under false pretenses that reduced losses by another $1.9 million.

After the issuance of the Senior Notes in November 2004, Overstock.com has twice restated financial reports for Q1 2003 to Q3 2004 (the accounting periods immediately preceding the issuance of such notes) because of reported accounting errors and material weaknesses in internal controls.

While new CFO Steve Chestnut hyped that "It's been a great Q1," the reality is that Overstock.com’s reported losses actually widened by $1.2 million after considering violations of GAAP ($1.9 million) and buying back notes issued under false pretenses ($1.9 million).

How Overstock.com improperly reported of an accounting error and created a “cookie jar reserve” to manage future earnings by improperly deferring recognition of an income

Before we begin, let’s review certain events starting in January 2008.

In January 2008, the Securities and Exchange Commission discovered that Overstock.com's revenue accounting failed to comply with GAAP and SEC disclosure rules, from the company's inception. This blog detailed how the company provided the SEC with a flawed and misleading materiality analysis to convince them that its revenue accounting error was not material. The company wanted to avoid a restatement of prior affected financial reports arising from intentional revenue accounting errors uncovered by the SEC.

Instead, the company used a one-time cumulative adjustment in its Q4 2007 financial report, apparently to hide the material impact of such errors on previous affected individual financial reports. In Q4 2007, Overstock.com reduced revenues by $13.7 million and increased net losses by $2.1 million resulting from the one-time cumulative adjustment to correct its revenue accounting errors.

Q3 2008

On October 24, 2008, Overstock.com's Q3 2008 press release disclosed new customer refund and credit errors and the company warned investors that all previous financial reports issued from 2003 to Q2 2008 “should no longer be relied upon.” This time, Overstock.com restated all financial reports dating back to 2003. In addition, Overstock.com reversed its one-time cumulative adjustment in Q4 2007 used to correct its revenue accounting errors and also restated all financial statements to correct those errors, as I previously recommended.

The company reported that the combined amount of revenue accounting errors and customer refund and credit accounting errors resulted in a cumulative reduction in previously reported revenues of $12.9 million and an increase in accumulated losses of $10.3 million.

Q4 2008

On January 30, 2009, Overstock.com reported a $1 million profit and $.04 earnings per share for Q4 2008, after 15 consecutive quarterly losses and it beat mean analysts’ consensus expectations of negative $0.04 earnings per share. CEO Patrick Byrne gloated, "After a tough three years, returning to GAAP profitability is a relief." However, Overstock.com's press release failed to disclose that its $1 million reported profit resulted from a one-time gain of $1.8 million relating to payments received from fulfillment partners for amounts previously underbilled them.

During the earnings call that followed the press release, CFO Steve Chesnut finally revealed to investors that:

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.

Before Q3 2008, Overstock.com failed to bill its fulfillment partners for offsetting cost reimbursements and fees resulting from its customer refund and credit errors. After discovering foul up, Overstock.com improperly corrected the billing errors by recognizing income in future periods when such amounts were recovered or on a cash basis (non-GAAP).

In a blog post, I explained why Statement of Financial Accounting Standards No. 154 required Overstock.com to restate affected prior period financial reports to reflect when the underbilled cost reimbursements and fees were actually earned by the company (accrual basis or GAAP). In other words, Overstock.com should have corrected prior financial reports to accurately reflect when the income was earned from fulfillment partners who were previously underbilled for cost reimbursements and fees.

If Overstock.com properly followed accounting rules, it would have reported an $800,000 loss instead of a $1 million profit, it would have reported sixteen consecutive losses instead of 15 consecutive losses, and it would have failed to meet mean analysts’ consensus expectation for earnings per share (anyone of three materiality yardsticks under SEC Staff Accounting Bulletin No. 99 that would have triggered a restatement of prior year’s effected financial reports).

Patrick Byrne responds on a stock market chat board

In my next blog post, I described how CEO Patrick M. Byrne tried to explain away Overstock.com’s treatment of the “one-time gain” in an unsigned post, using an alias, on an internet stock market chat board. Byrne’s chat board post was later removed and re-posted with his name attached to it, after I complained to the SEC. Here is what Patrick Byrne told readers on the chat board:

Antar's ramblings are gibberish. Show them to any accountant and they will confirm. He has no clue what he is talking about.

For example: when one discovers that one underpaid some suppliers $1 million and overpaid others $1 million. For those whom one underpaid, one immediately recognizes a $1 million liability, and cleans it up by paying. For those one overpaid, one does not immediately book an asset of a $1 million receivable: instead, one books that as the monies flow in. Simple conservatism demands this (If we went to book the asset the moment we found it, how much should we book? The whole $1 million? An estimate of the portion of it we think we'll be able to collect?) The result is asymmetric treatment. Yet Antar is screaming his head off about this, while never once addressing this simple principle. Of course, if we had booked the found asset the moment we found it, he would have screamed his head off about that. Behind everything this guy writes, there is a gross obfuscation like this. His purpose is just to get as much noise out there as he can.

Note: Bold print and italics added by me.

In other words, Overstock.com improperly used cash basis accounting (non-GAAP) rather than accrual basis accounting (GAAP) to correct its accounting error. I criticized Byrne’s response noting that:

… Overstock.com recognized the "one-time of $1.8 million" using cash-basis accounting when it "received payments from partners who were under-billed earlier in the year" instead of accrual basis accounting, which requires income to be recognized when earned. A public company is not permitted to correct any accounting error using cash-basis accounting.

Overstock.com tries to justify improper cash basis accounting in Q4 2008 to correct an accounting error

Overstock.com needed to justify Patrick Byrne’s stock chat board ramblings. About two weeks later, Overstock.com filed its fiscal year 2008 10-K report with the SEC and the company concocted a new excuse to justify using cash basis accounting to correct its accounting error and avoid restating prior affected financial reports:

In addition, during Q4 2008, we reduced Cost of Goods Sold by $1.8 million for billing recoveries from partners who were underbilled earlier in the year for certain fees and charges that they were contractually obligated to pay. When the underbilling was originally discovered, we determined that the recovery of such amounts was not assured, and that consequently the potential recoveries constituted a gain contingency. Accordingly, we determined that the appropriate accounting treatment for the potential recoveries was to record their benefit only when such amounts became realizable (i.e., an agreement had been reached with the partner and the partner had the wherewithal to pay).

Note: Bold print and italics added by me.

Overstock.com improperly claimed that a "gain contingency" existed by using the rationale that the collection of all "underbilled...fees and charges...was not assured....”

Why Overstock.com's accounting for underbilled "fees and charges" violated GAAP

Overstock.com already earned those "fees and charges" and its fulfillment partners were "contractually obligated to pay" such underbilled amounts. There was no question that Overstock.com was owed money from its fulfillment partners and that such income was earned in prior periods.

If there was any question as to the recovery of any amounts owed the company, management should have made a reasonable estimate of uncollectible amounts (loss contingency) and booked an appropriate reserve against amounts due from fulfillment partners to reduce accrued income (See SFAS No. 5 paragraph 1, 2, 8, 22, and 23). It didn’t. Instead, Overstock.com claimed that the all amounts due the company from underbilling its fulfillment partners was "not assured" and improperly called such potential recoveries a "gain contingency" (SFAS No. 5 paragraph 1, 2, and 17).

The only way that Overstock.com could recognize income from underbilling its fulfillment partners in future accounting periods is if there was a “significant uncertainty as to collection” of all underbilled amounts (See SFAS No. 5 paragraph 23)

As it turns out, a large portion of the underbilled amounts to fulfillment partners was easily recoverable within a brief period of time. In fact, within 68 days of announcing underbilling errors, the company already collected a total of “$1.8 million relating to payments from partners who were underbilled earlier in the year.” Therefore, Overstock.com cannot claim that there was a "significant uncertainty as to collection" or that recovery was "not assured."

No gain contingency existed. Overstock.com already earned "fees and charges" from underbilled fulfillment partners in prior periods. Rather, a loss contingency existed for a reasonably estimated amount of uncollectible "fees and charges." Overstock.com should have restated prior affected financial reports to properly reflect income earned from fulfillment partners instead of reflecting such income when amounts were collected in future quarters. Management should have made a reasonable estimate for unrecoverable amounts and booked an appropriate reserve against "fees and charges" owed to it (See SFAS No. 5 Paragraph 22 and 23).

Therefore, Overstock.com overstated its customer refund and credit accounting error by failing to accrue fees and charges due from its fulfillment partners as income in the appropriate accounting periods, less a reasonable reserve for unrecoverable amounts. By deferring recognition of income until underbilled amounts were collected, the company effectively created a "cookie jar" reserve to increase future earnings.

In addition, Overstock.com failed to disclose any potential “gain contingency” in its Q3 2008 10-Q report, when it disclosed that it underbilled its fulfillment partners (See SFAS No. 5 Paragraph 17b). Apparently, Overstock.com used a backdated rationale for using cash basis accounting to correct its accounting error in response to my blog posts (here and here) detailing its violation of GAAP.

PricewaterhouseCoopers warns against using "conservatism to manage future earnings"

As I detailed above, Patrick Byrne claimed on an internet chat board that “conservatism demands" waiting until "monies flow in" from under-billed fulfillment partners to recognize income, after such an error is discovered by the company. However, a document from PricewaterhouseCoopers (Overstock.com’s auditors thru 2008) web site cautions against using “conservatism” to manage future earnings by deferring gains to future accounting periods:

SFAS No. 5 Technical Notes cautions about using “conservatism” to manage future earnings by deferring gains to future accounting periods:

"Conservatism...should no[t] connote deliberate, consistent understatement of net assets and profits." Emphasis added] CON 5 describes realization in terms of recognition criteria for revenues and gains, as:"Revenue and gains generally are not recognized until realized or realizable... when products (goods or services), merchandise or other assets are exchanged for cash or claims to cash...[and] when related assets received or held are readily convertible to known amounts of cash or claims to cash....Revenues are not recognized until earned ...when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues." Almost invariably, gain contingencies do not meet these revenue recognition criteria.

Note: Bold print and italics added by me.

Overstock.com "substantially accomplished what it must do to be entitled to the benefits represented by the revenues" since the fulfillment partners were "contractually obligated" to pay underbilled amounts. Those underbilled "fees and charges" were "realizable" as evidenced by the fact that the company already collected a total of “$1.8 million relating to payments from partners who were underbilled earlier in the year" within a mere 68 days of announcing its billing errors.

If we follow guidance by Overstock.com's fiscal year 2008 auditors, the amounts due from underbilling fulfillment partners cannot be considered a gain contingency, as claimed by the company. PricewaterhouseCoopers was subsequently terminated as Overstock.com's auditors and replaced by Grant Thornton.

Q1 2009

In Q1 2009, even more amounts from underbilling fulfillment partners were recovered. In addition, the company disclosed a new accounting error by failing to book a “refund due of overbillings by a freight carrier for charges from Q4 2008.” See quote from 10-Q report below:

In the first quarter of 2009, we reduced total cost of goods sold by $1.9 million for billing recoveries from partners who were underbilled in 2008 for certain fees and charges that they were contractually obligated to pay, and a refund due of overbillings by a freight carrier for charges from the fourth quarter of 2008. When the underbilling and overbillings were originally discovered, we determined that the recovery of such amounts was not assured, and that consequently the potential recoveries constituted a gain contingency. Accordingly, we determined that the appropriate accounting treatment for the potential recoveries was to record their benefit only when such amounts became realizable (i.e., an agreement had been reached with the other party and the other party had the wherewithal to pay).

Note: Bold print and italics added by me.

Overstock.com continued to improperly recognize deferred income from previously underbilling fulfillment partners. The new auditors, Grant Thornton, would be wise to review Overstock.com's accounting treatment of billing errors and recommend that its clients restate affected financial reports to comply with GAAP. Otherwise, they should not give the company a clean audit opinion for 2009.

Using accounting errors to previous quarters to boost profits in future quarters

Lee Webb from Stockwatch sums up Overstock.com's accounting latest trickery:

… Overstock.com managed to turn a controversial fourth-quarter profit last year after discovering that it had underbilled its fulfillment partners to the tune of $1.8-million earlier in the year. Rather than backing that amount out into the appropriate periods, Overstock.com reported it as one-time gain and reduced the cost of goods sold for the quarter by $1.8-million. That bit of accounting turned what would have been an $800,000 fourth-quarter loss into a $1-million profit.

As it turns out, Overstock.com managed to find some more money that it used to reduce the cost of goods sold for the first quarter of 2009, too.

"In Q1 2009, we reduced total cost of goods sold by $1.9-million for recoveries from partners who were underbilled in 2008 for certain fees and charges that they were contractually obligated to pay and a refund due of overbillings by a freight carrier for charges from Q4 2008," the company disclosed.

"We just keep squeezing the tube of toothpaste thinner and thinner and finding new stuff to come out," Mr. Byrne remarked during the conference call after chief financial officer Steve Chesnut said that the underbilling and overbilling had been found "as part of good corporate diligence and governance."

In addition, Overstock.com managed to record a $1.9-million gain, reported as part of "other income," by extinguishing $4.9-million worth of its senior convertible notes, which it bought back at rather hefty discount. If not for the fortuitous 2008 underbilling recoveries, fourth-quarter overbillings refund and the paper gain from extinguishing some of its debt, Overstock.com would have tallied a first-quarter loss of $5.9-million or approximately 26 cents per share.

So, while Overstock.com did not manage to conjure up a first-quarter profit by using the same accounting abracadabra employed in the fourth quarter, it did succeed in trimming its net loss to $2.1-million.

Bad corporate diligence and governance

During the Q1 2009 earnings conference call, CFO Steve Chesnut boasted about finding accounting errors:

So just as part of good corporate diligence and governance we've found these items.

Note: Bold print and italics added by me.

Actually, it was bad corporate diligence and governance by CEO Patrick Byrne that caused the accounting errors to happen by focusing on a vicious retaliatory smear campaign against critics, while he runs his company into the ground with $267 million in accumulated losses to date and never reporting a profitable year.

Memo to Grant Thornton (Overstock.com's new auditors)

Overstock.com is a company that has not produced a single financial report prior to Q3 2008 in compliance with Generally Accepted Accounting Principles and Securities and Exchange Commission disclosure rules from its inception, without having to later correct them, unless such reports were too old to correct. Two more financial reports (Q4 2008 and Q1 2009) don't comply with GAAP and need to be restated, too.

To be continued in part 2.

In the mean time, please read:

William K. Wolfrum: "Sam E. Antar: From Crazy Eddie to Patrick Byrne's Worst Nightmare."

Gary Weiss: "The Whisper Campaign Against an Overstock.com Whistleblower"

Written by:

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

Blog Update:

Investigative journalist and author Gary Weiss commented on Overstock.com's history of GAAP violations in his blog:

There are few certainties in this world: gravity, the speed of light, and, more obviously every quarter, the utter unreliability of Overstock.com financial statements.

Acclaimed forensic accountant and author Tracy Coenen notes in her blog:

Don’t laugh too hard at Patrick Byrne’s explanation of the repeated accounting errors and improper treatment of those errors, as reported by Lee Webb of Stockwatch:

“We just keep squeezing the tube of toothpaste thinner and thinner and finding new stuff to come out,” Mr. Byrne remarked during the conference call after chief financial officer Steve Chesnut said that the underbilling and overbilling had been found “as part of good corporate diligence and governance.”

Good corporate diligence and governance? Is this guy for real? How about having an accounting system that prevents errors from occurring every quarter?

Of course, Overstock.com management has to explain away why Sam Antar is finding all these manipulations and irregularities in their financial reporting. They can stalk and harass him all they want, call him a criminal all they want, but there is no explaining it away. The numbers don’t lie. Overstock.com just always counted on no one being as thorough as Sam.

Disclosure:

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

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