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A close examination of Overstock.com's (NASDAQ: OSTK) Q1 2010 10-Q report financial disclosures reveals that the company still failed to remediate serious material weaknesses in internal controls that have resulted in three restatements of financial reports in four years to correct GAAP violations. In addition, a close examination of the company's financial disclosures reveals serious questions about the quality of its reported Q1 2010 earnings of $3.7 million and claimed improvement in financial performance when compared to Q1 2009.

Continuing Weaknesses in Internal Controls

Each and every initial financial report for every reporting period issued by Overstock.com from the company's inception in 1999 to Q3 2009 violated GAAP or some other SEC disclosure rules. Likewise, every single audit report from 1999 to 2008 was wrong and every single Sarbanes-Oxley internal control certification signed by management turned out to be false, too.

In its Q1 2010 10-Q report, Overstock.com disclosed that the company has not remediated serious weaknesses in internal controls:

...the Chief Executive Officer (principal executive officer) and Senior Vice President, Finance (principal financial officer) concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this Quarterly Report on Form 10-Q due to the following material weaknesses:

• We lacked a sufficient number of accounting professionals with the necessary knowledge, experience and training to adequately account for and perform adequate supervisory reviews of significant transactions that resulted in misapplications of GAAP.

• Information technology program change and program development controls were inadequately designed to prevent changes in our accounting systems which led to the failure to appropriately capture and process data.

[Snip]

As of March 31, 2010, we had not remediated the material weaknesses.

Note: Bold print and italics added by me.

Based on Overstock.com's past history of accounting irregularities and financial reporting violations, we cannot be reasonably assured that Overstock.com's current Q1 2010 financial report is free of GAAP and SEC disclosure violations due to continuing reported material weaknesses in internal controls.

Quality of Earnings Issues for Q1 2010

In Q1 2010, Overstock.com reported a net profit of $3.72 million compared to a net loss of $3.96 million in Q1 2009 or a $7.68 million improvement in earnings. However, Overstock.com's reported Q1 2010 $3.72 million profit was helped in large part by a $3.1 million reduction in its estimated allowance for returns or sales returns reserves when compared to Q1 2009.

According to Overstock.com's Q1 2010 10-Q report:

The allowance for returns was $7.4 million and $11.9 million at March 31, 2010 and December 31, 2009, respectively. The decrease in the sales returns reserve at March 31, 2010 compared to December 31, 2009 is primarily due to decreased revenues due to seasonality.

Note: Bold print and italics added by me.

It is normal for sales return reserves to drop from Q4 2009 to Q1 2010 "due to seasonality" issues such as decreased revenues from an earlier quarter (Q4 2009) compared to a later quarter (Q1 2010). However, in many cases such reserves drop due to changes from previous reserve estimates that artificially increase reported profits in later periods when such estimates are adjusted.

As the chart demonstrates, Overstock.com's reduction in allowances for returns may not be seasonal at all, but instead due to a change of estimate. As I detailed above, Overstock.com claimed that its reduction in sales return reserves was "primarily due to...seasonality" and the company did not claim any other factors such as operating improvements as a significant reason for the drop in reserves.

After Q4 2008, Overstock.com's allowance for returns steadily dropped in total dollars from $16.2 million to $7.4 million in Q1 2010, or a 54% reduction in reserves. On a relative basis, Overstock.com's allowance for returns steadily dropped from 6.38% of revenues in Q4 2008 to a mere 2.8% of revenues in Q1 2010, or a 56% drop in relative reserves.

If Overstock.com's return allowance had not dropped in dollar amounts from $10.5 million in Q1 2009 to $7.4 million in Q1 2010, the company would have reported a Q1 2010 profit of only $672k instead of $3.72 million.

In Q1 2010, Overstock.com's allowance for returns was 2.80% of revenues compared to 5.65% of revenues in Q1 2009. If we use that same percentage of revenues in Q1 2010 that Overstock.com used in Q1 2009 (5.65%), the company's allowance for reserves would have been $14.9 million, instead of $7.4 million as reported by the company. In such case, Overstock.com would have reported a Q1 2010 $3.78 million loss instead of a $3.72 profit.

Quality of Reported Improvement in Earnings

In Q2 2010, Overstock.com reported a net profit of $3.72 million compared to a net loss of $3.96 million in Q1 2009 or a $7.68 million improvement in earnings. However, a significant amount of Overstock.com's reported improvement in earnings resulted from a reduction of estimated allowances for returns, as described above, and other one-time items:

  • $3.100 million from reduction in estimated return allowances Q1 2009 to Q1 2010

  • $1.926 million from gain on early extinguishment of debt in Q1 2009

  • $0.600 million reduction of legal expenses in Q1 2010 due to a settlement of a legal matter in Q1 2009

  • $0.126 million restructuring credit in Q1 2010

  • Total: $5.752 million

$5.752 million of Overstock.com's reported $7.68 million improvement resulted from a reduction of estimated allowances for returns and other one-time items.

As I described above, if Overstock.com's allowances for returns on a percentage of revenue basis in Q1 2010 was the same percentage as Q1 2009, the company would have reported a Q1 2010 $3.78 million loss instead of a $3.72 profit. If we add the one-time items detailed above, Overstock.com would have reported a decline in earnings performance of $2.6 million instead of an improvement of $7.68 million.

Another peculiar issue is that unlike previous reporting periods, Overstock.com failed to disclose the amount of inventory reserves at the end of Q1 2010.

In any case, based on Overstock.com's historical failure to produce financial reports free from material errors and GAAP violations, the company's Q1 2010 reported profit is highly suspect.

Other Earnings Quality Issues

In previous periods when Overstock.com reported losses, the company instead focused in improvements in operating cash flows by showcasing them in the key metrics portion of its press releases announcing quarterly financial results (See an example, here). In Q1 2010 operating cash flows were reported at negative $28.2 million compared to negative $27 million in Q1 2009. In its press release announcing Q1 2010 financial results, Overstock.com left out the $1.2 million decline in operating cash flows in its key metrics section.

In addition, Overstock.com reported negative free cash flow of $32.6 million in Q1 2010 compared to negative $28.8 million in Q1 2009 or a decline of $3.8 million in that financial measure.

Loss Contingencies

In its Q1 2010 10-Q report, Overstock.com disclosed loss contingencies that could put a big hole in its corporate pockets in future periods:

  • District Attorneys of Marin and four other counties in Northern California to settle criminal investigation into fraudulent advertising practices: $8.5 million.

  • Ohio taxes: $613k

  • Total potential future losses: $9.13 million

SEC Investigation

The Securities and Exchange Commission continues to investigate Overstock.com for GAAP violations, such as those issues described below.

In a series of blog posts during 2009, I accurately reported that Overstock.com deliberately violated GAAP in its accounting for recoveries from underbilled and overpaid fulfillment partners by improperly claiming that a “gain contingency” existed when it did not actually exist under accounting rules.

Degenerate Judd Bagley

Under GAAP, Overstock.com is required to recognize income from underbilling and overpaying its fulfillment partners when such income was actually earned (before Q3 2008). By improperly claiming that a “gain contingency” existed, Overstock.com improperly recognized income as monies were recovered from the underbilled and overpaid fulfillment partners in future reporting periods on a non-GAAP cash basis.

Therefore, Overstock.com improperly shifted income earned before Q3 2008 to future accounting periods (Q4 2008 to Q3 2009). In Q4 2008, Overstock.com improperly reported a $1.014 profit, instead of a $750k because of GAAP violations.

I notified both the company and the SEC of Overstock.com's improper accounting for recoveries from underbilled fulfillment partners and later on, for overpaid fulfillment partners. Instead of properly complying with GAAP, Overstock.com CEO Patrick Byrne defamed me in various quarterly conference calls with analysts and investors and orchestrated a smear campaign to discredit me.

Patrick Byrne sent his paid stalker Judd Bagley to interfere with my divorce involving my ex-spouse and spy on my family (including minor nieces and nephews) using a fake Facebook name. The Big Picture (over 140k subscribers) blogger Barry Ritholtz labeled Judd Bagley "A career douche bag (and possible pedarast)" because of Bagley's efforts to stalk his children, my children, and the children of other Overstock.com critics on behalf of Patrick Byrne.

On January 29, 2010 Overstock.com finally ate crow and admitted that its accounting for recoveries from both underbilled and overpaid fulfillment partners was "inappropriate" and that no gain contingency existed, as I previously reported in my blog.

Closing Comment

Aside from Overstock.com's serial GAAP violations, smoke and mirrors accounting, and stalking of critics and their families, just take another look at those scary images of Patrick Byrne and "possible pedarast" Judd Bagley above and think hard about trusting any financial reporting by this company.

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 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.

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 because my sins are unforgivable. I expect Overstock.com CEO Patrick Byrne and "possible pedarst" Judd Bagley to join me to fry in hell. In any case, analyzing the company's financial reporting is a forensic accountant's wet dream.

Source: Overstock.com's Q1 2010 Numbers Are Highly Suspect