Discuss the culpability of the accountants in preparing the questionable accounting estimates for the cost to compete.

Fraudulent Behavior

Beazer homes was the sixth largest U.S. home builder during the 1998-2006 housing boom.  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 2006 and then collapsed in 2007.

The SEC alleged that Michael T. Rand, Beazer’s chief accounting officer, understated Beazer’s reported profits in every quarter but one from 2000 through 2005 by understating Beazer’s “land inventory” account and by overstating 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 profits by increasing the “land inventory” account, decreasing the “cost to complete” reserve, and fraudulently recording sale-and-leaseback transactions for model homes.

The case provides an excellent overview of the U.S. housing boom and collapse.  It can be used prior to New Century Financial Corp (Chapter 3), which covers the collapse of a sub-prime and Alt A mortgage lender.  The case is also excellent for covering the practical issues of accrual accounting in uncertain environments.

The SEC 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 new housing development, some land is set aside for streets and sidewalks, some for parks or lakes, and some for open space near busy roads.  The builder then subdivides the remaining land into lots it hopes to sell.  Lots near a park or lake are more desirable, while lots near the entrance to a subdivision are typically less desirable.  Someone assigned a cost of the land to individual lots, and that assignment process is clearly arbitrary.  In addition, as the property becomes more or less desirable, the remaining land becomes more or less valuable than when the firm first estimated the value of each lot.  The SEC’s complaint made the valuation process seem far more objective than it is in practice.

The cost-to-complete reserve covers the cost to complete sold homes.  That includes, for example, cracked driveways or basement floors, leaking faucets, roofs, or windows, or faulty painting or landscaping.  The average cost per home might be $5,000 or $10,000, depending on the home cost and the history of the development.  After 6-12 months, the allowance for a particular home might be reduced to zero as the warranty expired or as the likelihood of claims declined.  The SEC complaint made that valuation process seem far more objective than it is in practice, particularly for a rapidly growing firm that almost certainly was relying on less experienced managers and workers, and less experienced accountants.

The case 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 $72 million for a firm that had about $2 billion of operating profits.  In addition, during nine quarters from 2007-2009, Beazer recorded about $1 billion of impairment charges.  Given the implicit subjectivity in those nine impairment charges, it seems highly likely that the “land inventory” and “cost to complete” accounts were also highly subjective numbers.

I use this case to consider the subjectivity of various accrual accounts.  I also use it to consider who would make the accrual calculations.  Beazer constructed housing developments throughout the nation.  Michael T. Rand almost certainly was not personally responsible for preparing accrual estimates at the operating level.

  • Discuss the motives of the executives to commit fraud. Discuss the culpability of the accountants in preparing the questionable accounting estimates for the cost to compete.
  • In the Beazer Homes USA case (i.e., Case 10), the chief accounting officer was accused of duping the external auditors through the use of an earnings manipulation scheme. Imagine that you were the auditor of the mortgage company. Design an audit plan to address the important accounting issues highlighted in the case. For each issue identified, recommend a risk mitigation strategy.
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