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Vendor allowances in retail industry, not cut and dry

Jul. 29 2009 By David P. Hoffman

In 2003, Dutch supermarket conglomerate Royal Ahold announced that it had overstated earnings by at least $500 million because its U.S. operation had improperly accounted for vendor allowances. Further probes by Royal Ahold and the U.S. SEC revealed that two other subsidiaries had also acted improperly, bringing the total restated earnings to $1.12 billion -- one of the largest accounting restatements in the industry. Royal Ahold’s CFO and CEO resigned and nine of its foodservice executives in the United States faced fraud charges (1).

A common practice in the retail industry, vendor allowances have become the subject of interest to legal and regulatory authorities. Royal Ahold is only one of numerous well-known retailers whose improper accounting for vendor allowances resulted in regulatory actions, civil lawsuits, restatements, indictments and/or the loss of corporate reputation. Vendors have also faced allegations of irregularities related to allowances paid to their customers.

Companies in the retail sector need to be aware of such risks and strengthen their internal controls and compliance practices accordingly.

Accounting regulations
Cooperative advertising agreements, margin protection agreements, slotting fees, incentive rebates, compliance charge-backs and the like are normal practice in the retail sector. But creative accounting for such allowances in order to boost income and mislead shareholders could be determined to be fraudulent.

Revenue and expense recognition are the main pitfalls. Depending on the nature of the allowance, they are treated either as a decrease to gross margin or a decrease to operating costs by the retailer. However, a retailer is generally limited to recognizing a vendor allowance as an increase to net income when it has no further obligations in its arrangement with the vendor. The same goes for the vendor and expense recognition.

Vendor allowances generally should be recorded in the accounting records of both the paying and receiving entities over the life of a related agreement. For example, if Vendor A agrees to give Retailer B an upfront payment in exchange for a five-year exclusive supplier agreement, this revenue is generally amortized across each year of the exclusivity agreement, even though Retailer B collects the money in full in the first year.

Likewise, should Vendor A give Retailer B a nonrefundable payment to guarantee shelf-space for five years, the payment constitutes a reduction of revenue for the vendor during the five years. A portion of the fund is maintained on the vendor’s balance sheet until it has no further obligation to the supplier.

Generally, retailers recognize the benefit of a nonadvertising or marketing-related allowance by reducing cost of goods sold. If a pillow costs $10, for example, the retailer should record pillows in inventory at $10, less the amount of the allowance. The impact to gross margin and net income is realized at the time of sale. Pillows unsold during the accounting period remain in inventory at year-end, net of the allowance.

If the allowance is a reimbursement to the retailer for marketing a supplier’s product, the retailer should reduce advertising or marketing costs only if the allowance can be tied to direct and incremental cost to promote the product. Otherwise, the allowance should be recorded as a reduction to cost of goods sold.

Consider an advertising co-op payment. A retailer must demonstrate that it incurred direct and incremental costs to promote a vendor’s pillow, thus offsetting its selling, general and administrative costs. If it cannot meet this test, it must record pillows purchased at cost, less the amount of the advertising support. The benefit is recognized in the income statement of the retailer at the time the units are sold.

Risks with vendor allowances
Vendor allowance frauds may be perpetrated by retailers in order to meet earnings expectations or be perpetrated by rogue buyers to meet goals for product lines or departments. A merchant’s employees may also intentionally mislead their accounting department about “side deals,” such as exclusivity agreements, thus inviting company accountants to book revenue too soon. Retailers have been known to deceive their vendors as well.

Saks Fifth Avenue and many of its suppliers, for example, were victimized by rogue buyers who sought to increase the profitability of their departments. The buyers and vendors agreed on a target for gross margins for individual product lines, having an undocumented agreement that suppliers would provide end-of-season mark-down money if the targeted gross margin was not achieved. Among other methods, buyers fabricated reports that artificially increased mark-downs for products that did not perform as expected, reflecting a lower gross margin. Consequently, vendors paid allowances to support a gross margin that, in some cases, had in fact been achieved. In addition, certain merchants failed to mark goods down during the appropriate season or accounting period, delaying the timing of the impact of negative income and thus over-stating inventory balances. Buyers frequently refer to this activity as “rolling mark-downs.” The result of Saks’s actions totaled more than $20 million before interest on amounts owed to aggrieved suppliers (2).

Some suppliers have been know to help perpetuate frauds by signing false confirmations that the retailer has no ongoing commitment with the suppliers, thus allowing the retailer to immediately recognize the vendor allowance. Alternately, vendor sales personnel may offer bribes or kickbacks to retail buyers to ensure a competitive advantage.

Control measures
Though it is impossible to prevent all such instances of vendor allowance fraud, increased controls can help mitigate the risk. Potential deterrents to irregularities and corruption include:

  • Documentation of all vendor agreements.
  • A whistleblower protection program to make employees more likely to report illicit side deals.
  • Robust internal audit scrutiny of vendor relationships.
  • Thorough review of the structure and terms of all vendor contracts, commitments and allowance agreements.
  • Company policies that do not unduly pressure executives to hit financial targets.
  • A written code of conduct for retailers and vendors.
  • Mandatory certification of practices and agreements.
Accounting irregularities pertaining to vendor allowances are generally related to an improper tone at the top or poor finance and accounting controls, lack of transparency in accounting procedures and the linking of management compensation to ambitious revenue targets. Companies most successful at preventing such accounting improprieties are those that establish appropriate controls and a commitment to compliance and transparency.

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