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:
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
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.
Read this article in its entirety at the re: The Auditors, a blog
by Francine McKenna.
For more information about LexisNexis
products and solutions connect with us through our corporate site.