Monday, October 28, 2013

Is Overstock.com Trying to Cook The Books, Again?

I hoped that Overstock.com (NASDAQ: OSTK) had finally learned the error of its ways. Now it seems that the company has again resorted to accounting shenanigans to inflate its reported income.

Background

From Q2 2007 to Q2 2008, Overstock.com used an improper EBITDA calculation to materially overstate its pro-forma income in violation of Securities and Exchange Commission Regulation G. From Q4 2008 to Q3 2009, the company violated Generally Accepted Accounting Principles (GAAP) and materially overstated its reported earnings. I endured malicious personal attacks, cyber-stalking, pretexting, and threats to my personal safety from Overstock.com’s gun-toting CEO Patrick Byrne and his paid thugs in retaliation for exposing its illegal accounting practices. In each case, I complained to the Securities and Exchange Commission. Eventually Overstock.com was forced to stop using those illegal accounting practices. It seems that Overstock.com is up to its old tricks again.

Executive summary

In the three month period (third quarter) ended September 30, 2013, Overstock.com claimed that its pretax income was $3.624 million compared to $2.824 million in the same quarter of 2012, an $800,000 increase over the previous year. However, the validity of the increase in pretax income is questionable.

In 2013, Overstock.com quietly changed the useful life of certain fixed assets. The company did not inform investors in its 2013 financial reports that the useful life of its computer software and computer hardware costs was higher in 2013 than it was in 2012, leaving the impression that their useful lives were the same in both years. It simply changed the useful life numbers without providing an explanation. Since it was able to spread depreciation and amortization expenses over a longer period of time, it was able to report a lower depreciation and amortization expense in each quarter and inflate its reported profits.

Furthermore, there is a $700,000 numerical discrepancy in the amount reported for capitalized internal use-software and website development costs in the third quarter. There is another $400,000 numerical discrepancy in the amount reported for amortization expense associated with internal use-software and website development in the third quarter.

Moreover, in the third quarter of 2013, Overstock.com reduced its accrual for loss contingencies by $300,000 from the previous quarter despite a growing number of serious lawsuits against the company. If the company reversed its previous estimate of loss contingencies, it added $300,000 to its third quarter pretax income.

At the very least it appears that a substantial part of the $800,000 increase in pretax income would have disappeared if Overstock.com had not changed the useful life of certain fixed assets. It's possible that Overstock.com could have reported a decline in pretax income. The third quarter numbers don't add up. The numbers cannot be trusted. These accounting irregularities could be a red flag for a material weakness in internal controls over financial reporting.

Depreciation and amortization accounting

Fixed assets are required to be depreciated or amortized over their “estimated” useful lives. For example, a company purchases computer software for $10,000. It amortizes computer software over its 2 year useful life. Initially, the computer software is reported on the balance sheet as fixed asset. No expense is initially recognized on the income statement. Over the next two years, the company recognizes $5,000 per year of amortization expense in its income statement ($10,000 cost divided by 2 year useful life).

If a company lengthens the useful life of a fixed asset, it spreads out depreciation and amortization expense over a longer period of time. Therefore, it can report higher profits by recognizing a lower depreciation and amortization expense in each period. For example, if a company changes its policy to amortize computer software over 4 years instead of 2 years, it can reduce its amortization expense from $5,000 per year to $2,500 per year ($10,000 cost divided by 4 year useful life). Therefore, the company can increase its profits by $2,500 per year in the first 2 years it owns the software by extending the useful life from 2 years to 4 years.

As the amount of fixed assets increase on the balance sheet, the amount reported for depreciation and amortization expense should grow too. However, after analyzing Overstock.com's numbers, I discovered that its fixed assets increased year-over-year, while its depreciation and amortization expense decreased year-over-year. The numbers grew in opposite directions. That occurs when a company is either reporting an erroneous amount of depreciation and amortization expense or when it lengthens the useful life of its fixed assets.

Overstock.com buries changes in the useful life of fixed assets

To find out how Overstock.com changed the useful life of its fixed assets, you have to compare different S.E.C. flings over two years because the company did not fess up and tell investors about the change. Buried under 72 pages of disclosures and another 9 page of footnotes in Overstock.com's 2012 10-K report, we finally learn that the useful life of computer software was 2 to 3 years and the useful life of computer hardware was 3 years in 2012. See below (highlights added):

Overstock.com 2012 10-K report

However, Overstock.com's 10-Q reports issued for each quarter of 2013 show a different useful life for computer software and computer hardware than was reported in 2012. Buried on page 9 of the first two quarter 10-Q reports and page 10 of the third quarter 10-Q report, Overstock.com revealed that the useful life of computer software was 2 to 4 years. However, the useful life of computer software was 2 to 3 years in 2012. In those same 2013 10-Q reports, the useful life of computer hardware was 3 to 4 years. However, the useful life of computer equipment was only 3 years in 2012. (Source: Q1 10-Q, Q2 10-Q, and Q3 10-Q reports)

In each of those 2013 10-Q reports, Overstock.com disclosed:

Fixed assets

Fixed assets, which include assets such as technology infrastructure, internal-use software, website development, furniture and fixtures and leasehold improvements, are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related assets or the term of the related capital lease, whichever is shorter, as follows:


Note: Yellow highlights were added for emphasis

Overstock.com's fixed asset disclosure leaves the impression that the useful life of its computer software and computer hardware was the same in both 2013 and 2012. The company did not inform investors that the useful life of computer software and computer hardware was higher in 2013 than it was in 2012. It simply changed the numbers without explanation. It did not provide a year-to-year comparison of the useful life of its fixed assets in its 2013 financial reports.

Third quarter 2013: Higher level of fixed assets but lower depreciation and amortization expense

In the three month period (third quarter) ended September 30, 2013, Overstock.com claimed that its pretax income was $3.624 million compared to $2.824 million in the same quarter of 2012. Pretax income increased by $800,000 over the previous year. However, the validity of the increase in pretax income is questionable.

In the three month period ended September 30, 2013 (third quarter) depreciation and amortization expense was $3.307 million compared to $3.839 million in the same three month period of the previous year. Depreciation and amortization expense decreased by $532,000 year-over-year.

At the end of the third quarter of 2013, Overstock.com reported fixed assets of $26.892 million on its balance sheet compared to $23.034 million at the end of the same quarter of the previous year. The amount of fixed assets on its balance sheet was $3.858 million higher in 2013 than it was in 2012. Depreciation and amortization expense was $532,000 lower despite a $3.858 million higher amount of fixed assets.

Third quarter 2013: Numbers don't add up

The amount of internal-use software and website development costs that the company claimed it capitalized for the entire nine month period (first three quarters) ended September 30, 2013 is $700,000 lower than the totals it claimed that it capitalized in each of the three quarters of the year. In the previous quarter ended June 30, 2013, the six month total equaled the total reported for the first and second quarters. Therefore, the $700,000 discrepancy appears to impact its third quarter 2013 numbers.

Moreover, amortization expense for internal-use software and website development costs that the company claimed it reported for the entire nine month period (first three quarters) ended September 30, 2013 is $400,000 higher than the totals it claimed it amortized in each of the three quarters of the year. In the previous quarter ended June 30, 2013, the six month total equaled the total reported for the first and second quarters. Therefore, the $400,000 discrepancy appears to impact its third quarter 2013 numbers.

According to the third quarter ended September 30, 2013 10-Q report:

During the three months ended September 30, 2013 and 2012, we capitalized $3.3 million and $3.0 million, respectively, of costs associated with internal-use software and website development, both developed internally and acquired externally. Amortization of costs associated with internal-use software and website development was $1.8 million and $2.0 million for those respective periods. During the nine months ended September 30, 2013 and 2012, we capitalized $8.1 million and $6.8 million, respectively, of such costs and had amortization of $5.9 million and $6.3 million for those respective periods. [Emphasis added.]

In three month period ended September 30, 2013, Overstock.com claimed that it capitalized $3.3 million of costs associated with internal-use software and website development. In the nine month period ended September 30, 2013, the company claimed that it capitalized $8.1 million of such costs.

In the three month period ended September 30, 2013, Overstock.com claimed that its amortized $1.8 million of internal-use software and website development costs. In the nine month period ended September 30, 2013, the company claimed that it amortized $5.9 million of such costs.

In the second quarter ended June 30, 2013 10-Q report, Overstock.com claimed that:

During the six months ended June 30, 2013 and 2012, we capitalized $5.5 million and $3.9 million, respectively, of such costs and had amortization of $3.7 million and $4.3 million for those respective periods. [Emphasis added.]

Let's do some basic math.

During the six month period ended June 30, 2013, Overstock.com capitalized $5.5 million of costs associated with internal-use software and website development. In the three month period ended September 30, 2013 it claimed that it capitalized an additional $3.3 million of such software costs. Therefore, Overstock.com should have reported a nine month total of $8.8 million. However, it reported a nine month total of $8.1 million, leaving a $700,000 discrepancy in its third quarter numbers.

During the six month period ended June 30, 2013, Overstock.com amortized $3.7 million of costs associated with internal-use software and website development. In the three month period ended September 30, 2013 it claimed that it amortized an additional $1.8 million of such software costs. Therefore, Overstock.com should have reported a nine month total of $5.5 million. However, it reported a nine month total of $5.9 million, leaving a $400,000 discrepancy in its third quarter numbers.

Third quarter 2013: Reduction in amounts accrued for loss contingencies

In the three month period (third quarter) ended September 30, 2013, Overstock.com reduced its accrual for loss contingencies by $300,000 from the previous quarter despite a growing number of serious lawsuits against the company. If the company reversed its previous estimate of loss contingencies, it added $300,000 to its third quarter pretax income.

In the third quarter ended September 30, 2013 10-Q report, Overstock.com disclosed:

We establish liabilities when a particular contingency is probable and estimable. At September 30, 2013, we have accrued $2.6 million in light of these probable and estimable liabilities. It is reasonably possible that the actual losses may exceed our accrued liabilities. We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated. [Emphasis added.]

In the second quarter ended June 30, 2013 10-Q report, Overtock.com reported:

We establish liabilities when a particular contingency is probable and estimable. As of June 30, 2013, we have accrued $2.9 million in light of these probable and estimable liabilities. It is reasonably possible that the actual losses may exceed our accrued liabilities. We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated. [Emphasis added.]

A loss contingency reserve can be reduced two ways. Either the company paid out money it previously accrued (no effect on income) or it changed its estimate of contingent liabilities (reversed prior accruals of loss contingency expense). Such a change in estimate would increase its pretax income. Was Overstock.com trying to further tweak its third quarter numbers?

Conclusion

Given Overstock.com's prior history of accounting violations and its past malicious retaliatory actions against journalists, independent whistleblowers like me, and other critics, investors should be skeptical of its accounting and financial disclosures.

Written by,

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin 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 heroic 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. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

There is a saying, "It takes one to know one." I've provided professional work for the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify fraud and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. In addition, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. Recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud.

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

Thursday, October 03, 2013

Is Medifast a Cry Baby or a Corporate Bully?

This is the way corporate bullying works. Last Monday, September 30, 2013, I reported that Medifast (NYSE: MED), its former CFO, and the engagement partner who supervised its audits for its former accounting firm agreed to the entry of separate Cease-and-Desist Orders by the Securities and Exchange Commission for various violations of securities laws. On Wednesday, October 2, 2013, I received a letter from its lawyers with the following barely veiled threat, “…The Company, is not adverse to taking decisive action to redress false accusations against its business.”

Background

On September 19, 2013, Medifast (NYSE: MED) disclosed that on the previous day it consented to an entry of a Cease-and Desist Order and agreed to pay a $200,000 civil money penalty in connection with an "investigation" by the Securities and Exchange Commission into its improper financial reporting from 2006 to 2009. I reported that Medifast's press release and 8-K report made no mention that Brendan N. Connors, its former CFO and Marc G. Nochimson, the engagement partner who had supervised Medifast's audits for its former accounting firm, consented to the entry of separate Cease-and-Desist Orders which alleged improper conduct. Furthermore, I wrote that "I did not find any specific disclosure of the above referenced investigation in any of Medifast's previous filings with the S.E.C. I asked the company for an explanation via email, but it did not respond my request."

Therefore, I asked a reasonable question: "Was Medifast transparent with investors about an S.E.C. investigation?" based on underlying facts that were referenced in the S.E.C.’s three Cease-and-Desist Orders, Medifast’s S.E.C. filings and a certain press release). Medifast responded by having their lawyer Robert A. Giacovas send me a threatening legal letter. The letter cannot cite a single false or erroneous fact that it claims I published. Instead, it resorts to veiled threats, personal attacks, and innuendo in an attempt to distort the meaning of what I wrote and to bully me. [Read a copy of the letter from Robert A. Giacovas, Esq. here.]

Medifast's letter and my response

If I may be so bold as to summarize their lawyer’s letter, they are complaining that I “did not find any specific disclosure of the [SEC] investigation in any or Medifast’s previous filings with the S.E.C.” They claim “the Company cannot locate any email” from me asking them for an explanation. They requested that I forward them "the email that was supposedly sent to the Company and went unanswered." [Emphasis added.]

On September 20, 2013 at approximately 3:00 AM, I filled out an online inquiry for Medifast's Investor Relations Department:

Did Medifast make any PRIOR disclosure referenced in the 8-K report filed on 9/13/2013?
Here is the link:
http://www.sec.gov/Archives/edgar/data/910329/000114420413051618/v355486_8k.htm
I cannot find any disclosure by the company of the referenced SEC investigation PRIOR to the filing of the 8-K.
Please respond via email.

See the screen shot below (Click on image to enlarge it):




At about 3:01 AM ET, I received the following confirmation that my inquiry was received. See the screen shot below (Click on image to enlarge it):



In addition, on September 20, 2013 at 4:41 AM ET, I sent an email to Medifast’s Investor Relations Department which made the same request: [Read the full email here.].

Question: Did Medifast make any disclosure of the above referenced investigation into Medifast's financial reporting in its previous filings with the S.E.C.? I cannot find any reference to the above referenced investigation in any of Medifast’s filings with the S.E.C. prior to the filing of the 8-K report referenced above.

I’d appreciate a prompt answer to this question via email.

However, Medifast did not respond to me as of the time I published my blog 10 days later on September 30, 2013. If Medifast cannot find my online inquiry and email detailed above, I respectfully suggest that apparently either someone at the company is not being truthful to them or it has a problem with its information technology infrastructure.

Medifast's letter does not deny that it failed to report the existence of an S.E.C. investigation prior to the issuance of a Cease-and-Desist Order, press release, and 8-K filing. Instead, it explains that Medifast had no specific legal obligation to disclose such an investigation:

However, there is no statute, regulation, or rule that explicitly imposes an affirmative duty upon a public company to disclose the existence of an SEC investigation.

The letter says:

First, you state that you "did not find any specific disclosure of the [SEC] investigation in any of Medifast's previous filings with the SEC." The statement and your emphasis on the word "any" is clearly meant to convey that the Company has somehow not made proper disclosures to investors."

Apparently, the letter claims that I inferred that Medifast had broken the law by not reporting the existence of an ongoing investigation prior it consenting to the entry of a Cease-and-Desist Order. I made no such claim or inference. I asked a reasonable question: “Was Medifast transparent with investors about an S.E.C. investigation?” For example, many public companies report the existence of confidential S.E.C. investigations. Whether or not public companies should disclose the existence of ongoing S.E.C. investigations has been a matter of endless public debate. Therefore, even if we accept Medifast’s contention that by the letter of the law it was not required to report the existence of the S.E.C. investigation, it is still reasonable to ask a question about whether it was transparent with investors in communicating with them.

In addition, I reported that Medifast did not disclose in its press release and 8-K filing that its former CFO and the former engagement partner who supervised its audits also consented to the entry of separate Cease-and-Desist Orders. Their letter claims that I inferred that Medifast “purposely omitted mention of these other settlements." [Emphasis added]. As I detailed above, Medifast claimed that it had no specific legal obligation to report the S.E.C. investigation prior to it accepting the entry of a Cease-and Desist Order against it. Is Medifast now claiming it would have reported the other two Cease-and-Desist orders if they had known about them prior to its press release and filing of an 8-K report? If that is so, Medifast could have issued another press release and filed an amended 8-K report with the S.E.C. if it had chosen to do so. It did not.

The letter goes on to say that:

For your information, as a matter of policy, the SEC does not disclose the status of any investigations and settlement discussions with other potential parties (and it did not in this case).

The letter claims that:

The Company learned about details of those settlements at the same time as everyone else – when they were released by the S.E.C.

Those statements raise another reasonable question. Their letter is silent on whether Medifast knew that its former CFO and the engagement partner who supervised its audits were being simultaneously investigated by the S.E.C. Is Medifast inferring that it did not know that the S.E.C. was investigating its former CFO and the engagement partner who handled its audits until after it learned that they consented to the entry of Cease-and-Desist Orders? If Medifast did know that its former CFO and the engagement partner were being investigated by the S.E.C., wouldn't its lawyers be in contact with their lawyers to monitor the ongoing investigation? Again, these are reasonable questions based on the information presented.

Furthermore, Medifast, its former CFO, and the engagement partner who supervised its audits for its former accounting firm all consented to Cease-and-Desist Orders on the same day: September 18, 2013. The respective Cease-and Desist Orders entered against all three parties contain sequential Securities Exchange Act of 1934 file numbers, sequential Accounting and Auditing Enforcement Release numbers, sequential Administrative Proceeding file numbers, and sequential URLs to access them on the internet. A day later, on September 19 at around 9:19 AM Medifast issued a press release which reported its Cease-and-Desist Order, but omitted reference to the other two orders. Its 8-K filing with the S.E.C., which also omitted reference to the other two Cease-and-Desist Orders, was accepted by the S.E.C. later that same day at 4:59 PM. Based on that sequence of events, it’s a reasonable question to ask why Medifast did not disclose the two Cease-and-Desist Orders in its initial press release and 8-K report. In any case, as I suggested above, Medifast could have issued a new press release or filed an amended 8-K report disclosing the other two Cease-and-Desist orders if it chose to do so. It did not. There still remains a reasonable question to ask about whether Medifast was transparent in communicating with investors even if Medifast complied with S.E.C. reporting requirements on this issue. [Cease-and-Desist against Medifast, Cease-and-Desist against Brendan Connors, and Cease-and-Desist against Marc Nochimson]

What further amuses me about Medifast's bullying is their lawyer's apparent blundering. For example, the letter states:

Your post, which begins with the question – “Was Medifast transparent with investors about an S.E.C. investigation?” – then contains a number of statements that answers the question in the affirmative, thereby raising specter of some improper conduct by Medifast surrounding the entry of a cease and desist order with the Securities and Exchange Commission (“SEC’). [Emphasis added.]

Apparently, the letter erroneously claims that I answered my own question “in the affirmative” which means that I implied that Medifast engaged in proper conduct while it goes on to erroneously claim that I answered the question in the negative, meaning that Medifast engaged in improper conduct. I'm confused by their language. A company can follow the letter of the law and still not be transparent as I understand the term to mean. In any case, I did not say that Medifast was transparent or that it was not transparent. I simply asked a reasonable question about whether Medifast was transparent with investors and published the underlying facts accurately to help readers reach their own conclusion.

The letter references a certain defamation lawsuit Medifast brought against "...your friend and twice convicted felon Barry Minkow and (others)." I thought Minkow was a friend, but he is no longer a friend anymore and he has not been a friend for years. In any case, Medifast's defamation lawsuit against Barry Minkow was dismissed, although it is appealing the ruling. (See 10-Q report - Contingencies on page 14.)

Finally, Medifast requested that “And if you are truly interested in full transparency, you should publish this letter for your readers.” Well, I am interested in transparency. I made an upload of their letter available in the first paragraph of this blog, provided links to it several times above, and it can be uploaded here, too. In the spirit of the First Amendment to the Constitution of the United States, I welcome the debate. Back in 2012, I defended a government employee's right to free speech after he was fired for saying personal insults about me:

When Antar was asked about the critique of his talk and Mr. Kaplan’s firing his reaction was, “He has every right to voice his opinion of me. It was wrong for the City of Philadelphia to fire him for what he said about me."

In my humble opinion, Medifast appears to be thin-skinned. They are acting like crybabies. However, Medifast, like me has a constitutional right to the freedom of speech. Their opinions like mine here have a right to be heard. However, I will not allow them to bully me.

Written by:

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin 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 heroic 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. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

There is a saying, "It takes one to know one." I've done professional work for the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify fraud and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. Recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud.

I do not own any Medifast securities long or short.