A few months ago, I wrote about how Groupon had been using a non-GAAP accounting metric, “adjusted consolidated segment operating income” (CSOI), to explain its past performance — a practice the online coupon company has since given up. Well, Groupon’s questionable accounting practices are back in the news: A few days after the company launched its initial public offering on 4 November with just a 5.5% float, the second smallest of any IPO in the past ten years, the Wall Street Journal reported that many merchants are dissatisfied with how slowly Groupon disperses payments, a practice that can make a company’s cash position look stronger on its books.
Have you heard that song performed by the Propellerheads and Shirley Bassey titled “History Repeating”? It goes something like this:
They say the next big thing is here
That the revolution’s near
But to me it seems quite clear
That it’s all just a little bit of history repeating
Groupon’s accounting practices certainly have a familiar ring. Remember a decade ago when MicroStrategy shares collapsed after the company was forced to restate its books? Remember the dot.com bubble? Back in the late 1990s and early 2000s, a number of companies ran afoul of the Securities & Exchange Commission and were forced to restate their financial statements because of overly aggressive revenue recognition.
The online coupon company seems to have headed down this same path. On 23 September, the company announced that it would change the way that it accounts for revenue after discussions with the SEC. (Wouldn’t you have liked to have been a fly on that wall?) Previously, the company not only recognized as revenue the commissions it received on sales of coupons/gift certificates, but it also recognized the total value of those coupons and gift certificates. On a going-forward basis, Groupon agreed to report only its commissions as revenue. This move reduced its reported revenue for the three months ending 31 March 2011 by almost 50%, from $713.4 million to $312.9 million.
Now that’s a haircut!
Historically, revenue recognition has often been a source of controversy, especially for companies that are planning to go public. In the somewhat crude parlance of financial statement preparers, “Revenue recognition issues are to the technology and biotechnology industries what acne is to teenagers — part of growing up!”
That’s because revenue is the first line item on the income statement, and it is the primary determinant of a company’s profitability. As a result, companies — especially those searching for new investors — are under intense pressure to report robust revenue growth. That is particularly true, as the New York Times’ Andrew Ross Sorkin recently pointed out, of companies like Groupon that carry a working capital deficit. In Groupon’s most recent SEC filing, the company reported a 1,367% increase in revenue for the three months ending 31 March 2011 versus the same period in 2010. Unfortunately, during the same period, its growth margin declined from 45.1% to 41.9%.
Given that Groupon isn’t the first company — nor is it probably the last — to engage in questionable accounting practices shortly before going public, what are analysts and investors to do?
For starters, go back to basics. Any analyst worth his or her salt must read a company’s SEC filings carefully. As the Groupon filing states, “Revenue primarily consists of the gross amount paid by customers for purchased Groupons, excluding any applicable taxes, less customer refunds and obligations related to credits earned for customer loyalty and reward programs.” The company goes on to disclose: “We believe gross profit is an important indicator for our business because it is a reflection of the value of our service to our merchants. Gross profit is influenced by the mix of deals we offer. For example, gross profit can vary depending on the category of product or service offered in a particular deal. Likewise, gross profit can be adversely impacted by offers that we make for the principal purpose of acquiring new subscribers or establishing our brand and building scale in a new market.” The company attributes the decline in gross margin to the “mix of offered deals and their offer of several national deals to generate revenue and increase brand awareness.”
Investors should, of course, approach financial statements with a healthy dose of skepticism. We can’t just “eat what companies are feeding us.” Instead, we must scrutinize, analyze, and interpret what company executives are putting on our plate, and conduct both a smell test and a taste test. Below are links to some good articles on revenue recognition and related accounting issues that all financial analysts should keep top of mind as they search for the next Google.
- Revenue Recognition Fraud or Error – The Case of MicroStrategy, Inc.: A case study on the revenue recognition issues at MicroStrategy.
- A Jittery Public Appears Unforgiving about Revenue Management Missteps: Robert O’Conn, president and CEO of Softrax Corporation, discusses how proper revenue recognition can be particularly challenging for tech companies.
- Evaluating Financial Reporting Quality: Scott Richardson and Irem Tuna offer a primer on interpreting warning signs of potential problems in financial reporting.
- Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports: In this webcast, Howard Schilit discusses seven earnings manipulation shenanigans and points to specific examples of how companies use financial statements to disguise economic reality.
- Identifying Accounting Shenanigans: In this short video, Howard Schilit reviews a few cases of accounting fraud and discusses techniques on how to identify accounting irregularities.