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Deductive Reasoning: A Deferred Revenue Detective Story

October 26, 2017 / by Mark Wald

Image of businessman examining objects with magnifier.jpegMultiple sales platforms and fulfillment centers enable ecommerce companies to accumulate revenue through a variety of channels. But the hodgepodge of reporting timeframes, formats and protocols can create a nightmare for any company committed to following GAAP-compliant revenue recognition and inventory reconciliation processes.

Recently, Supporting Strategies | Los Angeles partnered with a client that purchases large quantities of inventory at a time. The company then sells the products through various channels and collects upfront payments from many customers before shipping fulfillment. (This business model requires that we record the company's revenue and expenses on an accrual basis rather than a simple cash basis.)

To maximize its reach, the company uses a variety of sales channels. Only one (Amazon) does its own fulfillment. Most of the others (including Kickstarter, Indiegogo, BackerKit and Shopify) use a third-party fulfillment service. In addition, our client sells their product at wholesale to many retail businesses in multiple countries using multiple currencies. Some wholesale sales are shipped from the manufacturer, others from the fulfillment center. Lastly, the company uses product giveaways as promotions.

All of the company's inventory must be accounted for. That turned out to be much easier said than done.

Tracing the Trouble to Its Source
The process is supposed to be straightforward. When the company procures inventory from the manufacturer, the cost is recorded on the balance sheet as an increase to assets. When the company receives an order, the customer's payment is deposited into the company's bank account with offset to deferred revenue. Once the order ships, we debit deferred revenue and credit income. At the same time, we credit inventory assets and debit COGS (cost of goods sold).

The trouble starts with the third-party platform processing thousands of transactions per month. At first, we relied exclusively on the company's fulfillment reports to recognize revenue and COGS when they reported items shipped. But after a few months, we discovered that our client's deferred-revenue and inventory-on-hand balances were climbing much higher than any reasonable projection. Our client's CPA agreed that we should audit the entire operation to ensure accurate year-end revenue reporting for tax purposes.

We found that while the third-party fulfillment partner had an enormous amount of data available, the data was grossly inaccurate. The fulfillment partner acknowledged this but couldn't offer any good solutions.

Realizing we needed to recalculate all historical entries for deferred revenue and inventory, we retraced every step along the supply and fulfillment chain.

Recalculating …
First, we went back to the beginning and reset our client's inventory to zero. We knew that the quantity of items produced from the manufacturer over time was accurate because it reconciled with what our client paid the manufacturer for procurement.

Then, using the manufacturer's detailed records, we determined the quantity and value of products shipped to each warehouse for distribution. We also:

  • Obtained the dollar value of all items sold by month through each ecommerce partner
  • Confirmed that Kickstarter and Indiegogo sales began two months before transactions began on any other platform our client used
  • Determined how many promotional units our client distributed

From there, it was a matter of painstakingly filling in all the unknowns, including:

  • The quantity (if any) of items produced and paid for that were still at the manufacturer
  • The quantity of items sold via Kickstarter and Indiegogo (complicating the math, some backers on crowdfunding platforms pay more than the minimum price)
  • The breakdown by month of sales on Kickstarter and Indiegogo for the first two months (we only had the two-month total)
  • Up-to-date monthly reports from Amazon fulfillment, Shopify and BackerKit; data quality varied from reliable (Amazon and BackerKit) to misleading (Shopify's reports appeared to be accurate and consistent, which gave us the false impression that their data was valid)

In addition, there was a three-month delay before we were able to get direct access to the manufacturer's reporting website. In the meantime, our only sources of information available for inventory produced and shipped from the manufacturer were derived from a collection of the historical invoices received from the manufacturer over time.

Designing a Solution
The simplified explanation of what we did was to post journal entries to recognize the net volume of activity in each related partner account on a monthly basis. But getting there was a painstaking process. For one thing, no integrated solution can capture transaction-level detail from each system to flow through the accounting software that might enable real-time revenue and inventory postings. We ultimately used a combination of data sources and deductive reasoning to recalculate inventory and deferred revenue as of year-end, and each month going forward leading up to current time.

Moreover, we had to adapt our approach to fit each partner account's unique issues. When crowdfunding customers paid more than the asking price, for example, we booked the difference as miscellaneous additional revenue.

And although Amazon provided reliable reports for total items on hand, the data applied only on the date the report was run. In other words, we weren't able go back and run the inventory report as of a specific date to obtain inventory-on-hand at each prior month-end.

Historical sales quantities and dollars by date were available from Amazon, however, which allowed us to back into the item-quantities-on-hand balances to each prior month-end by starting with the current inventory-on-hand numbers. Then we added back each prior month's sales volume and subtracted each prior month's shipment quantities that the manufacturer reported delivering to Amazon's warehouse.

Little by little, the pieces of the puzzle fell into place.

Case Closed
All in all, it was a challenging bit of detective work, but the results were well worth it to our client. And this case reinforced the value of working with experienced bookkeeping and financial reporting professionals who can identify and resolve serious issues before they spin out of control.

Topics: Santa Monica, Los Angeles, Ventura County

Mark Wald

Written by Mark Wald

Mark is managing director of Supporting Strategies | Santa Monica, CA.

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