Late last Friday, Groupon, the online discount-coupon distributor that splits the price consumers pay for coupons with retailers, announced it would slash its fourth-quarter revenue outlook and incur deeper losses as a result of higher-than-expected customer refunds. It blamed those losses on the fact that it sold a greater-than-anticipated number of big-ticket deals (LASIK eye surgeries, spa packages, laser hair-removal procedures) in that quarter and, lacking a historical record of deals at those higher price points, had failed to set aside sufficient reserves to cover refunds.

This morning Groupon’s stock plunged 14% as its first-as-a-public-company 10-K filing with the Securities and Exchange Commission revealed that its auditor, Ernst & Young, found “a material weakness in its internal controls over its financial statement close process,” raising questions in some quarters as to why these weaknesses were not identified earlier.

The weaknesses identified in the 10-K included “a number of manual post-close adjustments” (that is, a lack of adequately automated financial reporting leading to a welter of difficult-to-consolidate spreadsheets), and a failure to maintain both “effective controls to provide reasonable assurance that accounts were complete and accurate” and measures to ensure that account reconciliations “were properly performed, reviewed and approved.”

Groupon also stated that it lacked adequate “historical experience” to estimate refund claims, which could (and did) result in inadequate reserves having an “adverse effect on our liquidity and profitability.”

Groupon records an allowance for customer refunds when it records revenue. As refund costs are recorded as revenue reductions, underestimating the refund cost would inevitably lead to a revenue misstatement.

“You should be able to come up with a reasonable and reliable estimate of return before you’re permitted to recognize revenue,” says Ashwinpaul C. Sondhi, president of A.C. Sondhi & Associates, a financial consulting and investment advisory. “It appears Groupon did not have that ability. They were in an area where they hadn’t offered discounts before: new and high-ticket items, unlike other things they had been doing.”

In its 10-K, Groupon states it has updated its refund model and believes that will enable it to “more accurately track and anticipate refund behavior” going forward.


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