Case 7-10 Beazer Homes

Beazer Homes is a home-building company headquartered in Atlanta, Georgia. Its stock is listed on the New York Stock Exchange. Beazer is required to file Form 10-Q and Form 10-K, as well as an 8-K form when certain changes occur, such as restating financial statements.

As a homebuilder, Beazer often builds “model homes” for prospective homebuyers to tour while the remainder of a neighborhood and its future homes are under construction. As one of the last homes to be sold, model homes often may not be sold to a homebuyer for years, and thus may not provide a homebuilder with revenue and income on their sale until years after construction.

What follows is a description of the SEC’s agreement, in SEC v. Michael T. Rand, to resolve charges that Beazer engaged in fraudulent accounting that led to material noncompliance with federal securities laws by improperly inflating Beazer’s income by reducing or eliminating previously established artificial reserves and improperly recognizing sales revenue and income in sale-leaseback transactions involving its model homes.

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Sale-Leaseback Scheme

Under its sales-leaseback program, Beazer sold its model homes to investors, typically at a discounted price, thereby permitting it to recognize revenue and income from the sales. Under the “leaseback” portion of the transaction, Beazer leased back from the investor/buyer the same model homes, which Beazer could then use to show prospective home buyers.

In December 2005, the chief accounting officer, Michael T. Rand, CPA, entered into a secret side-agreement with one or more GMAC Model Home Finance personnel under which: (a) Beazer would “sell” the model homes and recognize revenue and income from such sales; (b) the homes would be leased back to Beazer for its use; but (c) Beazer would secretly receive a share of any profits from any subsequent sale of the model homes to a third party at the end of the leases. Under GAAP, a seller is not permitted to recognize revenue and income from a sale in a sale-leaseback transaction if the seller retains a continuing interest in the property after it has been sold. Beazer’s continuing and secret interest in a share of any profits from the ultimate sale of the models was such a continuing interest.

What follows is a table showing model homes sold and improper pretax income recognized from the sale-leaseback transactions in violation of GAAP.

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Cookie-Jar Reserves

Prior to 2006, Rand and other Beazer employees engaged in an accounting scheme involving “cookie-jar accounting.” Specifically, Rand improperly decreased Beazer’s income by artificially establishing, increasing, and/or maintaining future anticipated expenses or “reserves.” He executed this strategy by manipulating, among other accounts, Beazer’s land development and house reserve accounts.

In fiscal year 2006, when Beazer was in jeopardy of not meeting analysts’ expectations, Rand eliminated certain unnecessary excess reserves that had been built up, thereby improperly boosting Beazer’s pretax income by over $27.5 million. Beazer’s arbitrary elimination of reserves to boost income resulted in financial statements that were not compiled in accordance with GAAP.

Land Inventory Accounting

As part of its home building and sale operations, Beazer purchased parcels of land upon which it constructed houses to form subdivisions. Beazer recorded the acquired land, along with costs for the common development of the parcel, such as sewer systems and streets, as an asset on Beazer’s balance sheet in the land inventory accounts. As subdivisions were built, Beazer allocated the costs accumulated in the land inventory accounts to individual home lots, which were then offered for sale. When the home sale was recorded in Beazer’s books, all associated homebuilding costs, including allocated costs recorded in the land inventory accounts, were expensed as a cost of the sale, with a corresponding reduction, or credit, in the land inventory account.

Because Beazer sold houses within a subdivision as the development of that subdivision progressed, the land inventory expense recorded for any particular house sale was necessarily an estimate. The setting of inventory credits was done by each division based on estimates of costs to acquire, develop, and complete subdivisions plus an added amount for contingencies. Once established, divisions needed approval from Rand, who reviewed the reserves on a monthly basis, to make adjustments.

As additional houses in a subdivision were sold, the land inventory account continued to be decreased (credited) by amounts representing the land acquisition and development costs allocated to each individual house. If costs had been allocated properly, then, shortly after the final house in a development had been sold, the balance in the land inventory account should have been at or near zero.

What follows is a table showing the overstatement in land inventory costs between 2001 and 2005.

In order to reduce its first quarter 2002 earnings, which had exceeded analysts’ EPS expectations, Rand fraudulently increased the land inventory expense recorded for homes sold during the quarter.

On January 8, 2002, after the end of the first quarter, Rand e-mailed a target earnings amount to the relevant financial personnel in numerous Beazer divisions with instructions not to exceed the target by a certain amount. The distributed target for each division was less than each division’s previously expected quarterly results. Rand advised the divisions to review their land inventory accounts in order to increase expenses and reduce earnings. In one particular e-mail, Rand instructed the Florida division to provide “more than adequate land allocations in communities closing out this year” as a means to reduce its earnings.

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On January 10, 2002, Rand, via e-mails, directed certain divisions to, “[s]et aside all the reserves you reasonably can . . . the quarter is too high.” This was followed by a series of e-mails in which Rand specified the amounts by which certain divisions should increase their reserves, along with targets for their EBIT (earnings before interest and taxes). The divisions substantially carried out his directions, and Rand was able to reduce Beazer’s quarterly EPS from $2.60 to $2.47 a share, which exceeded analysts’ consensus of $2.00 per share. In total, Beazer recorded approximately $1.827 million in excess land inventory costs for that quarter, or approximately 8 percent of its reported net income.

By increasing land inventory expenses, Rand caused Beazer to understate its net income by a total of $56 million ($33 million after tax effect; approximately 5 percent of reported net income) between 2000 and 2005. Beginning in the first quarter of 2006, Rand began to reverse the reserves existing in the land inventory accounts, which increased then-current period earnings. The credit balances in land inventory accounts were debited (i.e., zeroed out), and a cost of sales expense credited (i.e., reduced). These reversals improperly reduced expenses and increased Beazer’s earnings. During all four quarters of 2006, Rand caused Beazer to release these land inventory reserves, boosting then-current period earnings by approximately $100,000 in the first quarter of 2006, approximately $301,000 in the second quarter of 2006, approximately $14,278,000 in the third quarter of 2006, and approximately $10,816,000 in the fourth quarter of 2006.

Manipulation of “House Cost-to-Complete” Reserves

Under its accounting policies, Beazer recorded revenue and profit on the sale of a house after the close of the sale of that house to a homebuyer. In the journal entries to record the sale, Beazer typically reserved a portion of its profit earned on the house. This reserve, called a “house cost-to-complete” reserve, was established to cover any unknown expenses that Beazer might incur on the sold house after the close, such as minor repairs or final cosmetic touch-ups. Although the amount of this reserve varied by region, it was typically $1,000 to $4,000 per house.

Beazer’s policy was to reverse any unused portion of the house cost-to-complete reserve within four to nine months after the close, taking any unused portion into income at that time. As specified below, in various quarters between 2000 and 2005, Rand over-reserved house cost-to-complete expenses. Rand then took steps to maintain these reserves beyond the typical four to nine months and until increased earnings were required in future periods.

The following table shows the over-expensing of the cost-to-complete expense from 2000 to 2005.

Quarter 1

Quarter 2

Quarter 3

Quarter 4

N/A

N/A

N/A

N/A

N/A

N/A

N/A

N/A

N/A

N/A

N/A

Beginning in 2006, Beazer began reversing some of the excess cost-to-complete reserves that it had previously recorded. As a result of Rand’s directives, Beazer reduced its cost of sales expense by approximately $1.5 million by reducing the cost-to-complete reserve to zero on a number of houses. The following shows the amount of reversal of excess cost-to-complete reserves as earnings of the period that were previously recorded fraudulently.

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Quarter Ended

March 31

Additionally, at Rand’s instruction certain Beazer divisions, in order to report more income, failed to establish a house cost-to-complete reserve on house sales closing during the quarter. Beazer’s Las Vegas division failed to record any cost-to-complete reserve for approximately 85 houses sold during December 2005. This resulted in an improper recognition, in violation of GAAP, of more than $200,000 of income for the period. All totaled, the additional income due to cost-to-complete reserve accounting added approximately $0.03 to Beazer’s EPS.

Deloitte & Touche

Beazer’s auditor, Deloitte & Touche, specifically advised Rand via e-mail that Beazer’s appreciation rights in the homes represented a continuing interest that, pursuant to GAAP, precluded Beazer from recognizing revenue when the homes were sold to GMAC. In an attempt to circumvent GAAP, and to deceive Deloitte, Rand caused the final, written versions of the sale-leaseback agreements to omit any reference to Beazer’s continuing profit participation. Rand then directed, by e-mail, his subordinates to record revenue at the time the model homes were initially sold to the GMAC investor pools. Rand provided Deloitte with copies of the sale-leaseback agreements that intentionally omitted the provisions relating to the continuing profit participation by Beazer. Rand also failed to disclose the side agreements to Deloitte.

Additionally, on January 18, 2006, Rand provided to Deloitte a memo that specifically stated Beazer would not “participate in the appreciation” of the leased assets (model homes). Based on Rand’s concealment and misrepresentations, Deloitte agreed that immediate revenue recognition was proper.

As reported by CFO Magazine and summarized in the following paragraphs,

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 a class-action lawsuit filed against Deloitte was settled on May 7, 2009. The agreement said that the audit firm should have considered the homebuilder’s “make the numbers” culture to be a red flag as the housing market tanked. Deloitte agreed to pay investors of Beazer Homes nearly $1 million to settle the claim.

The investors had accused Beazer of managing earnings, recognizing revenue earlier than allowed under generally accepted accounting principles, improperly accounting for sale-leaseback transactions, creating “cookie-jar” reserves, and not recording land and goodwill impairment charges at the proper time.

The investors accused Deloitte of turning “a blind eye” to the myriad of “red flags” that should have alerted the firm to potential GAAP violations. These warning signs included the “excessive pressure” employees were under to meet their higher-ups’ sales goals, tight competition in Beazer’s market, and weak internal controls. Accusing the auditor of “severe recklessness,” the shareholders alleged, for example, that Deloitte should have noticed that Beazer was likely overdue in recording impairments on its land assets, as the real estate market began to decline, among the other alleged accounting violations.

“Deloitte either knowingly ignored or recklessly disregarded Beazer’s wide-ranging material control deficiencies and material weaknesses during the class period,” according to the shareholders’ complaint. “For example, Deloitte was specifically aware that financial periods were regularly held open or re-opened because it had access to Beazer’s detailed financial and accounting information via, among other means, access to Beazer’s JD Edwards software.”

In the Beazer settlement, Deloitte denied all liability and settled to avoid the expense and uncertainty of continued litigation, according to a spokeswoman.

Restatements of Financial Statements

Due to Beazer’s material noncompliance with the financial reporting requirements of the federal securities laws, Page 500Beazer was required to issue accounting restatements. On May 12, 2008, Beazer filed accounting restatements for the fiscal year 2006. In various reports filed that day, Beazer restated its financial statements for fiscal 2006 and each of the first three quarters of fiscal 2006. Beazer admitted to the improper accounting with the following statement:

During the course of the investigation, the Audit Committee discovered accounting and financial reporting errors and/or irregularities that required restatement resulting primarily from: (1) inappropriate accumulation of reserves and/or accrued liabilities associated with land development and house costs (“Inventory Reserves”), and (2) inaccurate revenue recognition with respect to certain model home sale-leaseback transactions.

In the filings, Beazer further acknowledged material weaknesses in its internal control over financial reporting including in its control environment and the design of accounting policy, procedures, and controls—“specifically related to the application of GAAP in accounting for certain estimates involving significant management judgments.”

As set forth in those filings, Beazer acknowledged that its material weaknesses had several impacts on the Company’s financial reporting, including “[i]nappropriate reserves and other accrued liabilities [being] recorded relating to land development costs, house construction costs and warranty accruals” and “[t]he accounting for certain model home sale and leaseback agreements [being] not in compliance with GAAP. . . [as the] Company’s arrangement for certain sale and leaseback transactions.”

Those filings went on to state that Beazer had “terminated our former Chief Accounting Officer who we believe may have caused, or allowed to cause, the internal control breakdown”; and that Beazer “believe[d] his termination has addressed concerns about the internal control deficiencies that we believe he caused or permitted to occur.”

According to a separate filing by the SEC against Ian McCarthy,

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 former CEO of Beazer Homes, during the 12-month period following Beazer’s filing of its inaccurate financial statements in 2006, and before any restatement or correcting disclosure by Beazer, McCarthy received bonuses and incentive- and equity-based compensation and profits from his sale of Beazer stock. In fiscal year 2006, McCarthy received a bonus of $7.1 million, of which he received $5,706,949 in cash. During fiscal year 2006 and the first quarter of fiscal 2007, McCarthy also realized total profits of $7.3 million dollars through his sale of Beazer stock. During this same time period, McCarthy was awarded 157,526 shares of restricted Beazer common stock, which were to vest in various subsequent years upon the achievement of certain performance criteria or continued employment. Of these amounts, 78,763 shares failed to vest as the result of Beazer failing to meet required performance criteria.

McCarthy had not reimbursed Beazer for the bonuses and incentive- and equity-based compensation and profits from his sale of Beazer stock received from Beazer during the relevant statutory periods, as required under the Sarbanes-Oxley Act and its clawback provision.

In July 2009, a federal bill of information was filed in U.S. District Court charging Beazer with, among other things, participation in the conspiracy and securities fraud with Rand. Beazer accepted responsibility for those charges and, in a deferred prosecution agreement, agreed to pay restitution of $50 million. Rand was indicted by a federal grand jury in August 2010.

On July 18, 2014, a federal jury convicted Rand of conspiracy and obstruction of justice charges stemming from the federal investigation into the seven-year accounting fraud and related conspiracy at Beazer. On April 30, 2015, U.S. District Judge Robert J. Conrad Jr. sentenced Rand to 120 months in prison and to three years of supervised release on conspiracy and obstruction of justice charges in connection with the investigation.

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Page 501A statement released by the U.S. Attorney’s Office quotes John A. Strong, the special agent in charge for the Charlotte Division of the FBI:

The U.S. Attorney’s Office is committed to safeguarding the integrity of our financial markets from corporate executives like Rand, who put profits ahead of duty. Rand’s actions breached his obligation to the investors and the public and jeopardized the stability of the housing industry. Today’s verdict should send a clear message that corporate fraud, in this case cooking the books, will not be tolerated and you engage in such frauds at the risk of your freedom.

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Questions

1. What role did organizational ethics play in the Beazer Homes fraud? Is this something the auditors of Deloitte should have been more conscious of? Explain.

2. Evaluate Beazer’s accounting for cost-to-complete reserves from a GAAP perspective. Was the initial accounting for the reserve in conformity with GAAP? What was the company trying to achieve with its accounting?

3. Categorize the accounting devices used by Beazer into one the financial shenanigan groupings. Include a discussion of how earnings were managed in each case.

4. Page 502Assume you were hired to analyze the information in this case and write a two- to three-page report on your findings. Discuss each element of the fraud and why Beazer, Rand, and/or Deloitte violated ethical and professional standards.