Effective Controls for Sales Through Distribution Channels

By Niranjan (Chips) Chipalkatti, Sanjoy Chatterji, and Sarah Bee

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SEPTEMBER 2007 - According to a study conducted by research firm Glass, Lewis & Co., nearly 70% of the internal control weaknesses of companies that reported control deficiencies in the post–Sarbanes-Oxley Act (SOX) era were attributable to financial systems/procedures (59%) and revenue recognition–related (11%) issues. A study by Weili Ge and Sarah McVay (“The Disclosure of Material Weaknesses in Internal Controls After the Sarbanes-Oxley Act,” Accounting Horizons, September 2005) obtained a similar proportion for revenue recognition–related weaknesses; it also documented that 40% of these were in the computer industry and 12% were from the pharmaceutical sector. In the post-SOX environment, CEOs and CFOs face a higher level of scrutiny with regard to complex revenue-recognition issues, such as those involving sales through distribution channels, and have a greater responsibility to identify, document, and test internal controls of their revenue cycles. Auditors of companies that sell through distribution channels must be alert to potential revenue-recognition risks like “channel stuffing” (i.e., significant increases in inventory in customers’ distribution systems).

This article describes a formal revenue accounting system that could be used by companies that sell through distribution channels. The advantage is that it incorporates appropriate key controls that can be easily documented and evaluated for their effectiveness. The system also facilitates strategic data mining of distribution channel information.

Revenue Recognition: Sales Through Distribution Channels with Right of Return

The revenue cycle for a company that sells through distribution channels (common in industries such as packaged software, computers and peripherals, semiconductors, and pharmaceuticals) is especially risky because the revenue is not considered earned as long as the distributor retains the right to return the goods. Distributors may have the right to return a certain percentage of unsold items; or they may have stock rotation rights, which allow a distributor to rotate a percentage of old stock for new, differently priced stock. For a company that sells through distributors which retain the right to return, the appropriate time for recognition of the revenue [Statement of Financial Accounting Standards (SFAS) 48, “Revenue Recognition When Right of Return Exists,” and SEC Staff Accounting Bulletins (SAB) 101 and 104] is when the reseller sells to the final end-user. This is the point at which the sale is considered to be final and the right to return by the distributor expires.

Two critical issues determine whether the sale to the distributor is final:

  • Whether the sales price is fixed or determinable, and
  • Whether collectability is probable.

If the distributor retains the right to return, then the sales price cannot be assumed to be fixed and determinable in its nature, and revenue cannot be recognized until the final sale has been made. Apart from the right to return, the price of a sales contract will not be fixed (footnote 5 of SAB 104 defines a fixed fee as a fee required to be paid at a set amount that is not subject to adjustment or refund, and it points to SOP 97-2, paragraphs 26–33, for further guidance) or determinable in nature if it includes clauses for price protection, stock rotation rights, incentive rebates and promotions, and special pricing arrangements, among other items. In all these cases, revenue from sales to distributors (sell-through revenue) can be recognized only when the sale is made to the final customer.

Accounting for Sell-through Revenue

Exhibit 1 depicts the sales process for a firm with sell-through revenue. Accounting entries are recorded at two points: upon shipment of goods to the distributor (Point A in Exhibit 1) and upon the sale of goods to the end-user or the final customer (Point B in Exhibit 1). A company with sell-through revenue has at least three options regarding accounting entries to record these transactions.

Option 1: Record sales at Point A and book an allowance for returns. This option involves recording sales and cost of sales at Point A but reducing sales by an estimate of future sales returns, assuming they can be reasonably estimated. The SEC requires that companies and their auditors carefully analyze all factors, including trends in historical data that may affect companies’ ability to make reasonable and reliable estimates of product returns, in order to take appropriate reserves. While estimates may be acceptable for established products, this method cannot be used for the rollout of a new product because there is no historical data upon which to base the sales estimates.

FASB disallows such revenue recognition for sales with right of return under the following conditions:

  • The product is susceptible to wide swings in demand or rapid obsolescence;
  • The return period is long;
  • The company has no specific or consistent historical experience with similar products or services; and
  • Return volume is materially large.

SAB 101, along with SAB 104, further precludes such immediate recognition of revenue under the following conditions:

  • Lack of “visibility,” or the inability to determine, or observe, the levels of inventory in a distribution channel and the current level of sales to end users;
  • Significant increases in, or excess levels of, inventory in a distribution channel (sometimes referred to as channel stuffing);
  • Expected introductions of new products that may result in the technological obsolescence of, and larger than expected returns of, current products;
  • The significance of a particular distributor to the firm’s business, sales, and marketing; and
  • The newness of a product.

This approach is fraught with danger for a company that has a high proportion of sell-through revenue. In 2000, Lucent Technologies restated its earnings, decreasing revenues by $679 million primarily because of a $452 million reversal of previously booked sales to distributors that were subsequently returned
(see www.aicpa.org/download/antifraud/120.ppt). Similarly, Bristol-Myers Squibb had to restate its earnings by $1.5 billion primarily due to improper booking of sales through distributors (Glass Lewis & Co., in its Revenue Recognition Trend Report dated May 4, 2004, available at www.glasslewis.com/solutions/trends.php).

In the opinion of FASB and the SEC, these circumstances make reasonable estimate of returns difficult, making Option 1 the preferred choice for only a limited set of companies. Also, this method is not available for companies which have other clauses in the sales contracts that make the sales price not fixed or determinable.

Option 2: Record sales at Point A, and reverse at period-end for unsold distributor inventory. This method may be an attractive option for companies with small proportions of sell-through revenue. The validity and reliability of the sales information depends critically on the timely, regular, and accurate reporting of distributor point-of-sale (POS) and ending-inventory data. Reconciliation of distributor-provided data with the company’s records is an essential step. This requires strong internal controls and a system that will automatically “peel back” the unsold inventory with the distributor from the booked revenues. A detailed description of the type of internal controls is provided in a later section. The issues raised in SFAS 48 and in SAB 104 (referred to in Option 1) are also applicable to this approach.

Option 3: Defer sales at Point A and record at Point B when the right of return expires. The right to return may expire after the distributor stocks the inventory for a prespecified period of time, or when the goods are sold by the distributor to the end user. (A more stringent variant of this scheme is consignment shipments. When consigned inventory is shipped, even receivables are not debited until sell-through notification is received from the point of sale.) Typically, companies debit receivables and credit deferred revenue, and also debit deferred cost of goods sold and credit inventory at Point A, when the goods are delivered to the distributor. On the balance sheet, the deferred revenue account is shown as a current liability and the deferred cost of goods is shown as a current asset. The company recognizes revenue at the time the sale is made to the final customer by the distributor at Point B. At this time, the company would debit deferred revenue and credit revenue, and also debit cost of goods sold and credit deferred cost of goods sold. Typically, the distributor sends period-end inventory data to the seller and then reconciles it with shipment data to arrive at the earned revenue from sales to final customers. (For example, Intel in its 10-K filing of December 30, 2006, states that “because of frequent sales price reductions and rapid technology obsolescence in the industry, sales made to distributors under agreements allowing price protection and/or right of return are deferred until the distributors sell the merchandise.”)

Challenges of Sell-through Revenue Recognition

A significant issue becomes apparent under Options 2 and 3. If revenue is to be recognized upon sale to the end user, the distributor must be willing to share sales and inventory data with the company that earns sell-through revenue. The company must also have confidence in the reliability of the distributor-supplied data to comply with SOX section 404 regarding internal controls. The company requires data to feed the revenue-recognition process, yet it has little control over this data. One of the most difficult problems in this scenario is the actual capture, cleansing (removing errors from source data), and validating of the data that comes in many different formats and involves different modes of transfer [e.g., electronic data interchange (EDI), website, and e-mail]. Standardizing how data come in from different distributors is an elusive goal.

Because the latter two revenue-recognition procedures depend on external distributor data, there is the temptation to take a shortcut and use a single dimension (e.g., seller shipment data, distributor POS data, distributor ending-inventory data, carrier in-transit data) to arrive at the revenue-recognition entry. All of these dimensions must be taken into account to get complete transparency of inventory movement in the channel, and any variance should be highlighted and resolved.

Companies must put in place new processes and systems to collect this data and to resolve discrepancies, and then to use the data for revenue recognition and financial reporting.

Spreadsheets to the Rescue?

Many companies generate period-end sell-through revenue entries using ad hoc databases and spreadsheet analysis of the parameters mentioned above in Options 2 and 3. Companies have to cope with data collection and cleansing issues; huge transaction volumes; clerical inaccuracies; and control issues related to data entry and access, segregation of duties, and multiple copies. The entire estimation process must meet SOX requirements and pass the scrutiny of auditors in an era of heightened attention to revenue recognition–related matters. (For a fuller discussion, see “The Use of Spreadsheets: Considerations for Section 404 of the Sarbanes-Oxley Act,” PriceWaterhouseCoopers, September 2004, at www2.fei.org/advocacy/surveys_ic.cfm?.)

Because revenue recognition is a key reporting area, reliance on ad hoc spreadsheets may significantly delay the release of financial reports to stockholders, bondholders, and other providers of finance. Such delays might negatively affect the cost of obtaining funds in the future.

A Formal Sell-through Revenue Accounting System

The difficulties of using spreadsheets are significant enough to justify the use of a formal sell-through revenue accounting system. A better approach involves a centralized system that directly captures all POS (including sales and inventory) data of distributors and keeps track of distributor “roll-forward” (or period-end) inventory. The reconciled POS data should automatically trigger the entries for revenue recognition mentioned in Options 2 and 3. (The system should automatically book all sales to distributors as deferred revenue.) Such a system has the ability to incorporate access controls, validate data entry, and maintain a log and audit trail of transactions, all while automating calculations. Exhibit 2 compares the use of spreadsheets to a formal sell-through revenue accounting system. It clearly pinpoints the deficiencies of a spreadsheet approach from an internal controls perspective.

The centralized system will also provide a data warehouse and set of associated applications. The generated data warehouse provides the added strategic benefit of a resource that companies can data-mine for activities such as revenue projections and margin analysis. Additionally, the sales function can use it to calculate sales commissions and gather strategic information, such as the effect of promotional campaigns and sales trends. From a financial-reporting perspective consistent with SAB 104’s requirements, such a system provides companies with increased visibility into distributor channels and allows them to analyze historical sales data in order to make reasonable and reliable estimates of product sales, unsold inventory, and product returns. Such a system permits the design and incorporation of other key controls essential to the revenue cycle.

Design of Internal Controls Related to Sell-through Revenue Cycle

Under the PCAOB’s Auditing Standard 2 (AS2), every auditor (and, by implication, every manager) should examine the internal controls in place for all significant accounts. In the case of business models that involve sell-through revenue via distribution channels, these include all revenue-related accounts, including sales, sales returns, deferred revenue, distributor inventory, sales commissions, warranty revenue, and warranty expenses. For companies that sell through distribution channels, the inventory account is relevant as well. There is a potential for control deficiencies to exist in the revenue cycle if the company does not design a more robust sell-through revenue-recognition system. The design and testing of controls that reside within the purview of the company itself take on added importance, especially under SOX.

Exhibit 3 lists control activities that could be designed and implemented for companies that have sell-through revenues and also have a formal sell-through revenue accounting system. These controls are difficult to incorporate with spreadsheet-based systems. Therefore, revenue-recognition systems using spreadsheets and ad hoc databases are much more prone to control deficiencies. The exhibit assumes that the company has an automated system that records sales to sell-through distributors as deferred revenue.

Benefits of a Formal System

As per SFAS 48 and SABs 101 and 104, revenue from sales to distributors should be deferred until the sale is made to the final customer if the price or fee to the distributor is not fixed or determinable because of a retained right to return or other factors. (The authors assume that the sale involves only a single element. Sell-through revenue with multiple-element sales is a more complex issue.)

A significant problem with these revenue-recognition standards from the perspective of a company with sell-through revenue is that all the critical revenue data is initially captured by the distributor’s accounting system and then must be transmitted to the seller. Using ad hoc data-collection mechanisms and spreadsheets to arrive at the correct amount of sales revenue using distributor-provided data makes the system prone to many control deficiencies. In the post-SOX environment, companies with sell-through revenue need to ramp up their revenue accounting systems so they are better geared to capture sell-through revenue at the time of “final” sale. Such a system enables a company to design, document, and test the effectiveness of the associated key control activities. A centralized system using POS data from distributors offers a better solution, because it can incorporate essential control activities, provide channel visibility, and better meet the stringent requirements of SOX section 404.

The use of such centralized POS-based systems by companies with sell-through revenue has other strategic benefits as well. This data can be mined and analyzed for other uses, such as sales trends, sales commission calculations, and channel replenishment strategies.

Niranjan (Chips) Chipalkatti, PhD, ACA, is an associate professor in the department of accounting of the Albers School of Business and Economics at Seattle University, Seattle, Wash. Sanjoy Chatterji is a computer architect and founder of Entomo, Inc. Sarah Bee, MBA, is an instructor of accounting at Seattle University.




















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