Friday Rant: Obfuscating GAAP – IPO Buyers Beware

If we've learned anything over the past few years about U.S. financial markets, we shouldn't expect much protection from that seemingly all powerful instrument of federal regulation called the Securities and Exchange Commission (SEC). But if you've ever taken Accounting 101, you might believe that knowledge of generally accepted accounting principles (GAAP) can provide a requisite advantage when considering an Initial Public Offering (IPO) investment. Think again.

Though before you do, a short history is in order: Federal control was placed over the securities exchanges and the corporations whose shares were traded on them by the Securities Act of 1933 and by the Securities Exchange Act of 1934 to hopefully cure some of the ills that led to the stock market crash of 1929. These acts were intended to provide investors with reliable information, prevent stock price manipulation, and to discourage disastrous speculations that could damage the nation's economy.

Ironically, the SEC deferred to the American Institute of Certified Public Accountants (AICPA) to set and define accepted standard accounting principles, and the rooster remained in the hen house until the establishment of the Financial Accounting Standards Board (FASB) in the 1970s and the eventual passage of the Sarbanes-Oxley law in 2002. According to Wikipedia, "The Sarbanes-Oxley law created the Public Company Accounting Oversight Board (PCAOB) which has jurisdiction over virtually every area of CPA practice in relation to public companies ... as a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom ... which cost investors billions of dollars when the share prices of affected companies collapsed..."

End of history lesson, and now for the rub: Practically none of these regulations and standards apply to privately held companies -- those that market themselves to potential investors ahead of their initial public offering. And while according to yesterday's WSJ, SEC spokesman John Nester "said the agency's staff currently reviews all IPO filings, and an average range from filing to effective date might be three to six months", consider a recent case in point in the Journal column: "The Securities and Exchange Commission has asked Groupon to answer questions about the unusual measure it invented, which paints a more robust picture of performance by excluding marketing and other expenses ... in the company's IPO, expected this fall..."

Unspecifically, "Groupon, whose IPO is expected to value the company at $20 billion, has highlighted in regulatory filings something it calls "adjusted consolidated segment operating income," or adjusted CSOI. Investors and analysts said that draws attention away from marketing costs, which are causing the company to hemorrhage money." The Journal also quotes Ben Strubel, a portfolio manager with Strubel Investment Management, saying "While it isn't unusual for companies to use nonstandard financial measurements ... In essence Groupon is asking investors to look at their profit before any expenses..."

Groupon "... one of several multibillion dollar technology offerings teed up for this year... said it generated $81.6 million in adjusted CSOI in the first quarter of 2011, though if marketing costs are taken into account that figure would be a loss of $98 million." And "some of those companies, which are unprofitable, also highlight creative ways to measure their businesses", according to the Journal column.

So watch out for these new acronyms and don't be lulled into believing that there are new generally accepted accounting principles sanctioned by the AICPA, FASB, PCAOB or even the SEC for that matter. At the end of the week, blow bubbles. Trust your instincts and demand the GAAP you studied years ago in Accounting 101.

- William Busch

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