Beazer homes was the sixth largest U.S. home builder
during the 1998-2006 housing boom. Like
other major home builders, Beazer’s market value grew by a factor of 8-10
during that period. However, the new
home market slowed in 2006 and then collapsed in 2007.
The SEC alleged that Michael T. Rand, Beazer’s chief
accounting officer, understated Beazer’s reported profits in every quarter but
one from 2000 through 2005 by understating Beazer’s “land inventory” account
and by overstating its “cost to complete” reserve. The SEC further alleged that during each of
the four quarters in 2006, and in the first quarter of 2007, Mr. Rand increased
Beazer’s reported profits by increasing the “land inventory” account,
decreasing the “cost to complete” reserve, and fraudulently recording
sale-and-leaseback transactions for model homes.
The case provides an excellent overview of the U.S.
housing boom and collapse. It can be
used prior to New Century Financial Corp
(Chapter 3), which covers the
collapse of a sub-prime and Alt A mortgage lender. The case is also excellent for covering the
practical issues of accrual accounting in uncertain environments.
The SEC charges imply that it is relatively simple to
estimate the value of the firm’s “land inventory” and “cost to complete”
accounts. When a home builder acquires
land for a new housing development, some land is set aside for streets and
sidewalks, some for parks or lakes, and some for open space near busy
roads. The builder then subdivides the
remaining land into lots it hopes to sell.
Lots near a park or lake are more desirable, while lots near the
entrance to a subdivision are typically less desirable. Someone assigned a cost of the land to
individual lots, and that assignment process is clearly arbitrary. In addition, as the property becomes more or
less desirable, the remaining land becomes more or less valuable than when the
firm first estimated the value of each lot.
The SEC’s complaint made the valuation process seem far more objective
than it is in practice.
The cost-to-complete reserve covers the cost to
complete sold homes. That includes, for
example, cracked driveways or basement floors, leaking faucets, roofs, or
windows, or faulty painting or landscaping.
The average cost per home might be $5,000 or $10,000, depending on the
home cost and the history of the development.
After 6-12 months, the allowance for a particular home might be reduced
to zero as the warranty expired or as the likelihood of claims declined. The SEC complaint made that valuation process
seem far more objective than it is in practice, particularly for a rapidly
growing firm that almost certainly was relying on less experienced managers and
workers, and less experienced accountants.
The case also covers a sale-and-leaseback
transaction. Those accounting rules are
complex, so again, it might not be clear that Mr. Rand engaged in fraud.
Finally, the cumulative alleged profit understatement
for 2000-2005 was about $72 million for a firm that had about $2 billion of
operating profits. In addition, during
nine quarters from 2007-2009, Beazer recorded about $1 billion of impairment
charges. Given the implicit subjectivity
in those nine impairment charges, it seems highly likely that the “land inventory”
and “cost to complete” accounts were also highly subjective numbers.
I use this case to consider the subjectivity of
various accrual accounts. I also use it
to consider who would make the accrual calculations. Beazer constructed housing developments
throughout the nation. Michael T. Rand
almost certainly was not personally responsible for preparing accrual estimates
at the operating level.
- Discuss the motives
of the executives to commit fraud. Discuss the culpability of the
accountants in preparing the questionable accounting estimates for the
cost to compete.
- In the Beazer Homes
USA case (i.e., Case 10), the chief accounting officer was accused of
duping the external auditors through the use of an earnings manipulation
scheme. Imagine that you were the auditor of the mortgage company. Design
an audit plan to address the important accounting issues highlighted in
the case. For each issue identified, recommend a risk mitigation strategy.
keep the bullet point and solution together and make the solution at least a