Why Groupon’s Fuzzy Math Should Worry Investors

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Antoine Antoniol / Bloomberg / Getty Images

Groupon's CEO Andrew Mason.

What is it with daily-deals website Groupon and accounting? The latest snafu came Friday when the company restated earnings to reflect a larger fourth-quarter loss after failing to set aside enough money to account for customer refunds. Groupon’s continuing accounting woes have reignited concerns about its management and internal controls that have dogged the company since before it went public last year.

Groupon’s restatement increased the company’s fourth-quarter losses from $42.7 million to $64.9 million. While the dollar amount of the correction isn’t massive — Groupon had over $500 million in revenue last year — the fact that the company continues to have accounting problems should concern investors. And it has. Groupon shares plunged 6% in after-hours trading Friday following the announcement.

Most ominously, Groupon’s accountant, Ernst & Young, said the accounting error came from a “material weakness in its internal controls” — a phrase that should set off alarm bells because it suggests a more fundamental deficiency in the company’s financial mangement. “It’s a complete fiasco,” venture capitalist Paul Kedrosky told Bloomberg TV. “Do we believe the controls are in place for this company to be run in a fashion reflective of a credible large capitalization public company? This has always been the concern with Groupon.”

(More: Groupon Shares Tumble 15% After Fourth Quarter Loss)

In truth, however, those alarm bells have been ringing since before the company even went public. The company raised eyebrows last summer as it was preparing its IPO by emphasizing 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. 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 CEO Andrew Mason also ran afoul of the SEC when a lengthy memo he authored touting the company’s prospects was leaked to the press — right smack in the middle of the company’s pre-IPO quiet period. In the memo, Mason trashed the financial press for critical coverage of the company. The SEC ultimately forced Groupon to include the memo in its IPO documents. Then, in September, Groupon radically changed how its accounted for revenue after pressure from the SEC — causing it to slash its 2010 revenue by half.

Groupon’s latest restatement is partially a consequence of the “Groupon Promise” feature of its business model. The company pledges to refund deals if customers aren’t satisfied. Because it has been selling those deals at higher prices lately — which leads to a higher rate of returns — it needs to set aside larger amounts to account for refunds — something it hasn’t been doing. It’s another example of Groupon failing to accurately account for a part of its business that reduces its financial performance. That shouldn’t inspire investor confidence.

In an updated filing with the SEC, Groupon said it is working to “remediate the material weakness,” in its internal financial reporting controls, and will hire “additional finance personnel.” But it warned: “If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results.”

(More: Are Daily Deals Dying? Or as Hot as Ever?)

Reaction to Groupon’s restatement wasn’t all negative on Wall Street, however. Scott Devitt, a tech analyst at Morgan Stanley, cautioned against reading too much into the issue. “While the announcement creates additional negative noise, we believe it is a [one-time] impact, and a mild hiccup in Groupon’s compelling long-term story,” Devitt wrote in a note to clients.

But the stock’s precipitous drop after the announcement showed that market confidence in Groupon has taken a blow.

In a statement, Groupon sounded an upbeat note despite the restatement. “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 Groupon Chief Financial Officer Jason Child.

Groupon’s latest accounting stumble could damage already shaky investor confidence in the company. Since going public at $20 per share last November, the company’s stock price has languished below that level. At a time when Groupon needs to cultivate investor trust in its business, the latest restatement is a step in the wrong direction, and one the company would be advised not to repeat.