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Revenue Recognition Challenges in the High-tech

Industry: The Importance of Channel Data Integrity


A White Paper by
Zyme Solutions, Inc.
May 2009

About Zyme
Zyme is the leading provider of hosted channel data integrity services for global technology companies
that sell through indirect channels. On behalf of these companies, Zyme processes and validates millions
of private point-of-sale and inventory transactions each week from nearly 2,000 distribution and retail
channel partners in 175 countries. Zyme supports its customers with verified channel sales and inventory
data for mission-critical business processes such as revenue recognition, SOX compliance, incentive and
rebate payments, sales commissioning, and supply chain planning. Zyme serves clients through a unique
Service-ON-Software offering that combines a best-in-class channel data processing software platform
with domain-deep analyst teams, earning Zyme an unparalleled reputation for value in the industry. For
more information, call 1-877-262-8993 or visit www.zymesolutions.com.

Executive Overview
High-tech companies that sell through indirect channels face many challenges when deciding
on a revenue recognition policy. They must comply with regulations, ensure access to accurate
and timely channel sales data, and maintain robust systems and processes that support
revenue accounting. Company finance departments need to evaluate the pros and cons of the
sales-in vs. sales-out approach for revenue recognition. While the sales-out approach is
considered to be more conservative, and may benefit companies by leading to lower required
reserves, it poses implementation challenges because it is dependent on self-reported
distributor information and lacks because the company lacks control over information accuracy.
Transitioning from a sales-in to a sales-out approach is a significant effort, but one that can be
managed by systematically on-boarding channel partners, consolidating and validating partners
point-of-sale (POS) and inventory data, and using a compliance scorecard to ensure timeliness
and data quality. Partner compliance in providing timely and accurate POS and inventory data
enables companies to perform an accurate reconciliation of sales-in vs. sales-out data. Such
data forms the basis of inventory valuation, while rigorous monitoring of variances between
calculated and reported inventory can provide valuable insights.

Background
The technology industry has a complex, global, multi-tier distribution channel, and continuous
technological innovation, which drives short product lifecycles and constant price pressure. Due
to the pace of technological change, most products are sold with a right of return; many hightech manufacturers also offer some type of price protection, ship and debit, or back-end rebate
program based on sales volume.
These industry characteristics make proper revenue recognition a challenge, and one that is
complicated further by the lack of timely, complete, and accurate sales and inventory data from
channel partners. Too often, critical revenue recognition decisions are made without adequate
visibility into channel sales activity, which creates audit and regulatory compliance exposure for
high-tech companies. Improving the accuracy, timeliness, and transparency of channel sales
data has therefore become an important objective for finance and sales departments.

Revenue Recognition Policies in the High-Tech Industry


Based on a variety of business criteria, including price volatility, product lifecycle, and stock
rotation predictability, high-tech manufacturers must select one of two approaches to
recognizing revenue:
1) Sales-in, or ship-to, in which revenue is recognized at the time of sale by the
manufacturer to the distributor or retailer
2) Sales-out, or sell-through, in which revenue is recognized when the product ships from
the distributor to the reseller or end customer

Before discussing the advantages and drawbacks of each method, its important to examine two
relevant publications: SAB 104, published by the SEC; and FAS 48, published by the Financial
Accounting Standards Board (FASB).

SAB 104: Revenue Recognition


The staff believes that revenue generally is realized or realizable and earned when all of the
following criteria are met:

Persuasive evidence of an arrangement exists,


Delivery has occurred or services have been rendered,
The seller's price to the buyer is fixed or determinable, and
Collectibility is reasonably assured.

FAS 48: Revenue Recognition When the Right of Return Exists


If an enterprise sells its product but gives the buyer the right to return the product, revenue
from the sales transaction shall be recognized at time of sale only if all of the following
conditions are met:
a) The seller's price to the buyer is substantially fixed or determinable at the date of
sale.
b) The buyer has paid the seller, or the buyer is obligated to pay the seller and the
obligation is not contingent on resale of the product.
c) The buyer's obligation to the seller would not be changed in the event of theft or
physical destruction or damage of the product.
d) The buyer acquiring the product for resale has economic substance apart from that
provided by the seller.
e) The seller does not have significant obligations for future performance to directly
bring about resale of the product by the buyer.
f) The amount of future returns can be reasonably estimated (paragraph 8).
FAS 48 further states that when companies choose to recognize revenue at the time of
sale using the ship-to method, the amount of future returns must be estimated and
companies must accrue any costs or losses expected from returns.

The Sales-in, or Ship-to, Method


In the ship-to model, revenue recognition is triggered by shipments that are typically tracked in
the manufacturers ERP system, rather than by data from channel partners. Relying on ship-to
data from internal back-end systems, rather than on sell-through data from external partners,
also means that the timing of revenue recognition for any given period can be quick and
straightforward. However, with this approach:
!

Companies need to establish a methodology for estimating product returns and to


establish reserves in accordance with FAS 48.

There may be delays in receiving reported inventory, and reconciling to calculated


inventory may be complex.

Companies must evaluate whether partner-reported inventory levels are reasonable in


order to ensure that companies ability to estimate returns is not impaired.

A ship-to policy may expose companies to risks of excess or insufficient reserves for returns,
particularly as trends in returns diverge from the estimates upon which reserves were based.
The Sales-out, or Sell-through, Method
The sell-through method is considered the more conservative of the two revenue recognition
policy options. Because revenue is not recognized until products ship to the end customer,
typically the company does not need to maintain reserves against revenue for estimated
returns. The sell-through method does, however, rely on POS and inventory data that is selfreported by channel partners. Channel partners vary widely in their ability and willingness to
report this data in an automated fashion, and reporting standards may vary regionally for
channel partners located around the globe. Given these challenges, this self-reported data may
not be as reliable, accurate, and timely as companies desire for revenue recognition.

Transitioning from a Sales-in to a Sales-out Revenue Recognition Policy


Given the advantages of the sales-out revenue recognition model, many companies review their
contractual arrangements with channel partners, such as price protection and return policies,
and determine that a sales-out policy is more appropriate than a sales-in policy. Transitioning to
a sales-out model for revenue recognition poses several challenges and can take between three
and six months.
For example, a common barrier to transitioning to the sales-out model is the lack of data from
channel partners in emerging markets such as Asia-Pacific and Latin America. In order to
maximize the number of channel partners that report data, it is important to onboard them using
their own systems and tools. While many distributors in these markets do not send data via EDI,
they typically have their own transaction systems that generate invoices, issue purchase orders,
and record sales and inventory positions. Thus, it is worthwhile for companies to set up a
process that can accept channel partner data in a variety of formats (including Excel, text, and
XML), sent via e-mail or SFTP.
To facilitate the transition from a sales-in to a sales-out revenue recognition policy and minimize
the audit risks involved, companies can additionally take the following steps:

Get channel partners on board in a systematic fashion and ensure that channel partners
submit the correct data at the necessary level of frequency, accuracy, detail, and
timeliness to meet sell-through revenue recognition requirements.

"

Cleanse data to ensure the accuracy of date formats, product names, contract
manufacturer names, and end customer names.

Establish a robust data validation processincluding sales-in, sales-out (SISO)


reconciliation and trend analysesto ensure the accuracy of reported quantities and
prices; documenting this process is important for SOX compliance.

Follow up with partners on a weekly basis to resolve exceptions identified during the
validation process.

Generate partner compliance scorecards to drive ongoing data quality improvements.


This compliance scorecard should (at minimum) measure whether or not distributors
have reported data on time, accurately, and completely, with no missing fields.

Apply complex pricing rules to POS and inventory data, using the rules to value
inventory and test POS-based calculations, such as semiconductor special pricing or
ship and debit functionality.

Sales-in, Sales-out (SISO) ReconciliationA Key Step Toward Sales-out Revenue


Recognition
As mentioned above, reconciling sales-in and sales-out data is an important step in the accurate
valuation of channel inventory, which is critical for accurate revenue recognition. Best practices
include:

Roll-forward assessing of channel inventory


Identifying/monitoring SISO exceptions and flagging them so that analysts can work with
channel partners to reconcile them
Reviewing trends in calculated vs. partner-reported inventory
Analyzing the potential causes of any variances in calculated vs. partner-reported
inventory

In addition to improving inventory valuation, SISO reconciliation also helps companies make
more accurate price protection payments.
The calculated inventory for SISO reconciliation is computed as follows:
Previous weeks calculated inventory
+ Sales-in
Shipments in transit
Sales-out (sell-through, POS)
Returns
Cross-shipments and other adjustments
= Current weeks calculated inventory

Minimizing Risks in Revenue Recognition


Each of the two revenue recognition approaches entails some risks that can lead to overly
conservative or overly aggressive sales and revenue reporting. Companies with a sales-in
policy risk under- or over-estimating reserves, while companies with a sales-out policy are at
risk of misstating revenues due to inaccuracies in data reported by channel partners. As
discussed above, to mitigate these risks, technology companies should begin by automating
partner data collection and improving channel data integrity through a robust data consolidation
and validation process.
Once companies are receiving cleansed and validated channel partner data in an automated
manner, they can begin a regular process to reconcile calculated vs. partner-reported inventory
and conduct a trend analysis on the variances. A trend analysis can reveal issues that may
have a material impact on revenue recognition. For example, an increasing positive variance, as
shown in the graph below, may mean either that some POS data is missing altogether (as when
a single warehouse of a given distributor consistently fails to report inventory), or it may mean
that certain categories of inventory are not being reported (perhaps product masters were not
properly updated).

Figure 1: An increasing positive variance in calculated vs. reported inventory

Conversely, a close convergence between calculated and reported inventory indicates that no
systemic problems exist; therefore, variations are likely due to issues either in the transit time
model or in the timing of POS vs. inventory reports.

Figure 2: A close convergence between calculated and reported inventory

Conclusion
While the high-tech industry uses both the sales-in and sales-out revenue recognition policies,
the sales-out approach offers some important advantages: It is seen as more conservative,
revenues are seen as more reflective of actual market dynamics, and it enables companies to
decrease reserves against returns. Transitioning from a sales-in to a sales-out approach,
however, can be a challenge. Ensuring accurate, reliable, and timely data from sales channel
partners and establishing a robust SISO reconciliation process are important steps in
addressing this challenge. To minimize risks in revenue recognition, technology companies
should focus on increased automation, improved channel data integrity, and enhanced analysis
of channel sales data, no matter what revenue recognition policy they follow.

This document contains proprietary information of Zyme Solutions, Inc., based on the experience and research of Zyme and its
partners, and may not be reproduced without prior consent from Zyme Solutions, Inc. While every attempt has been made to ensure
that the information in this document is accurate and complete, some typographical errors or technical inaccuracies may exist. The
information contained in this document is subject to change without notice. Zyme does not accept responsibility for any kind of loss
resulting from the use of information contained in this document. Further, Zyme is not, by means of this document, rendering
business, financial, investment, or other professional accounting advice or services. Before making any decision or taking any action
that may affect your business, you should consult a qualified professional advisor.