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 computerindustry 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. …