This morning OfficeMax (NYSE:OMX) announced that the SEC has opened an official probe into the company's accounting for vendor allowances. This is the same accounting-controls problem that recently earned Saks (NYSE:SKS) a spanking and plagued Dutch grocery behemoth Ahold. While OfficeMax claims to have corrected the problem itself back in February, the company does have a history of playing its accounting fast and loose, so you can hardly blame the SEC for wanting to make sure the company really came clean.
These payments can get a bit tricky to account for, particularly when different rates apply to different products and there are various types of marketing payments that can be made. To name a few, there are payments for shelf space, general marketing expenses to appear in a retailer's advertisements, and rebates on volume sold. Tying each of these to the individual products does take a bit of effort.
If you're a vendor to, say, Home Depot (NYSE:HD), Lowe's (NYSE:LOW), or Albertson's (NYSE:ABS), it's not so bad. As payments to vendors are made, the costs are matched to sales to the customer as a reduction of revenue from that customer. It requires a bit of work, but it's manageable.
Until 2003, retailers had a great deal of freedom as to how they recognized these payments, because there wasn't a defined accounting rule on how to recognize the payments and when. There is the natural law of accounting that costs and revenues should match, but without a defined convention the door was open for abuse. This led to some retailers recognizing the payments as revenue and others as a reduction in cost of goods sold. Given that vendors recognize it as reduction of their revenue from the customer, it makes the most sense for the customer to recognize the payments as a reduction in cost of goods sold.
But then there is the issue of when to recognize the reduction. It gets a bit more complicated, but as a general rule, retailers that recognize these payments as a reduction in cost of goods sold when sales of the individual product(s) are made -- and for which they received payment -- are doing this properly.
It's interesting that the market is giving OfficeMax the benefit of the doubt here. I couldn't disagree more. This is a company whose 2004 10-K shows that last year's negative free cash flow wiped out at least the last three years of reported positive free cash flow. Add that to the fact that OfficeMax has seen numerous changes in the executive ranks recently -- including a CFO who left after two months -- and I think investors considering OfficeMax should not only rigorously analyze the company's financials, but also take a very deep look at the company's proxy statement (SEC filing DEF14A) and its board of directors.
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Nathan Parmelee has no financial interest in any of the companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.
