IS THIS AN ERROR OR A FRAUD? A CASE OF REVENUE RECOGNITION- GROUP ON BURCU ADILOGLU 1 Istanbul University School of Business Accounting Department Turkey E-mail: adiloglu@istanbul.edu.tr Abstract- Misstatements in the financial statements can arise from either fraud or error. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. True and fair view in auditing means that the financial statements are free from material misstatements and faithfully represent the financial performance and position of the entity. Preparation of true and fair financial statements has been expressly recognized as one of the responsibilities of the directors of companies in the corporate law of several countries. Auditors must therefore consider whether directors have fulfilled their responsibility for the preparation of true and fair financial statements when providing an audit opinion. In this study firstly the importance of true and fair presentation of financial statements and responsibilities of auditors in fraud and error cases are briefly explained and then one of the huge restatement of financial statement related to revenue recognition is discussed. Keywords- Fraud, Error, Revenue Recognition, Groupon, Case I. INTRODUCTION According to International Financial Reporting Standards the objective of International Accounting Standard (IAS) 1 is to prescribe the basis for presentation of general purpose financial statements, to ensure comparability both with the entity's financial statements of previous periods and with the financial statements of other entities. IAS 1 sets out the overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content. Standards for recognizing, measuring, and disclosing specific transactions are addressed in other Standards and Interpretations. The objective of general purpose financial statements is to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions. To meet that objective, financial statements provide information about an entity's: assets, liabilities, equity, income and expenses, including gains and losses, contributions by and distributions to owners (in their capacity as owners) and cash flows. That information, along with other information in the notes, assists users of financial statements in predicting the entity's future cash flows and, in particular, their timing and certainty. International Accounting Standard (IAS)- 8 Accounting Policies, Changes in Accounting Estimates and Errors is applied in selecting and applying accounting policies, accounting for changes in estimates and reflecting corrections of prior period errors. According to IAS 8 material Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Examples of accounting errors included the following: (http://accountingsimplified.com/standard/ias-8/correction-ofaccounting-errors.html#sthash.6ve38vu0.dpuf Misapplication of accounting policies: e.g. not recognizing sale upon transfer of goods to a customer Fraud: e.g. overstating sales revenue by issuing fake invoices before the reporting date Misunderstanding of, or failure to notice, information at the time of preparation of financial statements:e.g. not writing off a receivable who had been announced as insolvent before the authorization of financial statements Arithmetical Errors Omission of transactions and events from the financial statements The general principle in IAS 8 is that an entity must correct all material prior period errors retrospectively in the first set of financial statements authorized for issue after their discovery by: restating the comparative amounts for the prior period(s) presented in which the error occurred; or if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented. However, if it is impracticable to determine the period-specific effects of an error on comparative 77
information for one or more prior periods presented, the entity must restate the opening balances of assets, liabilities, and equity for the earliest period for which retrospective restatement is practicable (which may be the current period). Further, if it is impracticable to determine the cumulative effect, at the beginning of the current period, of an error on all prior periods, the entity must restate the comparative information to correct the error prospectively from the earliest date practicable. The rest of the paper is organized as follows. First the responsibilities of auditors in fraud and error cases is briefly explained the and then one of the huge restatement of financial statement related to revenue recognition is discussed. II. RESPONSIBILITIES OF AUDITORS IN FRAUD CASES The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. It is important that management, with the oversight of those charged with governance, place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty and ethical behavior which can be reinforced by an active oversight by those charged with governance. Oversight by those charged with governance includes considering the potential for override of controls or other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in order to influence the perceptions of analysts as to the entity s performance and profitability. An auditor conducting an audit in accordance with ISAs is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the financial statements may not be detected, even though the audit is properly planned and performed in accordance with the ISAs. As described in ISA 200, the potential effects of inherent limitations are particularly significant in the case of misstatement resulting from fraud. The risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting one resulting from error. This is because fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Such attempts at concealment may be even more difficult to detect when accompanied by collusion. Collusion may cause the auditor to believe that audit evidence is persuasive when it is, in fact, false. The auditor s ability to detect a fraud depends on factors such as the skillfulness of the perpetrator, the frequency and extent of manipulation, the degree of collusion involved, the relative size of individual amounts manipulated, and the seniority of those individuals involved. While the auditor may be able to identify potential opportunities for fraud to be perpetrated, it is difficult for the auditor to determine whether misstatements in judgment areas such as accounting estimates are caused by fraud or error. Furthermore, the risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud, because management is frequently in a position to directly or indirectly manipulate accounting records, present fraudulent financial information or override control procedures designed to prevent similar frauds by other employees. 8. When obtaining reasonable assurance, the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls and recognizing the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud. The requirements in this ISA are designed to assist the auditor in identifying and assessing the risks of material misstatement due to fraud and in designing procedures to detect such misstatement. In the following section one of the huge restatement of financial statement related to revenue recognition is presented and discussed. III. CASE: GROUPON Groupon is a local e-commerce marketplace and the leading daily deal site worldwide, connecting millions of subscribers around the world with merchants by offering goods and services at a discount. The name Groupon is a blend of group and coupon. Groupon's first deal was a half-price offer for pizzas for the restaurant on the first floor of its building in Chicago. Groupon, Inc. operates online local commerce marketplaces that connect merchants to consumers by offering goods and services at a discount in North America, Europe, the Middle East, Africa, and internationally. It also provides deals on products for which it acts as the merchant of record. The company offers deals in various categories, including food and drink, events and activities, beauty and spa, health and fitness, home and garden, and automotive; and deals on various product lines, such as electronics, sporting goods, jewelry, toys, household items, and apparel, as well as provides discounted and market rates for hotel, airfare, and package deals. It offers its deal offerings to customers through Websites; search engines; and mobile applications and mobile browsers, which enable consumers to browse, 78
purchase, manage, and redeem deals on their mobile devices, as well as sends emails to its subscribers with deal offerings that are targeted by location and personal preferences. The company was formerly known as ThePoint.com, Inc. and changed its name to Groupon, Inc. in October 2008. Groupon, Inc. was founded in 2008 and is headquartered in Chicago, Illinois.(Bloomberg) Fig.1. How Groupon Works-Business Model Groupon (GRPN) had priced its initial public offering at $20 a share. Groupon began trading on the Nasdaq Stock Exchange in New York November 4, 2011 and opened at $28, 40% above the target. Groupon Inc raised $700 million after increasing the size of its initial public offering, becoming the largest IPO by a U.S. Internet company since Google Inc raised $1.7 billion in 2004. (Barr, Baldwin, 2011) On November 4, 2011, Groupon went public and surged from an opening price of $20/share to over $31/share. Investment banks, including Morgan Stanley, Goldman Sachs, Credit Suisse and Allen & Company, made millions in fees by building the hype for the company and placing those initial shares with investors. Groupon s CEO, Andrew Mason, was beaming that day and said, With our IPO behind us, I couldn t be more excited about what lies ahead. What was less than 4 months ahead was an accounting scandal. (Pavlo, 2012) In its first earnings release as a public company, Groupon reported a 2011 fourth-quarter loss of $9.8 million on an adjusted basis, disappointing investors. (Merced, 2012) Groupon, Inc. (NASDAQ: GRPN announced a revision of its reported financial results for its fourth quarter and year ended December 31, 2011. According to the company, it actually made $14.3 million less in revenue during the fourth quarter of 2011 than it previously reported $492.2 million, compared to the previously stated $506.5 million. It also spent more in operating expenses than it previously said it did resulting in its Q4 operating income and net income being $30 million and $22.6 million less, respectively, than the company initially said it as. (Taylor, 2012) The revisions resulted in a reduction to fourth quarter 2011 revenue of $14.3 million. The revisions also resulted in an increase to fourth quarter operating expenses that reduced operating income by $30.0 million, net income by $22.6 million, and earnings per share by $0.04. Financial results for prior periods, including as of and for the nine months ended September 30, 2011, were not affected by the revisions. There is no change to Groupon's previously reported operating cash flow of $169.1 million for the fourth quarter 2011 and $290.5 million for the full year 2011. There is also no change to Groupon's previously reported free cash flow, which is a non-gaap financial measure that reflects cash flow from operations less purchases of property and equipment, of $155.1 million for the fourth quarter 2011 and $246.6 million for the full year 2011. The revisions are primarily related to an increase to the Company's refund reserve accrual to reflect a shift in the Company's fourth quarter deal mix and higher price point offers, which have higher refund rates. The revisions have an impact on both revenue and cost of revenue. A more detailed explanation of the refund reserve is included in the Critical Accounting Policies and Estimates section of Groupon's Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission (SEC). "We remain confident in the fundamentals of our business, as our performance continues to highlight the value that we provide to customers and merchants," said Jason Child, Groupon CFO. Groupon affirmed its guidance contained in its February 8, 2012 press release regarding expectations for first quarter 2012 revenue of $510 million to $550 million and income from operations of $15 million to $35 million. This guidance includes approximately $35 million for stock-based compensation and acquisition-related expense, and it assumes no material business acquisitions or investments and no further revisions to stock-based compensation estimates. In conjunction with the completion of the audit of Groupon's financial statements for the year ended December 31, 2011 by its independent auditor, Ernst & Young LLP, the Company included a statement of a material weakness in its internal controls over its financial statement close process in its Annual Report on Form 10-K for year ended December 31, 2011. The Company has been working for several months with another global accounting firm in preparation for reporting on the effectiveness of its internal controls by the end of 2012, as required following Groupon's initial public offering. The Company continues to implement process improvement initiatives and augment its 79
staffing, and is expanding the accounting firm's engagement scope to address the underlying causes of the material weakness. Further discussion of the material weakness can be found in the Company's Form 10-K, filed with the SEC. Groupon s accounting issues first came to light when regulators questioned the company including revenue it had to turn back over to merchants running their deal, a clever accounting term called, adjusted consolidated segment operating income. DealBreaker comically called it earnings before everything. (Pavlo, 2012) Groupon s restatement increased the company s fourth-quarter losses from $42.7 million to $64.9 million, more than a 50% increase in the reported loss. Moreover, the company had $500 million revenue so the amount of restatement is significant, or material as accountants would say. According to Groupon s accountant, Ernst & Young, the accounting error came from a material weakness in its internal controls. This means other transactions may be at risk since poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raise questions about the management of the company and its corporate governance. The red flags have been waving even before the company went public. In preparing its IPO, the company used a financial metric it called Adjusted Consolidated Segment Operating Income. The problem was that figure excluded marketing costs, which make up the bulk of the company s expenses. The net result was to make Groupon s financial results appear better than they actually were.(http://www.ethicssage.com/2012/04/grouponrestatement-of-earnings-a-cause-for-concern.htm) Fig 2.Groupon Revenue Growth and Earnings Per Share Source: http://www.businessinsider.com.au/ 80 Regulators have been scrutinizing Groupon's accounting since it filed for an initial public offering that could value the Chicago Company at $20 billion. Groupon said it would change what it books as revenue after discussions with the Securities and Exchange Commission. It will now only count as revenue its commission on sales, rather than the total value of an online coupon. Previously, when it sold a restaurant gift certificate for $10, for instance, it would book the full amount, even though a portion
went to the business owner. That change reduces Groupon's stated revenue for 2010 to $312.9 million, down from the $713.4 million previously reported. (Raice, 2011) The method of restatement is explained by journal entries below. CONCLUSIONS Public companies are a key part of the economy. They play a major role in the savings, investment, and retirement plans of many people. The term public company can be defined in various ways. There are two commonly understood ways in which a company is considered public: first, the company s securities trade on public markets; and second, the company discloses certain business and financial information regularly to the public. Here it is shown the difference between the revenues before revisions and after revisions. Adjustements for the yeae 2008,2009 and 2010 are shown below.. ACKNOWLEDGEMENTS This work was supported by Scientific Research Projects Coordination Unit of Istanbul University. Project number 22311" Groupon, Inc. (NASDAQ: GRPN) announced a revision of its reported financial results for its fourth quarter and year ended December 31, 2011 on March 2012. The revisions resulted in a reduction to fourth quarter 2011 revenue of $14.3 million. The revisions also resulted in an increase to fourth quarter operating expenses that reduced operating income by $30.0 million, net income by $22.6 million, and earnings per share by $0.04. Groupon restated its financial statements to correct the accounting revenue error.,groupon also initially reported its revenue on a gross basis, meaning that it included in its revenue the portion of a Groupon s value that is shared with merchants. This was clearly in conflict with FASB regulations. In preparing its IPO, the company used a financial metric it called Adjusted Consolidated Segment Operating Income. The problem was that figure excluded marketing costs. If company ignored its marketing expenses, Groupon generated a profit. But when it converted normal accounting metric, it reported loss. The net result was to make Groupon s financial results appear better than they actually were. According to Groupon s accountant, Ernst & Young, the accounting error came from a material weakness in its internal controls. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. In this revenue recognition case SEC decided that this is a wrong implementation of accounting principles and financial statements had to be revised. In complex, global nature of today s capital markets, investor access to audited financial information is more important than ever in order to protect investors. Preparation of true and fair financial statements are one of the most important responsibility of the managers and auditors must consider whether directors have fulfilled their responsibility for the preparation of true and fair financial statements when providing an audit opinion. Both managers and auditors have responsibility in this revenue recognition and restatement of financials scandal. REFERENCES [1]. Barr, A., Baldwin, C., (2011), Groupon's IPO biggest by U.S. Web company since Google November 4, 2011 81
Retrieved from http://www.reuters.com/article/us-grouponidustre7a 352020111104 [2]. Bloomberg, Retrieved from http://www.bloomberg.com /research/stocks/private/snapshot.asp?privcapid=82311805 [3]. Groupon Annual Report, 2010 and 2011 Retrieved from http://investor.groupon.com/ [4]. http://www.ethicssage.com/2012/04/groupon-restatement-of earnings-a-cause-for-concern.htm [5]. http://accounting-simplified.com/standard/ias-8/correction - of-accounting-errors.html#sthash.6ve38vu0.dpuf [6]. International Accounting Standard 1- Presentation of Financial Statements, Retrieved from http://iasb.org.tr [7]. International Accounting Standard 8-Accounting Policies, Changes in Accounting Estimates and Errors- Retrieved from http://iasb.org.tr [8]. Merced, M. J., D.,(2012) Groupon Posts Loss of $9.8 Million By, 8 February, 2012, Retrieved from http://dealbook. nytimes.com/2012/02/08/groupon-postsquarterly-loss/?_r=0 [9]. Pavlo, W.,(2012) Groupon Accounting Scandal, and We're Surprised?, April 3, 2012, Retrieved from http://www.forbes.com/sites/walterpavlo/2012/04/03/groupon -accounting-scandal-and-were-surprised/#104f79101525 [10]. Raice, S., (2011), More Trouble for Groupon IPO Wall Street Journal, September 24, 2011, Retrieved from http://www.wsj.com/articles/sb100014240531119037915045 76589211214409214 [11]. Taylor, C., (2012), Groupon s Profit In 2011 Was Actually $22.6 Million Less Than They Previously Said Mar 30, 2012 Retrieved from http://techcrunch.com/2012/03/30/ groupons-profit-in-2011-was-actually-22-6-million-less-thanthey-previously-said/ 82