Are vendor allowances more trouble than they’re worth?

Don’t ask Michael Meurs that question. The one-time CFO at Dutch supermarket operator Royal Ahold, Meurs was forced to resign from his job in February — along with Ahold CEO Cees van der Hoeven. The reason for the sudden departures: Ahold management discovered that its U.S. Foodservice unit had improperly accounted for vendor rebates, overstating earnings by at least $500 million from 2001 to 2002. Reportedly, the American subsidiary had been booking the allowances before they were earned.

Last month, Ahold, which owns U.S. grocery chain Stop & Shop, announced an end to an internal probe, revealing a wider $1.12 billion discrepancy on the books — including inflated profits at two other subsidiaries.

Such bookkeeping irregularities have not gone unnoticed at the Securities and Exchange Commission. The agency, in addition to a reported investigation into Ahold, has been investigating irregular accounting of rebates at beleaguered food distributor Fleming. What’s more, two former Kmart executives have been indicted, charged with accounting fraud for allegedly understating losses by 6 cents per share by improperly booking a $42-million vendor allowance.

Similarly, several other retailers in and out of the food business — including CVS, Staples, Albertson’s, Kroger, and BJ’s Wholesale Club — have reportedly received informal inquiries by the SEC on their accounting practices for vendor allowances.

Still, the SEC is not the only standards-setting body examining how public companies account for vendor rebates, cooperative advertising, and slotting fees (money paid by vendors to retailers to gain prime shelf space in stores).

Late last year, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) declared that promotional dollars received by a customer from a vendor are presumed to be a reduction of the prices of the vendor’s products or services. Hence, unless certain conditions are met, such allowances must be characterized as a reduction of the cost of sales when recognized in the customer’s income statement.

That decision — along with the SEC’s scrutiny — should have CFOs worried. Greg Gundlach, visiting eminent scholar of wholesaling and professor of marketing at the Coggin College of Business at University of North Florida, points out that the EITF decision could raise more questions about whether slotting fees and or other large promotional payments amount to anti-competitive business practices.

“If CFOs are not aware of these payments now, they should be,” insists Gundlach. “And if they are aware, they should be aware of how those payments are being used and the issues that can arise when they are abused.”

The Wild West

Over the years, vendor allowances have pretty much become SOP in the retailing world. Vendors, eager to meet sales targets or promote their products through shelf placements and in-store advertisements, have been most happy to grease the palms of retailers with rebates, allowances, and price breaks.

And before the EITF issued its proclamation, No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” retailers’ records of vendor payments were often all over the income statement, both in recognition timing and classification, say industry observers. The task force had previously issued accounting guidance only for the vendor side of such transactions.

Typically, most retailers recorded vendor allowances as a reduction in marketing expense. Often that was done before the related products were sold. In some cases, it was impossible to tell who was paying whom what. Says Robert Willens, Lehman Brothers’ accounting and tax analyst, “It was the Wild West.”

Others agree. “I think companies were changing the way they record [vendor allowances] upfront versus over time,” says John Maxwell, retail and consumer industry leader for PricewaterhouseCoopers, “just so the numbers in the quarters were more comfortable with where they wanted it.”

Under the new rules, if a company buys inventory that the company’s management expects to sell over six months, the company should recognize the vendor allowance over those six months. “A lot of companies [previously] would simply take all of their allowances and spread them over inventory turns,” notes Maxwell. But now, if a company has certain products in inventory tied to vendor allowances, and the items are in inventory on the balance sheet at year-end, “then the vendor allowances should not be accounted for in the income statement because the inventory has not turned,” he says.

To comply with 02-16, several retailers have had to make various write-downs of inventory and adjustments to their net income, depending on their previous treatment for vendor funds. Staples, for instance, recorded a one-time, non-cash adjustment, reducing its first quarter net income by $62 million, or 13 cents per share. Lowe’s estimated the change in accounting would cut its fiscal 2004 earnings estimate by approximately 12 cents per share.

Room for Mischief

Willens, among others, says that 02-16 adds a greater degree of consistency to the financial statements. But he remains “a little surprised” by the guidance for booking rebates. According to the Lehman tax expert, that treatment deviates somewhat from traditional accrual accounting procedures — and still leaves room for manipulation.

The Task Force says that the rebate (payable only if the customer completes a certain volume of purchases or remains a customer for a specified period) should be recognized as a reduction of the customer’s cost of sales, based on systematic and rational allocation — provided that the amounts are both probable and “reasonably estimable.”

The wording has Willens worried. “They could have said you only recognize the rebates when you earn them,” he says. With the new definition, “they’ve left it open for some degree of mischief.”

Of course, accounting edicts are always subject to judgment. Alan Kessock, CFO of Ultimate Electronics, says he welcomes the Task Force’s added clarity. In general, he says whenever there’s more guidance on accounting, “there’s even less risk” and naturally “less things subject to management interpretation.”

System Upgrades

Still, PwC’s Maxwell believes that 02-16 compliance presents a thorny logistical problem for CFOs. “The biggest risk is that many of the retail companies out there don’t have integrated systems that link the vendor allowance contact accounting to inventory accounting,” he says. “That’s where some of the problems have been. You have allowance contracts that are accounted for as income before the inventory is sold.”

Maxwell believes it will be difficult for retailers to get those siloed systems talking. “Those with the greatest [number of] contracts, where the volume is high, will struggle the most,” he argues.

Not surprisingly, several technology companies are already looking to capitalize on increased scrutiny of vendor allowance accounting, particularly for a CFO’s certification of the financials under Sarbanes-Oxley. Last month technology vendor Fuego introduced a Supervisory Control Application, a program that uses the risk libraries of auditor Deloitte & Touche to automate, manage, and control vendor allowances, handling documentation, verification, and approval of the deals.

Likewise, JDA Software Group offers a tool to help managers organize, track, and claim vendor allowances. JDA claims that the software will improve a company’s cash flow by expediting manufacturer reimbursements.

In fact, CFO Kessock is optimistic that his company’s ongoing implementation of a new Oracle platform for merchandizing back-end operations will do a much better job of tracking vendor allowances with inventory. The company’s current system? Manual keying of data.

Maxwell concedes that to get the job done, some companies may nothing more sophisticated than Excel spreadsheets. If CFOs can already determine inventory turns by category because those figures are consistent from year to year, he explains, then they should be able to reasonably estimate what amount of vendor allowances should be left on the balance sheet at year-end and what amount would likely get reported on the income statement as a reduction to cost of goods sold.

Blunt, Imperfect

Other observers of the retailing scene say the corporate scandals and accounting changes should have finance chiefs rethinking the whole notion of vendor allowances. According to a recent opinion piece by Adam Fein, president of Pembroke Consulting, “volume rebates are a distribution management tool whose time has passed.”

In most industries where rebates are common, argues Fein, producers have gotten very powerful — so powerful that they’ve been able to squeeze the margins of their distributors. In short, he claims, rebates have become a tool for manufacturers to manage the behavior of the distributor.

“It’s very common for a grocer product manufacturer to offer trade discounts to wholesaler to purchase more of a product in a given time period, and presumably shift market share,” he added during a discussion with CFO.com. But by his lights, rebates and slotting fees basically amount to “blunt, very imperfect tools to pay for the services.”

Moreover, adds North Florida’s Gundlach, greater disclosure of vendor allowances may make some companies more susceptible to litigation from competitors. He says that CFOs should know the penalty of getting mixed up with the Department of Justice or the Federal Trade Commission, both of which monitor anti-competitive behavior. While there’s no threat of prison as would be the case under Sarbanes-Oxley, he says, “In the antitrust judgment, the damages are tripled.”

The 2002 case Conwood Co. L.P. vs. United States Tobacco Co., for instance, resulted in a United States Supreme Court judgment against UST for $1.05 billion, triple the original amount of $350 million. The plaintiffs alleged that the use of slotting fees, among other allowances, limited the promotional capability of industry competitors.

Rather than risk a run-in with the FTC, Fein recommends a shift to fee-for-service pricing, which separates product costs from a distributor’s costs of providing services. A shift from markup margins on products to service fees provides a more direct and accountable means of measuring value and services, he notes. “By unbundling product prices from the costs of services, distributors also have new economic incentives to create innovative services for retailers and suppliers.”