IS GROUPON “COOKING ITS BOOKS?”

Our recent commentaries on the state of Groupon’s financial reporting have been greeted by many investors and journalists with disbelief, particularly our concerns about revenue recognition improprieties (see Trust No One, Particularly Not Groupon’s Accountants).  Moreover, why should anyone lend much credence to the ravings of a couple of “grumpy old accountants?”  Historical perspective is why!  Our advancing years have yet to erase our memories of past financial reporting tragedies, and the detective frameworks and tools that evolved from them.  And, not surprisingly, several of these “techniques” suggest that Groupon may indeed be cooking its books!

A decade ago in the July-August 2001 issue of the Harvard Business Review, H. David Sherman and S. David Young in their article “Tread Lightly Through These Accounting Minefields,” warned of several characteristics common to companies that manipulate their financial reporting.  They assert that companies that exhibit these factors should be scrutinized closely for the quality of their financial reporting practices.  Not surprisingly, most of these can be found in Groupon:

• High-growth companies entering a low-growth phase.  Many that follow the “daily deals space” now question not only the viability of Groupon’s business model, but also the “online discount-site craze.”  As Groupon continues its IPO efforts, the Company clearly has incentives to dress its revenue numbers up, particularly in the face of slower or declining market growth.
• Companies that receive extensive coverage in the business and popular press. The idea here is that when problems attract widespread media attention (e.g., Groupon’s ACOSI issue, etc.), Company managers feel pressure to “manage” reported amounts which otherwise might disappoint the markets. In Groupon’s case, it seems as though a day does not go by without CEO Andrew Mason in the news touting improved performance.
• New businesses where there are ambiguities about how key transactions are and should be measured.  Sherman and Young actually single out Internet sector businesses as those where the accounting may be ambiguous, thus providing an increased opportunity for manipulation.  Hence our concerns about Groupon’s gross revenue recognition.  And let’s not forget, the Company’s prideful assertions of uniqueness:

  We are unusual and we like it that way…we don’t measure ourselves in conventional ways (S-1, pages 31 and 32).

• Weak control environments in which managers can manipulate reported financial results with relative impunity. In a previous piece, we raised concerns about the quality of Groupon’s internal controls given the Company’s rapid and global growth, coupled with the absence of an internal control audit by Ernst & Young.  This is a very serious problem affecting the quality of Groupon’s reported numbers.
• Companies with complex ownership and financial structures.  Related party transactions often signal conflicts of interest which in turn create pressures for less than transparent financial reporting.  And how does Groupon stack up on this dimension?  Not well.  Just check out note 14 to its audited 2010 financial statements for a laundry list of potential conflicts.

The accuracy and transparency of Groupon’s financial statements clearly is suspect.  And we have not even evaluated the Company using the Fraud Risk Factors outlined in the Appendix to AICPA’s Statement on Audit Standards (SAS) No. 99.  So what’s the big deal?  We are worried that these risk factors are prevalent with Groupon, that all!  According to the Association of Certified Fraud Examiners “financial statement fraud involves the intentional publishing of false information in any portion of a financial statement.”

Up to this point, our arguments have been largely qualitative supported by actual Groupon examples.  Now, however, we will let the Company’s financial statements speak for themselves.  In the September/October 1999 issue of the Financial Analysts Journal, Messod Beneish described an eight variable statistical model that uses financial statement accounting information to detect the likelihood of earnings manipulation.  Beneish’s eight factors and the rationale for their use follow:

• Days Receivables Index. This index relates the ratio of accounts receivable at the end of the current year as a percentage of sales for the current year to the corresponding amounts for the preceding year. An increase in this metric can signal aggressive revenue recognition.
• Gross Margin Index.  This index relates gross margin (i.e., sales less cost of goods sold) as a percentage of sales last year to the gross margin as a percentage of sales in the current year.  An increase in this metric signals declining gross margins, and firms with decreasing margins are considered more likely to engage in earnings manipulation.
• Asset Quality Index. This index equals the proportion of lower-quality assets during the current year relative to the preceding year.  Lower quality assets are defined as total assets less current assets, PP&E, and investment securities.  An increase in this metric might suggest efforts to capitalize and defer costs which should have been expensed.
• Sales Growth Index. This index equals sales of the current year relative to sales of the preceding year.  Since growing companies usually rely on external financing to fuel their growth, the need to access capital markets (an IPO in Groupon’s case) can motivate managers to inflate revenues and earnings.
• Depreciation Index. This index equals depreciation expense as a percentage of net PP&E before depreciation for the preceding year relative to the corresponding percentage for the current year.  An increasing metric suggests a slowing in the depreciation rate, thereby increasing earnings.
• Selling & Administrative Expense Index. This index equals selling and administrative expenses as a percentage of sales for the current year relative to the corresponding percentage for the preceding year.  Firms attempting to manipulate earnings would defer costs, and the index value would be less than 1.0, and the coefficient on the variable would be negative.
• Leverage Index. This index equals the proportion of total financing comprising current liabilities and long-term debt for the current year relative to the proportion for the preceding year.  An increase in the metric subjects a firm to a greater risk of violating debt covenants and the need to manipulate earnings to avoid a breech.
• Total Accruals to Total Assets. Total accruals equals the difference between income from continuing operations and cash flow from operations.  Dividing total accruals by total assets at the end of the year scales total accruals across firms and time.  A large accrual metric indicates the possibility that accruals are being used to manipulate earnings.

This model is widely recognized as a useful tool in identifying companies engaged in fraudulent financial reporting. So, what happens when we use the Amended S-1 financial statement data in the Beneish model?  You guessed it…nothing good!  In fact, the below table shows that Groupon has a 100% probability of earnings manipulation based on 2009 and 2010 financial data.

What drives this virtual certainty of massaging the accounting numbers?  The primary factor is the Company’s meteoric growth in revenues, evidenced by Sales Growth Index.  Beneish notes that financial professionals view growth companies as more likely to commit financial statement fraud because their financial positions and capital needs put pressure on managers to achieve earnings targets.  Also, there are the previously mentioned concerns about controls and reporting quality due to the rapid growth. 

The second major contributing factor to the perfect score manipulation probability is the high Asset Quality Index (note that high is not good) which is due to the dramatic increase in goodwill, intangible, and deferred tax assets.  There are significant valuation concerns associated with all of these “imaginary assets” which we previously discussed (see Groupon: Comedy or Drama?).  So management has incentives to defer write-downs to inflate earnings.

Last, but not least, there is the high Days Receivable Index which suggests possible aggressive revenue recognition.

So, there you have it: qualitative and quantitative evidence that Groupon is likely “cooking its books!”  So why isn’t anybody listening to us?  Two explanations come to mind.  The first is Escalation of Commitment.  The venture capital firms invested in Groupon simply cannot give up.  Surely, you’ve heard of “throwing good money after bad?”  That’s escalation of commitment: a phenomenon where people justify increased investment in a decision, based on the cumulative prior investment, despite new evidence suggesting that the cost of continuing the decision outweighs the expected benefits.

Also, market participants today seem more impressed with the “sexy” marketing pitches of venture capital investors like those investing in Groupon who stand to make millions if they can just figure out a way to take this Company public…any way.  If only the darn accountants wouldn’t read the registration statement!

Surely, now you can understand our “grumpiness”…we have seen this play before and we know exactly how it will end.  We aren’t getting our handkerchiefs out when the tears start flowing.

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.