Groupon revenue recognition

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 29, No. 1 DOI: 10.2308/iace-50595 2014 pp. 229–245

Growing Pains at Groupon

Saurav K. Dutta, Dennis H. Caplan, and David J. Marcinko

ABSTRACT: On November 4, 2011, Groupon Inc. went public with an initial market capitalization of $13 billion. The business was formed a couple of years earlier as an offshoot of ‘‘The Point.’’ The business grew rapidly and increased its reported revenue from $14.5 million in 2009 to $1.6 billion in 2011. Soon after going public, prior to its announcement of its first-quarter results, the company’s auditors required Groupon to disclose a material weakness in its internal controls over financial reporting that impacted its disclosures on revenue and its estimation of returns.

This case uses Groupon to motivate discussion of financial reporting issues in e- commerce businesses. Specifically, the case focuses on (1) revenue recognition practices for ‘‘agency’’ type e-commerce businesses, (2) accounting for sales with a right of return for new products, and (3) use of alternative financial metrics to better convey the intrinsic value of a business. The case requires students to critically read, analyze, and apply authoritative accounting guidance, and to read and analyze communications between the Securities and Exchange Commission (SEC) and the registrant.

Keywords: Groupon; revenue recognition; allowance for sales returns; e-commerce; non-GAAP metrics.

GROWING PAINS AT GROUPON

A s an undergraduate music major at Northwestern University, Andrew Mason eagerly

sought a version of rock music that would fuse punk with the Beatles and Cat Stevens.

Little did he imagine that within ten years he would be the CEO of one of history’s fastest-

growing businesses. After Northwestern and faded dreams of rock stardom, Mason, a self-taught

computer programmer, was hired to write code by the Chicago firm InnerWorkings. InnerWorkings

was founded in 2001 by Eric Lefkofsky, who had built several businesses around call centers and

the Internet. In 2006, Lefkofsky became interested in an idea of Mason’s for a website that would

act as a social media platform to bring people together with a common interest in some problem—

Saurav K. Dutta is an Associate Professor and Dennis H. Caplan is an Assistant Professor, both at University at Albany, SUNY; and David J. Marcinko is an Associate Professor at Skidmore College.

We thank the editor, associate editor, and two reviewers for their helpful insights, comments, and suggestions. We also acknowledge our accounting students who completed the case and provided us with valuable feedback.

Editor’s note: Accepted by William R. Pasewark

Published Online: August 2013

229

most often some sort of social cause. Lefkofsky provided Mason with $1 million of capital to

develop the concept that became known as ‘‘The Point.’’1

Virtually no one associated with The Point initially envisioned commercial aspirations for the

venture. In the fall of 2008, at the height of the financial crisis, ventures with little or no commercial

aspirations were in jeopardy. Lefkofsky and Mason faced a decision on how to proceed with The

Point. Lefkofsky seized on an idea proposed by a group of users of The Point. This group attempted

to identify a number of people who wanted to buy the same product, and then approach a seller for a

group discount. Mason had originally mentioned group-buying as one application of The Point, and

now Lefkofsky latched onto the concept and pursued it relentlessly. In response, Mason and his

employees began a side project that they named Groupon.

The business plan was relatively simple. Groupon offered vouchers via email to its subscriber

base that would provide discounts at local merchants. The vouchers were issued only after a critical

number of subscribers expressed interest. At that point, Groupon charged those subscribers for the

purchase and recorded the entire proceeds as revenue. Subsequently, when the subscriber redeemed

the voucher with the merchant, Groupon remitted a portion of the proceeds to the merchant and

retained the remainder. For example, a salon might offer a $100 hairstyling in exchange for a $50

Groupon voucher and agree to a 60-40 split of the price. Once a sufficient number of subscribers

agreed to the deal, Groupon sold the voucher for $50. After providing the service, the salon would

submit the voucher to Groupon and receive $30. Groupon would keep the remaining $20.

The idea took off with enthusiastic support from the local media in Chicago. By the end of

2008, it was clear to Lefkofsky and Mason that The Point would become Groupon. Understanding

that the key to competitive success would be a massive increase in scale, Lefkofsky pushed the

company to grow vigorously through quick expansion to many cities. Within a year, the new

company had 5,000 employees, and by 2012 had more than 10,000. The company’s revenue

growth was also impressive. Beginning with $94,000 in 2008, revenue had grown to $713 million

in 2010. In the first quarter of 2011, the company nearly equaled its entire 2010 sales, reporting

revenue of $644 million, and total revenue for 2011 was $1.6 billion. Andrew Mason became a

media star, appearing on CNBC and The Today Show. In August of 2010, he appeared on the cover of Forbes magazine, which touted Groupon as ‘‘the fastest growing company—ever.’’

The spectacular growth attracted more than media attention. Groupon quickly found itself

pursued by corporate suitors. By mid-2010, Yahoo! offered to purchase the company for a price

between $3 billion and $4 billion—it was an offer that Mason, who had no wish to work at Yahoo!,

quickly turned down. Google then approached Groupon with an offer that would eventually grow to

nearly $6 billion. Groupon rejected Google’s offer, as well. Faced with an ever-growing need for

cash, this decision left Mason and Lefkofsky with only one option: to take Groupon public. They

did so on November 4, 2011, at an IPO price of $20 per share, yielding a market capitalization of

$13 billion.

On the day of the IPO, the stock closed near its all-time high of $26 a share. It traded in the

range of $18 to $24 for several months following the IPO. The stock price then declined

precipitously after March 30, 2012, as shown in Figure 1, following the announcement of a material

weakness in internal controls, when Groupon announced that it planned:

to take additional measures to remediate the underlying causes of the material weakness,

primarily through the continued development and implementation of formal policies,

improved processes and documented procedures, as well as the continued hiring of

additional finance personnel. (Groupon 2012b, 23)

1 For additional background information on Groupon, see Steiner (2010), Carlson (2011), and Stone and MacMillan (2011).

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REVENUE RECOGNITION

Sale of products to customers prior to purchase by the vendor/retailer is a common business

model for ‘‘e-tailers’’ such as Expedia and Priceline. These vendors provide a platform for exchange

of goods, but do not necessarily transact in those goods. When the customer makes a purchase

through an e-tailer’s platform or interface, the e-tailer takes the payment from the customer and

places an order with the supplier to send goods directly to the customer. At a later date, it remits a

payment to the supplier for the prearranged price. Like a traditional business, the e-tailer retains the

difference between the payment received from the customer and the payment it makes to the

supplier. However, unlike a traditional merchandiser, the e-tailer never takes possession of the

merchandise.

The manner in which these transactions are recorded has significant impact on the financial

statements. There are primarily two ways of recording the transaction: on a ‘‘gross’’ or ‘‘net’’ basis.

Under the gross method, the entire amount received from the customer is recorded as revenue, and a

corresponding cost of sales is recorded to account for the payment made to the supplier for the

merchandise. Under the net method, only the difference between what is received from the

customer and what is paid to the supplier is recorded as revenue. This is consistent with recognizing

that the vendor earns a commission on the sale. We illustrate the concept further with the use of an

example. Suppose an e-tailer sells an airline ticket to a customer for $1,000 online and remits $950

to the airline. The issue is how the e-tailer should journalize the two transactions: (1) the sale to the

customer, and (2) the payment to the airline. Under the gross method of recognizing revenue, on the

date of sale to the customer, the journal entry is:

FIGURE 1 Groupon’s Stock Price Chart

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Cash 1,000

Revenue 1,000

Cost of Sales 950

Accounts Payable 950

When the company pays the airline, the corresponding journal entry is:

Accounts Payable 950

Cash 950

Under the net method of recording the transaction, the journal entry on the date of sale to the

customer is:

Cash 1,000

Accounts Payable 950

Revenue 50

And on the date of payment to the airline, the journal entry is identical to the gross method:

Accounts Payable 950

Cash 950

The differences between the gross and net methods of recording the transactions are:

� Higher revenue is recorded under the gross method. � Higher cost of sales is recorded under the gross method.

However, gross profit—the excess of revenue over the cost of sales—is the same under the two

methods; $50 in our example.

In its original S-1 filing with the SEC on June 2, 2011, Groupon noted in its footnote on

revenue recognition that, ‘‘The Company records the gross amount it receives from Groupons, excluding taxes where applicable, as the Company is the primary obligor in the transaction’’ (Groupon 2011a, F-11). In its response to the S-1, the SEC commented:

it is unclear to us why you believe the company is the primary obligor in the arrangement.

Please advise us, in detail, and provide us management’s comprehensive analysis of its

revenue generating arrangements and explain the consideration given to each of the

indicators of gross reporting and each of the indicators of net reporting found in ASC 605-

45-45 . . . If, in fact, the company is the primary obligor, then explain to us why it is appropriate for the company to recognize revenue prior to delivery of the underlying

product or service by the merchant to the customer. (SEC 2011a, 11)

In its response, Groupon reasserted that it was the primary obligor and, hence:

it recognizes revenue on a gross basis in accordance with ASC 605-45-45 based on its

assessment of the facts and circumstances of the arrangement. The purchase of a Groupon

voucher gives the Customer the option to purchase goods or services at a specified price in

the future. For instance, a Customer may pay $25 for a Groupon that entitles him or her to

$50 of merchandise or services at a Merchant’s store. However, it is important to note that

the Company is not selling the underlying goods or services, only the voucher to obtain

discounted goods or services. (Groupon 2011b, 31)

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The SEC followed up:

Considering your view that the Company, and not the merchant, is the primary obligor in

the Groupon transaction, please explain the terms and conditions included in the

Company’s website that state ‘‘Vouchers you purchase through our Site as a Groupon

account holder are special promotional offers that you purchase from participating

Merchants through our service’’ and further that ‘‘The Merchant is the issuer of the

voucher and is fully responsible for all goods and services it provides to you’’ and why you

believe this is consistent with your view. (SEC 2011b, 4)

In response, Groupon contended:

the Company believes that, by virtue of the credit risk it bears and the Groupon Promise, it

is both a seller and an issuer of vouchers. The Company is the primary obligor when it

issues a Groupon voucher on behalf of a merchant, which in turn is solely responsible to

deliver goods or perform services. (Groupon 2011c, 2)

Although the Company provides the Groupon Promise, the Company does not accept any

other responsibility for the delivery of goods or services provided to a customer and has

never delivered the goods or services underlying a Groupon voucher to a customer on

behalf of a merchant or otherwise. (Groupon 2011c, 3)

However, in an amended S-1 filing on October 7, 2011, Groupon changed the related footnote on

revenue recognition to identify itself as the agent for the merchants. It noted:

we record as revenue the net amount we retain from the sale of Groupons after paying an

agreed upon percentage of the purchase price to the featured merchant excluding any

applicable taxes. Revenue is recorded on a net basis because we are acting as an agent of

the merchant in the transaction. (Groupon 2011d, 68)

The effect of this change in definition of revenue from gross to net on the income statement is

shown in Table 1. The first and third columns present the Income Statements for 2009 and 2010 as

originally reported on June 2, 2011, when revenue was reported on a gross basis. The second and

TABLE 1

Abridged Income Statements for Groupon

Income Statement Account

2009 2010

Gross Net Gross Net

Revenue $30.4 M $14.5 M $713.4 M $312.9 M

Cost of Sales 19.5 M 4.4 M 433.4 M 32.5 M

Gross Margin 10.9 M 10.1 M 280.0 M 280.4 M

Marketing Expense 4.6 M 4.9 M 263.2 M 284.3 M

General and Admin. Expense 7.5 M 6.4 M 233.9 M 213.3 M

Other Expenses 203.2 M 203.2 M

Net Loss 1.34 M 1.09 M 413.4 M 420.1 M

Net Loss to common shareholders 6.92 M 6.92 M 456.3 M 456.3 M

EPS (Basic) (0.04) (0.04) (2.66) (2.66)

This information was obtained from Groupon’s S-1 filing with the SEC on June 2, 2011, and the amended filing (Amendment No. 4) on October 7, 2011.

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the fourth columns present the Income Statements for 2009 and 2010 as amended in the October 7

filing, to reflect revenue recognition on a net basis.

Groupon further elaborated on the change in revenue recognition when it filed its first-quarter

10-Q on May 15, 2012. The company noted that it had to ‘‘restate’’ the Statements of Operations

filed with the SEC on June 2, 2011, to ‘‘correct for an error in its presentation of revenue.’’ It

explained the change as follows:

The Company restated its reporting of revenues from Groupons to be net of the amounts

related to merchant fees. Historically, the Company reported the gross amounts billed to its

subscribers as revenue . . . The effect of the correction resulted in a reduction of previously reported revenues and corresponding reductions in cost of revenue in those periods. The

change in presentation had no effect on pre-tax loss, net loss or any per share amounts for

the period. (Groupon 2012c, 10)

The controversy over reporting revenue on a net versus gross basis is not new. This was a

much-debated issue in 1999, when the company in the center of the controversy was Priceline. In

the third quarter of 1999, Priceline reported revenue of $152 million. This amount included the full

price the customers paid to Priceline for hotel rooms, rental cars, airline tickets, and holiday

packages. However, much like travel agencies, Priceline retained only $18 million, a small portion

of the $152 million; the rest it remitted to the actual service providers, the hotels, the airlines, etc.

The revenue recognition issue was resolved in 2000, when Priceline reported only the commission

as revenue. During the same period, Priceline’s stock decreased about 98 percent from April to

December 2000.

Subsequent to the Priceline revenue recognition controversy, the SEC issued Staff Accounting

Bulletin No. 101, Revenue Recognition in Financial Statements. This guidance specifically required firms to report revenue on a net basis when the firm acts as an agent or broker without assuming the

risks of ownership of the goods or the risk of default on payment. Concurrently, the SEC directed

the Financial Accounting Standards Board (FASB) to explore the issue. In July 2000, the Emerging

Issues Task Force (EITF) of the FASB reached a consensus on Issue No. 99-19. The FASB

affirmed the guidance of EITF 99-19 in ASC Section 605, Revenue Recognition.2

Although net income is generally not affected by the use of gross versus net revenues, the issue

is important because revenue itself is a critical component in the financial statements, and revenue is

materially affected by the choice. ASC Section 605-45-45 (FASB 2012b) identifies indicators

supporting the use of gross revenue rather than net revenue. Two of these indicators, credit risk and

inventory risk, can be assessed for Groupon from its balance sheet and related footnote disclosures.

These are reproduced in Table 2 from Groupon’s original S-1 filing on June 2, 2011 (Groupon

2011a, F-4, F-9).

SALES WITH A RIGHT OF RETURN

Companies that provide a right of return to customers are required to establish an allowance for

sales returns if the amount is material. A merchandiser satisfies its obligations when it provides the

product to the customer and, hence, can recognize revenue for the amount of sale. However, if the

possibility exists that the customer could return the merchandise for a full or partial refund, the

company is required to create a reserve for such occurrences. The amount to be reserved is based on

past experience with returns and management estimates of future trends. When historical data do

not exist and estimation of future returns is not possible, recognition of revenue must be deferred

2 See Phillips, Luehlfing, and Daily (2001) for a discussion of SAB No. 101 and EITF 99-19.

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until the right of return has expired (FASB 2012a, ASC 605-15-25). Until then, any cash received

should be accounted for as unearned revenue, a liability.

Groupon’s business plan entails selling coupons for a product or service, and collecting cash

prior to the merchant providing the product or service. That is, customers pay up front for a coupon

for services or goods, and can redeem the coupon within the next six months. Moreover, the

product is provided by a separate merchant, independent of Groupon. To entice customers to

transact with Groupon, rather than directly with the vendor, Groupon features a generous right of

return for its subscribers at least on par with the vendor’s own right of return. The return policy is

featured prominently on the company’s website. Since Groupon does not directly provide the

service, it guarantees the quality of services/goods on behalf of the vendor. Furthermore, since

customers pay cash to Groupon while receiving services/goods from the vendor, customers expect

‘‘cash-back’’ from Groupon should they be dissatisfied. Groupon summarizes its policy as ‘‘The Groupon Promise,’’ which states simply: ‘‘If Groupon ever lets you down, we will return your purchase—simple as that.’’ In addition, it allows for full or partial refunds in the following situations:

� If a business closes permanently; � Any unredeemed Groupon can be returned for a full refund within seven days of purchase;

TABLE 2

Groupon Selected Disclosures Balance Sheet Excerpts (in ’000s)

December 31

2009 2010

Assets

Current assets:

Cash and cash equivalents $12,313 $118,833

Accounts receivable, net 601 42,407

Prepaid expenses and other current assets 1,293 12,615

Total current assets 14,207 173,855

Property and equipment, net 274 16,490

Goodwill — 132,038

Intangible assets, net 239 40,775

Deferred income taxes, non-current — 14,544

Other non-current assets 242 3,868

Total Assets $14,962 $381,570

Footnote Disclosure of Accounts Receivable, net:

Accounts receivable primarily represent the net cash due from the company’s credit card and other payment

processors for cleared transactions. The carrying amount of the company’s receivables is reduced by an

allowance for doubtful accounts that reflects management’s best estimate of amounts that will not be

collected. The allowance is based on historical loss experience and any specific risks identified in

collection matters. Accounts receivable are charged off against the allowance for doubtful accounts when it

is determined that the receivable is uncollectible. The company’s allowance for doubtful accounts at

December 31, 2009, and 2010 was $0 and less than $0.1 million, respectively. The corresponding bad debt

expense for the years ended December 31, 2008, 2009, and 2010 was $0, $0, and less than $0.1 million,

respectively (Groupon 2011a, F-9).

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� In other cases, unredeemed Groupons are evaluated on a ‘‘case-by-case’’ basis; � After the expiration date, the Groupon is still worth the amount paid, which never expires.

In reviewing Groupon’s initial S-1 filing, the SEC noted: