Creative Accounting Causes Problems For Groupon
I recently wrote about Groupon’s planned initial public offering (IPO) and the operational and financial data provided by the company in its Securities and Exchange Commission (SEC) filings—it was quite an eye-opener. Towards the end of the article, I discussed some of Groupon’s accounting practices which were considered untraditional. Now, the company is paying for this creativity. Big time.
If you ask any business person how to calculate profitability, they give you more or less the same answer with different degrees of sophistication: subtract expenses from your revenues and what you have left over are profits. This represents how we evaluate the success or failure of a business. For some industries, this simple measure can sometimes mask the true condition of the underlying business.
If a company has, for example, large amounts of depreciation expense on its books, profitability will appear low or even negative. But this condition is manageable if the company generates large amounts of cash flow. A company with good cash flow and low accounting profitability could be a very attractive investment or acquisition opportunity. In order to evaluate this potential, we'll use EBITDA (a common metric for profitability). EBITDA is “earnings before interest, taxes, depreciation and amortization”. It’s a simple way to measure the cash profitability of the underlying business.
Why don’t we call it adjusted CSOI?
What Groupon has done is something entirely different. The company based its profitability on a measure they called “adjusted consolidated segment operating income”—or adjusted CSOI. That mouthful was invented by the company as a way to gauge performance. The fact that a company planning on issuing shares to the public would invent its own method for evaluating profitability is disconcerting. Even more disconcerting is the way the company calculated adjusted CSOI.
In order to calculate the adjusted CSOI number, Groupon excluded marketing costs from its expenses. During the first quarter of 2011, the company reported in its S-1 filing that it earned $81.6 million in adjusted CSOI. That sounds great. Or at least it would sound great if that were “pre-tax profits” or even “operating income.” But remember, that adjusted CSOI leaves out one detail: marketing expenses. In effect, they are taking a traditional measure of profitability, excluding one major expense and then calling it something else. After adding back marketing expenses, the nearly $82 million in “profits” turns into a loss of $98 million.
This should have been a huge red flag to the company. Such a wild swing from a loss to a profit by using a “new profitability measure” just doesn’t pass the smell test. This isn’t to say that as a company Groupon isn’t a success nor does it pass judgment on Groupon as a good or bad investment. It does, however, raise many legitimate questions.
The SEC wasn’t too happy about this. They asked the company to explain themselves. Groupon subsequently discontinued its use of adjusted CSOI. The damage, however, has been done. The company’s IPO will be delayed. Institutional investors are taking a much closer look at its core business model and its customers are starting to question whether this is really a new sales channel or just a fad.
Playing accounting games isn’t being creative; it isn’t being accurate; it’s just not being smart. Use traditional measure to evaluate your company. If you don’t make your numbers then you don’t make them. Rewriting the accounting dictionary to what suits you at a particular moment in time is a recipe for disaster.