978-0077862213 Chapter 5 Case Groupon

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Case 5-10

Groupon

Introduction

The Groupon case was first discussed in Chapter 3. Here, we expand on the discussion of internal controls

and the risk of material misstatement in the financial statements. Groupon is a deal-of-the-day

recommendation service for consumers. Launched in 2008, Groupon – a fusion of “group” and “coupon” –

combines social media with collective buying clout to offer daily deals on products, services and cultural

events in local markets. Promotions are activated only after a certain number of people in a given city sign

up.

Groupon pioneered the use of digital coupons in a way that created an explosive new market for local

business. Paper coupon use had been declining for years. But when Groupon made it possible for online

individuals to achieve deep discounts on products in local stores using emailed coupons, huge numbers of

people started buying. Between June 2009 and June 2010, revenues grew to $100 million. Then, between

June 2010 and June 2011, revenues exploded tenfold, reaching $1billion. In August 2010, Forbes magazine

labeled Groupon the world’s fastest growing corporation. And that did not hurt the company’s valuation

when it went public in November 2011.

On November 5, 2011, Groupon took its company public with a buy-in price set at $20 per share.

Groupon shares rose from that IPO price of $20 by 40% in early trading on NASDAQ, and at the 4 p.m.

market close, it was $26.11, up 31 percent. The closing price valued Groupon at $16.6 billion, making it

more valuable than companies such as Adobe Systems and nearly the size of Yahoo!

But after trading up for a couple of months, at the beginning of March, 2012, Groupon’s stock price

turned downward and the company has since lost 75 percent of its market capitalization. Groupon is now

valued at about $3.6 billion – approaching half of what Google offered to pay for the company in 2011

before Groupon leadership decided to go public.

The problem seems to be growing competition from sites such as LivingSocial and AmazonLocal. Also,

the leadership of the company also has come under scrutiny for some of its practices. But the main reason

Groupon seems to be struggling is concern over its reported numbers.

Problems with Financial Results

Less than five months after its IPO on March 30, 2012, Groupon announced that it had revised its financial

results, an unexpected restatement that deepened losses and raised questions about its accounting practices.

As part of the revision, Groupon disclosed a “material weakness” in its internal controls saying that it had

failed to set aside enough money to cover customer refunds. The accounting issue increased the company’s

losses in the fourth quarter to $64.9 million from $42.3 million. These amounts were material based on

revenue of $500 million in the prior year. The news that day sent shares of Groupon tumbling 6 percent to

$17.29. Shares of Groupon had fallen by 30 percent since it went public and the downward trend continues

today.

In its announcement of the restatement, Groupon explained that it had encountered problems related to

certain assumptions and forecasts the company used to calculate its results. In particular, the company said

it underestimated customer refunds for higher-priced offers such as laser eye surgery.

Groupon collects more revenue on such deals, but it also carries a higher rate of refunds. The company

honors customer refunds for the life of its coupons, so these payments can affect its financials at various

times. Groupon deducts refunds within 60 days from revenue; after that, the company has to take an

additional accounting charge related to the payments.

Groupon’s restatement is partially a consequence of the “Groupon Promise” feature of its business

model. The company pledges to refund deals if customers aren’t satisfied. Because it had been selling those

deals at higher prices — which leads to a higher rate of returns — it needs to set aside larger amounts to

account for refunds, something it had not been doing. It is an example of Groupon failing to accurately

account for a part of its business that reduces its financial performance.

The financial problems escalated after Groupon released its third-quarter 2012 earnings report, marking

its first full-year cycle of earnings reports since its IPO in November 2011. While the net operating results

showed improvement year-to-year, the company still showed a net loss for the quarter. Moreover, while its

revenue had been increasing in fiscal 2012, its operating profit had declined over 60 percent. This meant

that its operating expenses were growing faster than its revenues, a sign that trouble may be lurking in the

background. The company’s stock price on NASDAQ went from $26.11 per share on November 5, 2011,

the end of the IPO day, to $4.14 a share on November 30, 2012, a decline of more than 80 percent in one

year. The company did not meet financial analysts’ expectations for the third quarter of 2012.

Groupon’s fourth quarter 2012 results show a revenue increase to $638.8 million but with an operating

loss of $12.9 million and a loss per share of 12 cents, falling short of analyst expectations on the EPS front

– they had predicted $638.41 million in revenue and EPS of $0.03. The Groupon share price has recovered

somewhat to $7.65 on June 14, 2013.

Groupon blamed the disappointing results on its European operations. Some analysts took solace in the

fact that Groupon reported it has 39.5 million active customers, an increase of 37 percent from the previous

year. But, what good does it do to have a larger customer base if it also leads to larger-than-expected

operating costs?

Problems with Internal Controls

As Groupon prepared its financial statements for 2011, its independent auditor, Ernst & Young (EY),

determined that the company did not accurately account for the possibility of higher refunds. By the firm’s

assessment, that constituted a “material weakness.” Groupon said in its annual report, “We did not

maintain effective controls to provide reasonable assurance that accounts were complete and accurate.”

This means other transactions may be at risk since poor controls in one area tend to cause problems

elsewhere. More important, the internal control problems raise questions about the management of the

company and its corporate governance. But Groupon blamed EY for the admission of the internal control

failure to spot the material weakness.

In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon accusing the

company of misleading investors about its financial prospects in its IPO and concealing weak internal

controls. According to the complaint, the company overstated revenue, issued materially false and

misleading financial results, and concealed the fact that its business was not growing as fast and was not

nearly as resistant to competition as it had suggested. These claims bring up a gap in the sections of the

SOX that deal with companies’ internal controls. There is no requirement to disclose a control weakness in

a company’s IPO prospectus.

The red flags have been waving even before the company went public in 2011. In preparing its IPO, the

company used a financial metric it called “Adjusted Consolidated Segment Operating Income”. The

problem was that figure excluded marketing costs, which make up the bulk of the company’s expenses. The

net result was to make Groupon’s financial results appear better than they actually were. After the SEC

raised questions about the metric — which The Wall Street Journal called “financial voodoo” — Groupon

downplayed the formulation in its IPO documents.

In an updated filing with the SEC, Groupon said it is working to “remediate the material weakness,” in

its internal financial reporting controls, and will hire “additional finance personnel.” But it warned: “If our

remedial measures are insufficient to address the material weakness, or if additional material weaknesses or

significant deficiencies in our internal control over financial reporting are discovered or occur in the future,

our consolidated financial statements may contain material misstatements and we could be required to

restate our financial results.”

Questions

1. What is the responsibility of management and the auditor with respect to the internal controls of

a client?

Internal control is a process which aids a firm in providing reasonable assurance towards the achievement

of its objectives of reliability of financial reporting, effectiveness and efficiency of operations, and

compliance with applicable laws and regulations. Management is responsible for designing, implementing

and maintaining internal controls. Auditors test internal controls designed to safeguard a firm’s assets to

2. Groupon disclosed a “material weakness” in its internal controls saying that it had failed to set

aside enough money to cover customer refunds. Do you believe the company engaged in fraud

with respect to customer refunds? Why or why not?

Groupon should have treated customer refunds like a warranty expense; i.e., at the time of revenue

recognition, an amount for customer refunds would have been estimated and recorded. It is possible the

Groupon did not have the history, assumptions, or forecasts to have a reasonable estimate of customer

refunds, particularly for large dollar items like laser eye surgery. It is also possible the Groupon’s success

3. Groupon blamed EY for the admission of the internal control failure to spot the material

weakness. Do you agree that EY should have spotted the internal control weakness earlier and

taken appropriate action? Include in your response the role that risk assessment should have

played in EY’s actions.

The material weakness of internal controls with respect to the refunds was noted by the company and EY

for the 2011 financial statements. The company had been in existence for three years and EY had been their

auditors the entire time. The 2008, 2009, and 2010 audits all have standard, unmodified opinions from EY.

Thus, if EY was aware of the weakness in those years, it was not serious enough to quality the audit

Optional Question

4. According to Groupon, the merchants are responsible for fulfilling the obligation to deliver the

goods and services. Groupon disclosed that fact and the following statement in its restated

financial statements. “We record the gross amount received from Groupon, excluding taxes

where applicable, as the Company is the primary obligor in the transaction, and records an

allowance for estimated customer refunds on total revenue primarily based on historical

experience…the Company also records costs related to the associated obligation to redeem the

award credits granted as issuance as an offset to revenue.”

Review SEC Staff Accounting Bulletin (SAB) 101 (Question 10) and Emerging Issues Task Force

(EITF) pronouncement 99-19 using the links provided below and evaluate whether Groupon’s

accounting for the allowance referred to above met GAAP requirements.

SAB 101 – Revenue Recognition in Financial Statements

http://www.sec.gov/interps/account/sab101.htm

EITF No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent

http://www.fasb.org/cs/BlobServer?

blobkey=id&blobwhere=1175820914023&blobheader=application

%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Question 10 of SAB 101 looks at a company (e.g., Groupon) operating an internet site from which it will

sell other companies’ products. Customers place their orders for the product by making a product selection

directly from Groupon’s internet site and providing a credit card number for the payment. Groupon receives

The response was that a company (e.g., Groupon) should report the revenue from the product on a net

basis. In assessing whether revenue should be reported gross with separate display of cost of sales to arrive

at gross profit or on a net basis, the staff considers whether the registrant:

1. Acts as principal in the transaction,

2. Takes title to the products,

EITF 99-19 further discusses the issue of SAB 101 of when a company should report revenue based on (a)

the gross amount billed to a customer because it has earned revenue from the sale of the goods or services

The indicators of gross revenue reporting are:

The company is the primary obligor in the arrangement

The company has general inventory risk (before customer order is placed or upon customer return

The company has latitude in establishing price

The indicators of net revenue reporting include:

The supplier (not the company) is the primary obligor in the arrangement

The amount the company earns is fixed