zyme channel data validations for financial reporting and sox compliance

7/24/2019 Zyme Channel Data Validations for Financial Reporting and SOX Compliance

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3CHANNEL DATA VALIDATIONS FOR ACCURATE FINANCIAL REPORTING AND SOX COMPLIANCE |

1 Executive SummaryThe channel now accounts for 66% of overall technology sales, according to an Accenture

analysis based on Gartner data1. Because so much revenue flows through channels, and

because Sarbanes-Oxley (SOX) has increased the industrys scrutiny of financial data,

obtaining reliable channel partner data has become a critical component of creating accurate

financial statements. At the same time, unreliable data is a potential SOX control weakness.

Technology vendors use channel partner data to:

Calculate revenue sold through indirect channels

Generate analyses that validate their revenue recognition decisions and accounting estimates

Better manage the indirect channel by assessing current data against historical trends

and ratios

Determine sales compensation

Calculate partner incentives to be paid

This paper discusses the role of channel partner data in financial reporting. It outlines several

data validation and analysis methods that vendors can use to ensure the reliability, accuracy,

and auditability of their financial statements and improve channel management.

2 How Channel Data Is Used in Financial Reporting

2.1 Revenue Reporting

For financial reporting purposes, the reliability and accuracy of partner-reported sales and

inventory data is important, whether a company recognizes revenue on a sell-through,

sell-in, or hybrid basis. For companies with a sell-through revenue recognition policy, in

which revenue is recognized only when product ships from distributors to resellers or end

customers, anywhere from 40% to 100% of a companys reported revenue may be based on

partner-reported sales and inventory data.

Companies with a sell-in revenue recognition policy recognize revenue immediately when

product ships to the channel. However, future product returns, rebates, warranty claims, and

special pricing adjustments must be estimated based on historical data. Through contra-revenue accounts, these estimates are then commonly applied as reductions to recognized

revenue on the income statement. These estimates are a prime target for scrutiny by auditors.

Partner-reported inventory data provides the required audit trail to support the adequacy of

the various allowances and reserves for special pricing, returns, warranty, and incentives.

In calculating revenue to be recognized, companies must assign prices to units sold

through the channel. This can be a complicated task for companies that use the sell-through

approach for any portion of their indirect sales. This task can be accomplished through a

number of methods:

On a first-in, first-out (FIFO) basis, which assumes that the units sold into the channel first

were also sold out of the channel first. To account for price protection or other special

pricing situations, the applicable price for revenue recognition purposes is the price listed

on the date of sell-through. Exceptions must be made when the listed price is greater

than the sell in invoice price, when the sold-through goods are no longer eligible for

recent price protections, etc. Because of the complexity of the rules for pricing transac-

tions, it is especially critical for audit purposes for companies to have a reliable, consis-

tent process, as well as clean and accurate channel data to work with.

On a serial number basis, in which the serial numbers of point of sale (POS) units or the

units remaining in inventory are tied to their respective sell-in invoices, thereby using the

exact sell-in price of the unit for accounting.


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On the basis of an assigned value based on price books.

On the basis of an assigned value based on a calculated average partner sell-in price.

As the flip side of the revenue calculation, the FIFO or serial-number methods are also applied

to channel inventory to generate an inventory aging report, which details the number of units

held in inventory for given time frames and the current value of those units. The inventory

aging report can be used to adjust allowances for returns and warranty claims, as well as to

evaluate the overall health of the channel.

2.2 Reporting of Deferred Revenues for the Balance Sheet

To recognize revenue for some portion of their indirect sales, many companies create a

deferred revenues entry on the balance sheet for units that have been sold into the channel

but have not yet been sold through. This is calculated by subtracting total partner-reported

sell-through from total sell-in. For products with relatively stable prices, the price per unit is

determined using an average selling price (ASP). For products with more volatile pricing, the

price can be established by associating the partner-reported unsold inventory to the sell-in

invoices on a FIFO basis, using adjustments for recent pricing actions.

2.3 Estimates for Accounting Allowances

As discussed above, it is common to use channel partner POS and inventory data to estimate

the reserves required for revenue adjustments due to price protection, tier 2 incentives, warrantyclaims, returns, and inventory obsolescence. Below are some examples of this process.

2.3.1 Estimating price protection reserves

Many high-tech companies use price protection to ensure an adequate level of distributor

inventory in the channel. However, by definition, price protection means that the sale price is

not final at the time of sell-in. Thus, making accurate projections of price protection liability

and allowing for this liability becomes important.

In general, companies govern price protection through a number of rules. For example, it is

typical for only recent inventory (e.g., inventory procured within the last two months) to be price

protected. To estimate the price protection allowance, companies generally look at past sell-

through rates to determine the quantity of goods that would be in the channel within a specified

period of time after sell-in. A more accurate method is the FIFO method. FIFO is based onactual data, while looking at past sell-through rates provides a more general estimate.

Reports such as the example report below would help the companys finance manager assess

the adequacy of allowances made. This report shows, by SKU and distributor, the estimated

value of price protection claims, corresponding to inventory of various ages, that result from a

10% decrease in price. Vendors can look at the liability by inventory age and adjust the timing

of their price changes in order to minimize price protection claims.

Figure 1: Report of Liability for Price Protection Claims; by SKU, Distributor, and Age of Inventory Units

Partner SKU

Liability Resulting from a 10% Decrease in Price (by Inventory Age)

1 Week

or less

1 to

Weeks

2 to 4

Weeks

4 to 8

Weeks

8 to 12

Weeks

More

than 12

Weeks

Total

Distributor A

SKU-A $100 $200 $100 $100 $0 $0 $500

SKU-B $0 $0 $0 $500 $400 $500 $1,400

SKU-C $23 $0 $10 $0 $0 $0 $33

Sub total $123 $200 $110 $600 $400 $500 $1,933

Distributor B

SKU-A $0 $100 $20 $100 $0 $0 $220

SKU-B $0 $0 $0 $0 $600 $0 $600

SKU-C $50 $30 $10 $0 $0 $0 $90

Sub total $50 $130 $30 $100 $600 $0 $910

Total $175 $330 $140 $700 $1,100 $500 $2,843


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2.3.2 Estimating the Returns Allowance

Most companies provide an allowance for future returns. Typically, this allowance is estimated

based on the quantity of return material authorizations (RMAs) received historically in

proportion to sales. However, additional checks are necessary under some circumstances,

such as the launch of a new product with no comparable history, changes in the overall

business environment, or the high variability of past return rates.

Greater-than-average return rates can be discovered by comparing the number of recent

POS returns and RMAs with the historical average. If the POS return rate has been steadilyincreasing or decreasing in recent months, the current return allowance might have to be

revised. A report like the one shown in the example below, which compares the POS returns

to sell-through during various periods over the prior year, would help the finance manager

determine the adequacy of the return reserves. In this example, return reserves are currently

set at 3.5% of sell through. SKUs with return rates between 3.5% and 3.99% are flagged

in light gray, while those over 4% are flagged in dark gray. Managers can easily identify

return rates that exceed current allowances over a period of time and adjust the allowances

accordingly. Using the graph, managers can spot trends over time by distributor and use the

information to better manage their channel partners. Similar reports could also be prepared

based on RMA and sell-in data.

Figure 2: Returns as a Percent of Sell-Through (Rates Exceeding Currently Established Reserve Levels are Flagged)

Partner SKU

12-

Month

Return

Rate

6-

Month

Return

Rate

3-

Month

Return

Rate

1-

Month

Return

Rate

12-

Month

Sell-

Through

12-

Month

POS

Return

6-

Month

Sell-

Through

6-

Month

POS

Return

3-

Month

Sell

Through

3-

Month

POS

Return

1-

Month

Sell

through

1-

Month

POS

Return

Dist A

SKU-A 3.00% 3.4% 3.10% 3.20% $57,828 $1,735 $29,212 $993 $15,005 $465 $4,567 $146

SKU-B 3.60% 4.00% 4.80% 5.60% $65,122 $2,344 $29,034 $1,161 $11,892 $571 $3,412 $191

SKU-C 2.9% 2.8% 3.20% 3.00% $97,612 $2,831 $53,312 $1,493 $27,098 $867 $10,966 $329

Sub total 3.13% 3.27% 3.52% 3.52% $220,562 $6,910 $111,558 $3,647 $53,995 $1,903 $18,945 $666

Dist B

SKU-A 3.20% 2.90% 3.10% 3.10% $23,123 $740 $11,560 $335 $5,991 $186 $1,808 $56

SKU-B 3.45% 3.98% 4.40% 5.10% $62,422 $2,154 $31,211 $1,242 $13,122 $577 $4,800 $245

SKU-C 2.88% 2.88% 3.00% 2.87% $10,999 $317 $5,989 $172 $3,400 $102 $900 $26

Sub total 3.33% 3.59% 3.84% 4.35% $96,544 $3,210 $48,760 $1,750 $22,513 $865 $7,508 $327

Total 3.19% 3.37% 3.62% 3.75% $317,106 $10,120 $160,318 $5,397 $76,508 $2,768 $26,453 $ 993

Figure 3: Overall Return Rate and Return Rate by Distributor for Given Time Periods


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When, for a period of several weeks, there are high levels of inventory for a product

whose sales are generally slowing, this serves as another leading indicator that higher-

than-normal returns can be expected. The example report below highlights a case where

abnormally high inventory is present for products that are not selling well (i.e., aged

inventory). This report, in conjunction with the one that analyzes return rates, would

help the decision-maker zero in on cases where the return allowances might need to be

adjusted from normal levels. Such reports could prove useful in cases such as a new

product launch where its market acceptance is different from that of similar products. For

example, there are currently 14 weeks of inventory of SKU-B at Distributor A, and 64% ofthat inventory is older than 8 weeks. Distributor B is also reporting a buildup of SKU-B.

inventory over 8 weeks. This is a flag to look more closely at the return reserves for SKU-B.

3 Validations and Analyses for Channel Partner Data

Accurate channel partner data is a critical input for reliable financial statements. However,

most companies have little ability to assess the data from their partnersthey must accept

it on the honor system. To ensure that the data is complete and accurate enough to

be used for financial reporting, there are several levels of validation and analysis that are

considered best practices.

Figure 4: Inventory Aging Report, by Distributor and SKU

Partner SKU

1

Week

or

Less

1 to 2

Weeks

2 to 4

Weeks

4 to 8

Weeks

8 to 12

Weeks

Over

12

Weeks

Total

Unsold

Inventory

(Units)

Total

Unsold

Inventory

($ )

Inventory

Older

Than

8 Weeks

Weeks of

Inventory

Dist A

SKU-A $1,000 $2,000 $1,000 $1,000 $0 $0 125 $5,000 0% 5

SKU-B $0 $0 $0 $5,000 $4,000 $5,000 700 $14,000 64% 14

SKU-C $225 $0 $100 $0 $0 $0 13 $325 0% 0.7

Sub total $1,225 $2,000 $1,100 $6,000 $4,000 $5,000 838 $19,325 47% 7.7

Dist B

SKU-A $0 $1,000 $200 $1,000 $0 $0 55 $2,200 0% 5

SKU-B $0 $0 $0 $0 $6,000 $0 300 $6,000 100% 5

SKU-C $500 $300 $100 $0 $0 $0 36 $900 0% 4

Sub total $500 $1,300 $300 $1,000 $6,000 $0 391 $9,100 66% 4.9

Total $1,725 $3,300 $1,400 $7,000 $10,000 $5,000 1,229 $28,425 53% 6.5

Figure 5: Graph of Inventory Balances, by Partner and Age of Inventory


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Sales in, sales out (SISO) reconciliation is a good first step to take in establishing the

reliability and accuracy of the data used in financial statements. Additional analyses serve

to highlight and resolve such business issues, as well as to improve the accuracy of certain

accounting allowances. For example, to determine whether reported channel partner

inventory levels are reasonable and accurate, finance personnel can analyze the trend of

weeks of inventory on hand to see whether it is increasing. If the inventory is increasing,

finance personnel might use an inventory aging report to compare its data against trends

in the SISO ratio and observe historical seasonality. Over an extended period of time, sales

into the channel and sales out should match closely; however, inventory may increaseseasonally, as it does prior to the U.S. holiday season. A report that shows the ratio of

sell-in to sell-out over a rolling period of between 4 and 8 weeks can highlight cases

where sell-in and sell-out are not aligned. The aging report can provide important insights

about whether the inventory is aged or has built up recently, in order to support expected

future spikes in demand. A more detailed discussion of some useful channel management

analysis tools follows.

3.1 SISO Reconciliation

The SISO reconciliation approach can serve as an internal SOX control (Section 404)

that can give a manufacturer confidence in distributor-reported data. In this method, the

sell-through and inventory data provided by the channel partner is compared to the sell-in

data to see whether variances between them fall within reasonable limits that could be

explained by causes such as transit time. The method relies on making an estimate of the

inventory (i.e., calculated inventory) based on the previous weeks calculated inventory,

SISO data, etc. The calculated inventory for SISO reconciliation is computed as follows:

Calculated inventory =

Previous weeks calculated inventory

+ Sell-in

+ Transfers from other partners

Transfers to other partners

Sell-through

+ Returns to partner

RMAs (returns to the company)

Adjustments (scrap, theft, etc.)

The difference between calculated inventory and partner-reported inventory is the

variance, or delta. The sign of the delta can be positive or negativevariance in either

direction is equally relevantso the absolute value of the delta for each SKU and channel

partner is considered. Variances are expressed as a fraction of the partner-reported

inventory. An acceptable variance depends on a number of factors, including product type,

volume of sales for the product, and region. The primary output of SISO reconciliation is a

report, such as the one below, that gives a quick snapshot of which partners have reliable

data and which do not. The first four partners on the list have a delta equaling or exceeding

a predefined limit of 20%, while the next three are approaching the limit.


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3.2 Inventory Aging

A report on the age of inventory held by the par tner can be used as a tool to improve

overall channel managementfor example, aging inventory can highlight unintentional

channel stuffing. Two common methods for assessing inventory aging include:

FIFO method. In this method, the age of the inventory is estimated by assuming that

the goods that were sold into the channel first were also sold through the channel first.

Partner-reported inventory units are therefore assigned to the latest sell-in invoices, and

the dates of these invoices provide an estimate of the age of the inventory. Its also pos-sible to calculate an average inventory age weighted by value.

Serial number method. This method is more accurate, but it requires partners to provide

serial numbers for each individual unit in inventory. The serial numbers can be tied back

to the sell-in data for each unit, and the age of each unit can be estimated based on the

date it was shipped from the company.

3.2.1 Using the inventory aging report for financial reporting

In addition to its use as a channel management tool, the inventory aging report is required for:

Estimating reserves for inventory obsolescenceas inventory ages, it is more likely to

become obsolete

Estimating price protection reservesonly inventory that is older than a given threshold

(e.g., older than two months) is eligible for price protection

Assessing the adequacy of warranty/return reserves in special circumstances, such as:

o New products that are not comparable to those for which historical return data exists

o Changes in the overall business environment

o Large variations in return rates in the past

In these cases, observing very high weeks of inventory of a product whose sales are

slowing down overall indicates that higher-than-normal returns could be expected.

3.2.2 Trend AnalysisWeeks of Inventory on Hand

Weeks of inventory on hand is calculated by dividing on-hand inventory by a four-week

average of weekly sales. Typically, this metric is used in conjunction with the inventory

aging report. For channel management purposes, an increase in the weeks of inventory on

hand may highlight issues such as slowing demand or channel stuffing.

3.2.3 Using a trend analysis for financial repor ting

As a quick method of assessing excess inventory in the channel, the weeks of inventory on

hand metric is often used to help make the appropriate adjustments to various allowances.

When the value of this metric is very high, it could indicate additional liability for any

upcoming pricing action (due to price protection), and if the value is high primarily due to

aged inventory, this could indicate a higher possibility of returns.

3.3 Sell-in Trend and Timing Analysis

In the absence of upcoming product promotions, sudden spikes in the quantity of sell-

in inventory could be a cause for concern. An analysis of the weekly sell-in quantity in

conjunction with the weeks of inventory on hand could highlight instances of unnecessary

sales into the channel.

In general, over an extended period of time, the sell-in and sell-out quantities should match

closely. A report showing the ratio of sell-in to sell-out over a rolling period between 4 and

13 weeks would help highlight cases where the sell-in is not aligned to the sell-out.


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4 Conclusion

Inaccurate channel partner data or an inadequate process for consolidating and

reconciling channel partner data can lead to material financial statement issues, such as:

Inaccurate revenue reporting

Inaccurate balance sheet numbers (deferred revenues)

Inaccurate accounting estimates or an inadequate audit trail for accounting estimates,

such as:

o Reserves for returns and warranty claims

o Reserves for rebates, price protection, and other special pricing programs

o Allowances for inventory obsolescence

These problems arise in part due to the nature of the financial reporting process. Instead

of setting specific, detailed rules for internal controls around the financial reporting

process, SOX-compliant financial reporting requires accounting and finance departments

to make many judgment calls, guided by the high-level principles set forth by the Public

Company Accounting Oversight Board (PCAOB) and the SEC.

With the onus on companies to provide adequate supporting information for their financial

reporting decisions and to demonstrate that they have proper controls over financial data

in place, obtaining timely and accurate POS and inventory data from channel partnersbecomes a critical step in the financial reporting process. By focusing on validations and

analysis of this data, companies can improve the reliability, accuracy, and auditability of

their financial statements and can better manage their indirect channel.

1Developing Indirect Channels: A Structured Approach to Reaching New Customers and Growing Revenues.

Accenture, May 27, 2009.

zyme channel data validations for financial reporting and sox compliance

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