It has been suggested that discussing the inventory issues at Overstock.com is a waste of time. Surely there is more interesting stuff going on. like Sith Lords and such.

So I’ll explain why it’s so important.

Inventory is a financial statement line item that is notorious for being abused. Some companies are loath to record proper reserves, and so inventory may be on the balance sheet at too high a value. On the other hand, when a company has a really good quarter, it may be tempting to overstate the reserve to create a little “cookie jar” for later. (The idea is that we recognize additional expense in this good quarter, since we still have “room” for more expenses. Then during a later quarter when numbers aren’t as good, we can dip into that reserve to pump up the earnings.)

Companies can have motives both for overstating and understating inventory. Overstating inventory allows the company to avoid booking an expense now and also creates a larger asset base. Understating the inventory with a too-large reserve can create that cookie jar for future quarters.

I state all of this simply to illustrate why inventory numbers might be manipulated by companies. No particular company. Just companies in general.

Sam Antar has wisely pointed out some unusual variances in Overstock.s SEC filings. The executives at Overstock.com apparently felt it was important at one time to explain how the manipulation of inventory reserves might affect the financial statements, but later did not.

From the 6/30/02 10-Q:

Overstock writes down its inventory for estimated obsolescence of damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Our inventory balance was $8.8 million, net of allowance for obsolescence or damaged inventory of $943,000 as of June 30, 2002. If we underestimate our reserves or allowances our gross margins, and net income, if any, will be overstated (or our net loss, if any, will be understated). Contrarily, if we overstate our reserves or allowances, our gross margins and net income, if any, will be understated (or our net loss, if any, will be overstated). (emphasis mine)

The 12/31/02 10-K then omits the disclosure about underestimating or overstating the inventory allowance.

The disclosure about inventory reserves is then added back to the 10-Qs for 3/31/03, 6/30/03, and 9/30/03.

The 12/31/03 10-K omits the inventory reserve disclosure.

The 3/31/06 10-Q has a new disclosure about inventory reserves:

We write down our inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Once established, the original cost of the inventory less the related inventory reserve represents the new cost basis of such products. Reversal of these reserves is recognized only when the related inventory has been sold or scrapped. As of March 31, 2006, our inventory balance was $81.4 million, net of allowance for obsolescence or damaged inventory of $3.3 million. At December 31, 2005, our inventory balance was $93.3 million, net of reserve for obsolescence or damaged inventory of $5.2 million. (emphasis mine)

I find the changing disclosures curious and would love to hear an explanation from Patrick Byrne. I.m sure Sam would love to hear the explanation too!

Last week I questioned Overstock.s description of its 12/31/06 inventory as .more attractive, higher margin inventory.. Here are the numbers:

• At 12/31/05, Overstock reported $98.5 million of inventory, with a reserve of $5.2 million. The reserve was 5.3% of the total inventory.
• At 12/31/06, Overstock reported $26.9 million of inventory, with a reserve of $6.6 million. The reserve was 24.5% of the total inventory.

The junk inventory (reserves) are bigger at 12/31/06 in total dollars and as a percentage of total inventory. That raises questions about whether the current inventory is really more attractive. Seems like more junk isn’t really better than less junk, but let.s see what might be going on.

First quarter gross margins at Overstock.com are up, which could signify that there was better inventory on hand. Or it might not. We don.t know if the improved margins are related to a real improvement in inventory, or whether they could be related to some earnings management.

But for the sake of discussion, let.s suppose for a minute that the Overstock numbers at 12/31/06 and 3/31/07 are all on the up-and-up. We.ll pretend gross inventory and the reserves are both fairly stated. The question then becomes whether or not the inventory was properly valued on the earlier financial statements.

And indeed, there are many questions.

An examination of the numbers at 9/30/06 and 12/31/06 suggests that inventory at the end of the third quarter may have been overstated by $6 million to $10 million. Some will say it doesn.t matter or isn.t material. Overstock ditched a bunch of stuff in the fourth quarter, took their lumps then, and all is well at 12/31/06. All is well, right?

Not so fast. The accounting rules say that the company must write down the inventory when they become aware that the value is impaired. That means you write it down sooner, rather than later. In Overstock.s case, they may have waited until later.

On the earnings call for second quarter 2006, Jason Lindsey represented the following about the inventory:

.We really want to have any slow-moving inventory out. We just do not know yet, I do not think, how much, how easily and how quick that stuff is going to be selling.

And he says:

“. we are more than adequately reserved, I think, for all of it, but just as far as having sold the last of it, so that there is no more drag on margins…

So here the company is representing, in the middle of 2006, that inventory reserves are adequate. No big write-down or big loss should be coming.

Still sound plausible to you? How about this statement by Patrick Byrne during the first quarter 2007 earnings call:

“Really, we had our game plan as of Q1 last year of what was going to have to happen. We knew things were going to get really ugly and the company was going to have take medicine but that we could come out of it a far better company, and that medicine was going to be in the form of some expenses, it was going to be in the form of dumping a bunch of inventory as we figured out really how to take our inventory management to the next level — all kinds of things. We knew it was going to get ugly. Maybe not as ugly as it got but we thought we would come out in the first quarter smelling like a rose operationally and this is exactly what we — what I at least thought was going to happen in the first quarter.. (emphasis mine)

So now he.s representing that all of 2006 Overstock knew it had lots of junk inventory it would have to unload. This seems to conflict directly with what the executives represented in that second quarter earnings call.

Indeed, the fourth quarter financial statements suggest that inventory was unloaded at a loss. What does it mean when it.s unloaded at a loss? That the reserves weren.t adequate and the inventory was overstated.

And per Patrick.s own words last month, Overstock knew they had junk on hand the entire year of 2006. Where is the write-down??? It.s not there. The losses on inventory don.t happen until the 4th quarter of 2006.

Was there a reason why Overstock did not want to properly write down inventory in the second or third quarter of 2006?

Does all of this really answer any questions? No. Only Patrick Byrne and company know what the real numbers are. I am only asking some questions. And pointing out that after a certain point, all of the questions, concerns, inconsistencies, and unusual items start to look rather suspect. But you already knew that.