Groupon’s coupons, Botox and revenue

I posted about Groupon’s difficulty figuring out how to record revenue 18 months ago.  It got its knuckles rapped then and, as I mentioned in my latest post on Livent, revenue recognition is a common problem in accounting errors and frauds.  Groupon has some tricky revenue to sort out, its not exactly clear to many people what Groupon sells.  Do it simply broker transactions between the customers paying for the coupons and the restaurants, spas, and Botox providers or does it do more than that?  

In the financial reporting world we refer to this as the “principal versus agent” (or “gross versus net”) revenue recognition problem.  For instance, assume Groupon sells you a coupon that you pay $10 for.  Further, assume that Groupon pays $8 of the $10 to the Botox provider.  Should Groupon record revenue of $10 and cost of sales of $8 for net income of $2?  Or should they record revenue of $2 and net income of $2?  A simple view of this says, “Who cares!?  Net income is the same under both approaches!”  But it does matter.  It affects things like revenue growth rates and gross profit margins.  Investors care about those sorts of things.

This is a tricky area and has caught many large businesses including Ebay and Amazon.  IFRS, particularly IAS 18: Illustrative example #21, deals with exactly this type of revenue and reporting dilemma and is very similar to US GAAP (EITF N0. 99-19) which Groupon reports under.  Answering “yes” to most of the key factors from that standard determine whether Groupon should record the gross or net revenue.  The key criteria are:

  1. Does Groupon have any inventory and inventory risk? (In my opinion, no),
  2. Does Groupon establish the selling price? (In my opinion, perhaps),
  3. Does Groupon have the primary responsibility for providing the spa or Botox treatment? (In my opinion, no).
Groupon used to report their revenue using the gross method, that is the $10 of revenue and $8 of costs.  After getting its hands slapped 18 months ago, it seems that it adjusted its revenue recognition policies.  The income statement (or statement of operations) below indicates that Groupon earned $1.8 Billion in revenue from coupon sales (third party transactions) and only recorded $297 Million in related costs.  That very high gross profit suggests that they are recording net revenue, that is the $2.

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To really figure this out though we need to dive deep into Groupon’s financial statement notes, particularly Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73 which is copied below for easy reference.  Look carefully at the third paragraph, particularly the portion I’ve highlighted for you.  Groupon now records the net revenue, that is just the $2 (based on the $10 it initially receives from the customer less the $8 it submits to the merchant/Botox provider).  The final sentence of that paragraph clearly explains that the revenue recognition policy is based on the interpretation that Groupon is simply an agent, matching buyers and sellers.  That is completely consistent with my brief analysis of Groupon’s business model using the criteria from IAS 18.

The final thing I will point out is in the fourth paragraph and highlighted for you as well – Groupon loves it when you buy a coupon and don’t ever redeem it.  You lose the coupon, they win.  You forget about the coupon, they win.  It reminds me of the gift card scam, millions of dollars of gift cards expire and the retailers love it.

Finally, I will point out that I have nothing against Groupon although I’ve personally never bought a Groupon coupon.  Perhaps when I need a Botox injection in a few years …

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The following excerpt is copied directly from Groupon’s December 31, 2012 financial statements, Note 1, pages 72-73:

Revenue Recognition

The Company recognizes revenue when the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the selling price is fixed or determinable; and collection is reasonably assured.

Third party revenue recognition

The Company generates third party revenue, where it acts as a third party marketing agent, by offering goods and services provided by third party merchant partners at a discount through its local commerce marketplace that connects merchants to consumers. The Company’s marketplace includes deals offered through a variety of categories including: Local, National, Goods, Getaways and Live. Customers purchase the discount vouchers (“Groupons”) from the Company and redeem them with the Company’s merchant partners.

The revenue recognition criteria are met when the number of customers who purchase a given deal exceeds the predetermined threshold (where applicable), the Groupon has been electronically delivered to the purchaser and a listing of Groupons sold has been made available to the merchant. At that time, the Company’s obligations to the merchant, for which it is serving as a marketing agent, are substantially complete. The Company’s remaining obligations, which are limited to remitting payment to the merchant and continuing to make available on the Company’s website information about Groupons sold that was previously provided to the merchant, are inconsequential or perfunctory. The Company records as revenue the net amount it retains from the sale of Groupons after deducting the portion of the purchase price that is payable to the featured merchant, excluding any applicable taxes and net of estimated refunds for which the merchant’s share is recoverable. Revenue is recorded on a net basis because the Company is acting as a marketing agent of the merchant in the transaction.

For merchant payment arrangements that are structured under a redemption model, merchant partners are not paid until the customer redeems the Groupon that has been purchased. If a customer does not redeem the Groupon under this payment model, the Company retains all the gross billings. The Company recognizes revenue from unredeemed Groupons and derecognizes the related accrued merchant payable when its legal obligation to the merchant expires, which the Company believes is shortly after deal expiration in most jurisdictions that have payment arrangements structured under a redemption model.

Direct revenue recognition

The Company evaluates whether it is appropriate to record the gross amount of its sales and related costs by considering a number of factors, including, among other things, whether the Company is the primary obligor under the arrangement, has inventory risk and has latitude in establishing prices.

Direct revenue is derived primarily from selling consumer products through the Company’s Goods category where the Company is the merchant of record. The Company is the primary obligor in these transactions, is subject to general inventory risk and has latitude in establishing prices. Accordingly, direct revenue is recorded on a gross basis, excluding any applicable taxes and net of estimated refunds. Direct revenue, including associated shipping revenue, is recorded when the products are shipped and title passes to customers. For Goods transactions where the Company is performing a service by acting as a marketing agent of the merchant, revenue is recorded on a net basis and is presented within third party revenue.

 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)

The Phantom of the Audit

 

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You have probably never heard of Livent Inc. or if you have your memory of what transpired within the company may have faded over the past 15 years.  Yes, one of Canada’s most disgraceful accounting scandals is “celebrating” its 15th anniversary this year.  Livent has also recently been in the news since the Ontario Securities Commission, the stock exchange regulator for Livent, has finally decided to actually regulate.  I don’t want to be too harsh on the OSC, but really – it takes 15 years for you to decide that the perpetrators should be banned from being involved with publicly traded companies?  

Let’s rewind to 1998 when the *&^% hit the fan. Livent had been on a roll; it was producing great theatre performances in Toronto including the Phantom of the Opera and had been reporting fantastic financial results.  Ex-Disney executive Michael Ovitz purchased Livent in 1998 and then realized that it was a financial house of cards.  Note: all the following documents are publicly available through SEDAR.com

First, let’s take a look at the original December 31, 1997 balance sheet:

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Things to note:

  • A small negative deficit ($27M)
  • Accounts payable and accruals ($29 M) that are less than the cash available ($10M) and the accounts receivable ($32M)
  • A preproduction cost asset, representing money already paid to develop future performances, $67M

Now, here is the restated balance sheet after examining some dodgy accounting practices:

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Look at the December 31, 1997 column and compare that to the original figures:

  • The deficit is longer small, it is $124M, approximately $100M larger than originally reported.  Total equity now represents just 1% of the total assets.  That means that 99% of the assets really belong to debt holders
  • Accounts receivable have gone down by $13M and accounts payable has gone up by almost $20M
  • Preproduction cost assets have decreased by $8M

With virtually all frauds, one key culprit is revenue recognition.  Revenue would seem to be an easy thing to account for, but it can get complex pretty easily; primarily timing and amounts.  A simple example of this was Livent’s treatment of certain sponsorship revenue.  Like many arts organizations, Livent earned a portion of its revenue through sponsorship dollars – companies paying for the right to have their logo and signage in the lobby, on the stage, or on the playbill.  This is very similar to the corporate logos you see at the hockey rinks.  Assume that a business paid Livent $500,000 for the right to have their logo on the playbill of the Phantom.  The company probably paid months in advance to secure its sponsorship right.  When should Livent record that payment as revenue?  (a) When they received the cash?  (b) When the show started its 3 year run? (c) Or spread evenly over the three year run?  If you answered (a) you want to review revenue recognition criteria ASAP, before you meet Livent executives in jail (IAS 18).  If you answered (c), congratulations you’re well on your way to becoming an excellent accountant.  Or it was just common sense.  Its interesting how accounting, when done right, involves a lot of common sense.

Another frequent area of accounting fraud is to record expenses as an asset.  How does this work?  Well there is a fine line between assets and expenses.  To keep it relatively simple, assets are expenses that have a benefit in the future.  That’s why we capitalize property and buildings – they will provide a benefit for years to come.  Conversely expenses do not have any future benefit, their benefit has all been used up in the current period.  Well a fairly simple (and fraudulent) technique is to increase your net income by recording expenses as an asset.  Did you notice that decrease in Livent’s preproduction costs?  Yep, that’s what was going on.  They were capitalizing (recording as an asset) production costs that were never going to generate any future value.

A third area where Livent got caught with their hand in the cookie jar was less common (I’ll explain why in a minute) – not even recording the expense.  What was happening was as Livent got a bill in near year end, they were not paying the bill yet (that’s fine, that’s good cash flow management).  A proper accounting system would set that bill up as an expense and as an account payable before year end.  By ignoring that, Livent was artificially increasing their net income (since they didn’t record the expense) and artificially decreasing their liabilities (since they didn’t record the accounts payable).  Wrong on both accounts.  Now why is this not a common area of fraud?  Because its pretty damn easy to find.  All an auditor has to do is look through a stack of unpaid bills and subsequent bill payments and note the date on the bill.  Prior to yearend?  It should be recorded.  Just after yearend?  Let’s do a little more investigation.  So Livent was a case of really sloppy auditing.  No surprise that the three key auditors have all got their knuckles rapped pretty hard.

In conclusion, I know this case is REALLY old but its worth revisiting since it highlights very basic accounting principles that all accounting students should be able to understand.  One final thought – if you’re involved as an accountant with a business avoid this kind of crap at all costs, its not worth it to your reputation.

Here is the official description of the accounting restatements that I discussed above (November 18, 1998 letter):

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 Note: this blog was originally posted on my site hosted by Pearson Education(http://php2.pearsoncanada.ca/highered/inthenews/accounting_in_the_news/)