Case 5-10 Groupon Groupon is a deal-of-the-day recommendation service for consumers. Launched in 2008, Groupona fusion of the words group and couponcombines 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 obtain deep discounts on products in local stores using e-mailed coupons, huge numbers of people started buying. Revenues were reported as $14.5 million in 2009, $312.9 million in 2010, and $1.6 billion in 2011. At the same time, the company had a net loss from operations of $1.0 million, $420.3 million, and $233.4 million, respectively, in those same years. The cause of the huge losses was acquisition-related costs and marketing costs. On November 5, 2011, Groupon took its company public with a buy-in price of $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%. 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. However, after disclosures of fraud and increased competition from the likes of AmazonLocal and LivingSocial, its value had dropped to about $6 billion. 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 needed to increase the refund reserve accrual to reflect a shift in the Companys fourth quarter 2011 deal mix and higher price point offers, which have higher refund rate, such as laser eye surgery. Groupon failed to set aside enough money to cover customer refunds. The news that day sent shares of Groupon tumbling 6%, to $17.29.

The following information was disclosed in Groupons December 31, 2011 Form 10K Report.1

We concluded there is a material weakness in the design and operating effectiveness of our internal control over financial reporting. We did not maintain financial close process and procedures that were adequately designed, documented and executed to support the accurate and timely reporting of our financial results. As a result, we made a number of manual post-close adjustments necessary in order to prepare the financial statements included in this Form 10-K. We did not have adequate policies and procedures in place to ensure the timely, effective review of estimates, assumptions and related reconciliations and analyses, including those related to customer refund reserves. As noted previously, our original estimate disclosed on February 8 of the reserve for customer refunds proved to be inadequate after we performed additional analysis.

The financial problems escalated after Groupon released its third-quarter 2012 earnings report, marking its first fullyear cycle of earnings reports since its IPO. 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%. This meant that its operating expenses were growing faster than its revenues, a sign that trouble might be lurking in the background. The companys stock price on NASDAQ dropped to $4.14 a share on November 30, 2012, a decline of more than 80% in one year. The company did not meet financial analysts expectations for the third quarter of 2012. There had been other oddities with Groupons accounting that reflected a culture of indifference toward GAAP and its obligations to the investing public. It reported a 1,367% increase in revenue for the three months ending March 31, 2011 versus the same period in 2010. It admitted to recognizing as revenue commissions received on sales of coupons/gift certificates, but also recognized the total value of the coupons and gift certificates at the date of sale. 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 firms 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 meant that other transactions could be at risk because poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raised questions about the management of the company and its corporate governance. 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 identified a gap in the sections of SOX that deal with companies internal controls. There is no requirement to disclose a control weakness in a companys IPO prospectus. The complaint does not name Groupons accounting firm, Ernst & Young, which noted in the 10-K filing that Groupon has a material weakness in its internal controls related to financial reporting.

Groupons 10-K filing revised the figures executives had presented during the companys February 2012 earnings call. The revision shaved $14.3 million off fourth-quarter revenue (the new total was $492 million). The companys stock fell on the news, dropping to $15.28 per share by the end of trading Monday. That price was down from the $26.11 per share close on the day of Groupons initial public offering last November. Groupon reported the weakness in its internal controls through a Section 302 provision in SOX that requires public companies top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The company seems to have concluded that the internal control shortcoming was serious enough to treat as an overall deficiency in disclosure controls rather than pointing it out in its report on internal controls that is required under Section 404. EY expressed no opinion on the companys internal controls in its audit report, which makes us wonder whether it was willing to stand up to Groupons management on the shortcomings in its internal controls and governance. In fact, the firm signed clean audit opinions for four years.

Questions

1. Does it matter that Groupon reported its weakness in internal controls as a disclosure control under SOX Section 302 rather than pointing it out in its report on internal controls under Section 404? Explain.

2. Describe the risks of material misstatements in the financial statements that should have raised red flags for EY.

3. According to a 2012 survey of 192 U.S. executives conducted by Deloitte & Touche LLP and Forbes Insights, social media was identified as the fourth-largest risk, on par with financial risk.2 This ranking derives from social medias capacity to accelerate to other risks, such as financial risk associated with disclosures in violation of SEC rules, for example. Other risks inherent to social media include information leaks, reputational damage to brand, noncompliance with regulatory requirements, and third-party and governance risks.

a. Why is it important for a firm such as EY, in a case such as Groupon, to fully understand the nature of risk when a company conducts its business online?

b. What role can internal auditors play in dealing with such risks?

c. How should external auditors adapt their risk assessment procedures for social media/networking clients?