Take-Two Interactive Software, Inc.
Grand Theft Auto ranks among the best-selling video games of all time as well as one of the
most controversial. By the time Grand Theft Auto V was released in 2013, over 125
million copies of the video game had been sold worldwide since the original version of the
game was introduced in 1997. Wikipedia provides the following general description of the
game.
Game play focuses on an open world where the player can choose missions to
progress an overall story, as well as engaging in side activities, all consisting of
actionadventure, driving, occasional role-playing, stealth, and racing elements. The
subject of the game is usually a comedic satire of American culture, but the series
has gained controversy for its adult nature and violent themes.
Prominent public officials, major media outlets, and public service organizations have
condemned Grand Theft Auto. Senator Hillary Clinton urged the Federal Trade Commission
(FTC) to assign a rating of “Adults Only” to the game because of its “pornographic and
violent content,” which includes one setting that “encourages them [game players] to have
sex with prostitutes and then murder them.” Senator Joseph Lieberman denounced the
game as “gruesome, and grotesque.” The mayor of New York City, Michael Bloomberg,
bluntly noted that the game “Teaches children to kill.”
In fact, law enforcement authorities have linked the commission of serious crimes to Grand
Theft Auto. A teenager killed three police officers in Alabama in June 2003 in a set of
circumstances similar to a scene in the game. The teenager, who played the game “day and
night” and had no previous criminal record, calmly told his captors that, “Life is like a video
game. Everybody’s got to die sometime.” In referring to that case, a CNN commentator
branded Grand Theft Auto a “cop killing simulator.”
Mothers Against Drunk Driving (MADD) have criticized the game for encouraging drunk
driving. “Drunk driving is not a game, and it is not a joke.” A spokesperson for Take-Two
Interactive Software, Inc., the producer of the game, responded by maintaining that MADD’s
criticism was unfair since the given version of Grand Theft Auto involved only one drunk
driving scene. “For the same reason that you can’t judge an entire film or television program
by a single scene, you can’t judge Grand Theft Auto IV by a small aspect of the game.”
Take-Two’s executives have been the target of most of the emotionally charged criticism of
Grand Theft Auto. A Wall Street analyst who tracked Take-Two’s stock for years suggested
that, “You’d be hard-pressed to find a worse set of guys.” Despite repeated challenges to the
suitability of Grand Theft Auto filed with the FTC by various parties, the federal
agency that eventually posed the most significant challenge for the company’s management
team was the Securities and Exchange Commission (SEC). The SEC sanctioned several of
Take-Two’s top executives for issuing a series of financial statements that contained
fraudulent misrepresentations. Those sanctions resulted in Take-Two restating its financial
statements three separate times between 2001 and 2004.
Striking Out on His Own
In 1992, Ryan Brant graduated from the University of Pennsylvania’s Wharton School of
Business with a degree in economics. The 20-year-old Brant began his business career by
working for a company owned by his father, Peter Brant, a billionaire businessman.
Eighteen months later, Brant decided to leave that company and establish his own
business. After raising $1.5 million from family members and “angel” investors, Brant
organized Take-Two Interactive Software, Inc., in late 1993.
Robert Fish, a partner with Price Waterhouse, Take-Two’s audit firm, served as one of
Brant’s principal business advisors from the inception of his company. Following the merger
of Price Waterhouse with Coopers & Lybrand in 1998 to form PricewaterhouseCoopers
(PwC), Fish became the Senior Managing Partner of the Venture Capital Practice of PwC’s
New York City office. That unit provided a wide range of professional services to
developmental stage companies.
In addition to serving as a general business advisor to the much younger Brant, Fish
supervised the annual audits of Take-Two’s financial statements from 1994 through 2001. In
a 1998 interview with Crain’s New York Business, Fish suggested that he and Brant had a
father–son type relationship. In discussing PwC’s relationship with Take-Two, Fish noted
that, “We [PwC] make an investment of our time in growth-oriented companies.” He
went on to observe that, “Most start-ups coming to larger accounting firms know they don’t
just want the accountants to handle debits and credits, but to focus on the structure of the
enterprise.”
PwC’s “investment” in Take-Two included initially discounting the fees that it charged the
company for its professional services. According to Brant, PwC billed Take-Two “a mere
$20,000” for the services provided annually to the newly formed company, a figure that was
“roughly one-third what the firm would have charged had it applied its standard hourly rate.”
For the first few years of Take-Two’s existence, the company realized modest success with
several video games including Ripper and Hell: A Cyberpunk Thriller. To survive in the
ultracompetitive
video gaming industry, Brant realized that his company had to grow, and quickly.
Brant decided that the best strategy for achieving that goal was to acquire other video game
companies, which would require a considerable amount of external financing. To raise those
funds, Brant took his company public in 1997 with an initial public offering (IPO). Brant relied
heavily on Fish for professional advice regarding accounting and financial reporting issues
related to the IPO and the subsequent series of acquisitions made by the company.
Among the nearly 20 acquisitions that Take-Two made in the late 1990s was a small
operating unit of Bertelsmann, a large German mass media company. The video games
owned by that entity included the game that would become Grand Theft Auto, which would
prove to be Take-Two’s first major gaming “franchise.” Every few years, Take-Two releases
a new version of the game. On April 29, 2008, the date that Grand Theft Auto IV was
released, the game established the single-day sales record for the video gaming industry,
selling 3.6 million units with a total revenue of $180 million.
Grand Theft Auto resulted in Take-Two becoming one of the leading worldwide developers
and distributors of video games. The successful game also allowed Take-Two to survive the
“tech crash” that began in early 2000 with the bursting of the “dot-com bubble” in the stock
market. That financial crisis proved to be the death knell for many of Take-Two’s
competitors. Despite the challenging circumstances faced by Take-Two during that time
frame, the company continued to post surprisingly strong operating results.
Exhibit 1 presents key financial data for Take-Two that document the company’s rapid
growth from 1998 through 2000, the first three full fiscal years that it was a public company.
A footnote to that exhibit includes selected amounts included in Take-Two’s 1997 financial
statements.
Exhibit 1
Take-Two Interactive Software, Inc. Financial Highlights 1998–2000 (000s
Omitted)
“Parking” Violations
In 2000 and 2001, a stock analyst who tracked Take-Two’s financial statements and public
earnings releases noted apparent discrepancies between the company’s reported sales and
data reported by the NDP Group, a market research company that monitors video game
sales. That analyst’s concerns prompted an SEC investigation of Take-Two’s 2000 and 2001
financial statements. The federal agency’s investigation revealed that Take-Two executives
had recorded millions of dollars of sham sales transactions to inflate their company’s
reported operating results, transactions that involved Take-Two temporarily “parking” large
amounts of inventory with its customers.
On October 31, 2000, the final day of Take-Two’s fiscal year 2000, the company’s chief
operating officer (COO) and chief financial officer (CFO) arranged a bogus sale of $5.4
million of video games to Capitol Distributing, a video game distributor based in Virginia.
The transaction was the largest individual sale ever recorded by Take-Two. To make the
sale appear legitimate to the company’s PwC auditors, Take-Two shipped 230,000 video
games to Capitol. Both parties agreed prior to the shipment that the games would be returned by
Capitol to Take-Two over the following few months. When the video games were
returned to Take-Two in fiscal 2001, the two parties forged various documents to make the
returns appear as if they were purchases of new product inventory by Take-Two from
another company—this latter company was an affiliate of Capitol.
In 2001, Take-Two recorded three additional fictitious sales of video games to Capitol that
totaled more than $9 million. Similar to the $5.4 million transaction, the merchandise
shipped to Capitol as a result of these “sales” was returned to Take-Two under the guise of
inventory purchases.
During fiscal 2000 and 2001, Take-Two recorded dozens of smaller bogus sale transactions
to four other video game distributors. Nearly all of this merchandise was subsequently
reacquired by Take-Two—some of these transactions were camouflaged as purchases of
new inventory, while others were processed and recorded as normal sales returns. TakeTwo also recorded sales during 2000 and 2001 for video games that were still in production
and that would not be delivered to the given customers until a subsequent quarterly
reporting period.
Take-Two’s fraudulent accounting during 2000 allowed the company to meet or surpass its
consensus quarterly earnings forecasts for that year. For the fourth quarter of 2000, for
example, Take-Two reported earnings of $.42 per share, slightly higher than the company’s
consensus earnings forecast of $.41 per share and considerably higher than the company’s
actual earnings per share of $.27. The accounting fraud also allowed Take-Two to report a
net income for that quarter that was higher than the figure reported for the prior quarter. This
fact was significant to Take-Two’s CFO since his bonus each quarterly reporting period was
contingent on the company increasing its net income over the previous quarter.
In February 2002, Take-Two issued restated financial statements for fiscal 2000 and for the
first three quarters of fiscal 2001 to eliminate the fraudulent sales transactions recorded
during those periods and to correct other instances of improper accounting treatments. Two
years later, in February 2004, Take-Two issued restated financial statements for fiscal years
1999 through 2003 after additional improper accounting decisions were discovered for those
years. The two restatements materially reduced Take-Two’s revenues and earnings from
1999 through 2003, but the company’s reported operating results for 2000 bore the brunt of
those restatements. Take-Two’s 2000 sales were reduced from $387 million to $358 million,
while its net income for that year was lowered from $25 million to $4.6 million.
PwC’s 2000 Audit of Take-Two
Despite the fact that Take-Two actively concealed its fraudulent schemes from PwC, the
SEC alleged that PwC failed to comply with generally accepted auditing standards (GAAS)
while auditing the company’s financial statements. The SEC’s allegations centered on the
role that Robert Fish had played in supervising PwC’s 2000 audit of Take-Two.
In preparing for the 2000 engagement, Fish identified “revenue recognition” and “accounts
receivable reserves” as “areas of higher risk” that would be given “special attention” during that
audit. Following its investigation of the 2000 audit, the SEC concluded that, “Fish
did not properly respond to those risks as he failed to exercise due professional care and
professional skepticism, and failed to obtain sufficient competent evidential matter.” The
SEC ruled that as a result of Fish’s poor decisions, PwC improperly issued an unqualified
opinion on Take-Two’s 2000 financial statements.
A major focus of the 2000 audit was the $104 million of “domestic” accounts receivable that
represented the majority of Take-Two’s total receivables at the end of fiscal 2000. The
principal audit test applied to the domestic receivables was the mailing of positive
confirmation requests to 15 of Take-Two’s customers that accounted for approximately 70
percent of those receivables. The PwC auditors received only one confirmation from that
sample of customers, a confirmation that represented less than 2 percent of the company’s
domestic receivables. Capitol Distributing was among the 14 customers that failed to
respond to PwC’s confirmation requests.
Because of the poor response rate to the confirmation requests, Fish decided that PwC
would apply alternative audit procedures to Take-Two’s domestic receivables. The principal
alternative audit procedure employed by Fish and his subordinates was reviewing payments
that Take-Two received in the new fiscal year from the 14 customers who had failed to
return a confirmation.
The PwC auditors identified $18 million of cash payments received by Take-Two from those
14 customers over the first 6 weeks of the new fiscal year. During its investigation, the SEC
determined that the auditors had failed to track many of those payments to specific invoiced
sales transactions because Take-Two’s accounting records often reflected only “aggregate”
cash collections for individual customers.
As a result, Fish knew, or should have known, that he could not be certain whether
the cash he examined from November 1 through December 8, 2000, related to the
accounts receivable balances that existed as of October 31, 2000, or to sales
recorded after that date…. The fact that Take-Two’s records often showed only
aggregate cash collected was a red flag to Fish that any subsequent cash receipts
testing relying on this data would prove ineffective.
The SEC also harshly criticized the audit procedures PwC used to test the sufficiency of the
client’s reserve for sales returns. One of these tests involved examining five sales returns
received by Take-Two during the first few days of fiscal 2001. Because Fish and his
subordinates did not track these returns to the original sales invoices, they failed to discover
evidence suggesting that Take-Two was grossly underestimating its year-end reserve for
sales returns.
Of the five specific returns tested, Fish did not compare the returns with the original
sales invoices. Had he done so, he would have discovered that in four of the five instances, much
more than 75% of the games purportedly purchased had been
returned … when Take-Two only reserved for returns at the rate of 5%. Fish
determined, nonetheless, that Take-Two’s reserves were adequate without, for
instance, examining other returns from fiscal year 2000, or inquiring of the
customers regarding these particular sales.
The SEC went on to point out that the four sales returns in question involved “parking
transactions” that Take-Two had used to inflate its 2000 sales and earnings.
Epilogue
In June 2005, the SEC sanctioned Take-Two’s vice president of sales and three of
its former executives for their role in the company’s accounting fraud. These latter
individuals included Ryan Brant, Take-Two’s former chief executive officer, as well
as the company’s former COO, and former CFO. Take-Two was fined $7.5 million,
while the four executives paid fines ranging from $50,000 for the vice president of
sales to $500,000 for Brant. Brant was also ordered to forfeit $3.1 million of stock
market gains he had earned on Take-Two’s common stock. The company’s former
CFO, who was a CPA, was also suspended from practicing before the SEC for 10
years.
In Februar y 2008, the SEC issued an Accounting and Auditing Enforcement
Release focusing on Robert Fish’s role as Take-Two’s audit engagement partner.
The federal agency imposed a one-year suspension on Fish, who had previously
resigned from PwC.
In 2007, the SEC filed dozens of civil cases against companies and individual
executives involved in the “backdating” of stock option grants. Over the previous two
decades, these defendants had identified specific dates on which a given
company’s stock price was at a relatively low level and then retrospectively issued
stock option grants on those dates. This ex post dating of stock option grants
allowed the grantees to receive “in the money” stock options that they subsequently
exercised, resulting in large stock market gains. Take-Two and Ryan Brant were
among the parties that the SEC filed charges against in the huge options backdating
scandal.
The SEC alleged that Brant was the master-mind of Take-Two’s options backdating
scheme. “From 1997 to September 2003, Brant awarded himself 10 backdated
option grants, representing a total of approximately 2.1 million shares of Take-Two
common stock.” Brant exercised all of those options before he left the company
during the midst of the SEC’s investigation of Take-Two’s stock option grants. The
SEC fined Brant $1 million for his role in the scheme and required him to forfeit
more than $5 million in stock market gains that he realized as a result of it. In a
related criminal case, Brant pleaded guilty to a felony charge filed by a New York state prosecutor.
Brant’s plea bargain agreement required him to pay a $1 million
fine and serve five years of probation.
In April 2009, Take-Two reached an agreement with the SEC to settle the charges
filed against it for the backdating of options by paying a $3 million fine. Prior to
reaching that settlement, the company had restated its financial statements for the
third time in five years to correct the misrepresentations linked to the improper stock
option grants.
Take-Two weathered the fraudulent financial reporting and options backdating
scandals and retained its prominent position in the video gaming industry. In 2008,
Electronic Arts, the largest video gaming company in the U.S., launched a $2 billion
hostile takeover bid for Take-Two. Electronic Arts dropped that take-over bid in late
2008 after it met with fierce resistance from the management team that had
replaced Ryan Brant and his former colleagues. Analysts’ expectations of continued
strong revenue growth for the video gaming industry pushed Take-Two’s stock price
to an all-time high by early 2016 despite sharp declines in most market indices
during that time.
Questions
1. Analyze Take-Two’s 1998-2000 financial data included in Exhibit 1. Compute
the following financial ratios for each of those years: age of accounts
receivable, age of inventory, gross profit percentage, profit margin percentage,
return on assets, return on equity, current ratio, debt-to-equity ratio, and the
quality-of-earnings ratio. What major “red flags,” if any, were present in Take-
Two’s financial statements given these ratios? Explain.
2. Identify the primary audit objectives that auditors hope to accomplish by
confirming a client’s year-end accounts receivable. Explain the difference
between “positive” and “negative” confirmation requests and discuss the
quality of audit evidence yielded by each.
3. Identify audit tests that may be used as alternative audit procedures when a
response is not received for a positive confirmation request. Compare and
contrast the quality of audit evidence yielded by these procedures with that
produced by audit confirmation procedures.
4. In your opinion, did the apparent mistakes made by the PwC auditors in
auditing Take-Two’s receivables and reserve for sales returns involve “negligence” on their part?
Would you characterize the mistakes or errors as
“reckless” or “fraudulent”? Justify your answers.
5. Is it appropriate for audit firms to sharply discount their professional fees for
developmental stage companies? Why or why not? What problems, if any,
may this practice pose for audit firms?
6. Do you believe that the relationship between Robert Fish and Ryan Brant was
inappropriate? Explain.
7. Should audit firms accept “ethically challenged” companies and organizations
as audit clients? Defend your answer.
Overstock.com, Inc.
In March 2000, the Securities and Exchange Commission (SEC) began requiring public
companies to have their quarterly financial statements “reviewed” by their independent
auditors. The broad purpose of this new requirement was to improve the quality and
credibility of quarterly financial reporting. A more specific goal was to reduce the frequency
of accounting restatements by SEC registrants. In addition, the SEC hoped the new rule
would serve to counteract the “increasing pressure” being imposed on public companies to
“manage” their interim financial results.
On November 16, 2009, Overstock.com shocked its stockholders, regulatory authorities,
and Wall Street by filing an “unreviewed” Form 10-Q with the SEC. In a press release issued
that same day, Patrick Byrne, Overstock’s mercurial chief executive officer (CEO), reported
that the decision to file the unreviewed 10-Q had been necessary because of an unresolved
dispute with Grant Thornton LLP, the company’s audit firm. That dispute centered on the
proper accounting treatment to apply to an unusual transaction involving one of Overstock’s
business partners. Byrne also revealed that the company had dismissed Grant Thornton as
a result of that dispute–later that day, Overstock filed a Form 8-K with the SEC reporting the
audit firm’s dismissal.
Overstock’s surprising decision to file an unreviewed 10-Q with the SEC caused the
investment community to wonder what would happen next. How would the SEC react to
Overstock’s decision to seemingly thumb its nose at the federal securities laws? Would the
NASDAQ stock exchange suspend the trading of Overstock’s common stock? When or
would Overstock be successful in retaining another accounting firm to serve as its
independent auditor?
Buffett, Byrne & The Bubble
Before entering the business world, Patrick Byrne, the son of a wealthy associate of Warren
Buffett, lived the life of a bon vivant and Renaissance man. After spending time as a student
in China, Byrne earned an undergraduate degree from Dartmouth, a Master’s degree from
Cambridge, and a doctorate in philosophy from Stanford. In addition to accumulating an
impressive educational portfolio, Bryne traveled the world, earned a black belt in martial
arts, made a brief foray into professional boxing, and served as a university instructor.
Warren Buffet launched Patrick Byrne’s career in the field of corporate management in 1998
when he asked him to serve as the interim CEO of a financially troubled subsidiary of
Berkshire Hathaway, Buffett’s flagship company. Eighteen months later, Byrne struck out on
his own when he acquired a controlling interest in a small online company based in Salt
Lake City that marketed “excess” and “closeout” merchandise over the Internet. Byrne was
convinced that with the proper business plan, capitalization, and management team in
place, the company’s core concept could be wildly profitable. Over the following few months,
Byrne appointed himself CEO, invested several million dollars to expand the company’s
operations, and renamed it Overstock.com.
In 2000 and 2001, the spectacular bursting of the “dot.com bubble” decimated hundreds of
New Age Internet-based companies that had sprung up like wild mush-rooms over the prior
decade. The resulting carnage caused the NASDAQ Composite Index that is laced with ecommerce
companies to decline by approximately 80 percent in less than three years.
While most online companies were either being forced to shut down or significantly curtail
their operations, Patrick Byrne recognized that the dot.com debacle created an opportunity
for his company. Overstock began liquidating the unsold merchandise of failing online
businesses at fire sale prices. In 2002, the company’s growing revenues and apparently
strong business model caused Business Week to name Byrne one of the 25 most influential
corporate executives in the rapidly evolving e-commerce sector of the national economy.
That same year, Patrick Byrne took Overstock public, the first online retailer to do so in
almost two years. The company raised $40 million with its initial public offering (IPO) and
listed its common stock on the NASDAQ stock exchange.
Gradually, two distinct lines of business emerged within Overstock’s exclusively online
operations. Overstock’s “Direct” line of business sold merchandise that it had acquired from
other sources to individuals and companies. In Overstock’s much larger “Partner” line of
business, the company served as an intermediary or sales agent for more than 3,000
“business partners.” Overstock earned a commission on the merchandise sales that it
arranged or facilitated for those partners. For accounting and financial reporting purposes,
Overstock recorded most sales of partners’ merchandise as gross revenue and then
subtracted the cash remittances made to those partners as cost of goods sold; the
differences between those amounts represented the commissions earned by Overstock on
the sales transactions.
Overstocked on Problems
By 2009, Overstock’s annual revenues were approaching $1 billion; one decade earlier
when Patrick Byrne acquired the company, it had annual revenues of a few hundred
thousand dollars. Despite the company’s impressive revenue growth, the company
struggled to become profitable. When the controversy arose regarding Overstock’s
unreviewed 10-Q in November 2009, the company had yet to report a profit for a full fiscal
year. Making matters worse, the company’s stock had been pummeled in the market over
the previous several years, falling from a high of $76 per share in December 2004 to less
than $15 per share by November 2009.
Several factors in addition to Overstock’s recurring operating losses caused investors to shy
away from the company’s common stock. Patrick Byrne, himself, attracted a storm of
negative attention to the company by the relentless attacks that he unleashed on major Wall
Street firms and regulatory authorities. Byrne claimed that several hedge funds and other large
institutional investors were driving down the price of Overstock’s common stock and
attempting to destroy the company. Those parties’ efforts allegedly involved “naked short
selling” of Overstock’s common stock, a tactic that in most circumstances is illegal.
Byrne insisted that regulatory authorities responsible for policing the nation’s stock markets,
including the SEC, were involved in the conspiracy to destroy Overstock and other
companies targeted by the alleged cartel of naked short sellers. According to Byrne, those
regulatory authorities refused to prosecute or otherwise rein in the naked short sellers.
Byrne’s fierce and highly public crusade caused Overstock to take the unprecedented step
of listing its CEO as a “risk factor” faced by the company; public companies are required to
identify in their periodic SEC filings the major risk factors that could undermine them.
Overstock reported in multiple SEC registration statements that controversial public
statements made by Byrne, particularly those directed at the SEC, might focus unwarranted
regulatory attention on the company.
Even more disconcerting to potential investors than Byrne’s bombastic persona were the
company’s recurring accounting problems. During its first several years as a public
company, Overstock restated prior financial statements multiple times. Audit Integrity, a
forensic consulting firm, reports “accounting and governance risk” (AGR) measures for
public companies that are intended to be predictive of financial statement fraud. Overstock’s
repeated restatements caused Audit Integrity to assign Overstock an “aggressive” AGR
rating. The November 2009 disclosure of Overstock’s dispute with Grant Thornton
raised the possibility that the company might be forced to restate its prior financial
statements once more.
Overstock was also criticized for using pro forma accounting measures—earnings before
interest, taxes, depreciation, and amortization (EBITDA) in particular—to draw investors’
attention away from, and downplay the significance of, its recurring operating losses. Sam
E. Antar, a self-appointed crusader against financial reporting fraud and the author of a blog
entitled “White Collar Fraud,” charged that Overstock improperly and opportunistically
computed the EBITDA amounts that it reported to investors.
“Cookie Jar” Accounting
The dispute that culminated in Overstock’s audit committee firing Grant Thornton was
triggered by an error made by the company’s accounting staff in 2008—company officials
readily admitted that the error resulted from a deficiency in Overstock’s internal controls.
The accounting error caused Overstock to remit a $785,000 overpayment to one of its
business partners which overstated Overstock’s cost of goods sold for 2008 by the same
amount. Because of uncertainty regarding whether the $785,000 would be recovered,
Overstock’s accounting staff characterized the overpayment as a “gain contingency” and
chose not to record a correcting entry for it.
Overstock recovered the overpayment from its business partner during the first quarter of
2009. The company’s accountants recorded the offsetting credit for the $785,000 cash
receipt as a reduction in costs of goods sold for that period. To assess the impact of the $785,000
amount on Overstock’s 2008 and first-quarter 2009 financial statements, refer to
Exhibit 1 which presents selected financial data initially reported by Overstock in its 2008
Form 10-K and its 10-Q for the first quarter of 2009.
Exhibit 1
Overstock.com, Inc. Selected Financial Data
Overstock’s frequent and harsh critic, Sam E. Antar, suggested that the $785,000
accounting error was actually an intentional ploy to create a “cookie jar” reserve to overstate
Overstock’s 2009 operating results. Floyd Norris, a prominent business journalist for the
New York Times, offered a similar explanation for the accounting treatment that Overstock
applied to the $785,000 overpayment. Again, at this point in time, Overstock had yet to
report a profit for a full fiscal year, but company officials were hoping 2009 would prove to be
the company’s breakthrough year.
PricewaterhouseCoopers (PwC), which had served as Overstock’s audit firm since prior to
the company’s IPO in 2002, agreed with the accounting treatment applied by the company
to the $785,000 overpayment and issued an unqualified opinion on Overstock’s 2008
financial statements. Following the completion of the 2008 audit, Byrne reported that
Overstock had decided to retain a new audit firm because of concern that company
management and the PwC audit staff were becoming too “cozy” after having worked
together for the previous several years. In March 2009, Overstock’s audit committee
selected Grant Thornton as the company’s new audit firm.
He Said, They Said
On October 1, 2009, Overstock received a letter of inquiry from the SEC regarding several
accounting decisions that the company had made, including the accounting treatment
applied to the $785,000 overpayment. Overstock’s accounting staff consulted with both the
Grant Thornton auditors assigned to the 2009 Overstock engagement team and with the
company’s former PwC auditors before responding to the SEC inquiry. According to a
subsequent Form 8-K filed by Overstock with the SEC, Grant Thornton and PwC reportedly
agreed the accounting treatment that had been applied to the overpayment was reasonable.
On November 3, 2009, Overstock received a second letter of inquiry from the SEC. This
inquiry asked for additional information regarding the accounting treatment for the $785,000
overpayment. Again, Overstock’s accounting staff consulted with both Grant Thornton and
PwC in preparing the company’s response to the SEC inquiry. At this point, a Grant
Thornton representative reportedly informed Overstock that the accounting firm had “revised
its earlier position of agreement with the Company’s accounting treatment” for the
overpayment. Grant Thornton then recommended that the company restate its 2008
financial statements and record the $785,000 amount as both a receivable and a reduction
in the company’s cost of goods sold in those financial statements. The firm also
recommended that the company restate its 10-Q for the first quarter of 2009 to eliminate the
$785,000 reduction in cost of goods sold that was recorded when the 2008 overpayment
was recovered.
Overstock and PwC disagreed with Grant Thornton’s recommendation to restate the
company’s prior financial statements for the overpayment error as Patrick Byrne explained
in a press release included as an exhibit to an 8-K filed with the SEC on November 17,
2009. “We, along with PwC, continue to believe that we accounted for the $785,000
correctly…. Both we and PwC believe that it is not proper to reopen our 2008 Form 10-K.”
Byrne went on to explain the “quandary” that the dispute with Grant Thornton posed for
his company. “Thus, we are in a quandary: one auditing firm won’t sign off on our Q3 Form
10-Q unless we restate our 2008 Form 10-K, while our previous auditing firm believes that it
is not proper to restate our 2008 Form 10-K.”
Byrne reported that the dispute with Grant Thornton had resulted in Overstock deciding to
“engage another independent audit firm.” In the meantime, the company had decided to
file an unreviewed 10-Q for the third quarter of 2009 with the SEC. Exhibit 2 presents an
“Explanatory Note” that Overstock included as a prologue to that 10-Q. The note identified
the potential “consequences” that Overstock might face as a result of filing a “deficient” 10-Q
with the SEC. Those potential consequences included the inability to sell registered
securities because of a failure to comply with federal securities laws and the delisting of the
company’s common stock by the NASDAQ stock exchange.
Exhibit 2
“Explanatory Note” Included with Overstock’s Initial Form 10-Q for the Third
Quarter of 2009
On November 13, 2009, Overstock.com, Inc. (“The Company”), dismissed Grant
Thornton LLP (“Grant Thornton”) as the Company’s independent registered public
accounting firm. At the time of the dismissal, the Company and Grant Thornton had
a disagreement on a matter of an accounting principle or practice. See Note 15 –
“Subsequent Events.” The Company has not yet engaged a successor accounting
firm.
As a result of Grant Thornton LLP’s dismissal, the accompanying 2009 unaudited
interim financial statements and notes thereto for the quarterly period ended
September 30, 2009, have not been reviewed in accordance with Statement of
Auditing Standards No. 100 (“SAS 100”), as required by Rule 10-01(d) of Regulation
S-X promulgated under the Securities Exchange Act of 1934. The Company intends
to file an amendment to this Form 10-Q to file unaudited interim financial statements
for the quarterly period ended September 30, 2009, reviewed in accordance with
SAS 100 as required by Rule 10-01(d) as promptly as practicable after it has
resolved outstanding matters addressed in a comment letter it has received from the
Division of Corporation Finance of the Securities and Exchange Commission
(“SEC”) and has engaged a successor independent registered public accounting
firm.
Because the financial statements contained in this Form 10-Q do not meet the
requirements of Rule 10-01(d) of Regulation S-X, the Company may not be
considered current in our filings under the Securities Exchange Act of 1934. Filing
an amendment to this report, when the independent registered public accountants’
review is complete, would eliminate certain consequences of a deficient filing, but
the Company may become ineligible to use Form S-3 to register securities until all
required reports under the Securities Exchange Act of 1934 have been timely filed
for the 12 months prior to the filing of the registration statement for those securities.
The Company is evaluating the impact of filing a deficient Form 10-Q due to lack of
a review by an independent registered public accounting firm on its covenants under
its contractual commitments, its obligations under the NASDAQ Stock Market listing
standards, and the Securities Exchange Act.
Source: Overstock.com, Inc., initial Form 10-Q for the third quarter of 2009.
During Overstock’s November 18, 2009, quarterly earnings conference call, Byrne justified
his decision to file the unreviewed 10-Q with the SEC. He maintained that providing
investors with an unreviewed 10-Q was better than providing them nothing at all. He then
went on to explain that Overstock would file an amended 10-Q after retaining a new audit
firm and resolving the issues raised by the SEC letters of inquiry.
As required by the SEC, Overstock asked Grant Thornton to prepare an exhibit letter to be
filed as an attachment to the 8-K announcing the company’s decision to dismiss the
accounting firm as its independent auditor. In that exhibit letter, Grant Thornton was required
to indicate whether or not it agreed with Overstock’s discussion of the circumstances and
events that had preceded the decision to change auditors.
In Grant Thornton’s exhibit letter dated November 20, 2009, the firm stated that it had never
agreed with the accounting treatment applied by Overstock to the $785,000 overpayment.
According to the accounting firm, it had become aware of the overpayment for the first time
in October 2009 when Overstock brought that item to its attention. Grant Thornton also indicated
repeatedly in the exhibit letter that it disagreed with Overstock’s description of
other circumstances and events preceding the company’s decision to change auditors.
Grant Thornton’s statements in the exhibit letter prompted a caustic reply by Patrick Byrne.
In a press release included as an exhibit to an 8-K filed by Overstock with the SEC on
November 25, 2009, Byrne contested Grant Thornton’s assertion that it had never
acquiesced to the accounting treatment initially applied to the $785,000 overpayment by
characterizing that assertion as a “falsehood.” Byrne reported that Grant Thornton had
reviewed Overstock’s 10-Q for the first quarter of 2009 and informed “the audit committee
before we filed those financial statements that it had no changes to those financial
statements.”
Byrne went on to flatly contest most of the other assertions made by Grant Thornton in the
exhibit letter filed with Overstock’s earlier 8-K. Near the end of the lengthy press release,
Byrne summarized his views regarding his company’s spat with its former audit firm. “We
are surprised by these inconsistencies and inaccurate statements in Grant Thornton’s
November 20 letter to the SEC. I take them as proof (as though further proof was needed)
that our audit committee made the correct decision to dismiss Grant Thornton.”
The SEC did not publicly comment on the deficient 10-Q filed by Overstock for the third
quarter of fiscal 2009. On November 19, 2009, three days after filing that 10-Q, Overstock
was notified by the NASDAQ that it had violated the organization’s “listing rules.” The
NASDAQ informed Overstock it had 60 days to submit a plan to reestablish its compliance
with those rules. If that plan was approved, Overstock would have an additional four months
to implement the plan.
Epilogue
On December 30, 2009, Overstock filed an 8-K with the SEC disclosing that it had
hired KPMG as its new audit firm. Overstock filed another 8-K on February 4, 2010,
quietly announcing that it intended to restate its prior financial statements for 2008
and for each of the first three quarters of 2009. The 8-K indicated that those prior
financial statements should not be relied upon and that the restated financial
statements would be released “as soon as practicable.”
The items that required correction in Overstock’s prior financial statements included
overpayments made to certain of the company’s business partners; the $785,000
overpayment that had been central to the dispute between Grant Thornton and
Overstock was not identified separately. The company admitted the “gain
contingency accounting” applied to those overpayments had been determined to be
“inappropriate.” According to the 8-K, “Correction of these errors is expected to shift
approximately $1.7 million of income recognized in fiscal 2009 back to fiscal year
2008.”
Overstock’s promised financial restatements were included in SEC filings made by
the company on March 31, 2010. One week later, Overstock issued a press release
reporting that it had received a letter from the NASDAQ. The letter indicated that
following the filing of the restated financial statements with the SEC, the company
was in compliance with the NASDAQ’s listing rules. In April 2012, the SEC notified
Overstock that its investigation of the company’s accounting affairs initiated in
October 2009 had been completed. The SEC informed Overstock that it would take
no enforcement action against the company as a result of that investigation.
After reporting a $7.7 million net income for 2009, its first-ever annual profit,
Overstock reported a significant net income in four of the following five years, the
exception being 2011. During that five-year period, the company’s annual revenues
steadily increased, reaching almost $1.5 billion in 2014. Overstock did not restate
any prior financial statements during that time frame and KPMG issued an
unqualified opinion each year on the company’s financial statements. Patrick Byrne
remains the company’s CEO at last report.
Questions
1. The Overstock-Grant Thornton dispute was publicly aired via disclosure
statements filed with the SEC. What impact do you believe those disclosures
had on the investing public’s confidence in the financial reporting domain and
the independent audit function? Were the interactions between Overstock and
Grant Thornton unprofessional or otherwise inappropriate? Explain.
2. Do you believe that the $785,000 amount at the center of the Overstock-Grant
Thornton dispute was material? Defend your answer. What factors other than
quantitative considerations should have been considered in deciding whether
the $785,000 amount was material?
3. Briefly compare and contrast the nature and purpose of an independent audit
versus a quarterly review.
4. The SEC requires registrants to have their quarterly financial statements
reviewed by an independent accounting firm but does not mandate that a
review report be included in a Form 10-Q. Under what circumstances must a
review report accompany quarterly financial statements in a 10-Q? Why
doesn’t the SEC routinely require public companies to include their review
reports in their 10-Q filings?
5. What is the purpose or purposes of Form 8-K filings by SEC registrants? What
specific items of information must be included in an 8-K that announces a
change in audit firms?
6. Do you agree with the accounting treatment that Overstock typically applied to
the revenues generated by its “Partner” line of business? Why or why not?
Purchase answer to see full
attachment