After years of gangbuster growth, Groupon has had a difficult past few months. Revenue growth has been flat. Their COO left for Google after just five months with the company. CEO Andrew Mason caught flack for his internal memo—which was promptly leaked—that violated the SEC mandated quiet period that precedes an IPO. And speaking of the IPO, the date has been pushed back more than once. On top of it all, the company has tried to introduce a series of, ahem, non-standard accounting practices.
Anup Srivastava, an assistant professor of accounting information and management who teaches a course on securities analysis (FINC-463), detailed for me the many ways Groupon configures its balance sheet to produce apparent profits instead of losses. Among them is the most public accounting issue—the insistence that customer acquisition costs not be included in revenue calculations. “By excluding customer acquisition costs, Groupon tried to have its cake and eat it, too,” Srivastava said. Groupon also reports revenue from the entire price of a deal, not the amount it nets. So though Groupon’s cut of a $30 deal may only be $15, they report the entire $30. These two representations—along with others—portray the startup as having higher revenue than generally accepted accounting principles (GAAP) would otherwise report.
With Groupon’s IPO set for November 4, Srivastava’s take of the company’s accounting practices offers prospective investors some sobering perspective. Read on for the complete Q&A.
What were the problems with Groupon’s accounting?
Groupon’s accounting had two problems. First, it violated well established revenue-recognition principles. This by itself does not alter the bottom-line numbers. Groupon compounded its problems by providing a distorted picture of its operating performance, in order to show operating profits when it actually incurred operating losses.
What was this revenue-recognition problem?
Think of Walmart, Amazon, and eBay. Neither firm sells goods that it produces. Standard setters have long grappled with the issue of revenue-recognition of these firms. Whether revenue is the gross amount billed to the customer, because it has earned revenue from the sale of the goods or services, or the net amount retained, that is, the amount billed to a customer less the amount paid to a supplier. The issue is especially important for firms that do not stock inventory and simply arrange for third-party suppliers to provide goods and services. This issue became especially important during the internet boom in the late 1990s, when many start-up firms attempted to show large revenues, when they, at best, were earning small referral fees.
Revenue recognition standards, such as SAB 101, EITF 99-19, EITF 00-25 provide strict guidelines for revenue recognition in such cases. A firm may recognize revenues on a gross basis, if it acts as principal in the transaction, takes title to the products, has risks and rewards of ownership. Groupon’s business model does not comply with these conditions. If Groupon had purchased those coupons from vendors and assumed risks of unsold coupons, it might report revenues on a gross basis.
Let us go back to the example of Walmart, eBay, and Amazon. Walmart owns almost all the inventory it sells. Ebay owns none. Amazon falls in between the two firms. eBay reports revenues on the commissions it received from third party vendors that sell goods using eBay platform. Amazon follows a two-fold policy. It reports gross revenues for the goods, when it is the primary party obligated in a transaction, is subject to inventory risk, and has latitude in establishing prices and selecting suppliers. Otherwise, Amazon records net amounts as revenues.
Why should we care about revenues if it does not affect bottom-line metric of earnings?
Revenue is often the single-largest item on firm’s financial statements. Revenue portrays a firm’s size and growth prospects. Both size and growth are important metrics for a start-up firm’s valuation perspective. Size conveys whether a firm has reached a minimum size, has established economies of scale and scope, and has created a barrier to entry by its sheer size. At the margin, lenders, creditors, and lessors prefer to extend credit to large firms that are not mom-and-pop stores. Vendors and employees prefer to deal with large firms in an economy characterized by uncertainty.
Revenue also conveys the size of market. For example, eBay’s potential market size is not the value of goods its sells, which can potentially be a country’s GDP, but the size of online commission’s market.
For a loss making firm, investors often use revenue multiple to estimate a firm’s value. Note that many start-ups incur loss.
By recognizing revenues on a gross basis, Groupon was able to show much larger firm size, much larger market size, and much higher growth potential. For example, for second quarter of 2011, its net revenue was $393 million and its gross revenue was $929 million. In other words, its net revenue is less than half of its gross revenue.
How did Groupon misrepresent its operating performance?
Groupon claims that its business should be measured using revenue and “consolidated segment operating (loss) income (CSOI)”. I have already shown above that it was misrepresenting its revenues. It was also misrepresenting its operating performance. It tried to convey that it was earning operating profits, when, in reality, it was incurring operating losses.
For example, in the first quarter of 2011, it had an operating loss of $117,000. It added back its customer acquisition costs and stock-option compensation to show an operating profit of $81,000. I will not comment on the stock-option compensation because I do not trust accounting of firms that do not believe stock-options should be expensed. Wouldn’t they pay their employees salary otherwise? Wouldn’t that be expensed?
By excluding customer acquisition costs, Groupon tried to have its cake and eat it to. It counted revenues from its new customers (as it should), and used that revenue to show growth, but did not show customer-acquisition costs as operating costs.
Are there any other revenue-recognition issues that are of potential concern?
Groupon currently offers various subscriber loyalty and reward programs to customers. When subscribers provide a referral to a new subscriber or participate in promotional offers, Groupon grants the customer credits that can be redeemed for awards such as free or discounted goods or services in the future. Groupon currently accrues for such costs and does not deduct those amounts from its revenues. I believe that this may not be a correct accounting policy. Note that eBay offers similar incentives to drive traffic to their website. eBay provides incentives to its users in the form of coupons and buyer and seller rewards. These incentives are treated as reductions in revenue.
Any other concerns?
The firm’s business model concerns me. It has 115 million subscribers. Of those, only 23 million have ever purchased from the firm, implying that approximately 80 percent have never purchased from the firm. Of those 23 million, only 12 million have purchased more than once, implying that approximately half have purchased only once, arguably taking advantage of a great one-time offer. My concern is that firm’s revenues represent “loss-leader” sales. There is no customer loyalty and hardly any barrier to entry in this business. I teach equity valuation at the Kellogg School. I would not value this firm at $40 billion, as the firms’ founders once expected.
Photo by swanksalot.