Creative Accounting: Groupon’s ACSOI Profits

Where did the phrase “creative accounting” originate?

It’s a tongue-in-cheek expression that refers to accountants who find “creative” ways to manipulate the books and make companies appear to be healthy when they are actually near ruin. The phrase was originally used in the Mel Brooks film The Producers when accountant Leo Bloom explained to Broadway impresario Max Bialystock that he could optimize his profits by intentionally producing a “flop” of a show. He could then close the show, pay the outstanding bills, and keep the significant remaining balance of his shareholders’ investment proceeds.

Although Brooks was primarily a comedian and not a financier, he had actually devised a strategy that has subsequently been applied in the real world. Some small-market professional sports teams, for instance, have been accused by their wealthier and more successful rivals of pocketing their share of league-wide revenues and then optimizing profits by refusing to sign talented (and costly) players.

Earlier this month, in another display of creative accounting, the internet coupon distributor Groupon astonished the financial markets while filing a plan to “go public” soon. Their filing plan itself didn’t generate any astonishment; rather, it was the valuation that advisors placed on the firm, and the manner in which they quantified that valuation.

Profits vs. Losses

Financial analysts have traditionally multiplied a firm’s accounting profits by a risk-adjusted multiple to estimate its value. A low-risk, low-growth firm with $1 million in profits, for instance, might be assigned a multiple of 2.0 and valued at $2 million. A high-risk, high growth firm with the same $1 million in profits, however, might be assigned a multiple of 10.0 and valued at $10 million.

The higher valuation of the second firm is attributable to its greater growth potential, a condition that inevitably attracts Wall Street investors. Those same investors, though, would take note that the second firm’s price-to-earnings ratio is 10:1 instead of 2:1; they would thus be forewarned that an investment in the second firm might carry a higher risk of failure.

What if a firm “goes public” while it is earning no profits at all? What if it is actually losing money and yet needs to value itself? Traditionally, investors would expect such a firm to develop detailed strategic plans to turn its losses into profits in the relatively near future, and thus would utilize that future profit forecast as a basis for valuing the firm.

Groupon, though, is using a novel approach to support its valuation methodology. Although it is currently incurring losses in a traditional accounting sense, it has creatively invented a new accounting term called ACSOI to restate those losses as profits.

Introducing … Adjusted CSOI!

Groupon acknowledges that it is losing money when profits and losses are measured in accordance with Generally Accepted Accounting Principles (GAAP). The firm claims, however, that its profits and losses are more meaningfully measured by a metric they call Adjusted Consolidated Segment Operating Income (ACSOI).

How does this number differ from profits and losses that are measured in accordance with GAAP? ACSOI apparently includes all of the revenues, but only some of the expenses, that are recognized by GAAP. By excluding certain significant expenses, Groupon manages to convert its losses into profits.

The expenses that are excluded from ACSOI encompass some of the most common expense items found in GAAP reports. Marketing expenses, for instance, are ignored by the ACSOI formula. So are acquisition-related expenses, stock compensation costs, and interest and taxation expenses. Groupon claims that these expenses are all unrelated to its current business of serving its core customers, but prospective investors may wish to think twice before embracing this creative accounting metric.

More Aggressive Than EBITDA

In all fairness, Groupon is certainly not the only firm that utilizes a profit measurement that is different than the traditional GAAP metric. Many analysts, for instance, utilize a measurement known as EBITDA, which refers to Earnings Before Interest, Taxation, Depreciation and Amortization Expenses. As is the case with ACSOI, EBITDA includes all revenues recognized by GAAP but excludes certain expenses, ensuring that it will usually produce a larger profit number than GAAP.

ACSOI is particularly aggressive, though, because it excludes marketing expenses. Groupon claims that its marketing activities are targeted primarily at attracting new clients and are not designed to retain current clients, and thus should be excluded from any profit measurement that is focused on current operating activity. Nevertheless, analysts have noted that Groupon’s “customer acquisition” marketing expenses are extremely high; such costs are completely ignored when excluded from metrics like ACSOI.

Ultimately, each investor must decide for himself whether Groupon actually deserves the mammoth $30 billion valuation estimate that has been calculated by analysts on the basis of its ACSOI metric. Whether you agree or disagree with that particular valuation number, you would be hard-pressed not to admire the creativity of the ACSOI metric, as well as (as Max Bialystock might say) Groupon’s sheer chutzpah in promoting it.

Netflix vs. Comcast: A “Ma Bell” Moment?

Do you remember Ma Bell? Do you miss her?

Ma Bell, as you may recall, was the colloquial name for AT&T’s national monopoly, a business that controlled virtually every telephone in the United States. From the time that the Justice Department granted it that franchise in 1913, until the time that the government launched a lawsuit in support of spunky upstart MCI’s antitrust case in 1974, AT&T possessed what might have been the most lucrative unchallenged legal monopoly in American business history.

Throughout that period, AT&T owned and operated every telephone pole, every phone line, and every piece of voice transmission equipment in the United States. It also provided service to each citizen and each organization that needed a telephone. But once MCI introduced a competitive plan to deliver voice services over AT&T’s system, the Justice Department decided to require AT&T to provide the same level of access to any external service provider that it provided to its own service division.

It remains a topic of conjecture as to whether the innovative threats of mobile phone service and the internet would have brought down the AT&T monopoly any way, had AT&T not voluntarily agreed to a break-up under Justice Department auspices in 1984. Amazingly, though, a very similar debate erupted last week between a cable television company and a pair of internet service firms.

Comcast: The New AT&T?

Comcast, like the old AT&T, is a communication transmission company, albeit one that enables customers to receive cable television service. In each of its communities, Comcast has been granted a monopolistic license to maintain the television transmission cables under (or over) the public streets, and to sell access to those transmissions to the general public. They have also been granted an exclusive license to provide the public with cable-based internet access as well.

Recently, however, a relatively new service firm named Netflix has begun streaming Hollywood films and shows to the television sets of Comcast customers through Comcast’s transmission cables. At first, Comcast did little or nothing to oppose that practice. But now that the Netflix movie streaming service has grown to the point where it utilizes over 20% of America’s internet bandwidth traffic during the peak evening hours, Comcast is suddenly paying attention.

Once Netflix agreed to rely on the internet service firm Level 3 Communications to help it grow even further, Comcast suddenly demanded that Level 3 pay it special fees for the privilege of using its transmission cables. But will the federal government permit Comcast to charge independent providers special fees for competing with Comcast’s own cable television service?

Net Neutrality Under Fire

Negotiations between Netflix, Level 3 and Comcast are now in progress. The federal government is looking on as a highly interested observer, due to the importance of a general principle known as net neutrality.

To put it simply, net neutrality means that an internet service provider cannot “play favorites” by providing one web based service with preferential transmission rights over another. It cannot, for instance, stream its own movies at full speed over the internet while slowing down or halting the streaming activities of rival firms. Likewise, it cannot transmit the email messages of its own customers more quickly than the email messages of others.

The problem with net neutrality, of course, is that internet service providers appear to be the only firms that are being held to the principle. Apple’s iPad, for instance, plays streaming videos in the HTML5 format but refuses to play videos in Adobe’s Flash format. And Facebook’s new email service initially places the messages of each user’s Facebook friends in a more easily accessible box than the messages of others.

To force full neutrality on all of these parties would be an overwhelming task; no one is currently suggesting that the federal government enforce such a standard. That being the case, though, can the government selectively enforce the net neutrality principle on Comcast and other cable television firms?

The Future: Web 2.0

One vision of the future, dubbed Web 2.0, is that the very concept of net neutrality will fall victim to the evolution of the communication medium itself. Facebook, for instance, seems to be evolving into a private password-protected version of the internet, with its users maintaining “walls” that function like web pages, and with email, text chat, and other communication capabilities available as well. And Iridium provides the entire earth with its own privately owned transmission service, operating via a network of 66 planetary satellites.

As such firms continue to grow in size and power, it will become progressively harder to force them to provide equal access to upstarts like Netflix. What may eventually emerge is a bimodal internet system, with a theoretically “net neutral” world wide web that relatively few people continue to use, and a number of private, proprietary services that represent the future of the medium.