Last week was Groupon’s big week, although not in a good way. What happened? Well, the premier source of daily deal dish got knocked down a few more pegs after announcing a revision to 4th quarter earnings and the announcement by management that there was a material weakness in internal controls over financial reporting that was causing their disclosure controls to be ineffective. Groupon went public just a few months ago, last November, and the annual report was the company’s first filing as a public company.
Here’s one of the few journalists who got the details right, Jonathan Weil of Bloomberg, explaining why, in this case, the news was especially bad:
Didn’t Groupon know before its initial public offering that its controls were weak? A company spokesman, Paul Taaffe, declined to comment. Let’s assume for the moment, though, that its executives did know. Even then, they wouldn’t have had to tell investors beforehand.
That’s because there is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon would have had no obligation to disclose the problem until it filed its first quarterly or annual report as a public company — which is what it did. Sandbagging IPO investors in this manner is perfectly legal, it turns out.
The reason lies with a gaping hole in the Sarbanes-Oxley Act, which Congress passed in 2002 in response to the accounting scandals at Enron Corp. and WorldCom Inc. That statute had two main sections related to companies’ internal controls, which are the systems and processes that companies are supposed to have in place to ensure the information they report is accurate. Those provisions apply only to companies that are public already, not ones that have registered for IPOs.
One section, called 302, requires public companies’ top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The other section, known as 404, is better known. It requires public companies in their annual reports to include assessments by management and outside auditors about the effectiveness of their internal controls over financial reporting. Congress left it to the Securities and Exchange Commission to write the rules implementing those provisions.
Here’s where it gets tricky. Groupon reported the weakness in its financial-reporting controls through a Section 302 disclosure, not a Section 404 report. In other words, the problem was serious enough that it amounted to a shortcoming in the company’s overall disclosure controls.
Groupon won’t have to comply with Section 404’s requirements until its second annual report, due next year, under an exemption the SEC passed in 2006 for newly public companies. Likewise, Groupon’s auditor, Ernst & Young LLP, to date has expressed no opinion on the company’s internal controls in its audit reports.
From the moment Groupon announced the revision on March 30, there were two important facts that almost all major media financial journalists got wrong:
1) The announcement of lower revenue and lower income for the fourth quarter was a revision of an earnings release, not a restatement. Groupon never filed a 10Q so there was no SEC filing to restate. Fessing up to the right numbers in the annual report was the first time the company was bound to report those numbers and, at that time, they corrected previously announced earnings for the 4th Quarter.
2) Management made the assessment of the material weakness in internal controls over financial reporting that caused disclosure controls to be ineffective, not auditor Ernst & Young. Ernst & Young deserves no credit for the announcement, nor any blame, just yet, for the fact that the weaknesses had to be finally admitted. There is no transparency regarding the auditor’s agreement or disagreement previously with Groupon, any public documentation of their discussions or any reason to believe Ernst & Young either encouraged or discouraged Groupon to get their act together sooner.
We just don’t know.
What we do know is that Ernst & Young signed the fourth clean audit opinion when it signed the audit report included in Groupon’s annual report. With the three audited financial statements included in the S-1, we can assume that control weaknesses Ernst & Young was aware of, if they were aware of any, were not serious enough in their opinion to qualify the audit opinion.
Because I was very busy with some other projects when the Groupon announcement came out I chose to be quoted regarding Groupon, rather than to blog about it, last week. I also tried to use Twitter to alert fellow journalists and the readers that the reporting had mistakes.
I was asked to comment on the Groupon story by three media outlets: the Marketplace radio program on PRI/NPR, Phil Rosenthal at the Chicago Tribune, and Crain’s Chicago Business.
I haven’t seen the story in Crain’s yet, but it Here’s the Crain’s link. It was nice to have two local media outlets notice they had someone who writes about these issues right here in Chicago where Groupon is based.
Marketplace’s Heidi Moore, who I follow on Twitter, wrote a short piece and my comment is strictly color. You can read the text and listen here.
The Tribune piece is extensive and Phil Rosenthal does a great job explaining why Groupon’s success or failure means a lot to the Chicago tech scene. I get a long quote:
“As a Chicagoan, I’m really sad, because we’re proud when somebody does good here,” said Francine McKenna, an expert on the accounting and auditing industry who writes the Accounting Watchdog column for Forbes. “We love promoting our companies, especially homegrown success stories, and this is embarrassing.
“Because they’re growing so fast, because they’re trying to take a less conservative approach when they’re developing these numbers, because they want to shine the best possible light on what they’re doing, they got caught short. There was nothing they could do but admit they screwed up.”
To be honest, I’m holding back a bit on this subject because Groupon is a small part of a larger piece I’m wrapping up, hopefully, for the next issue of Forbes Magazine. So let me make a few comments that did not make it to the magazine piece.
The role of the auditor, Ernst & Young, is confusing to experts, let alone the average investor or business reader. Should the firm have caught Groupon’s errors before or after the IPO? Did Ernst & Young catch Groupon’s errors before the IPO and now? Did Ernst & Young influence Groupon management’s decision to make the painful acknowledgement that they were caught short in the return reserves department and had to revise revenue and earnings? We’ll never know.
Here’s what Groupon management admitted in the annual report:
“…management concluded as of December 31, 2011 that our disclosure controls and procedures were not effective at the reasonable assurance level due to a material weakness in our internal control over financial reporting, which is described below.
In connection with the preparation of our financial statements for the year ended December 31, 2011, we concluded there is a material weakness in the design and operating effectiveness of our internal control over financial reporting as defined in SEC Regulation S-X. “
Groupon says they are deficient in:
- Controls over monthly financial close process and procedures
- Controls to insure accounts were complete and accurate and agreed to detailed support
- Controls over account reconciliations to identify errors and omissions in journal entries
- Controls over timely, effective review of estimates, assumptions and related reconciliations and analyses, including those related to customer refund reserves
That’s a lot of weakness. I find hard to believe these weaknesses only showed up in the last month or so of the year, after the IPO and multiple S-1 filings. Could Ernst & Young have stopped the IPO? Could the SEC have stopped the IPO?
One proposal that the audit industry regulator, the PCAOB, has on the table that could help in the future – but maybe not for pre-registration filings and auditor opinions – is the Auditor’s Discussion and Analysis. (The italics are my comments back to the PCAOB, the audit industry regulator under the SEC.)
b. In what ways, if any, could the standard auditor’s report or other auditor reporting be improved to provide more relevant and useful information to investors and other users of financial statements? Two places where the current report could be improved are:
1. Development of a clearing house of auditor names attached to public company audit engagements worldwide with their biographies and information about sanctions, suspensions and litigation against them. I’m not so concerned about seeing a name on a printed report as knowing who is responsible for that audit over time and their qualifications and professional history.
2. The addition of an auditor’s “Disclosure and Analysis” would be priceless. It should be addressed directly to shareholders, not the Audit Committee, and be written in the style of Warren Buffet’s letter to shareholders. It should state where the auditors and management disagreed and which one prevailed. It should focus on judgments, estimates, and the range of practices especially regarding interpretation of key accounting standards amongst that issuer’s peer group.
c. Should the Board consider expanding the auditor’s role to provide assurance on matters in addition to the financial statements? If so, in what other areas of financial reporting should auditors provide assurance? Auditors should provide explicit assurance on MD&A. They are already required by standards to communicate with the Audit Committee regarding the adequacy of required disclosures. Interim Auditing Standard AU 380 requires auditors to determine whether all audit-related matters are communicated to the committee.
Potential Alternatives for Changes to the Auditor’s Report
A. Auditor’s Discussion and Analysis
5. Should the Board consider an AD&A as an alternative for providing additional information in the auditor’s report? Yes
a. If you support an AD&A as an alternative, provide an explanation as to why. See above 1.b.
b. Do you think an AD&A should comment on the audit, the company’s financial statements or both? Both. Provide an explanation as to why. Should the AD&A comment about any other information? The quality of management’s D&A and any disagreements in that regard over sufficiency or quality of disclosures.
c. Which types of information in an AD&A would be most relevant and useful in making investment decisions? I think information about how the issuer compares in key metrics, disclosures, aggressive interpretation of standards, and use of models and estimates to their peers would be very useful. In some industries, one auditor has an audit relationship with several major companies, addresses similar issues, evaluates similar approaches and either sees consistent or inconsistent results. This type of discussion and comparison would be very useful to identify outliers and anomalies as well as instances of collusion amongst companies with significant business with each other.
Another factor to consider is the auditor’s responsibility right now with regard to disclosure or reporting of fraud and illegal acts – if errors and misstatements rise to that level even pre-IPO. I’ve written previously that auditors are not very quick to tattle-tale on the executives of the companies they audit. The audit firms prefer to work it out internally and over time. There’s just too much money at stake both as an auditor and as a consultant. We do not know what Ernst & Young’s fees from Groupon – or Zynga or Facebook – are yet. The first proxies are not out. But we do know how much money was at stake with some other clients that have had issues:
- Ernst & Young was paid more than $150 million in fees by Lehman for 2001 to bankruptcy in 2008 according to the New York Attorney General complaint against Ernst & Young for fraud regarding lack of disclosure of Lehman’s issues.
- Google paid Ernst & Young $13 million in 2010 and 2009. Google’s proxy did not explain how Ernst & Young could reduce its fee for audit services to this high-risk company by $1 million in 2010. Google is a serial subject of SEC investigations for its accounting for stock options and taxes. The company recently settled a Department of Justice criminal investigation over the illegal use of its AdWords program by Canadian pharmacies. Ernst & Young did charge Google $500 thousand more in 2010 to address those tax issues.
- UBS, home of a recent rogue trader scandal, paid Ernst & Young $63 million in 2011 for their the audit, $12 million for audit-related activities such as assurance and attest services, control and performance reports, advisory on accounting standards, transaction consulting including due diligence, and tax advisory. Ernst & Young also earns another $32 million for services performed on behalf of UBS investment funds, many of which have independent fund boards or trustees.
- News Corp, where executives are accused of paying illegal bribes and hiding those payments on the balance sheet, paid Ernst & Young almost $35 million dollars in 2010 and about $31 million in 2009. The increase equals about 10% more for more tax consulting services, which make up almost half – $16 million – of the total fees paid to EY by News Corp. That, to me, is a serious indictment of EY’s independence as auditor.
Getting back to Groupon and their erroneous earnings release and uncontrolled S-1s…
According to a recently published academic paper entitled, Pro forma disclosures, audit fees, and auditor resignations:
Pro forma disclosures are non-GAAP disclosures; however, under the provisions of SAS 8, auditors are still responsible for ensuring that no overtly misleading voluntary disclosures are released to investors. That is, auditors are required to review voluntary disclosures and prevent any misleading or overtly optimistic information from being released. In addition, auditors are potentially responsible for ensuring consistency of pro forma reporting in voluntary disclosures, such as press releases, with any pro forma numbers included in mandated disclosures, such as SEC 10-K or 10-Q reports (PwC Dataline 2010-03).
I know I expect the auditors to be earning their fees by looking out for investors. But maybe that’s just pie in the sky.
The video is Glen Hansard and Marketa Irglova singing “You must have fallen from the sky” from The Swell Season.
Original main page art from this site.