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ACCOUNTING POLICIES
9 Months Ended
Sep. 30, 2012
ACCOUNTING POLICIES  
ACCOUNTING POLICIES

2. ACCOUNTING POLICIES

 

Principles of consolidation

 

The accompanying consolidated financial statements include our accounts and the accounts of our wholly-owned subsidiaries. All intercompany account balances and transactions have been eliminated in consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, investment valuation, receivables valuation, revenue recognition, sales returns, incentive discount offers, inventory valuation, depreciable lives of fixed assets and internally-developed software, goodwill valuation, intangible valuation, income taxes, stock-based compensation, performance-based compensation, restructuring liabilities and contingencies. Actual results could differ materially from those estimates.

 

Cash equivalents

 

We classify all highly liquid instruments, including money market funds with a remaining maturity of three months or less at the time of purchase, as cash equivalents. Cash equivalents were $48.1 million and $81.2 million at September 30, 2012 and December 31, 2011, respectively.

 

Restricted cash

 

We consider cash that is legally restricted and cash that is held as a compensating balance for letter of credit arrangements as restricted cash. Restricted cash was $2.1 million and $2.0 million at September 30, 2012 and December 31, 2011, respectively, and was held primarily in cash.

 

Fair value of financial instruments

 

Our financial instruments, including cash, cash equivalents, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. We are party to a Financing Agreement with U.S. Bank dated December 22, 2009 (as amended to date, the “Financing Agreement”). Our Financing Agreement is also carried at face value, which approximates its fair value due to its variable interest rate.

 

We account for our assets and liabilities using a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. These two types of inputs have created the following fair-value hierarchy:

 

·                  Level 1—Quoted prices for identical instruments in active markets;

 

·                  Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and

 

·                  Level 3—Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

This hierarchy requires us to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value.

 

The fair value of these financial instruments was determined using the following levels of inputs as of September 30, 2012 (in thousands):

 

 

 

Fair Value Measurements at September 30, 2012:

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents - Money market mutual funds

 

$

48,129

 

$

48,129

 

$

 

$

 

Trading securities held in a “rabbi trust” (1)

 

248

 

248

 

 

 

Total assets

 

$

48,377

 

$

48,377

 

$

 

$

 

Liabilities:

 

 

 

 

 

 

 

 

 

Restructuring Accrual (2)

 

$

66

 

$

 

$

 

$

66

 

Deferred compensation accrual “rabbi trust” (3)

 

244

 

244

 

 

 

Total liabilities

 

$

310

 

$

244

 

$

 

$

66

 

 

The fair value of these financial instruments was determined using the following levels of inputs as of December 31, 2011 (in thousands):

 

 

 

Fair Value Measurements at December 31, 2011:

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents - Money market mutual funds

 

$

81,159

 

$

81,159

 

$

 

$

 

Trading securities held in a “rabbi trust” (1)

 

302

 

302

 

 

 

 

 

Total assets

 

$

81,461

 

$

81,461

 

$

 

$

 

Liabilities:

 

 

 

 

 

 

 

 

 

Deferred compensation accrual “rabbi trust” (3)

 

302

 

302

 

 

 

Total liabilities

 

$

302

 

$

302

 

$

 

$

 

 

 

(1)  — Trading securities held in a rabbi trust are included in Other current and long-term assets in the consolidated balance sheets.

 

(2)  — The fair value was determined based on the income approach, in which we used internal cash flow projections over the life of the underlying lease agreement discounted based on a credit adjusted risk-free rate of return. See the roll forward related to the restructuring accrual at Note 3—Restructuring Expense.

 

(3) — Non qualified deferred compensation for rabbi trust is included in Accrued liabilities and Other long-term liabilities in the consolidated balance sheets.

 

Restricted investments

 

In December 2009, we implemented a Non Qualified Deferred Compensation Plan (the “NQDC Plan”) for senior management. Deferred compensation amounts are invested in mutual funds held in a “rabbi trust” and are restricted for payment to the participants of the NQDC Plan. We account for our investments held in the trust in accordance with Accounting Standards Codification (“ASC”) No. 320 “Investments — Debt and Equity Securities”. The investments held in the trust are classified as trading securities. The fair value of the investments held in the trust totaled $248,000 at September 30, 2012 and are included in Other current and long-term assets in the consolidated balance sheets. Our gains and losses on these investments were immaterial for the three and nine months ended September 30, 2012 and 2011.

 

Accounts receivable

 

Accounts receivable consist primarily of trade amounts due from customers and from uncleared credit card transactions at period end. Accounts receivable are recorded at invoiced amounts and do not bear interest.

 

Allowance for doubtful accounts

 

From time to time, we grant credit to some of our business customers on normal credit terms (typically 30 days). We perform credit evaluations of our business customers’ financial condition and payment history and maintain an allowance for doubtful accounts receivable based upon our historical collection experience and expected collectability of accounts receivable. The allowance for doubtful accounts receivable was $738,000 and $574,000 at September 30, 2012 and December 31, 2011, respectively.

 

Concentration of credit risk

 

Cash equivalents include short-term, highly liquid instruments with maturities at date of purchase of three months or less. At September 30, 2012 and December 31, 2011, two banks held the majority of our cash and cash equivalents. We do not believe that, as a result of this concentration, we are subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships.

 

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash equivalents and receivables. We invest our cash primarily in money market securities which are uninsured.

 

Our accounts receivable are derived primarily from revenue earned from customers located in the United States. We maintain an allowance for doubtful accounts based upon the expected collectability of accounts receivable.

 

Valuation of inventories

 

Inventories, consisting of merchandise purchased for resale, are accounted for using a standard costing system which approximates the first-in-first-out (“FIFO”) method of accounting, and are valued at the lower of cost or market. We write down our inventory for estimated obsolescence and to lower of cost or market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Once established, the original cost of the inventory less the related inventory allowance represents the new cost basis of such products. Reversal of the allowance is recognized only when the related inventory has been sold or scrapped.

 

Prepaid inventories, net

 

Prepaid inventories represent inventories paid for in advance of receipt. Prepaid inventories were $1.7 million and $1.0 million at September 30, 2012 and December 31, 2011, respectively.

 

Prepaids and other assets

 

Prepaids and other assets represent expenses paid prior to receipt of the related goods or services, including advertising, license fees, maintenance, packaging, insurance, and other miscellaneous costs, as well as investments in precious metals. Total prepaids and other assets were $13.6 million and $12.7 million at September 30, 2012 and December 31, 2011, respectively.

 

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:

 

 

 

Life 
(years)

 

Computer software

 

2-3

 

Computer hardware

 

3

 

Furniture and equipment

 

3-5

 

 

Leasehold improvements are amortized over the shorter of the term of the related leases or estimated useful lives.

 

Depreciation and amortization expense is classified within the corresponding operating expense categories on the consolidated statements of operations as follows (in thousands):

 

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Cost of goods sold - direct

 

$

123

 

$

137

 

$

350

 

$

583

 

Technology

 

3,371

 

3,766

 

10,570

 

11,009

 

General and administrative

 

345

 

307

 

1,015

 

880

 

Total depreciation and amortization, including internal-use software and website development

 

$

3,839

 

$

4,210

 

$

11,935

 

$

12,472

 

 

Internal-use software and website development

 

Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our Website and processes supporting our business. We capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of two to three years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.

 

During the three months ended September 30, 2012 and 2011, we capitalized $3.0 million and $2.3 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 $2.0 million and $2.1 million for those respective periods. During the nine months ended September 30, 2012 and 2011, we capitalized $6.8 million and $7.8 million, respectively, of such costs and had amortization of $6.3 million and $6.1 million for those respective periods.

 

Revenue recognition

 

We derive our revenue primarily from two sources: direct revenue and fulfillment partner revenue, including listing fees and commissions collected from products being listed and sold through our cars listing business, and from advertising on our shopping, travel and insurance pages. We have organized our operations into two principal segments based on the primary source of revenue: direct revenue and fulfillment partner revenue (see Note 8—Business Segments).

 

Revenue is recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or the service has been provided; (3) the selling price or fee revenue earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. Revenue related to merchandise sales is recognized upon delivery to our customers. As we ship high volumes of packages through multiple carriers, it is not practical for us to track the actual delivery date of each shipment. Therefore, we use estimates to determine which shipments are delivered and, therefore, recognized as revenue at the end of the period. Our delivery date estimates are based on average shipping transit times, which are calculated using the following factors: (i) the type of shipping carrier (as carriers have different in-transit times); (ii) the fulfillment source (either our warehouses or those of our fulfillment partners); (iii) the delivery destination; and (iv) actual transit time experience, which shows that delivery date is typically one to eight business days from the date of shipment. We review and update our estimates on a quarterly basis based on our actual transit time experience. However, actual shipping times may differ from our estimates.

 

We evaluate the criteria outlined in ASC Topic 605-45, Principal Agent Considerations, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. When we are the primary obligor in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not the primary obligor in the transaction and amounts earned are determined using a fixed percentage, revenue is recorded on a net basis. Currently, the majority of both direct revenue and fulfillment partner revenue is recorded on a gross basis, as we are the primary obligor. We present revenue net of sales taxes.

 

We periodically provide incentive offers to our customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases and other similar offers, which, when used by customers, are treated as a reduction of revenue.

 

Based upon our historical experience, revenue typically increases during the fourth quarter because of the holiday retail season.

 

Direct revenue

 

Direct revenue is derived from merchandise sales to individual consumers and businesses that are fulfilled from our leased warehouses. Direct revenue comes from sales that occur primarily through our Website, but may also occur through offline channels.

 

Fulfillment partner revenue

 

Fulfillment partner revenue is derived from merchandise sales through our Website which fulfillment partners ship directly to consumers and businesses from warehouses maintained by our fulfillment partners.

 

Fulfillment partner revenue also includes revenue from our other businesses, which include our online site for listing cars for sale, our travel shopping site, our insurance shopping site, our consignment service to suppliers, our online auction site (which was removed from our site in July 2011) and our online site for listing real estate for sale (which was removed from our site in June 2011). Revenue from our other businesses is less than 1% of total net revenues.

 

Club O loyalty program

 

We have a customer loyalty program called Club O for which we sell annual memberships. We record membership fees as deferred revenue and we recognize revenue ratably over the membership period. The Club O loyalty program allows members to earn reward dollars for qualifying purchases made on our Website. We also have a co-branded credit card program (see “Co-branded credit card revenue” below for more information). Co-branded cardholders are also Club O members and earn additional reward dollars for purchases made on our Website, and from other merchants. Reward dollars earned may be redeemed on future purchases made through our Website. Club O reward dollars expire 90 days after the customer’s Club O membership expires. We account for these transactions as multiple element arrangements and allocate value to the elements using their relative fair values. We include the value of reward dollars earned in deferred revenue and we record it as a reduction of revenue at the time the reward dollars are earned.

 

We recognize revenue for Club O reward dollars when customers redeem their reward dollars as part of a purchase at our Website.  We recognize other income when Club O reward dollars expire or the likelihood of reward dollars being redeemed by a customer is remote (“reward dollar breakage”). Due to the loyalty program’s short history, currently no reward dollar breakage is recognized until the reward dollars expire. However, in the future we plan to recognize such breakage based upon historical redemption patterns.

 

In instances where customers receive free Club O reward dollars not associated with any purchases, we account for these transactions as sales incentives such as coupons and record a reduction of revenue at the time the reward dollars are redeemed.

 

Co-branded credit card program

 

We have entered into a co-branded credit card agreement with a commercial bank for the issuance of credit cards bearing the Overstock.com brand, under which the bank pays us fees for new accounts and for customer usage of the cards. The agreement also provides for a customer loyalty program offering reward points that customers will accrue from card usage and can use to make purchases on our Website (See “Club O loyalty program” above for more information). New account fees are recognized as revenue on a straight-line basis over the estimated life of the credit card relationship. Credit card usage fees are recognized as revenues as actual credit card usage occurs.

 

Deferred revenue

 

Customer orders are recorded as deferred revenue prior to delivery of products or services ordered. We record amounts received for Club O membership fees as deferred revenue and we recognize it ratably over the membership period. We record Club O reward dollars earned from purchases as deferred revenue at the time they are earned and we recognize it as revenue upon redemption. If reward dollars are not redeemed, we recognize revenue upon expiration. In addition, we sell gift cards and record related deferred revenue at the time of the sale. We sell gift cards without expiration dates and we recognize revenue from a gift card upon redemption of the gift card. If a gift card is not redeemed, we recognize income when the likelihood of its redemption becomes remote based on our historical redemption experience. We consider the likelihood of redemption to be remote after 36 months.

 

Sales returns allowance

 

We inspect returned items when they arrive at our processing facility. We refund the full cost of the merchandise returned and all original shipping charges if the returned item is defective or we or our fulfillment partners have made an error, such as shipping the wrong product.

 

If the return is not a result of a product defect or a fulfillment error and the customer initiates a return of an unopened item within 30 days of delivery, for most products we refund the full cost of the merchandise minus the original shipping charge and actual return shipping fees. However, we reduce refunds for returns initiated more than 30 days after delivery or that are received at our returns processing facility more than 45 days after initial delivery.

 

If our customer returns an item that has been opened or shows signs of wear, we issue a partial refund minus the original shipping charge and actual return shipping fees.

 

Revenue is recorded net of estimated returns. We record an allowance for returns based on current period revenues and historical returns experience. We analyze actual historical returns, current economic trends and changes in order volume and acceptance of our products when evaluating the adequacy of the sales returns allowance in any accounting period.

 

The allowance for returns was $6.3 million and $10.9 million at September 30, 2012 and December 31, 2011 respectively. The decrease in allowance for returns at September 30, 2012 compared to December 31, 2011 is primarily due to decreased revenues mostly due to seasonality.

 

Credit card chargeback allowance

 

Revenue is recorded net of credit card chargebacks. We maintain an allowance for credit card chargebacks based on current period revenues and historical chargeback experience. The allowance for chargebacks was $157,000 and $187,000 at September 30, 2012 and December 31, 2011, respectively.

 

Cost of goods sold

 

Cost of goods sold includes product costs, warehousing costs, outbound shipping costs, handling and fulfillment costs, customer service costs and credit card fees, and is recorded in the same period in which related revenues have been recorded. Cost of goods sold, including product cost and other costs and fulfillment and related costs are as follows (in thousands):

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Total revenue, net

 

$

255,352

 

100

%

$

239,738

 

100

%

$

757,255

 

100

%

$

740,200

 

100

%

Cost of goods sold

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product costs and other cost of goods sold

 

196,522

 

77

%

189,074

 

79

%

582,436

 

77

%

573,204

 

78

%

Fulfillment and related costs

 

12,288

 

5

%

12,291

 

5

%

37,600

 

5

%

38,769

 

5

%

Total cost of goods sold

 

208,810

 

82

%

201,365

 

84

%

620,036

 

82

%

611,973

 

83

%

Gross profit

 

$

46,542

 

18

%

$

38,373

 

16

%

$

137,219

 

18

%

$

128,227

 

17

%

 

Advertising expense

 

We expense the costs of producing advertisements the first time the advertising takes place and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. Internet advertising expenses are recognized as incurred based on the terms of the individual agreements, which are generally: 1) a commission for traffic driven to the Website that generates a sale or 2) a referral fee based on the number of clicks on keywords or links to our Website generated during a given period. Advertising expense is included in sales and marketing expenses and totaled $12.8 million and $11.7 million during the three months ended September 30, 2012 and 2011, respectively. For the nine months ended September 30, 2012 and 2011, advertising expenses totaled $37.0 million and $35.9 million, respectively. Prepaid advertising, which consists primarily of prepaid advertising airtime, (included in Prepaids and other assets in the accompanying consolidated balance sheets) was $2.1 million and $1.4 million at September 30, 2012 and December 31, 2011, respectively.

 

Stock-based compensation

 

We measure compensation expense for all outstanding unvested share-based awards at fair value on date of grant and recognize compensation expense over the service period for awards expected to vest on a straight line basis. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results differ from estimates, such amounts will be recorded as an adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, and historical experience. Actual results may differ substantially from these estimates (see Note 7—Stock-Based Awards).

 

Loss contingencies

 

In the normal course of business, we are involved in legal proceedings and other potential loss contingencies. We accrue a liability for such matters when it is probable that a loss has been incurred and the amount can be reasonably estimated. When only a range of possible loss can be estimated, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. We expense legal fees as incurred.

 

Restructuring

 

Restructuring expenses are primarily comprised of lease termination costs. ASC Topic 420, Accounting for Costs Associated with Exit or Disposal Activities, requires that when an entity ceases using a property that is leased under an operating lease before the end of the contractual term, the termination costs should be recognized and measured at fair value when the entity ceases using the facility. Key assumptions in determining the restructuring expenses include the terms that may be negotiated to exit certain contractual obligations (see Note 3—Restructuring Expense).

 

Income taxes

 

Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis using enacted tax rates in effect for the year in which the differences are expected to affect taxable income.

 

Deferred tax assets are evaluated for future realization and are reduced by a valuation allowance to the extent that it is more likely than not that the deferred tax asset will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred assets including expectations of future taxable income, the carry-forward periods available for tax reporting purposes, the reversals of our deferred tax liabilities and tax planning strategies, to the extent available. At September 30, 2012 and December 31, 2011, we have a full valuation allowance against our deferred tax assets, net of expected reversals of existing deferred tax liabilities, as we believe it is more likely than not that these benefits will not be realized. Significant judgment is required in making this assessment, and it is very difficult to predict when, if ever, our assessment may conclude that the remaining portion of the deferred tax assets are realizable.

 

Earnings (loss) per share

 

Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing net income (loss) attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period. Potential common shares, comprising incremental common shares issuable upon the exercise of stock options, restricted stock awards and convertible senior notes are included in the calculation of diluted earnings (loss) per common share to the extent such shares are dilutive.

 

The following table sets forth the computation of basic and diluted net income (loss) per common share for the periods indicated (in thousands, except per share data):

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Net income (loss)

 

$

2,693

 

$

(7,787

)

$

5,882

 

$

(16,029

)

Deemed dividend related to redeemable common stock

 

 

 

 

(12

)

Net income (loss) attributable to common shares

 

$

2,693

 

$

(7,787

)

$

5,882

 

$

(16,041

)

Net income (loss) per common share—basic:

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common shares—basic

 

$

0.11

 

$

(0.33

)

$

0.25

 

$

(0.69

)

Weighted average common shares outstanding—basic

 

23,447

 

23,276

 

23,382

 

23,253

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Stock options and restricted stock awards

 

307

 

 

129

 

 

Weighted average common shares outstanding—diluted

 

23,754

 

23,276

 

23,511

 

23,253

 

Net income (loss) attributable to common shares—diluted

 

$

0.11

 

$

(0.33

)

$

0.25

 

$

(0.69

)

 

The following shares were excluded from the calculation of diluted shares outstanding as their effect would have been anti-dilutive (in thousands):

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Stock options and restricted stock awards

 

541

 

985

 

546

 

985

 

 

Accounting pronouncements issued not yet adopted

 

In July 2011, the Financial Accounting Standards Board (“FASB”) issued accounting pronouncement No. 2012-02, Intangibles—Goodwill and Other (FASB Accounting Standards Codification Topic 350) permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired. The Accounting Standard Update applies to both public and nonpublic entities and is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We do not expect this pronouncement to have a material effect on our consolidated financial statements.