It seems Groupon might be dumping Adjusted CSOI, its much ridiculed accounting metric that I frequently describe as “the best possible way to view our business if you ignore all the things that make our business look terrible.”

Although CSOI was an utterly ludicrous metric, there are other accounting practices that potential Groupon investors should be wary of.

I’ll preface this by saying that I’m not saying Groupon is violating accounting rules or doing something illegal. Because it’s a new business, these determinations haven’t been made. Ernst & Young, Groupon’s accountants, were comfortable signing their name to the S-1. Instead, I’m focusing on the economics that matter to investors.

Gift card liability

As of January 29, 2011, Target had $422 million in gift card liability. These were gift cards that were purchased by Target customers and hadn’t been redeemed yet. I know that because I found that in their 10-K statement.

How much liability does Groupon have? We don’t know. No one does — not even Groupon. The way their business and operations are structured, it’s currently impossible for anyone to know exactly how much Groupon value is outstanding. By my estimates, Groupon has between $300 million and $500 million in liabilities that don’t show up on its books. (This is based on their sales volume and assumes a U-shaped redemption curve.)

Here’s how revenue recognition for gift cards typically works: if you buy a $500 Target gift card, that $500 is recorded as “deferred revenue” by Target, not as revenue. “Deferred revenue” is a liability of the company because they owe you $500. Only when you use that $500 to buy an iPad does Target record the revenue as earned.

That’s not how Groupon does it. As soon as you buy a Groupon, they record the entire amount as revenue. They don’t even track how much Groupon value is outstanding.

Groupon does this because they claim that they’re just a marketing agent and that they aren’t responsible for the Groupons that are issued. It’s technically a liability of the merchant issuing the Groupon.

But that’s not how they’ve been acting — if a merchant goes out of business, Groupon has typically issued refunds. If a merchant simply decides they don’t want to honor Groupons (this happens), Groupon issues refunds. After a merchant has received their final payment from Groupon (usually 60 days), it has no financial incentive whatsoever to honor them. This risk is significant because of the general instability of small businesses.

In these cases, Groupon loses twice. They lose not only the amount they received from the transaction but also the money paid out to the merchant.

From an accounting standards perspective, we could argue over whether Groupon should be tracking this liability. But for investors, what matters is that Groupon and its customers are treating it as Groupon’s liability.

This exposure is only increased by the fact that many states don’t allow gift cards to expire and Groupon could be on the hook indefinitely.

Gross vs. net accounting

Groupon is booking the entire amount it receives in a transaction as revenue. If you spend $25.00 on a Groupon and the merchant gets $12.50, Groupon is saying they received $25.00 in revenue and paid $12.50 out as “cost of revenue.”

FASB 99-19 looks at gross vs. net and offers some guidance and examples on how revenue should be booked. My read is that Groupon should be recording just the portion of revenue that it receives. ($12.50 in the example.)

That’s how other companies who engage in similar transactions do it. When Amazon and eBay sell merchandise on behalf of others, they only book the fees that they receive as revenue. What Groupon calls its “gross profit” is what these companies would call their revenue.

To take an extreme example, if Square were to book revenue using the same methods that Groupon uses, it’s on a run rate to book more than $1 billion in annual revenue. It’s actual revenue would be closer to $28 million.

This matters because the top line revenue as Groupon reports it is extremely easy to manipulate. If they wanted to show $100 million in revenue growth, they could sell $200 American Express gift cards for $100. Sell a million of them and you’ve got $100 million in revenue. It’s a definite money loser, but it generates revenue growth.

Inflated customer numbers

As of March 31, 2011, Groupon claimed 15.8 million customers and a mailing list of 83.1 million. For most businesses, a 20% conversion rate would be phenomenal. For an opt-in mailing list where many deals are pretty close to giving away cash for half off that number is terrible.

And even that 15.8 million number is inflated. I recently set up a new test account with Groupon using a different email address. Four days later, I received an email with the subject “Incredible deal for you from AMC Theatres”. It was an incredible deal alright — $4 for a movie ticket worth up to $12. I bought two. This deal is not generally available on their Web site; it’s a new customer offer.

Groupon does this for two reasons: 1) It gets your credit card on file, which makes it even easier to make future purchases. 2) It gets to count you toward that 15.8 million customers and the $4 toward revenue. We have no idea what proportion of Groupon’s 15.8 million customers only a purchased a giveaway like this.

The movie theater deal is a no brainer. If you go to the movies, there’s little reason not to buy it. But if that’s all you ever buy from Groupon, you are just a loss to the company.

Except to the extent that they can use your numbers to sell their stock in their IPO.