In my first Open Letter, I asked the Securities and Exchange Commission Division of Corporation Finance to review Medifast's (NYSE: MED) revenue recognition policy to determine if it complies with Generally Accepted Accounting Principles (GAAP) and SEC Staff Accounting Bulletin Topic 13. In my second Open Letter, I promised the SEC "Forensic accounting in real time!" In this third open letter, I will deliver on that promise and provide you an updated analysis of Medifast's revenue accounting.
As I will detail below, a careful analysis of Medifast's disclosures to investors and customers raise a very serious question about the company's compliance with revenue accounting rules going back to 2004 and suggest that the company is possibly recognizing revenue up to 8 business days too early.
Chronology of Medifast's Revenue Recognition Disclosures
On March 14, 2005, Medifast filed its 10-KSB report for fiscal year 2004 with the SEC. The company reported its revenue recognition policy as follows:
[9] REVENUE:
Revenue from sales is recognized when the product is shipped to customers or purchased by wholesale customers. [Emphasis added.]
Medifast recognized revenue when product was shipped to its customers. However, revenue can only be recognized on the shipment date when certain conditions are met, such as the passing of risk by the company to its customers.
SEC reviewer asks for a clarification
On April 11, 2005, the SEC Division of Corporation Finance sent Medifast a comment letter and asked the company to& clarify its revenue recognition disclosure:
[9] - Revenue
4. We note the disclosure of your revenue recognition accounting policy. Expand your disclosures to address all the criteria to be met for revenue recognition as discussed in Staff Accounting Bulletin Topic 13. If certain industry-specific authoritative guidance applies, discuss your policies with regard to the application of that literature. [Emphasis added.]
The SEC reviewer asked Medifast the above question on April 11 and 35 days later on May 16, Medifast still could not answer the above question.
Medifast delays response to SEC
On May 16, 2005, Medifast asked the SEC for a "5-day extension" to respond to its comment letter and gave the following excuse:
I am writing request a 5-day extension on our SEC comment letter dated April 11, 2005. Having been consumed with work related to our recent filing of Form 10-Q on May 10, 2005 we would appreciate additional time in order to properly address the comments. In addition, our President has been out of the country and our Controller has been on vacation for the last few days making the completion of the SEC comment letter difficult. Thank you very much for your consideration.
Medifast finally responds to SEC
On May 21, 2005 Medifast finally responded
Note B - Significant Accounting Policies, page F-8
We have amended our disclosure on Form 10-KSB/A to address all the criteria discussed in Staff Accounting Bulletin Topic 13. Our disclosure is as follows:
"Revenue is recognized for product sales upon shipment and passing of risk to the customer and when estimates of discounts, rebates, promotional adjustments, price adjustments, returns, and other potential adjustments are reasonably determinable, collection is reasonably assured and the Company has no further performance obligations. These estimates are presented in the financial statements as reductions to net revenues and accounts receivable. Estimated sales returns, allowances and discounts are provided for." [Emphasis added.].
In other words, Medifast claimed that "upon shipment" the risk of ownership passes to its customers and the company had "no further performance obligations" to them. Therefore, the company claimed that it is permitted to recognize revenue on the shipment date under SEC rules.
In the years that followed, Medifast's revenue recognition disclosure stayed pretty much the same as its revenue recognition disclosure in 2005. According to the company's 2009 10-K report:
Revenue Recognition. Revenue from product sales is recognized net of discounts, rebates, promotional adjustments, price adjustments, returns and other potential adjustments upon shipment and passing of risk to the customer and when estimates of are reasonably determinable, collection is reasonably assured and the Company has no further performance obligations.
In both cases, other than changes in sentence structure, revenue from product sales are recognized "upon shipment and passing of risk to the customer."
As I will describe below, the "passing of risk to the customer" is a key issue in determining when to recognize revenue under accounting rules. If risk, in substance, does not pass to the customer on the shipping date, Medifast cannot record revenue on that date and the company is reporting revenue, too early.
Let's examine SEC rules governing revenue recognition.
SEC Staff Accounting Bulletin Topic 13 (SAB Topic 13) governing revenue recognition
According to SEC Staff Accounting Bulletin Topic 13:
The staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met:
Persuasive evidence of an arrangement exists,
Delivery has occurred or services have been rendered,
The seller's price to the buyer is fixed or determinable, and
Collectibility is reasonably assured. [Emphasis added.]
All the above four conditions must be met before revenue can be recognized.
In addition, the SAB Topic 13 noted:
The Commission has set forth criteria to be met in order to recognize revenue when delivery has not occurred. These include:
1. The risks of ownership must have passed to the buyer; [Emphasis added.]
In determining whether "risks of ownership" have passed to the buyer or customer for purposes of revenue recognition, the SEC requires public companies to consider the "substance" of a transaction over its "legal form" - the basic underlying principle of GAAP.
Applying "substance over form"
For example, in December 2007, the SEC Division of Corporation Finance reviewed Overstock.com's (NASDAQ: OSTK) revenue recognition policies. Overstock.com recognized revenue on the shipment date because legal title (in legal form, rather than substance) passed at point of shipment.
The company explained to the SEC reviewer:
Although we have no legal obligation to compensate the customer for goods that are lost or damaged in transit, it is industry practice (and is required by the carrier since items are shipped on our account with the carrier) that we act as the liaison between the customer and the carrier if a product is lost or damaged in transit. Therefore, we generally replace the product or reimburse the customer for goods lost or damaged in transit, and then subsequently file a claim for reimbursement from the carrier. [Emphasis added.]
However, the SEC Division of Corporation Finance rejected Overstock.com's argument by applying the basic principle of "substance over form" underlying GAAP:
...in your response, in substance, risk of loss does not transfer to the customer at point of shipment, but instead transfers to the customer upon delivery and acceptance. Since assumption for risk of loss is a significant obligation during the delivery process, we are not persuaded that you should recognize revenue before the delivery process is complete. Please revise disclosure of your accounting policy accordingly to clarify that risk of loss transfers to the customer upon delivery and acceptance for all sales at which time revenue is recognized. Please revise your financial statements accordingly to reflect revenue being recognized based on delivery to the customer for all periods presented and provide the disclosures required by SFAS 154 for correction of an error. [Emphasis added.]
Overstock.com was required to report an accounting error because the company was recognizing revenue at the point of shipment, instead of its delivery date. In the addition, the SEC required Overstock.com to clarify and expand its revenue accounting disclosures.
When should Medifast recognize revenue?
Likewise Medifast's return policy also appears "in substance" to transfer risk of loss to the customer on the delivery date and not the product shipment date. As of the shipment date, Medifast still has "significant" obligations to perform for its customers, since the company still handles issues related to: returns associated with substandard product or errors, damaged goods, shipping errors, order cancellation, and theft losses before delivery. See excerpts from Medifast's return policy below:
Returns Associated with Substandard Product or Errors
In the event that Medifast ships consumable products with defects or products that were not part of the order, Medifast will issue the customer a Return Merchandise Authorization (RMA) number and shipping labels so that the items in question can be returned at the company’s expense. Customers should report such issues and request RMA’s by calling 800-638-7867. Upon receipt of returned shipment, Medifast conducts a Quality Assurance test to determine appropriate resolution. If the customer receives defective non-consumable goods, the company will send replacement. Shipping charges related to original order will not be refunded.
[snip]
Damaged Goods
If a package arrives damaged and unacceptable, Medifast must be notified within fifteen (15) days of purchase. If notification is not given within fifteen (15) days, no claim will be placed with the shipping agent, and replacement products will not be shipped for the damaged package.
Shipping Errors
If a package is shipped to the wrong destination and it is the company’s error, the company will pay to have the package shipped to the proper location. Medifast will ship expedited freight for any products needed immediately (i.e. customer is out of supplements completely), but will ship UPS Ground for all other products. If the error is on the client’s part, they must make their own arrangements to send the shipment back to Medifast in order to receive credit. If the shipping agent (i.e. Federal Express, UPS, USPS) has delivered the shipment inaccurately, Medifast will send shipping labels to the customer. The customer will then bring the package to a shipping provider to have it returned to Medifast.
Order Cancellation
If a request for cancellation occurs after the order has been shipped; the customer will be instructed to refuse the package. Cost of products will be refunded however the customer is responsible to pay for shipping and handling.
Theft Losses
If a package is stolen from a doorstep, Medifast will ship a replacement order which will require a signature upon delivery. This policy applies to one occurrence of theft only. Medifast will investigate the theft of the original package and file a claim with the shipping agent. Medifast reserves the right to refuse replacement shipments based on customer history at any time.
An examination of the Adobe pdf document downloaded from Medifast's website indicates that such document was created on "7/12/06."
Therefore, at least starting in 2006, it appears that Medifast "in substance" transferred risk of loss to the customer on the delivery date and not the product shipment date. Since it appears that Medifast still had significant obligations to perform for its customers upon shipment, the company is required to recognize revenue on the delivery date and not the shipping date.
.
Medifast's discloses on its website:
What is your shipping policy?
Allow five to seven business days for standard shipping, or three to four business days for expedited shipping (additional charge).
Medifast delivers is product to customers from three to seven business days after shipment. If Medifast is actually recognizing revenue on the shipment date to its customers, the company is probably prematurely recognizing revenue three to seven business days too early - at least as far back as 2006.
Medifast's financial disclosures omit mention of any deferred revenue liabilities
Setting aside whether Medifast should recognize revenue upon shipment date or delivery date, the company must report a deferred revenue liability for customer orders processed and not yet shipped or delivered prior to the end of a reporting period. Otherwise, the company prematurely recognizes revenue under GAAP.
According to Medifast's shipping policy, "All orders are processed within 24 hours and shipped the next business day." However, Medifast's financial reports seem to omit any "deferred revenue" liability disclosure for customer orders processed but not yet shipped.
If Medifast processes an order from a customer prior to the end of a reporting period, but does not ship or deliver the product until the next reporting period, the company should report a "deferred revenue" liability to its customer instead of revenue, because it still has an obligation to perform services for that customer.
However, Medifast's financial reports going back to 2004 disclose no deferred revenue liabilities for customer orders processed before each fiscal year ended and either shipped or delivered after those respective fiscal years.
Starting in 2004, Medifast omitted reporting deferred revenues as a sub-item under “Accounts payable and accrued expenses. See excerpt from Medifast’s 2004 10-KSB report below (Click on image to enlarge):
From 2005 to 2009, Medifast omitted any mention of deferred revenues as a sub-item of "Account payable and accrued expenses." For example, see the excerpt from Medifast's 2009 10-K report below (Click on image to enlarge):
If deferred revenue liabilities were no longer being reported as a sub-item of "Accounts payable and accrued expenses" reason follows that it would be reported as a separate line item under the "current liabilities" section of Medifast's balance sheet. However, from 2005 to 2009, Medifast's current liability section of its balance sheet from 2004 to 2009 omits any mention of deferred revenue liabilities. See example for Medifast's 2009 10-K report below (Click on image to enlarge):
Sometimes companies will report deferred revenues as an offset against "Current assets" on their balance sheets. However, I examined Medifast's current asset disclosures and found no information about deferred revenues being used to offset any current asset accounts.
If Medifast actually reported deferred revenues as an offset to any current asset account, such an offset would be against the accounts receivable account. However, Medifast's "accounts receivable and allowance for doubtful accounts" disclosures omit any reference to reporting deferred revenues as an offset to accounts receivable.
For example, see Medifast's "accounts receivable and allowance for doubtful accounts" disclosure from the company's 2009 10-K report below:
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are recorded net of reserves for sales returns and allowances, and net of provisions for doubtful accounts. Allowances for sales returns and discounts are based on an analysis of historical trends, and allowances for doubtful accounts are based primarily on an analysis of aging accounts receivable balances and on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.
The "allowance for sales returns and doubtful accounts" which offsets accounts receivable was a mere $100,000 at the end of fiscal year 2009 and 2008. Just in case the company included deferred revenues as part of that account without disclosing it, the $100,000 reported for such an allowance does not seem reasonable enough given Medifast's volume of revenues and the dates it either ships or delivers its orders to customers after processing them.
Key issues - Red Flags
According to Medifast's shipping policy, "All orders are processed within 24 hours and shipped the next business day." However, since 2004, Medifast's financial disclosures apparently omit any reference to "deferred revenue" liabilities which reflect the company's obligation for unshipped products to its customers at the end of& each accounting period. At the very least, it appears that Medifast is recognizing revenue a business day early.
Since at least 2006, it appears that Medifast, in substance, effectively transfers risk of loss to the customer on the date of delivery, rather than when the product is shipped. Medifast ships its products to its customers on the next business day after its processing the customer's order. Those products are delivered to its customers three to seven business days later. In other words, Medifast is possibly recognizing revenue four to eight business days early.
Materiality
If the SEC determines that Medifast violated revenue recognition rules, SEC Staff Accounting Bulletin No. 99, requires the company to perform a quarter-by-quarter analysis to determine the impact of ;the accounting error on earnings, earnings trends, and whether such error caused the company to beat analyst earnings expectations.
I do not have enough information from publicly available sources to determine if Medifast's potential revenue recognition issues are material enough to cause a restatement of its financial reports. At the very least, it appears that Medifast would be required to record a one-time cumulative adjustment in its latest financial report to correct previously reported revenues and earnings.
According to SEC Staff Accounting Bulletin No. 99, registrants are not permitted to make intentional immaterial misstatements "in a manner inconsistent with GAAP." See below:
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.
Therefore, a public company cannot recognize revenue "in a manner inconsistent with GAAP" even if "any deviations from GAAP have been immaterial."
Even relatively small immaterial misstatements of revenue can cause disproportionately larger material misstatements of reported earnings. For example, Overstock.com CEO Patrick Byrne told the Associated Press that certain GAAP violations uncovered in this blog:
...involved 0.1 percent of revenue and gave the company no advantage.
However, the GAAP violation caused the company to report an improper Q4 2008 profit, instead of a properly reported loss.
A departure from GAAP is considered a material reportable event, even if it does not result in a restatement of financial reports or a one-time cumulative adjustment to financial reports to correct such a violation.
Closing comments
In my analysis above, I have presented a reasonable basis for concern that Medifast's revenue recognition policy possibly violates GAAP and SEC rules under SAB Topic 13. All public company financial reports are subject to a limited review by the SEC Division of Corporation Finance on a periodic basis (usually every three years). Medifast's last review was in 2007 and a new review is now due. I respectfully urge you to promptly review Medifast's revenue recognition policies before the company issues its Q2 2010 report sometime in late July or early August.
Respectfully,
Sam E. Antar
Note: The self-proclaimed "distinguished" people at Medifast are still invited to provide this convicted felon with a detailed line-by-line response to the analysis provided above and I will post their full response on my blog. I am simply using Medifast's own disclosures to investors and customers as a basis for expressing my reasonable concerns. If there is any confusion on my part, Medifast should clarify its financial disclosures and make them more transparent.
Disclosure:
I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.
If it weren't for the efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.
There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals.
Recently, I exposed financial reporting violations by Overstock.com (NASDAQ: OSTK) as an independent whistleblower. The Securities and Exchange Commission is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).
In addition, the SEC is now investigating possible GAAP violations by Bidz.com (NASDAQ: BIDZ) after I alerted them about the company's inventory accounting practices.
I do not own Overstock.com or Bidz.com securities long or short. My exposure of confirmed financial reporting violations by Overstock.com and possible financial reporting violations by Bidz.com was a freebie to securities regulators to get me into heaven, though I doubt that I will ever get there.
I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.
In the past, I was compensated by Fraud Discovery Institute to do certain research on InterOil and Medifast's auditors. However, I do not own InterOil or Medifast securities long or short. Fraud Discovery Institute, co-founder, Barry Minkow has publicly disclosed that he has held short positions in InterOil and Medifast securities. However, I am unaware if he has any position in InterOil or Medifast at this time.
I posted this open letter on my blog simply because I could - for fun and enjoyment. In America, even convicted felons like me have rights under the First Amendment to the US Constitution. If anyone has any complaints, please ask your elected officials to change the Constitution, feel free to complain to the SEC, take other legal measures, or rant, yell and scream. I personally don't give a damn.
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