Beazerhomes was the sixth largest U.S. home builder during the 1998-2006 housingboom. 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 2006and then collapsed in 2007.
TheSEC alleged that Michael T. Rand, Beazer’s chief accounting officer,understated Beazer’s reported profits in every quarter but one from 2000through 2005 by understating Beazer’s “land inventory” account and byoverstating 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 profitsby increasing the “land inventory” account, decreasing the “cost to complete”reserve, and fraudulently recording sale-and-leaseback transactions for modelhomes.
Thecase provides an excellent overview of the U.S. housing boom and collapse. It can be used prior to New Century FinancialCorp (Chapter 3), which covers the collapse of a sub-prime and Alt A mortgagelender. The case is also excellent forcovering the practical issues of accrual accounting in uncertain environments.
TheSEC 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 newhousing development, some land is set aside for streets and sidewalks, some forparks or lakes, and some for open space near busy roads. The builder then subdivides the remainingland into lots it hopes to sell. Lotsnear a park or lake are more desirable, while lots near the entrance to asubdivision are typically less desirable. Someone assigned a cost of the land to individual lots, and thatassignment process is clearly arbitrary. In addition, as the property becomes more or less desirable, theremaining land becomes more or less valuable than when the firm first estimatedthe value of each lot. The SEC’scomplaint made the valuation process seem far more objective than it is inpractice.
Thecost-to-complete reserve covers the cost to complete sold homes. That includes, for example, cracked drivewaysor basement floors, leaking faucets, roofs, or windows, or faulty painting orlandscaping. The average cost per homemight be $5,000 or $10,000, depending on the home cost and the history of thedevelopment. After 6-12 months, theallowance for a particular home might be reduced to zero as the warrantyexpired or as the likelihood of claims declined. The SEC complaint made that valuation processseem far more objective than it is in practice, particularly for a rapidlygrowing firm that almost certainly was relying on less experienced managers andworkers, and less experienced accountants.
Thecase 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 $72million for a firm that had about $2 billion of operating profits. In addition, during nine quarters from2007-2009, Beazer recorded about $1 billion of impairment charges. Given the implicit subjectivity in those nineimpairment charges, it seems highly likely that the “land inventory” and “costto complete” accounts were also highly subjective numbers.
Iuse this case to consider the subjectivity of various accrual accounts. I also use it to consider who would make theaccrual calculations. Beazer constructedhousing developments throughout the nation. Michael T. Rand almost certainly was not personally responsible forpreparing accrual estimates at the operating level.
Foreach of the accounting issues discussed in the body of Case 9:
- Discuss whether itseems likely that Dell recorded the transaction improperly to manipulateresults or whether it was more likely an honest mistake (e.g., Dell didnot know about the rule; the implementation relied on judgment and theinvestigators had the benefit of hindsight; or the sheer volume oflow-value orders Dell ships each day makes it very difficult to properlyimplement these detailed rules).
- Discuss whether theerror addressed in Part 1 of this discussion is material and should havebeen disclosed. Review the accounting changes and internal controlprocedures that Dell proposed, and evaluate those changes in terms oftheir probable costs and benefits
Pleasemake sure that the bullet point and solution is together and that the solutionis at least a paragraph long
