An investigation into creative accounting at Groupon

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Part C

Creative accounting focuses on the loopholes in the accounting standards to mislead the public into believing that the performance of the company is better than it really is. Even though, creative accounting are legal, there is a fine line between what is legal and what isn’t should a company decide to use creative accounting. I believe that there will come a time for many companies when they have exhausted their options and have no choice but to use creative accounting to manipulate financial reports to attract more investors or retain current clients. Due to this, accounting standards change over time to ensure the prevention of firms using creative accounting. In my opinion, it isn’t wrong but it can be misused very easily. It would be nearly impossible to completely eliminate creative accounting in companies. I feel that reducing it is more realistic compared to eliminating it. Frequent revaluation of companies’ financial reports and monitoring would help ensure the minimal activity of creative accounting in companies. It is indeed time consuming and costly but it would help minimize the usage of creative accounting.

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It is rather shocking to find out that a successful company such as Groupon would have to resort to finding loopholes in accounting standards. In May 2011, Groupon was using a metric called Adjusted Consolidated Segment Operating Income (ACSOI) to make their profits more appealing to the public and investors. Personally, it would not be wise to carry out schemes because it would be very risky should investors find out.

Fortunately for the investors of Groupon, Groupon’s financial reports and profits were revised. This provides a clearer picture of how well Groupon is really performing. Having said this, all investors shouldn’t look for the numbers the company provides them but the metrics that they desire. Despite all the scrutiny, Groupon is still surviving most likely because they have become “too big to fail”.

Interview

We interviewed Ms Yeong Gin Li who is currently a lecturer from KDU University College to get a better understanding of her professional view on creative accounting and the scandals Groupon was involved in. She is an ACCA lecturer with Cambridge International Diploma for Teaching & Learning and a Bachelor of Science. We conducted the interview via email as she was unavailable to meet in person.

Our first question was regarding her professional view on creative accounting. Her answer was ”I think it is an act of dishonesty, selfishness, unethical and irresponsible. Creative accounting is basically working through the loopholes of the accounting standards. Creative accounting is like going through a maze. You have to take turns here and there only then can you reach the end without being questioned for fraud. Creative accounting is not something which can be taught and not everyone has the ability to do it. You have to fully understand the accounting standards and framework before you can pull it off.”

We later asked her whether she thought creative accounting is ethical for organisations to use and why. She answers with “You know they say there are two sides to every story? That’s how the ethics of creative accounting is. I personally believe that it can be ethical if done smartly. It is not illegal so no one is breaking any laws. Everyone will have a different opinion on this subject. When an organisation uses creative accounting, the accounting department would have thought it thoroughly of all the options they have before using creative accounting.”

Moving on, we also asked her why did she think organisations are tempted to use creative accounting. She thinks that main temptation for creative accounting is that it has the ability to turn losses into profits. She also adds “Organizations these days are facing tremendous pressure due to the economy market as well as competitors. This reason drives organisations to show fake profits from losses or display an increase amount of profit from what the company actually recorded during the accounting period.”

Moreover, we asked her about her thoughts on what should be done to reduce or eliminate the use of creative accounting. Her response was “In my opinion, the easiest solution to reduce or eliminate creative accounting is by making creative accounting illegal. Implementing strict rules in accounting standard and regulations rules and taking legal actions will be taken against any company that uses creative accounting will help reduce creative accounting and eventually companies will be afraid to even use creative accounting.”

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We moved on to the topic of Groupon and its scandal. We asked her for her opinion on the Groupon scandal. Her statement was “Even though it seems legitimate for Groupon to have a lack of disclosure on the internal controls, however, not disclosing something that is material to the decision making of the investors is misleading. It reflects a lack of credibility with the top management of Groupon. Being a multinational company, the Groupon scandal was nothing much of a surprise. The Groupon accounting records and IPO was almost too good to be true. I would say that, it was a very foolish act by Groupon to falsify their records.”

Our last question for her was about how she thought Groupon should have handle this situation. She responded with “Supposing to be responsible to the investors, Groupon should have disclosed its weakness in the internal controls, rather than hiding the fact, despite of it is not required by statute. At the rate of the damage, Groupon handled the situation calmly. They, stated their mistake, apologized for their wrongdoings and also returned back a proportion of the money of their shareholders.”

Part D

An interview was conducted with an accounting professional and an academician.

Mr. Ramesh Chandran is an accounting professional who has been in the accounting field for over 30 years. He did the Institute of Chartered Accountants in India (ICAI) program and is currently a member of Malaysian Institute of Accountants (MIA). Mr. Ramesh is currently the Group Financial Controller at Josovina Commodities Sdn. Bhd. In the interview we conducted, we asked Mr. Ramesh on creative accounting in general and about the Groupon scandal. The first question we asked Mr. Ramesh was his opinion on creative accounting. He said that “creative accounting is inevitable and that approximately 2/3rds of companies practices creative accounting. Creative accounting refers to the flexibility that accounting standards allow to give a true and fair depiction of an organisation to benefit the users of financial statements and that if organisations step out of the regulatory framework and manipulate the accounts, then it is classified as fraud not creative accounting.” He does state that sometimes creative accounting and fraud do coincide. We then asked Mr. Ramesh whether creative accounting is ethical and if it can be eliminated or reduced. Regarding to whether it is ethical, Mr. Ramesh said it is very subjective. He states that “accountants follow accounting standards when preparing financial statements and there are perfectly legal methods when calculating certain items. Company’s will obviously choose a method that benefits them.” He also states that when preparing financial statements, sometimes estimates have to be made. So whether it is ethical or not, is an individual’s opinion. Regarding if it can be eliminated or reduced, he states that “creative accounting can never be eliminated as companies are always going to choose the accounting standards that make their financial statements look better whether it is ethical or not.” However, Mr. Ramesh states that it can be reduced as there are theoretical solutions available. He says that “there are various accounting treatments that are allowed can be reduced or the circumstances under which they can be used can be restricted. For instance under inventory valuation, the LIFO method is no longer acceptable. Auditors should be more careful when assessing the various estimates that the management has made. Penalties could be imposed on both the auditors and senior management of companies if accounts are deliberately manipulated.”

We then asked Mr. Ramesh his view on the Groupon scandal. He says that “the Groupon scandal refers to weaknesses that were discovered in the company’s internal control system over financial reporting which resulted in their disclosure controls to be defective. This resulted in the company restating its previous quarter earnings just over a month after going public. There was obviously some suspicion that the company waited until after the IPO to disclose this information.” He states that it is clearly fraud when ACSOI is used and that Groupon clearly engaged in questionable accounting practices. We then asked him how he thought Groupon should have handled this situation. He said “Groupon was perhaps not prepared for this but they probably have learnt their lesson. The company lost the public’s trust. So they should admit their failings and prepare a sound business model instead of hyping up their figures. If you make a mistake the best thing to do is own up to it and apologise.”

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Part A

Literature Review

Creative accounting is the change of financial accounting figures from the actual figures to what the preparer desires by manipulating the existing rules, regulations, standards and principles and/or ignoring some or all of them to meet the goals set by managers or the company’s management (Ali Shah, et al., 2011). It is said that creative accounting is a smart and sophisticated way accountants and the managers of a firm modify and improve the accounts and financial records of the organization to show and prove to the investors, creditors and financial institution that the company is well off. In accounting terms, creative accounting is said to be legal as well as allowed by the accounting boards and professions.

The users of financial reports and accounting data require credible and reliable information to make investments decisions. However, when a firms accounting department uses creative accounting practices, this reduces the expected benefit of financial information produced, because this information has transformed from useful to non-useful information for the purposes of users' decisions. Thus, users will make ineffective and inefficient decisions as they are blinded by the manipulated accounting information. As a result, users will be unable to achieve their investment, credit, and other objectives (Al Momani & Obeidat, 2013).

There are many reasons for a firm applies creative accounting into their record and displays in their companies financial statements. One of the reason creative accounting is applied is to meet the company’s internal goal. The managers will cook the books in order to meet internal targets which are set by higher management in respect to sales, revenue, and profits in return for higher prices of the company’s shares. Besides, organizations are required to meet external expectations from their stakeholders. Employees, one of the internal stakeholders would want precise directions and goals instructed in order for them achieve organizational success. External stakeholders such as suppliers would want strong guarantee for their payments and strong long term relationships with the company. Clients would require continuous improvements of products, services and after-purchase support. These pressures from internal and external stakeholders leave the firm’s management with no other option but to manipulate with the accounting reports. Moreover creative accounting helps the companies to provide smooth flow of income. Companies need to present continuous flow of income to impress the investors and keep prices of their share stable. Prepares of the accounts favor this as its helps evaluating an investment on the basis investments returns (Al Momani & Obeidat, 2013).

Companies depend on their employees, products and services as well as consumers to generate revenue and gain profits. Based on their performance, a company will be able to gain more investors, financial support and a large number of consumers. As a result, accountants will manipulate the accounts records by misusing accounting policies. There are many accounting policies and standards made and set. However, these policies and standards do not cover all aspects of accounts. This limitation of these policies is an advantage for accountant to go above and beyond in order to manipulate with the accounting records. The most common misuse of accounting policies is exploiting the technicality in revenue recognition standards. An example of the exploitation is that companies usually record the revenue even before their net profit is obtained. This will cause over-stated revenue as the profit yet to be determined. Another way a firm use creative accounting is with the help of the changes in accounting policy from time-to-time. Due the the lack of knowledge of these changes, companies often use the incorrect policy. There are times when a company adapts to a new policy, but they do not mention to the users of the financial information. This miscommunication will lead to a misinterpretation of the information (Ali Shah, et al., 2011). In addition, accountants at times create artificial transactions to play with the debit and credits of a double entry as well as the account types. This entries will affect all the accounts statements and records (Sanusi & Izedonmi, 2014).

Groupon is one of the world’s leading e-commerce companies. Groupon’s business is similar to a mediator, as it allows buyers and sellers meet online via price and discovery online (Anon., n.d.). In November 2011, Groupon was a publically listed company. Within days after they went public, their share prices rose tremendously. Many investors made million in returns. However, 4 months later an accounting scandal was discovered, which caused public shareholders to have lost billions of dollars. It was stated that the the main fall was due to the company’s disclosure control (Well, 2012). Moreover, it was revealed that the company had adjusted its consolidated segment of operating income. Groupon was asked many question of one regarding their revenues (Pavlo, 2012). Groupon’s internal auditors had made a mistake due to the lack of control in the materials for the preparation of their financial reports (McKenna, 2012).

Therefore, to avoid and prevent creative accounting, various accounting board have come together and made many amendments and brought upon new accounting standards, policies and regulations. For example, Financial Reporting Standards (FRS) 1 Cash flow statements was introduced which required companies officially publish their cash flow statement. This regulation prevents companied from manipulating and hiding the inflow and outflow of cash in the organization (Yadav, 2013). Besides FRS 2 Accounting for Subsidiary undertakings was created to allow more transparency in the consolidation statement prepared by the parent company. This will prevent the parent company form hiding the liabilities and not disclosing the income (Yadav, 2013).

Part B

In May of 2011, Groupon was preparing to go public. In preparation to go public, Groupon had to overcome a lot of media scrutiny, as there were people trying to dig out dirt on Groupon, to bring them down before it goes public. J. Edward Ketz and Anthony Catanach are professional accountants who managed to find, after much research, that Groupon had not complied with the Generally Accepted Accounting Principles (GAAP) (Antar, 2011). They found the violations from going through the financial statements Groupon filed with the Securities and Exchange Commission (S.E.C). They established that the company’s revenue accounting calculations were not in compliance with the GAAP and filed a complaint with the S.EC.

Groupon used a metric called Adjusted Consolidated Segment Operating Income (ACSOI), which violates the GAAP (The Wall Street Journal, 2011). ACSOI is calculated using the total actual revenues but only includes certain expenses. It excludes marketing costs, which takes up more than half of the company’s expenses (Gustin, 2013). Doing this allowed Groupon to change its losses into profits so that it looks more appealing to the investors when they go public. The company then revised its profits for 2009 and 2010. The actual profits made were less by more than half of what was initially stated. This affected Groupon’s image and had a slight impact in their IPO.

On November 4 2011 Groupon went public. Its share price increased from $20/share on the first day to $31/share the next day (Pavlo, 2012). Everything was looking good for Groupon. They were making profits and their share prices were increasing. Just shy of two months after going public, Groupon’s CEO Andrew Mason stated that he had discovered material weaknesses in the company’s internal controls (Northwestern Business Review, 2013). He stated that the figures for the fourth quarter of 2011 were incorrect and a revisal was being made. Share prices then dropped by 14% as shareholders were unsure if the revisal would be good or bad for them and the company (Northwestern Business Review, 2013). In March of 2012, the revised figures were released. The revised figure shows that revenue was overstated by approximately $14.3 million and there was an operating loss of $30 million (Gustin, 2013). Ernst and Young were the auditors of Groupon and concluded that the figures for the fourth quarter of 2011 were correct (McKenna, 2012). There was some negligence on their part as they obviously knew there were some weaknesses with the management control of Groupon and should have informed the S.E.C. After the revelation, Groupon’s share price dropped to $11/share. It had reached a low point of $7/share in July of 2012.

Groupon was already having problems before they went public. In January 2011, Groupon made $950 million in pre-IPO fundraising but by the end of March 2011, all that was left was $209 million. It turned out that Groupon had paid a little less than $800 million to their insiders, which included $300 million to chairman Eric Lefkofsky, all while they were making losses (Gustin, 2013).

Groupon had to revise their whole financial plan to make sure that this does not happen again. Groupon fired their CEO Andrew Mason in early 2013 as he couldn’t correct what had been done. After he was fired, Groupon’s share price increased by 4% (Gustin, 2013). The share prices have improved since then.