To KPMG, a warning about Overstock.com, your new audit client:
Recently, your firm was naive enough to become Overstock.com’s (NASDAQ: OSTK) new auditors, after the company fired and publicly vilified Grant Thornton rather than properly follow Generally Accepted Accounting Principles (GAAP) as recommended by them. Prior to firing Grant Thornton, the Securities and Exchange Commission started investigating your new audit client as a result of reports in this blog detailing how the company improperly setup “cookie jar” reserves to materially inflate its financial performance in future accounting periods (Q4 2008 and thereafter).
Roddy Boyd's exposed new troubling issues in the Big Money
Overstock.com faces a probable investigation by the New York State Department of Taxation and Finance for its sales tax dodge scheme known as “Operation Heist and Freeze” that was exposed by investigative journalist Roddy Boyd in The Big Money.
In addition, the SEC will widen its investigation of Overstock.com based on internal company documents obtained by the Big Money that show that CEO Patrick Byrne and former CFO David Chidester knowingly signed false Sarbanes-Oxley certifications. The Big Money obtained internal Overstock.com documents that revealed that the company's
software system couldn’t track its inventory well, its accounting staff had trouble deciphering how much it owed and whom it had to pay.
Those documents contradict Sarbanes-Oxley certifications signed by CEO Patrick Byrne and former CFO David Chidester claiming that Overstock.com had effective internal controls over financial reporting.
Overstock.com and David Chidester part ways
A day after Boyd's article was published, Overstock.com and David Chidester parted ways by "mutual agreement." Just Monday morning, Overstock.com announced that:
On January 20, 2010 Mr. David K. Chidester left by mutual agreement, effective immediately, from his position as Senior Vice President, Internal Reporting and Information, of Overstock.com, Inc. (the “Company”).
In addition to signing false Sarbanes-Oxley certifications, Chidester made false claims to investors about Overstock.com's compliance with SEC Regulation G, governing non-GAAP financial measures, as I will describe in more detail later in this blog post.
The term "mutual agreement" usually means that the company does not want David Chidester around to answer your questions and Chidester does not want to be readily available to respond to your inquires. After all, David Chidester knows where the "black holes" are to be found in Overstock.com's financial reporting irregularities.
Fate seems to bring us together again
It seems like fate that our paths must cross again. Many years ago, KPMG was Crazy Eddie’s auditors.* While, I scammed you, your audit team was grossly negligent. Your eagerness to please us as an audit client made committing fraud quite easy at Crazy Eddie.
Unlike you, Grant Thornton was not eager to please Overstock.com by going along with its financial reporting charades. Grant Thornton was fired and vilified by the Overstock.com, for telling the company to restate its financial reports and comply with GAAP.
Note: KPMG's predecessor firms Main Hurdman and Peat Marwick Main were Crazy Eddie's auditors. They are the "M" and the "P" in KPMG.
Personally, I believe that you should cut your potential exposure and resign. Some clients are simply not worth the risk. Since I don't believe that you will resign, I feel that I owe you some advice just for old time’s sake to avoid another audit meltdown similar to what happened at Crazy Eddie. However, I have my doubts that any firm can properly audit Overstock.com given its apparent lack of effective internal controls, its management integrity issues, and its continued willingness to violate GAAP and SEC disclosure rules.
Statement of Auditing Standards No. 99 - Consideration of Fraud in a Financial Statement Audit
In particular, you must consider Statement of Auditing Standards No. 99 entitled, “Consideration of Fraud in a Financial Statement Audit” in both the planning and execution of your Overstock.com audit engagement. KPMG was hired by the company only eight days before its fiscal year ended. It is quite easy for Overstock.com's dishonest management team to lie to you, to mislead you, and conceal transactions from you as its auditors because you arrived late on the scene. Hopefully, you paid careful attention to the requirements of SAS No. 99, in particular the following guidance provided below:
Creating a Culture of Honesty and High Ethics
It is the organization's responsibility to create a culture of honesty and high ethics and to clearly communicate acceptable behavior and expectations of each employee. Such a culture is rooted in a strong set of core values (or value system) that provides the foundation for employees as to how the organization conducts its business. It also allows an entity to develop an ethical framework that covers (1) fraudulent financial reporting, (2) misappropriation of assets, and (3) corruption as well as other issues.
Setting the Tone at the Top
Directors and officers of corporations set the "tone at the top" for ethical behavior within any organization. Research in moral development strongly suggests that honesty can best be reinforced when a proper example is set—sometimes referred to as the tone at the top. The management of an entity cannot act one way and expect others in the entity to behave differently.
In many cases, particularly in larger organizations, it is necessary for management to both behave ethically and openly communicate its expectations for ethical behavior because most employees are not in a position to observe management's actions. Management must show employees through its words and actions that dishonest or unethical behavior will not be tolerated, even if the result of the action benefits the entity. Moreover, it should be evident that all employees will be treated equally, regardless of their position.
For example, statements by management regarding the absolute need to meet operating and financial targets can create undue pressures that may lead employees to commit fraud to achieve them. Setting unachievable goals for employees can give them two unattractive choices: fail or cheat. In contrast, a statement from management that says, "We are aggressive in pursuing our targets, while requiring truthful financial reporting at all times," clearly indicates to employees that integrity is a requirement. This message also conveys that the entity has "zero tolerance" for unethical behavior, including fraudulent financial reporting.
The cornerstone of an effective antifraud environment is a culture with a strong value system founded on integrity. This value system often is reflected in a code of conduct. The code of conduct should reflect the core values of the entity and guide employees in making appropriate decisions during their workday.
The “tone at the top” at Overstock.com is set by its CEO and major shareholder Patrick M. Byrne, who has lied to investors about the company’s financial performance dating as far back as the year 2000 and continues his unabated lies to them today.
Every single initial financial report for every reporting period issued by Overstock.com from the company's inception to date has violated GAAP and other SEC disclosure rules. So called "clean" audit opinions issued by PricewaterhouseCoopers (predecessor auditor to Grant Thornton) turned out to be wrong as the company has already restated its financial reports two times in the last three years. Overstock.com now faces a third restatement of such reports as a result of its improper use of "cookie jar" reserves under investigation by the SEC.
Rather than comply with GAAP and SEC disclosure rules, the company stubbornly continued to violate such rules and engaged in a campaign of harassment, intimidation, smears, threats, and pretexting directed at me and other critics (Details from my blog here and here and from investigative journalist and blogger Gary Weiss here). Overstock.com's independent audit committee has failed to enforce the company's Code of Business Conduct and Ethics and rein in management's improper and illegal behavior.
Therefore, I believe that it is nearly impossible for you to adequately increase the scope of your field work to conduct a proper audit of Overstock.com, as required by SAS No. 99. There are simply too many management integrity issues. The company's management has continuously lied to investors and has shown a willingness to issue financial reports that violate GAAP and SEC disclosure rules. On top of that, you cannot make up for the fact that you arrived on the scene only eight days before the fiscal year ended.
Below is a summary of management's continuous pattern of lying to investors and willful failure to follow GAAP and SEC disclosure rules.
Lies by Patrick Byrne prior to Overstock.com's initial public offering in 2002
From December 2000 to March 2002, Patrick Byrne lied about Overstock.com’s financial performance in a series of interviews on national television and in various publications prior to the company’s initial public offering in March 2002. Patrick Byrne deceptively used pro forma non-GAAP “gross value merchandise value sales” (instead of the lower GAAP commission revenue) to hype the company’s top-line performance in order to falsely claim that Overstock.com was profitable, when it never was profitable (Details here).
Overstock.com violated SEC Regulation G governing non-GAAP financial measures
From Q2 2007 to Q2 2008 Overstock.com improperly computed EBITDA by starting its calculation with operating income and adding back interest, taxes, depreciation, amortization, and stock based compensation. In other words, Overstock.com improperly defined EBITDA as operating income before interest, taxes, depreciation, amortization, and stock based compensation.
However, SEC Regulation G requires EBITDA to be computed as net income (not operating income) before interest, taxes, depreciation, and amortization (and not stock-based compensation). Therefore, Overstock.com was not permitted by Regulation G to use operating income as the starting point to compute EBITDA and the company was not allowed to eliminate stock-based compensation from its EBITDA calculation.
Since Overstock.com had reported losses from discontinued operations in various reporting periods, by improperly using operating income as the starting point to calculate EBITDA, it was materially overstating EBITDA by the amount of loss from discontinued operations. Likewise, by Overstock.com improperly eliminating stock-based compensation from its EBITDA calculation, the company was materially overstating its reported EBITDA by such amount in each reporting period.
When I confronted management about its EBITDA violations, Patrick Byrne, Jonathan Johnson, and David Chidester lied about the company's compliance with SEC Regulation G during quarterly conference calls and Byrne vilified me for raising the issue. In Q3 2008, Overstock.com finally corrected its improper EBITDA calculation by calling it "adjusted EBITDA" when it restated financial reports and amended its filings with the SEC to correct certain GAAP violations involving customer refund and credit errors described below. However, the company improperly failed to disclose in amended SEC filings that the reason for changing its EBITDA calculation was because of violations of Regulation G (Details here).
Overstock.com's history of GAAP violations
In February 2006, Overstock.com restated financial reports dating from Q1 2002 to Q3 2005 to correct its improper inventory accounting.
In February 2008, the SEC Division of Corporation Finance discovered that Overstock.com's revenue accounting violated GAAP from the company's inception to Q3 2007 (Details here).
In October 2008, Overstock.com restated its financial reports from Q1 2003 to Q2 2008 due to customer refund and credit errors. However, the October 2008 restatement did not include corrections arising from underbilled offsetting costs and reimbursements that were already earned from its fulfillment partners during those same corresponding periods, less a reasonable estimate of uncollectable amounts.
In other words, Overstock.com should have gone back and corrected or restated its financial reports to properly reflect income it already earned from offsetting costs and reimbursements due from its fulfillment partners, less a reasonable estimate for uncollectable amounts. Instead Overstock.com violated GAAP by improperly moving income that the company already earned in Q2 2008 and prior reporting periods to Q4 2008 and future reporting periods. In effect, Overstock.com improperly created a "cookie jar reserve" to materially inflate future earnings or reduce future losses (Details here).
In February 2009, I alerted both the Securities and Exchange Commission and Overstock.com's audit committee and management about the company’s improper use of a "cookie jar" reserve to inflate its financial performance in future reporting periods. Overstock.com continued to stubbornly refuse to restate its financial reports to comply with GAAP.
In September 2009, the SEC Enforcement Division and later the Division of Corporation Finance started parallel probes of the company.
In October 2009, the SEC Division of Corporation Finance discovered that Overstock.com overpaid a fulfillment partner $785,000 during 2008. The company recovered that overpayment in Q1 2009 and improperly reported the overpayment recovery as income in that same quarter, rather than properly restate its 2008 financial reports to correct that error. In addition, Overstock.com improperly concealed the recovery of the overpayment by including that amount in recoveries from underbilled fulfillment partners in Q1 2009 instead of separately disclosing the overpayment recovery in its financial reports (Details here).
Grant Thornton claimed that it did not know about the 2008 overpayment and Q1 2009 recovery from the fulfillment partner until October 2009. After learning about the overpayment, Grant Thornton told Overstock.com that it must restate its prior financial reports to correct that error and comply with GAAP. On November 13, 2009, Overstock.com fired Grant Thornton, rather than restate its financial reports and later filed an "unreviewed" Q3 2009 10-Q that finally disclosed the overpayment to the fulfillment partner. (See details here).
SAS No. 99 clearly states:
The cornerstone of an effective antifraud environment is a culture with a strong value system founded on integrity.
If company management can lie to investors, what makes you think that they won't lie to you in their efforts to violate GAAP and SEC disclosure rules? Therefore, if you decide to maintain Overstock.com as your client, proceed at your own risk.
Sam E. Antar
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, 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.
I do not own Overstock.com securities short or long. My research on Overstock.com and in particular its lying CEO Patrick Byrne is a freebie for securities regulators and the public in order to help me get into heaven, though I doubt that I will ever get there anyway. I will probably end up joining corporate miscreants such as Patrick Byrne in hell. In any case, exposing corporate crooks is a lot of fun for a forcibly "retired" crook like me and analyzing Overstock.com's financial reporting is a forensic accountant's wet dream.
KPMG has sponsored at least two of my free speaking engagements to universities and colleges.