Differences in Groupons Business Model in Comparison with Wal-Mart and its Impact on Business Risks - Research Paper Example

? Groupon – Case Study Differences in Groupon’s Business Model in Comparison with Wal-Mart and its Impact on Business Risks and Financial Reporting Groupon works as an online business entity offering discount coupons which can be used its customers for purchasing discounted merchandise and other items from companies based in the United States. The whole business model followed by Groupon is actually built on online platform, whereby transactions are carried out with customers of the company. This allows Groupon to serve a large customer base all over the United States without being faced with the limitation of physical existence, unlike other retailing giants like Wal-Mart. The following illustration provides a simplified view of the business model followed by Groupon: Comparison of this business model of Groupon with Wal-Mart reveals some fundamental differences in the approach followed by the two businesses. First of all, as mentioned earlier, the virtual operating style of Groupon through internet is a primary factor which distinguishes the extent to which both companies can target their respective customers. Based on the differences identified in the business model for Groupon in comparison with the approach followed by Wal-Mart, it is possible to determine how these differences influence the risks identified by Groupon in its financial statements under management discussion and analysis and also the translation of these risks into financial reporting of the company. Before initiating a discussion as to how risks faced by Groupon would influence its business model, it is pertinent to understand that the success of the business model of the company largely rests on the revenue generating ability of the company through acquiring new subscribers to purchase coupons offered by the company. Since the company has only one product to offer, i.e. coupons, therefore any unfavourable changes in the circumstances may eventually lead to the disruption of whole business model. First of all, the company has expressly stated in its Form S - 1 that, “We may not maintain the revenue growth that we have experienced since inception.” (Groupon Incorporation 11). Although, the company would take measures to ensure that such a risk may not materialize in future; however, if such a situation is faced by the company where revenue growth becomes difficult, the business model may be affected severely, as there is no contingency plan for the company due to lack of its diversity in operations. Realizing the significance of influence this risk may have on the business model of the company, it has been mentioned that, “If we fail to retain our existing subscribers or acquire new subscribers, our revenue and business will be harmed.” (Groupon Incorporation 12). In addition to this, it is also important to note that apart from growth in subscribers to the business, the retention and growth of merchants for the business is also a risk factor. The company has expressly stated that if it fails to retain or grow the number of merchant it deals with, the revenues may shrink considerably in the future and therefore place impact on the whole business (Groupon Incorporation 13). Apart from this, it is also pertinent to understand that Groupon is not alone in its market; in fact there are other competitors who are improving their customer base and market standing. The company, in this regard, states that it operates in a highly competitive environment where competitors may pose a significant threat to the operations and growth opportunities for Groupon in the future (Groupon Incorporation 13). Issues regarding Revenue Recognition for Groupon The table presented as follows include information pertaining to revenues, cost of sales, other operating expenses and net profit / loss of the company for the financial years 2009 and 2010. Under each year, both gross and net based revenue recognition by the company has been presented so as to make the comparison possible between the two types of treatment for revenues earned by the company and the consequential impact on its profit / loss. It is also pertinent to mention here that the information presented in the table has been obtained from the company’s S – 1 filing with the Securities and Exchange Commission on June 2, 2011 and the amendment of the same, which was amendment no. 4, which was made on October 7, 2011 (Groupon Incorporation). 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 Administrative Expenses $ 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) Source: (Groupon Incorporation) In the above table, significant variations in revenues and other particulars of the income statement for Groupon, in both financial years, can be observed after amendments were being made therein. As for instance, upon shifting from recognizing revenues from gross to net, total revenues dropped from $ 30.4 million to $ 14.5 million and from $ 713.4 million to $ 312.9 million in the years 2009 and 2010 respectively (Groupon Incorporation). Income Statement Account 2009 2010 Gross Net Difference Gross Net Difference Revenue $ 30.40 M $ 14.50 M $ 15.90 M $ 713.40 M $ 312.90 M $ 400.50 M Cost of Sales $ 19.50 M $ 4.40 M $ 15.10 M $ 433.40 M $ 32.50 M $ 400.90 M Gross Margin $ 10.90 M $ 10.10 M $ 0.80 M $ 280.00 M $ 280.40 M $ (0.40) M Source: (Groupon Incorporation) The difference noted in the revenue and cost of sales figures is the result of netting off revenues with cost of sales. As for instance, earlier, under gross revenue approach, Groupon used to report its revenues which included gross payments received from customers when they purchased coupons, and then cost of sales, which included the portion of revenues to be paid to merchants, were deducted from revenues to arrive at a figure of gross margin. However, after Securities and Exchange Commission required the company to report revenues on a net off basis, the total revenues reported earlier declined as per reinstated figures due to exclusion of the amount owed to merchants by Groupon. The company, Groupon, preferred the former treatment of revenue recognition, as it believed that “… (it) is the primary obligor in these transactions, is subject to inventory risk and has latitude in establishing prices.” (Groupon Incorporation 10). This reflected that the company believed that it was acting in the capacity of originator and responsible of the transactions which ultimately earned the revenues reported under gross revenue recognition approach. After the company reinstated its revenue figures, there were material changes brought to the overall financial picture of the company’s operations and profitability. Ratios 2009 2010 Gross Net Gross Net Gross Margin (%) 35.86 % 69.66 % 39.25 % 89.61 % Asset Turnover 0.00203 0.00097 0.00187 0.00082 Source: (Groupon Incorporation) As for instance, the company increased significantly as per net revenue recognition approach, whereas asset turnover ratio declined to a significant extent, thus depicting the intensity and basis of concern shown by regulators that gross reporting of revenues could lead to material misstatements and unsound basis for decision making by investors when Groupon would go for public offering. Keeping in view these ratios, it can be said that Groupon would have surely liked to opt for a gross revenue recognition approach, as the company was about to go for public offering and would have wanted a sound balance sheet for grabbing investors’ interest. On the other hand, as far as the correspondence of the company with Securities and Exchange Commission is concerned, which took place after the company filed its initial S - 1, the regulators raised concerns over the method used by Groupon in reporting its revenues on gross basis rather than net basis. In response to this concern, Groupon justified its gross treatment of revenue on the basis of stipulations presented under ASC 605-45-45. The company stated that it fulfilled the criteria for reporting revenue on gross basis, as it: is acting in the role of a primary obligor, has discretion in determining the price, faces risks attached to inventory it deals with, is able to select suppliers on its own, has a role in determining the features and specifications of products being sold, and faced credit risk (Securities and Exchange Commission 32-33). However, the company could not present a convincing argument as to how it is involved changing the product or any part of the services provided and how Groupon faced risks related to physical loss of inventory. Moreover, as noted by the response to the aforementioned claims made by Groupon Incorporation, SEC raised another query which signified a material weakness in the claims made by the management of Groupon. SEC, in its response stated, “We note you recognize revenue when a certain number of customers who purchase the daily deal exceed the predetermined threshold. 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.” (Securities and Exchange Commission 33) Assessment of Groupon’s Revenue Recognition Practices and Approach Groupon, on its website, expressly mentioned that the company promises its customers a right of return if the product offered is not up to their expectations. However, the company was argued by SEC as having not complying with the requirements of revenue recognition where sale of a product carries a stipulation empowering the buyer to exercise a right of return. The company was of the view that it has reasonable means to estimate the returns in future and therefore was not required to create a refund liability. As per the regulations provided in Para 54 under the heading “Variable Consideration” provided in the accounting standard Revenue Recognition (Topic 605), “If an entity receives consideration from a customer and expects to refund some or all of that consideration to the customer, the entity shall recognize as a refund liability the amount of consideration that the entity reasonably expects to refund to the customer. The refund liability (and corresponding change in the transaction price) shall be updated at each reporting period for changes in circumstances.” (Financial Accounting Standards Board 23) In addition to this, the above mentioned excerpt from the standard also requires following the guidelines provided in Para IG2 to IG9. In Para IG5, it has been stated, “… For any amounts to which an entity is not reasonably assured to be entitled, the entity should not recognize revenue when it transfers products to customers but should recognize any consideration received as a refund liability.” (Financial Accounting Standards Board 44) Keeping in view these requirements and the fact that Groupon ultimately faced a situation in which it had to increase its refund liability account in its balance sheet, it can be said that the company’s assumptions regarding accounting treatment of revenues from sales with an unconditional stipulation of right of return required creation of refund liability at the first instance. The basis of accounting followed by Groupon was that the company operated in a geographical region where it was beyond reasonable doubt that there could be material changes in the circumstances which would ultimately render Groupon’s estimation as unreasonable. However, with the diversification of its operations in other sectors, the company was exposed to higher risks related to refunds and therefore the previous justification could not hold ground. It would have been a more prudent approach had the company opted for creating a refund liability in accordance with the applicable regulations and standard since the inception of its sales. In such a scenario, the revenues of the company could have been shrunk owing to the fact that a particular amount of total revenues would have to be apportioned as refund liability. Moreover, the balance sheet would have been affected as a result of the creation of refund liability. Restatement of Revenues and Impact on Financial Statements The restatement of financial statements by Groupon Incorporation in the fourth quarter results for the financial year 2011 resulted in numerous changes in the financial statements. Most of the changes were brought in the income statement of the company, as the company shifted its gross revenue recognition policy to net revenues recognition. With the change of this policy, major changes could be observed in the revenues and cost of sales of the company; however the net income of the company remained same as the changes in revenues and cost of sales reciprocated each other in the income statement. Due to these reasons, no changes could be observed in the net cash flows generated from operating activities of the company, as net income, depreciation, interest and taxes and changes in working capital of the company are only considered in arriving at the net cash flows generated from operating activities of the company. Refund Reserve and Accrued Expenses for Refund Reserve for Groupon (2011 - 2012) In order to determine the amount of refund issued in 2012 to the customers of Groupon, the accrued expense in the first quarter of 2012, which has been assumed to be $ 100 million, has been added and refund reserve as at March 31, 2012 has been subtracted from the refund reserve balance as at December 31, 2011. These calculations have been presented in the table presented as follows: Amount Refund Reserve as at 31 Dec 2011 $ 67.45 million Add: Accrued Expense in first quarter of 2012 $ 100 million Less: Refund Reserve as at 31 Mar 2012 $ (81.56) million Amount of refund issued in 2012 $ 85.89 million Source: (Groupon Incorporation) The above calculations reveal that the actual amount refunded by Groupon to its customers in the first quarter of financial year 2012 amounted to $ 85.89 million. The expense recorded in the first quarter of financial year 2012 is not equal to the amount paid to the customers in lieu of refund because the accrued expense represents the additional amount of expense which is over and above the cash payments actually made as per refund requests from the customers. Therefore, the increase of $ 14.1 million in the refund reserve can be stated as signifying the amount of refund expense over and above the amount paid to the customers during the first quarter of financial year 2012. Possible Impacts of Private Investment, Selling and IPO on Groupon’s Financial Reporting As Groupon’s management felt the need for increased cash requirement for the company as the business continued to grow and a viable future was being forecasted for the business. In this regard, there were several offers made to the owners of the company, first by Yahoo and then by Google, to sell their stakes to the said companies. However, the owners dismissed the idea of operating as a subsidiary of the prospective buyers. Instead, they decided to go for public offering in 2011, and generate funds from public investment. Considering the cash needs of the company, it can be stated that the owners of the company had three broad options to raise the required funding, which are: Invite private investment Selling the company to prospective buyers, such as Yahoo or Google Go for Initial Public Offering (IPO) Apart from other possible effects of exercising either of the above mentioned options, one major area of concern for the company would have been ascertaining the financial impact of the option exercised. In the first case, which is seeking private investment from investors, there would have been no particular changes required in the financial reporting of Groupon Incorporation; however, the sources of funding would have to be mentioned in the financial statements along with the disclosure explaining the amount and source of funding (Bramwell). On the other hand, had the owners of Groupon opted for selling the company to another company, there would have been significant challenges faced by the management of Groupon. As for instance, by selling Groupon Incorporation to another company, there would have been increased reporting requirements for the company to report its operations and financial standing as per the regulations provided by FASB for subsidiary companies. Moreover, there would have been changes in the financial reporting requirements for parent company of Groupon also. The last option for Groupon was to opt for public offering, which was ultimately preferred by the owners of the company over other options. After having selected IPO option for raising additional funds, the financial reporting of the company underwent strict scrutiny by the regulators, namely Securities and Exchange Commission. Owing to the special nature of the business of the company, revenue recognition was the biggest challenge for the company, for which SEC raised numerous concerns (Flood). Apart from this, there are other reporting requirements which had to be fulfilled by the company in accordance with the standards and regulations set by SEC and FASB before going for public offering, which include filing of certain statements to inform the Commission about the financial standing and other fulfilment of requirements to the satisfaction of the Commission (Flood). Works Cited Bramwell, Jason. FASB and PCC Finalize GAAP Framework for Private Companies. 18 July 2013. 19 November 2013 . Financial Accounting Standards Board. Proposed Accounting Standards Update (Revised) - Revenue Recognition (Topic 605). Exposure Draft. Washington: Financial Accounting Standards Board, 2012. Flood, Joanne M. Wiley GAAP 2013: Interpretation and Application of Generally Accepted Accounting Principles. Hoboken: American Institute of Certified Public Accountants, 2013. Groupon Incorporation. Annual Report. Chicago: Groupon Incorporation, 2012. —. Annual Report. Chicago: Groupon Incorporation, 2011. —. Financial Statements. Chicago: Groupon Incorporation, 2009. —. Financial Statements. Chicago: Groupon Incorporation, 2010. —. FORM 10-Q. SEC Filing. Chicago: Groupon Incorporation, 2012. —. FORM S-1. Washington: Securities and Exchange Commission, 2011. Securities and Exchange Commission. Reply to Registration Statement on Form S-1 filed on June 2, 2011. 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