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. 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 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 $1 billion. 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 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! 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 billionapproaching 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 has come under scrutiny for some of their 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 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. 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 priceswhich leads to a higher rate of returnsit needed to set aside larger amounts to account for refunds, something it had not been doing. It is an example of Groupon failing to account accurately 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 frontthey had predicted $638.41 million in revenue and EPS of $0.03. The Groupon share price has recovered somewhat to $7.65 per share on June 14, 2013. Groupon blamed the disappointing results on its European operations. Some analysts took solace in the fact Page 334that Groupon reported that 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 because 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 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 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 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 metricwhich The Wall Street Journal called financial voodooGroupon downplayed the formulation in its IPO documents. In an updated filing with the SEC, Groupon said that 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.

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