Monday, October 28, 2013

Is Overstock.com Trying to Cook The Books, Again?

I hoped that Overstock.com (NASDAQ: OSTK) had finally learned the error of its ways. Now it seems that the company has again resorted to accounting shenanigans to inflate its reported income.

Background

From Q2 2007 to Q2 2008, Overstock.com used an improper EBITDA calculation to materially overstate its pro-forma income in violation of Securities and Exchange Commission Regulation G. From Q4 2008 to Q3 2009, the company violated Generally Accepted Accounting Principles (GAAP) and materially overstated its reported earnings. I endured malicious personal attacks, cyber-stalking, pretexting, and threats to my personal safety from Overstock.com’s gun-toting CEO Patrick Byrne and his paid thugs in retaliation for exposing its illegal accounting practices. In each case, I complained to the Securities and Exchange Commission. Eventually Overstock.com was forced to stop using those illegal accounting practices. It seems that Overstock.com is up to its old tricks again.

Executive summary

In the three month period (third quarter) ended September 30, 2013, Overstock.com claimed that its pretax income was $3.624 million compared to $2.824 million in the same quarter of 2012, an $800,000 increase over the previous year. However, the validity of the increase in pretax income is questionable.

In 2013, Overstock.com quietly changed the useful life of certain fixed assets. The company did not inform investors in its 2013 financial reports that the useful life of its computer software and computer hardware costs was higher in 2013 than it was in 2012, leaving the impression that their useful lives were the same in both years. It simply changed the useful life numbers without providing an explanation. Since it was able to spread depreciation and amortization expenses over a longer period of time, it was able to report a lower depreciation and amortization expense in each quarter and inflate its reported profits.

Furthermore, there is a $700,000 numerical discrepancy in the amount reported for capitalized internal use-software and website development costs in the third quarter. There is another $400,000 numerical discrepancy in the amount reported for amortization expense associated with internal use-software and website development in the third quarter.

Moreover, in the third quarter of 2013, Overstock.com reduced its accrual for loss contingencies by $300,000 from the previous quarter despite a growing number of serious lawsuits against the company. If the company reversed its previous estimate of loss contingencies, it added $300,000 to its third quarter pretax income.

At the very least it appears that a substantial part of the $800,000 increase in pretax income would have disappeared if Overstock.com had not changed the useful life of certain fixed assets. It's possible that Overstock.com could have reported a decline in pretax income. The third quarter numbers don't add up. The numbers cannot be trusted. These accounting irregularities could be a red flag for a material weakness in internal controls over financial reporting.

Depreciation and amortization accounting

Fixed assets are required to be depreciated or amortized over their “estimated” useful lives. For example, a company purchases computer software for $10,000. It amortizes computer software over its 2 year useful life. Initially, the computer software is reported on the balance sheet as fixed asset. No expense is initially recognized on the income statement. Over the next two years, the company recognizes $5,000 per year of amortization expense in its income statement ($10,000 cost divided by 2 year useful life).

If a company lengthens the useful life of a fixed asset, it spreads out depreciation and amortization expense over a longer period of time. Therefore, it can report higher profits by recognizing a lower depreciation and amortization expense in each period. For example, if a company changes its policy to amortize computer software over 4 years instead of 2 years, it can reduce its amortization expense from $5,000 per year to $2,500 per year ($10,000 cost divided by 4 year useful life). Therefore, the company can increase its profits by $2,500 per year in the first 2 years it owns the software by extending the useful life from 2 years to 4 years.

As the amount of fixed assets increase on the balance sheet, the amount reported for depreciation and amortization expense should grow too. However, after analyzing Overstock.com's numbers, I discovered that its fixed assets increased year-over-year, while its depreciation and amortization expense decreased year-over-year. The numbers grew in opposite directions. That occurs when a company is either reporting an erroneous amount of depreciation and amortization expense or when it lengthens the useful life of its fixed assets.

Overstock.com buries changes in the useful life of fixed assets

To find out how Overstock.com changed the useful life of its fixed assets, you have to compare different S.E.C. flings over two years because the company did not fess up and tell investors about the change. Buried under 72 pages of disclosures and another 9 page of footnotes in Overstock.com's 2012 10-K report, we finally learn that the useful life of computer software was 2 to 3 years and the useful life of computer hardware was 3 years in 2012. See below (highlights added):

Overstock.com 2012 10-K report

However, Overstock.com's 10-Q reports issued for each quarter of 2013 show a different useful life for computer software and computer hardware than was reported in 2012. Buried on page 9 of the first two quarter 10-Q reports and page 10 of the third quarter 10-Q report, Overstock.com revealed that the useful life of computer software was 2 to 4 years. However, the useful life of computer software was 2 to 3 years in 2012. In those same 2013 10-Q reports, the useful life of computer hardware was 3 to 4 years. However, the useful life of computer equipment was only 3 years in 2012. (Source: Q1 10-Q, Q2 10-Q, and Q3 10-Q reports)

In each of those 2013 10-Q reports, Overstock.com disclosed:

Fixed assets

Fixed assets, which include assets such as technology infrastructure, internal-use software, website development, furniture and fixtures and leasehold improvements, are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related assets or the term of the related capital lease, whichever is shorter, as follows:


Note: Yellow highlights were added for emphasis

Overstock.com's fixed asset disclosure leaves the impression that the useful life of its computer software and computer hardware was the same in both 2013 and 2012. The company did not inform investors that the useful life of computer software and computer hardware was higher in 2013 than it was in 2012. It simply changed the numbers without explanation. It did not provide a year-to-year comparison of the useful life of its fixed assets in its 2013 financial reports.

Third quarter 2013: Higher level of fixed assets but lower depreciation and amortization expense

In the three month period (third quarter) ended September 30, 2013, Overstock.com claimed that its pretax income was $3.624 million compared to $2.824 million in the same quarter of 2012. Pretax income increased by $800,000 over the previous year. However, the validity of the increase in pretax income is questionable.

In the three month period ended September 30, 2013 (third quarter) depreciation and amortization expense was $3.307 million compared to $3.839 million in the same three month period of the previous year. Depreciation and amortization expense decreased by $532,000 year-over-year.

At the end of the third quarter of 2013, Overstock.com reported fixed assets of $26.892 million on its balance sheet compared to $23.034 million at the end of the same quarter of the previous year. The amount of fixed assets on its balance sheet was $3.858 million higher in 2013 than it was in 2012. Depreciation and amortization expense was $532,000 lower despite a $3.858 million higher amount of fixed assets.

Third quarter 2013: Numbers don't add up

The amount of internal-use software and website development costs that the company claimed it capitalized for the entire nine month period (first three quarters) ended September 30, 2013 is $700,000 lower than the totals it claimed that it capitalized in each of the three quarters of the year. In the previous quarter ended June 30, 2013, the six month total equaled the total reported for the first and second quarters. Therefore, the $700,000 discrepancy appears to impact its third quarter 2013 numbers.

Moreover, amortization expense for internal-use software and website development costs that the company claimed it reported for the entire nine month period (first three quarters) ended September 30, 2013 is $400,000 higher than the totals it claimed it amortized in each of the three quarters of the year. In the previous quarter ended June 30, 2013, the six month total equaled the total reported for the first and second quarters. Therefore, the $400,000 discrepancy appears to impact its third quarter 2013 numbers.

According to the third quarter ended September 30, 2013 10-Q report:

During the three months ended September 30, 2013 and 2012, we capitalized $3.3 million and $3.0 million, respectively, of costs associated with internal-use software and website development, both developed internally and acquired externally. Amortization of costs associated with internal-use software and website development was $1.8 million and $2.0 million for those respective periods. During the nine months ended September 30, 2013 and 2012, we capitalized $8.1 million and $6.8 million, respectively, of such costs and had amortization of $5.9 million and $6.3 million for those respective periods. [Emphasis added.]

In three month period ended September 30, 2013, Overstock.com claimed that it capitalized $3.3 million of costs associated with internal-use software and website development. In the nine month period ended September 30, 2013, the company claimed that it capitalized $8.1 million of such costs.

In the three month period ended September 30, 2013, Overstock.com claimed that its amortized $1.8 million of internal-use software and website development costs. In the nine month period ended September 30, 2013, the company claimed that it amortized $5.9 million of such costs.

In the second quarter ended June 30, 2013 10-Q report, Overstock.com claimed that:

During the six months ended June 30, 2013 and 2012, we capitalized $5.5 million and $3.9 million, respectively, of such costs and had amortization of $3.7 million and $4.3 million for those respective periods. [Emphasis added.]

Let's do some basic math.

During the six month period ended June 30, 2013, Overstock.com capitalized $5.5 million of costs associated with internal-use software and website development. In the three month period ended September 30, 2013 it claimed that it capitalized an additional $3.3 million of such software costs. Therefore, Overstock.com should have reported a nine month total of $8.8 million. However, it reported a nine month total of $8.1 million, leaving a $700,000 discrepancy in its third quarter numbers.

During the six month period ended June 30, 2013, Overstock.com amortized $3.7 million of costs associated with internal-use software and website development. In the three month period ended September 30, 2013 it claimed that it amortized an additional $1.8 million of such software costs. Therefore, Overstock.com should have reported a nine month total of $5.5 million. However, it reported a nine month total of $5.9 million, leaving a $400,000 discrepancy in its third quarter numbers.

Third quarter 2013: Reduction in amounts accrued for loss contingencies

In the three month period (third quarter) ended September 30, 2013, Overstock.com reduced its accrual for loss contingencies by $300,000 from the previous quarter despite a growing number of serious lawsuits against the company. If the company reversed its previous estimate of loss contingencies, it added $300,000 to its third quarter pretax income.

In the third quarter ended September 30, 2013 10-Q report, Overstock.com disclosed:

We establish liabilities when a particular contingency is probable and estimable. At September 30, 2013, we have accrued $2.6 million in light of these probable and estimable liabilities. It is reasonably possible that the actual losses may exceed our accrued liabilities. We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated. [Emphasis added.]

In the second quarter ended June 30, 2013 10-Q report, Overtock.com reported:

We establish liabilities when a particular contingency is probable and estimable. As of June 30, 2013, we have accrued $2.9 million in light of these probable and estimable liabilities. It is reasonably possible that the actual losses may exceed our accrued liabilities. We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated. [Emphasis added.]

A loss contingency reserve can be reduced two ways. Either the company paid out money it previously accrued (no effect on income) or it changed its estimate of contingent liabilities (reversed prior accruals of loss contingency expense). Such a change in estimate would increase its pretax income. Was Overstock.com trying to further tweak its third quarter numbers?

Conclusion

Given Overstock.com's prior history of accounting violations and its past malicious retaliatory actions against journalists, independent whistleblowers like me, and other critics, investors should be skeptical of its accounting and financial disclosures.

Written by,

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could. If it weren't for the heroic 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 want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

There is a saying, "It takes one to know one." I've provided professional work for the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify fraud and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. In addition, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. Recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud.

I do not own any Overstock.com securities long or short.

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