There had been other oddities with Groupon’s accounting that reflected a culture of indifference toward GAAP and its obligations to the investing public. It reported a 1,367 percent increase in revenue for the three months ending March 31, 2011, versus the same period in 2010It admitted to recognizing as revenue commissions received on sales of coupons/gift certificates but also recognized the total value of the coupons and gift certificates at the date of sale. As Groupon prepared its financial statements for 2011, its independent auditor, Ernst & Young (EY), determined that the company did not accurately account for the possibility of higher refunds. By the firm’s assessment, that constituted a “material weakness.” Groupon said in its annual report, “We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate.” This meant that other transactions could be at risk because poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raised questions about the management of the company and its corporate governance. But Groupable EY for the admission of the internal control failure to spot the material weakness. In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon accusing the company of misleading investors about its financial prospects in its IPO and concealing weak internal controls. According to the complaint, the company overstated revenue, issued materially false and misleading financial results, and concealed the fact that its business was not growing as fast and was not nearly as resistant to competition as it had suggested. These claims identified a gap in the sections of SOX that deal with companies’ internal controls. There is no requirement to disclose a control weakness in a company’s IPO prospectus. The red flags had been waving even before the company went public in 2011. In preparing its IPO, the company used a financial metric that 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 were. In fact, a reported $81.6 million profit would have been a $98.3 million loss had the marketing costs been included. After the SEC raised questions about the metric—which The Wall Street Journal called “financial voodoo”—Groupon downplayed the formulation in its IPO documents. Groupon reported the weakness in its internal controls through a Section 302 provision in SOX that requires public companies’ top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The company seems to have concluded that the internal control shortcoming was serious enough to treat as an overall deficiency in disclosure controls rather than pointing it out in its report on internal controls that is required under Section 404. EY expressed no opinion on the company’s internal controls in its audit report, which makes us wonder whether it was willing to stand up to Groupon’s management on the shortcomings in its internal controls and governance. In fact, the firm signed clean audit opinions for four years. Does it matter that Groupon reported its weakness in internal controls as a disclosure control under SOX Section 302 rather than pointing it out in its report on internal controls under section 404. Explain
Describe the risks of material misstatements in financial statements that should have raised red flags for EY.