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Recently, the Securities and Exchange Commission Enforcement Division issued two letters recommending no enforcement action against Overstock.com (NASDAQ: OSTK) and its executives. In my last blog post, I respectfully disagreed with the SEC Enforcement Division's decision recommending of no enforcement action based Overstock.com's continuous pattern of false and misleading disclosures, inconsistent and contradictory disclosures, lies and misconduct, and various violations of law detailed in my blog over the last year and a half.

Before the SEC Enforcement Division issued such no-enforcement letters, the SEC Division of Corporation Finance, in a separate limited review of Overstock.com’s revenue accounting practices and disclosures discovered that the company, from at least fiscal year 2000, was intentionally not presenting its revenues and related financial disclosures in compliance with federal securities law, including Generally Accepted Accounting Principles (“GAAP”).

In Overstock.com's responses to SEC Division of Corporation Finance inquiries, the company claimed that its revenue accounting error was not material. The company was clearly attempting to avoid a restatement of prior affected financial reports arising from its intentional revenue accounting errors uncovered by the SEC. Instead, the company wanted to report its revenue accounting error as a cumulative one-time adjustment in its Q4 2007 financial report, apparently to hide the impact of such errors on previous affected financial reports.

SEC Staff Accounting Bulletin No. 99 requires companies to make a "full analysis of all relevant considerations" including both "quantitative and qualitative factors" to assess the materiality of its accounting errors. After examining Overstock.com’s February 26, 2008 responses to the SEC Division of Corporation Finance inquiries, I believe that the company's answers to the SEC were misleading by omitting certain important "relevant considerations" in analyzing the materiality of its revenue accounting errors.

One such relevant consideration that Overstock.com omitted in its responses to the SEC was any mention of the impact of its inventory accounting error reported about two years ago. Unlike Overstock.com's revenue accounting error, the company claimed that its inventory accounting error was material and it restated prior affected financial reports to correct its inventory accounting error. However, we compare Overstock.com's so-called "immaterial" revenue accounting to its "material" inventory accounting error using both "quantitative and qualitative" material factors, the impact of the company's revenue accounting error equals or exceeds the impact of its inventory accounting error.

As I will detail in this blog post, Overstock.com did not use consistent materiality judgments for its revenue accounting error when compared to its inventory accounting error. However, Statement of Financial Accounting Concepts No. 2, mandates "a consistency in the application of methods over time" in reporting financial information. Furthermore, SAB No. 99 reiterates that "...most importantly, the users of financial statements who have a right to expect consistent accounting and reporting for, and disclosure of, similar transactions and events." The concept of consistency in financial reporting is the bedrock upon which Generally Accepted Accounting Principles (GAAP) are built. In other words, companies cannot arbitrarily change materiality judgments on the fly.

Comparing Overstock.com's so-called "immaterial" revenue accounting error with its "material" inventory accounting error using quantitative materiality factors

Let's compare Overstock.com's so-called "immaterial" revenue accounting error with its "material" inventory accounting error, reported two years earlier.

Overstock.com's revenue accounting error resulted in a one-time "$13.7 million deferral of revenue" and an "increased net loss of $2.1 million" in Q4 2007. In contrast, in February 2006, Overstock.com disclosed a "material" inventory accounting error arising from a "material weakness" in internal controls. The company restated affected prior financial reports to correct its inventory accounting error. According to Overstock.com's 8-K report, “The effect of the correction will be to decrease the amount of the net loss reported in each annual period affected. The cumulative effect of the corrections in all of the affected periods is to reduce the accumulated deficit and to increase inventory at September 30, 2005 by approximately $3.5 million.”

Overstock.com's inventory accounting error resulted in a higher cumulative correction to the company's accumulated deficit than its revenue accounting error ($3.5 million versus $2.1 million). However, as I will detail below, Overstock.com's so-called "immaterial" revenue recognition error resulted in higher relative adjustments to net income and losses in key overlapping reporting periods affected by the company's "material" inventory accounting error. See the chart below:

Reporting Period

Net Income or (Loss) After Inventory Accounting Error Restatement

Overstock.com's Calculated Revenue Accounting Error Adjustment

Overstock.com's Calculated Net Income or (Loss)

Percentage Change 

FY 2003

(11,810)

(188)

(11,998)

-1.59%

FY 2004

 (4,729)

 (923)

 (5,652)

 -19.52%

FY 2005

 (25,103)

 (456)

 (25,559)

 -1.82%

 

Note: In $000's

According to Overstock.com's calculations, the company's revenue accounting error understated its reported net loss for fiscal year 2004 by 19.52%.

Overstock.com's correction to fiscal year 2004's net loss is actually higher. Overstock.com’s above calculations to the SEC were not revised to include additional revenue accounting corrections required by the SEC which increased the company’s cumulative or total revenue and earnings adjustment by about 75% each (cumulative revenues reduced by $13.7 million instead of $7.8 million and accumulated deficits increased by $2.1 million instead of $1.2 million). However, Overstock.com did not revise its calculated revenue accounting errors for affected prior reporting periods and instead used a one-time cumulative adjustment. Therefore, we are unable to determine at this time the full effect of the company's revenue accounting errors on specific reporting periods.

In contrast, Overstock.com's inventory accounting error overstated its reported net loss for fiscal year 2004 by 8.88%. The largest annual adjustment to net losses arising from correcting Overstock.com's inventory accounting error was in the first nine months of fiscal year 2005 at 10.72%, before the company corrected its inventory accounting error. However, if Overstock.com continued to misstate inventory in Q4 2005, a later correction of that quarter's financial report would have reduced the company's full year inventory accounting correction to less than 9%.

Therefore, Overstock.com's computed fiscal year 2004 revenue accounting error correction was more than double its inventory accounting error adjustment for the same year. However, Overstock.com did not consider its revenue accounting error as material while in contrast the company considered its inventory accounting error as material. See the chart below:

Reporting Period

Net Income or (Loss) Before Inventory Accounting Error Restatement

Inventory Accounting Error Adjustment 

Restated Net Income or (Loss) 

Percentage Change

FY 2002

 (11,570)

241 

(11,329)

2.08%

FY 2003

 (12,149)

339 

(11,810)

2.79%

FY 2004

 5,190 

461 

(4,729)

8.88%

FY 2005 to date before inventory accounting change

 (21,029)

 2,254 

 (18,775)

 10.72%


Note: Net Income or (Loss) in $000s. EPS amounts in $.

For fiscal year 2004, Overstock.com's revenue accounting error corrections more than offset certain previous adjustments to earnings arising from the company’s inventory accounting errors. Overstock.com originally reported fiscal year 2004 net losses of $5.190 million. When Overstock.com corrected its inventory accounting error, the company's fiscal year 2004 net losses were reduced by $461,000 to $4.729 million or an 8.88% positive earnings adjustment. Overstock.com calculated that its revenue recognition error added $923,000 to its restated net losses of $4,729 million for fiscal year 2004 or 19.5% additional losses.

Therefore, based on Overstock.com’s calculations, net losses for fiscal year 2004 should have been $5.652 million instead of the $5.190 million originally reported before both its inventory and revenue accounting errors. In other words, Overstock.com’s positive adjustment to earnings arising from its inventory accounting error by decreasing net losses flips to an overall negative adjustment due to its revenue accounting error by increasing net losses. 

Overstock.com failed to calculate changes in earnings resulting from its revenue accounting error for quarterly periods during 2004 and 2005 and instead provided annual calculations for those affected periods. To compute such changes, I had to extract information from other tables in the company's February 26, 2008 responses to the SEC. In fact, for one key period, Q4 2004, Overstock.com used the wrong EPS figure of $0.12 per share instead of $0.13 per share which decreased the impact the company’s revenue accounting error by one-half. That quarter was Overstock.com's last profitable quarter and only one of two profitable quarters in the company's entire operating history. See the chart below:

Reporting Period

 EPS before  Inventory Accounting Error

Restated EPS After Inventory Accounting Error

Percentage Change 

Overstock.com's Calculated EPS Purportedly Correcting Revenue Accounting Error

Percentage Change 

Q1 2004

 (0.14)

 (0.14)

 0.00%

 (0.14)

 0.00%

Q2 2004

 (0.13)

 (0.13)

 0.00%

 (0.14)

 -7.69%

Q3 2004

 (0.16)

(0.16)

 0.00%

 (0.17)

 -6.25%

Q4 2004

 0.12 

0.13 

 8.33%

 0.11 

 -16.67%

Q1 2005

 (0.21)

(0.22)

 -4.76%

 (0.23)

-4.55%

Q2 2005

 (0.13)

(0.10)

 23.08%

 (.08)

 -20.00%

Q3 2005

 (0.75)

(0.66)

 -12.00%

 (0.67)

-1.52%

Note: EPS in $.

According to Overstock.com's calculations, the company's revenue accounting error resulted in a greater than 5% adjustment in reported earnings per share in four of the seven quarters in overlapping periods from Q1 2004 to Q3 2005: Q2 2004, Q3 2004, Q4 2004, and Q2 2005. However, Overstock.com’s inventory accounting error resulted in a greater than 5% adjustment in reported earning per share in only three of seven quarters from Q1 2004 to Q3 2005: Q4 2004, Q2 2005, and Q3 2005.

As I described above, Overstock.com’s revenue accounting error calculations were not revised to reflect additional corrections to revenues required by the SEC which would have increased earnings per share adjustments even further. For example, Q1 2005's calculated EPS adjustment of 4.55% would have likely exceeded 5% too, if Overstock.com revised its calculations to reflect additional corrections required by the SEC. In such a case, Overstock.com's adjustments to earnings per share as a result of its revenue accounting error would have been greater than 5% in five of seven quarters overlapping quarters from Q1 2004 to Q3 2005, compared to three of seven overlapping quarters from its inventory accounting error.

Comparing Overstock.com's so-called "immaterial" revenue accounting error with its "material" inventory accounting error using qualitative materiality factors

In its February 26, 2008 letter to the SEC, Overstock.com tried to convince the SEC that its revenue recognition error was not material by referring to certain qualitative materiality factors under SEC Staff Accounting Bulletin No. 99. However, when we compare the qualitative materiality factors used by Overstock.com for its so-called "immaterial" revenue accounting error to its "material" inventory accounting error, the impact of the company's revenue accounting error equals or exceeds the impact of its inventory accounting error.

SAB No. 99:

Does the misstatement hide a failure to meet analysts’ consensus expectations?

Overstock.com’s response:

No. Based on the following tables the misstatement does not hide a failure to meet analysts’ mean consensus expectations….

Note: Bold print and italics added by me.

At first glance, the same can be said about Overstock.com’s inventory accounting error, too. See the chart below for certain overlapping periods covering both errors:

Reporting Period

Analyst's Mean Consensus Expectations for EPS 

Originally Reported EPS before Inventory Accounting Error and Revenue Accounting Error 

Percentage Surprise

Restated EPS  after Correcting Inventory Accounting Error 

Percentage Surprise 

Overstock.com's Computed EPS not Revised for Additional Corrections Required by SEC

Percentage Surprise

Q1 2004

 (0.17)

(0.14)

17.65%

(0.14)

17.65%

(0.14)

17.65%

Q2 2004

 (0.15)

(0.13)

13.33%

(0.13)

13.33%

(0.14)

 6.67%

Q3 2004 

 (0.19)

(0.16)

15.79%

(0.16)

15.79%

(0.17)

10.53%

Q4 2004

 0.08 

0.12 

50.00%

0.13 

 62.50%

0.11 

37.50%

Q1 2005

 (0.12)

(0.21)

-75.00%

(0.22)

-83.33%

(0.23)

-91.67%

Q2 2005

 (0.22)

(0.13)

40.91%

(0.10)

54.55%

(0.08)

63.64%

Q3 2005

 (0.51)

(0.75)

-47.06%

(0.66)

-29.41%

(0.67)

-31.37%

Note: EPS amounts in $.

In its February 26, 2008 letter to the SEC, Overstock.com presented a chart to the SEC claiming that its revenue accounting "misstatement does not hide a failure to meet analysts’ mean consensus expectations." In at least one reporting period, had Overstock.com revised its revenue accounting error calculations to reflect additional corrections required by the SEC, such misstatements may in fact "hide a failure to meet analysts’ mean consensus expectations."

See the chart below:

Quarter 

Mean Analyst's Consensus Expectations for Revenues

Overstock.com's Originally Reported Revenues

Percent Surprise 

Overstock.com's Computed Revenues not Revised for Additional Corrections Required by SEC

Percentage Surprise 

Q3  2004

 102.0

 103.44

 1.37%

 102.25

 0.25%

 Note: Revenue amounts in $millions.

As I described above, Overstock.com’s above calculations to the SEC were not revised to include additional revenue accounting corrections required by the SEC which increased the company’s cumulative or total revenue and earnings adjustment by about 75% each (revenues reduced by $13.7 million instead of $7.8 million and accumulated deficits increased by $2.1 million instead of $1.2 million).

For example, in Q3 2004, the mean analyst’s consensus expectations for revenues were $102 million. Overstock.com originally reported $103.44 million in revenues or about 1.37% above mean analyst’s consensus expectations for revenues of $102 million. Overstock.com calculated its corrected revenues at $102.25 million or $1.19 million lower than previously reported revenues of $103.4 million. If the impact of the SEC’s additional corrections reduced Overstock.com’s Q3 2004 revenues by another $251,000 or just 21% more, the effects of the company's revenue accounting error would have caused Overstock.com not the meet mean analyst’s expectations for revenues in that quarter. Keep in mind that the SEC’s additional corrections to revenues increased Overstock.com’s cumulative adjustment by 75%.

Therefore, Overstock.com’s Q3 2004 positive revenue surprise based on both its originally reported revenues and unrevised revenue accounting error corrections can easily flip to a negative surprise based added corrections required by the SEC and not computed by Overstock.com for that quarter.

SAB No. 99:

Did the misstatement result in significant positive or negative market reaction?

Overstock.com’s response:

No. We disclosed the estimated cumulative effect of the error related to the correction in our Q4 and FY 2007 earnings release and conference call on January 30, 2008. The stock price has not moved significantly since the earnings release date. Therefore, we believe that recording the cumulative adjustment in Q4 2007 would not affect a reasonable investor making an investment decision. In addition, analyst reports published subsequent to the earnings release made no mention of the cumulative adjustment or the correction. Therefore, we believe that recording the full adjustment in Q4 2007 was not an issue of concern to analysts….

Additionally, the stock is closely held, with insiders and our three largest institutions (shareholders since 2005) holding nearly 63% of the 23.8 million shares outstanding, and of the 8.9 million shares remaining, 4.5 million are sold short (reported on 1/31/08). This high short interest and relatively low public float contribute to the higher volatility our shares tend to experience.

Note: Bold print and italics added by me.

Overstock.com failed to disclose to the SEC the impact of its stock buybacks from the date that its revenue accounting error was reported on January 30, 2008 to the date of the company's response to the SEC on February 26, 2008.

According to Overstock.com’s Q1 2008 10-Q report, the company repurchased 845,375 shares from February 1, 2008 to February 28, 2008 at an average price of $11.11 per share. During that same period, 6.75 million shares of Overstock.com traded on NASDAQ. Therefore, Overstock.com’s share repurchases accounted for 14% of all shares traded from February 1 to February 28, 2008.

During those same 19 trading days, Overstock.com repurchased close to 10% of its defined “relatively low public float” of “8.9 million shares.” In addition, the average closing price for Overstock.com shares from February 1 to February 28 was $10.88 per share (computed by dividing the closing price per share by the 19 trading days). Therefore, Overstock.com paid a premium of $0.23 per share or 2.1% over the average selling price during the February 1 to February 28 period.

Overstock.com did not repurchase any shares on January 30 and 31. On February 27 and 28, Overstock.com’s common shares closed at $10.61 and $10.79 per share respectively. Since Overstock.com paid an average of $11.11 per share from February 1 to February 26, it is very safe to assume that a significant majority of its share repurchases occurred during February 1 to February 26.

In comparison, Overstock.com repurchased less than 20,000 shares in the weeks after it announced its the impact of its inventory accounting error two years earlier on February 24, 2006. For example, from February 23, 2006 (the day before Overstock.com announced its inventory accounting error) to Friday March 10, 2006, the company’s shares dropped from $24.27 per share to $22.85 per share.

In is almost inconceivable that a muted market reaction to Overstock.com’s revenue accounting error accounted for the company’s relatively stable stock price during that period. Rather, it was Overstock.com’s major share repurchases at above the average closing market prices for such shares during a narrow trading period that stabilized the stock price and kept it from falling.

Restate financial reports when correcting an accounting error increases earnings and use a one-time adjustment when correcting an accounting error decreases earnings

It seems that Overstock.com’s policy is to restate prior period financial reports when correcting an accounting error (e.g. inventory accounting error) results in favorable prior period financial reports. In contrast, in seems that Overstock.com’s policy is to use a one-time cumulative adjustment when correcting an accounting error (e.g. revenue recognition error) results in unfavorable prior period financial reports.

In order to use a one-time cumulative adjustment to correct its revenue accounting errors rather than restate earnings, Overstock.com apparently uses inconsistent materiality judgments. In just about every comparison of materiality factors (both quantitative and qualitative), the impact of Overstock.com's so-called "immaterial" revenue accounting error equals or exceeds the impact of its "material" inventory accounting error. Therefore, Overstock.com's revenue accounting error is clearly material.

Overstock.com cannot properly take a one-time cumulative adjustment to correct its revenue accounting error and the company is required by  Statement of Financial Accounting Standards No. 154 to restate its financial reports to correct such errors.

Earnings management issues

In effect, Overstock.com by not being consistent in applying corrections to both its revenue accounting error and inventory accounting error engages in prohibited "earnings management" or what is commonly known as "smoothing its earnings stream." Refer to "Item 6. Selected Financial Data" in Overstock.com's fiscal year 2007 10-K report showing comparative financial reports for fiscal years 2003 to 2007. No reference is made to Overstock.com's restatement of affected financial reports to correct its inventory accounting error while the company discloses its one-time adjustment in 2007 to correct its revenue accounting error. Fiscal year 2004's financial report includes only positive earnings adjustments (reducing net losses by $461,000 or 8.88%) from correcting its inventory accounting error but does not include any negative adjustments (increases to net losses of $923,000 or 19.5%) from correcting its revenue account error.

Speaking of one-time charges, Overstock.com CEO Patrick Byrne once wrote:

One of the first lessons I was taught was to watch out for companies with "one-time" charges for rarely, if ever, did they turn out to be, truly "one time" charges.

Will there be future "one time" charges to correct accounting errors? Apparently, Overstock.com has a pattern of material accounting errors dating back to its inception. Future one-time charges to correct accounting errors may depend on whether any future accounting error corrections positively impact or negatively impact affected prior financial reports.

A message to the SEC 

Is the SEC going to continue giving Overstock.com a pass?

Is the SEC still the tenacious regulator that I knew and feared as a criminal?

I'll have more to say regarding that issue, soon.

To be continued…..

Written by:

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

For additional information on Overstock.com, please read Gary Weiss and Tracy Coenen's blog.

Source: What Overstock Didn't Tell the SEC