Revenue Recognition and the Channel Stuffing Question
Cresta Software sells annual licences and recognises revenue upfront on signature, consistent with its stated policy. In Q4, sales to three resellers rose 62% year on year, and the CFO approved extended payment terms of 180 days for two of them. One reseller, which accounts for 14% of Q4 revenue, has a side letter allowing it to return unsold licences within nine months for a 90% refund. The side letter was not disclosed to the auditors. Days sales outstanding has risen from 48 to 97 days. The CEO's bonus is tied to annual revenue. The audit committee meets in three weeks to approve the annual report. The finance director has privately told a non-executive that she is 'uncomfortable' but was told by the CFO that the arrangements are 'normal channel practice'.
1. Assess whether the Q4 revenue recognition is appropriate and identify the indicators of risk.
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The indicators point strongly toward revenue that should not be recognised, or at least heavily scrutinised. First, the side letter granting a nine-month right of return for a 90% refund means control and the risks of ownership have not transferred; under a principles-based approach, revenue should be deferred until the return right lapses or the reseller sells on. Second, the 62% Q4 surge concentrated in three resellers, combined with DSO rising from 48 to 97 days and 180-day terms, suggests sales pulled forward to meet targets rather than genuine demand. Third, the reseller at 14% of Q4 revenue is material. Fourth, the side letter was withheld from the auditors, which is a serious breach and may amount to misleading the auditor. Fifth, the CEO's revenue-linked bonus creates an incentive to push recognition. The finance director's discomfort, overridden by the CFO, is corroborating evidence. The audit committee should not approve the accounts without an independent review of these contracts and should consider whether revenue should be restated.
2. The CFO argues the arrangements are 'normal channel practice' and the auditors have previously accepted the policy. Advise the audit committee on its response and the disclosure implications.
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Precedent does not cure a misstatement. 'Normal practice' is not an accounting defence; the test is whether the specific contractual terms transfer control. The audit committee should: require the CFO to produce all side letters and reseller contracts; commission an independent review of Q4 revenue, including a sample of resellers and confirmation of sell-through; instruct the auditors to reassess the affected revenue with the side letter disclosed; and document its reasoning. If revenue is overstated, the committee should require correction before approval and consider whether prior periods are affected. Disclosure implications are significant: material revenue recognition judgements, the return rights, and any restatement must be disclosed; withholding the side letter from the auditor may trigger a legal and regulatory notification obligation. The committee should also review the CEO's bonus design, since a revenue-only metric with no cash or sell-through condition rewards exactly this behaviour, and should consider clawback and whether the CFO and finance director should remain in post pending the review.