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Case 5-10 Groupon The Groupon case was first discussed in Chapter 3. Here, we expand on the discussion of internal controls and the risk of

Case 5-10 Groupon

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, 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.

Page 335Groupon 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. Between June 2009 and June 2010, revenues grew to $100 million. Then, between June 2010 and June 2011, revenues exploded tenfold, reaching $1 billion. In August 2010, Forbes magazine labeled Groupon the worlds fastest growing corporation. And that did not hurt the companys valuation when it went public in November 2011.

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 percent 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. 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 had failed to set aside enough money to cover customer refunds. The accounting issue increased the companys 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 that the company used to calculate its results. In particular, the company said that 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.

Groupons restatement is partially a consequence of the Groupon Promise feature of its business model. The company pledges to refund deals if customers arent satisfied. Because it had been selling those deals at higher priceswhich leads to a higher rate of returnsit needed to set aside larger amounts to account for refunds, something it had not been doing.

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. 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 might be lurking in the background. The companys 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.

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 percent 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 Page 336be 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. 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 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 red flags had been waving even before the company went public in 2011. In preparing its IPO, the company used a financial metric that it called Adjusted Consolidated Segment Operating Income. The problem was that that figure excluded marketing costs, which make up the bulk of the companys expenses. The net result was to make Groupons financial results appear better than they actually were. In fact, a reported $81.6 million profit would have been a $98.3 million loss had the marketing costs been included. After the SEC raised questions about the metricwhich The Wall Street Journal called financial voodooGroupon downplayed the formulation in its IPO documents.

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:

In two to three pages, supported by evidence from your text and from other research (at least one resource is required), answer the following questions:

  1. What is the responsibility of management and the auditor with respect to the internal controls of a client?
  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?
  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 EYs actions.

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