SEC Charges California Company in Scheme to Improperly Capitalize Expenses to Cover Up Lost Profits from Compliance with a New Accounting Pronouncement
Thursday, 13 August 2009 17:14

SEC Charges California Company in Scheme to Improperly Capitalize Expenses to Cover Up Lost Profits from Compliance with a New Accounting Pronouncement

Complaint filed in the U.S. Distri ct Cour t for the Northern District of California requesting a permanent injunction against future violations of § 17(a)(2) and (a)(3) of the Securities Act of 1933, §§ 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Securities Exchange Act of 1934, and Rules 12b-20, 13a-1, and 13a-13 under the Exchange Act.

Allegations:

According to a complaint filed on July 23, 2009, in February 2004 West Marine, Inc., a publicly traded boating supply retailer, issued a press release preannouncing its earnings for fiscal year 2003.

Soon thereafter, West Marine determined that it needed to change its accounting for vendor allowances (payments West Marine received from product manufacturers) pursuant to Emerging Issues Task Force No. 02-16, 24 “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a 25 Vendor” (“EITF 02-16”).

Specifically, EITF 02-16 requires an entity receiving vendor allowances to recognize them through the income statement upon sale of the inventory for which the allowances were received in order better to match revenues and costs. Previously, West Marine’s approach had been to recognize vendor allowances as a generalized reduction of cost of sales without regard to when the inventory on which the allowance was earned was actually sold. Compliance with EITF 02-16 would reduce West Marine’s previously announced 2003 pretax income by approximately $13.2 million.

 

To neutralize the $13.2 million shortfall, West Marine set out to find an accounting offset and ultimately decided to capitalize 70% of its store occupancy costs, including expenses such as rent and utilities.

 

Capitalizing store occupancy costs had the effect of increasing West Marine’s net income for the year and directly offset the change in accounting for vendor allowances. This allowed West Marine to avoid having to report in its annual report on Form 10-K, filed with the Commission on March 18, 2004, results inconsistent with those in the February 2004 press release.

Capitalizing store occupancy costs had the effect of increasing West Marine’s net income for the year and directly offset the change in accounting for vendor allowances. This allowed West Marine to avoid having to report in its annual report on Form 10-K, filed with the Commission on March 18, 2004, results inconsistent with those in the February 2004 press release that pre-announced earnings for fiscal year 2003.

When making significant accounting changes, the Company’s historical (and subsequent) practice had involved detailed discussions by Company management with its audit committee and with its outside auditors in formal quarterly meetings. Typically, the accounting changes were further supported by comprehensive research memoranda produced by Company management. Here, however, the Company deviated considerably from its usual conduct. West Marine prepared no written materials for the outside auditors or audit committee other than a spreadsheet that made it unclear that significant accounting changes were being made and, in fact, suggested that West Marine was using a consistent method between 2003 and 2002.

West Marine’s subsequent registration statements (which offered company stock to employees) and annual and periodic reports continued to contain the false information until West Marine announced a restatement in 2007. Specifically, on May 27, 2005, West Marine filed a Form S-8 registering the offer of 375,000 shares and on May 11, 2006, West Marine filed a Form S-8 registering the offer of an additional 475,000 shares. Both registration statements incorporated by reference the false financial information contained in the Company’s 2003 Form 10-K.

On February 27, 2007, West Marine announced that it would restate its financial statements for fiscal years ended December 28, 2002, through December 31, 2005, and its quarterly 3 results for fiscal year 2005 and the first three quarters of fiscal year 2006.

West Marine indicated that the restatement would correct the improper accounting for two inventory-related accounting changes made in their fiscal year 2003: (1) the inclusion of store operating costs in inventory value; and (2) the improper reporting of a cumulative change in accounting principle for vendor allowances included in inventory value. In an annual report on Form 10-K filed March 27, 2007, West Marine reported its restated financial results for 2002 through 2005. Among other things, the Company reduced its previously reported 2003 net income from $20.1 million to $5.6 million, a 72% reduction.

Remedies by Consent:

The Complaint asks the Court permanently to enjoin West Marine from violating, directly or indirectly, § 17(a)(2) and (a)(3) ofthe Securities Act and §§ 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20, 13a-l, and 13a-13 thereunder.

 

[Editor’s Note: The Enforcement Division did not name any individual defendants or assess any monetary sanctions in the settlement, despite the fact that two registration statements for the sale of additional shares included the false and misleading information.]

 

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