Last week, Sam Antar exposed yet another set of accounting manipulations by Overstock.com (NASDAQ:OSTK) and CEO Patrick Byrne. Those who have carefully followed the Overstock saga are no doubt unsurprised at company’s use of a little accounting “presto chango” to make the fourth quarter of 2008 look better.
Had the company reported its financials properly for the year, the fourth quarter would have shown a loss of $800,000. With this bit of accounting magic, Overstock.com instead reports a profit of $1 million.
Sam reports the error in the 2008 fourth quarter financial statements for Overstock:
During the Q4 2008 earnings call, the new Overstock.com CFO Steve Chesnut, who recently replaced David Chidester, told investors:
Gross profit dollars were $43.6 million, a 6% decrease. This included a one-time gain of $1.8 million relating to payments from partners who were under-billed earlier in the year.
Note: Bold print and italics added by me.
That “one-time gain of $1.8 million” referred to above by CFO Steve Chesnut was actually an improper one-time cumulative adjustment of an accounting error.
Sam then goes through the rules a public company should consider when deciding whether to report the entire error in the fourth quarter (which Overstock did, and which improperly put them in the black for the quarter) or adjust the prior quarters’ financial statements.
Accrual basis accounting is simple: You record revenue when earned and expenses when incurred. You don’t record revenue sometime later when you realize it was earned earlier but never recorded. Doing so would not follow accrual accounting rules.
Overstock.com no doubt says that the $1.8 million adjustment booked in the fourth quarter was immaterial. I disagree, and the case for restatement of prior periods is clear if you read Statement of Financial Accounting Standards No. 154 and SEC Staff Accounting Bulletin No. 99.
If the amount of the adjustment is material, you must restate. How do we decide whether $1.8 million is material? It’s not simply a function of quantity (how much is being adjusted). It’s also very much a function of quality (what is being adjusted).
In this case, Sam Antar says that this particular adjustment is material, and I agree:
According to SFAS No. 154 paragraph 25:
Any error in the financial statements of a prior period discovered subsequent to their issuance shall be reported as a prior-period adjustment by restating the prior-period financial statements.
Note: Bold print and italics added by me.
Among the criteria that SAB No. 99 uses to define a material accounting error that requires a restatement of prior period financial reports are:
• whether the misstatement masks a change in earnings or other trends
• whether the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
• whether the misstatement changes a loss into income or vice versa
Overstock.com’s accounting error met in all three materiality criteria above and the company should have restated its prior financial reports, rather than use a one-time gain to correct its accounting error in Q4 2008.
The earnings trend for Overstock is clear. The company hasn’t had a profitable quarter since 2004. Now reporting a profit (in a quarter that really wasn’t profitable if the company had properly followed the accounting rules) changes that trend of 15 consecutive losing quarters.
This improper financial reporting also hides the fact that Overstock didn’t meet analysts’ expectations for the quarter. Analysts expected a 3 cent per share loss. Without the accounting shenanigans, Overstock would have reported a 4 cent per share loss. That’s obviously a failure to mee the expectations. But by including the cumulative adjustment in fourth quarter numbers, Overstock has now reported a 4 cent per share profit.
And finally, this accounting manipulation clearly changed Overstock.com’s fourth quarter numbers from a loss of $800,000, to a phony profit of $1 million.
Instead of coming clean, Overstock.com CEO Patrick Byrne instead deflects and digs the hole of lies deeper. Byrne says on the Investor Village message board:
Antar’s ramblings are gibberish. Show them to any accountant and they will confirm. He has no clue what he is talking about.
For example: when one discovers that one underpaid some suppliers $1 million and overpaid others $1 million. For those whom one underpaid, one immediately recognizes a $1 million liability, and cleans it up by paying. For those one overpaid, one does not immediately book an asset of a $1 million receivable: instead, one books that as the monies flow in. Simple conservatism demands this (If we went to book the asset the moment we found it, how much should we book? The whole $1 million? An estimate of the portion of it we think we’ll be able to collect?) The result is asymmetric treatment. Yet Antar is screaming his head off about this, while never once addressing this simple principle. Of course, if we had booked the found asset the moment we found it, he would have screamed his head off about that. Behind everything this guy writes, there is a gross obfuscation like this. His purpose is just to get as much noise out there as he can.
Too bad he’s completely wrong. Again, accrual basis accounting works very simply. You book revenue when earned, and expenses when incurred. You don’t book things “when you find them.” That’s simply not a part of accrual basis accounting.
Don’t take my word for it though. See what the New York CPA Journal has to say about it:
Revenue Recognition GAAP
GAAP for revenue recognition seems fairly straightforward: According to FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs and 1) the revenue is realized or realizable and 2) the revenue is earned. Revenue from a transaction must meet both criteria in order to be recognized. Revenue is generally considered realized when cash is received for the sale of a product or performance of a service. Revenue generally becomes realizable when a promise to pay is received in exchange for the sale of a product or performance of a service. The promise to pay could be verbal (account receivable) or written (note receivable). Revenue is generally earned when a legally enforceable exchange takes place (e.g., consideration has been tendered and the buyer takes possession of the product or benefits from the performance of a service).
In Overstock’s case, the items at issue were earned and realizable in prior quarters, not in the 4th quarter. The fact that the company is clueless and underbilled partners changes neither of those.
If you find items in months, quarters, or years after they should have been booked, the only proper way to record them under accrual basis accounting rules would be to go back and restate the prior period financial statement. Public companies don’t always do that, since under the rules they are sometimes permitted to do a cumulative adjustment in the current period’s statements.
That doesn’t mean, however, that booking the cumulative adjustment strictly follows accrual basis accounting rules. It does not. It is simply a convention that is allowed in certain situations.
Sometimes it’s hard to tell whether Overstock and Byrne are engaged solely in deliberate manipulation, or whether there’s a good bit of incompetence involved as well. Overstock is the only public company I’ve seen which has to restate restated financial statements. The list of accounting manipulations continues to grow.