GROUPON: STILL ACCOUNTING CHALLENGED

Groupon has suffered through several financial restatements, revisions of its revenues, SEC criticism of its non-GAAP performance metrics, internal control weaknesses over financial reporting, and public critiques of its reported operating cash flows.  One would have thought that Groupon might have learned its lesson about the importance of accounting quality and financial reporting transparency.  But no!  The Company’s latest 10-Q suggests that financial reporting quality remains less than stellar and that management has not learned its lessons.  The stock market has added its exclamation point as the price has dropped to all time lows.

What’s our beef this time?  The Company appears to have gone to great lengths to achieve profitability in the second quarter of 2012.  In addition to the goodwill and income tax accounting issues that we first raised in Groupon’s First 10-K: Looking Under the Hood, poor Company disclosures in two areas now have caught our eye: the gain recognized on an E-Commerce transaction (10-Q, p. 14) and direct revenue recognition (10-Q, p. 10). In fact, one of the Grumpies highlighted these issues in a brief chat with Reuters.TV shortly after the Company’s earnings release on August 13^th.

Gain on E-Commerce Transaction

 Here is today’s daily deal.  Groupon exchanged an ownership interest in E-Commerce King Limited, a Chinese investment, for one that appears to be in substance very similar to that given up.  Specifically, Groupon gives up a 49.8 percent interest in E-Commerce plus $25 million, and receives in return a 19 percent interest in F-tuan (Life Media, another Chinese investment).  The transaction is booked as follows:

While the bookkeeping entry is the correct way to handle the disposition of an investment, it raises several questions, and is valid only if the inputs are appropriate.

First, what is the purpose of the transaction?  You will notice that the Company’s 10-Q provides no insights whatsoever as to the real business purpose of the transaction… we wonder whether there is any real economic reason for it.  Groupon did say in a June 27^th Bloomberg report that the transaction is part of the Company’s strategy to “strengthen” its investment in China.  We thought that was why Groupon had a 49.8 percent investment in E-Commerce King Limited.

Second, while the bookkeeping entry is correct, it is correct only if the inputs are accurate, and the value of the asset received depends heavily on its fair value measurement.  In footnote 10 the company indicates that it measured this asset “using the income approach … due to the lack of relevant observable inputs and market activity.”  Given the company’s need to generate profits, we are worried that the valuation estimate of this Chinese investment might be overly optimistic.  And we won’t even get into recent problems with accounting and auditing in China…

Third, the timing of the transaction raises a question about management’s real motivation.  Just as the second quarter is ending, Groupon seems to buy a $56 million gain.  Was this business strategy or accounting strategy?

As an aside, is the investment community so naïve as to believe that Groupon’s 19 percent ownership was not purposefully structured to avoid the “significant influence” criteria for equity method accounting?  Could Groupon be trying to avoid booking the annual losses that historically have been incurred by E-Commerce?  Remember that equity method investees have been consistent losers for the Company—just look at the income statement.  But with this “transaction,” Groupon not only gets a huge gain this quarter, but postpones investment losses in the future by claiming no significant influence!

Direct Revenue Recognition

 What’s the issue here?  Well, the Company’s recent foray into the Groupon Goods channel has prompted it to add a revenue category where it now recognizes revenue on a “gross” basis, rather than “net”, because it is now the primary obligor given its assumption of inventory risk and control over price setting (footnote 1).  Our question is where’s the beef, or rather, where’s the inventory?  We sure don’t see any on the balance sheet!

And the Company’s inventory Risk Factor discussion (10-Q, p. 52) makes us wonder more about this new accounting treatment. Groupon indicates that (bold italics added for emphasis):

 We are subject to inventory management and order fulfillment risk as a result of our Groupon Goods business. We purchase some of the merchandise that we offer for sale to our customers…In addition, this is a new business for us, and therefore we have a limited historical basis upon which to predict customer demand for the products. If we are unable to adequately predict customer demand and efficiently manage our inventory, we could either have an excess or a shortage of inventory, either of which would have a material adverse effect on our business.

 So, if the Company has an inventory management system, where’s the inventory?  And more troubling is that only “some” of the inventory is purchased…if so, is it proper then to record all sales at “gross?”  We think you know the answer.  And of course, what’s the rush to break out this new revenue line item and accounting method?  The direct revenue reported accounts for only 7.5 percent of total revenue for the six months ended June 30, 2012.  Could it have anything to do with the pressures the Company is undoubtedly feeling to report a profit?

Recurring Accounting Problems

 Previously, in Groupon’s First 10-K: Looking Under the Hood, and Groupon’s Feeble Tax Assets: We Told You So…Again!, we warned you of forthcoming deferred tax asset quality problems.  Well, it happened again.

In case you hadn’t noticed, Groupon reported an effective tax rate of 66.6 percent for the quarter ended June 30, 2012 (10-Q, 24).  Why?  According to the Company, it will not be able to benefit from tax losses capitalized as deferred tax assets…no surprise there, as you need taxable income in order to use those assets, and the Company has yet to prove that it can create any taxable income on a consistent basis.  So, Groupon had to record a valuation allowance, just as it did in the first quarter of 2012, which increased income tax expense.

Then there is the looming write-off catastrophe called intangible impairment!  About 37 percent of the Company’s non-cash assets are intangible in nature (i.e., goodwill, identifiable intangibles, and deferred taxes).  Given the firm’s inability to generate taxable income or excess returns, we wonder about the intangibles, especially goodwill.  Intangibles are easy to add via acquisitions— in the second quarter Groupon created $28.7 million in goodwill and $19.5 million in identifiable intangibles—but they equally are easy to impair.  If this business enterprise does not increase values soon, these assets will generate expenses instead.

And of course, there’s the usual cast of characters in the 10-Q: flaky non-GAAP performance metrics and cash flow reporting, including Merchant Payables that should be reported as a financing item.

Maybe Peter Cohan is right—maybe the SEC should improve Groupon’s accounting, and shut down this ridiculous circus sideshow.  So far the Company is too accounting challenged to be left alone.