Use them or shun them, side letters (also called side agreements or side letter arrangements) are part of the business landscape. Any time parties enter a contract, whether it is for sales, purchases, an acquisition, or any other contract, there is a possibility that the contracting parties will create an agreement outside of the formal contract. The use of a side letter increases the risk of accounting and financial reporting irregularities.

Why Use Side Letters?

In its most basic form, a side letter is a written agreement that is ancillary to the primary contract. It may be used to clarify or supplement the original contract. Sometimes, situations arise where it's easier to make a side agreement rather than modify the whole contract. For instance, if the original contract did not have a clear term, or there was not sufficient time to modify the original contract for changes in circumstance that occurred when the contract was finalized, the parties to the contract may come to an agreement and document that in the form of a side letter. In some cases, the side letter may simply be an oral agreement.

A typical example of when a side letter may occur is when a sales team is trying to entice a customer to purchase a product or increase the volume of an order. A side letter in this circumstance may provide for a discount for larger quantity orders and discounts on products with an understanding of future purchases. Other forms of side agreements that may be seen with sales contracts include promises of future products, providing non-standard rights of return, acceptance conditions on the quality of a good or service or promises of additional support or services to be provided along with the contracted goods.

For example, a software company consultant may sell a customer a piece of software with the side agreement that a particular upgrade to the software will be made and provided to the customer without charge. While that may entice the buyer to purchase the soon-to-be-updated program, the software company's accounting department may not be aware that the consultant offered a specified upgrade on the product, and so the accounting department may inappropriately recognize revenue on the software sale.

Another common scenario is the use of side agreements to induce customers to purchase product on or near the end of a financial reporting period. Such behavior is common across a variety of industries including but not limited to manufacturing, technology and pharmaceuticals. In some instances, the price is lowered to induce the customer to purchase amounts in excess of their normal requirements. This gives rise to a variety of concerns and considerations, including the notion of "channel stuffing." Scenarios may also involve an implicit or written side agreement that the product may be returned after a period end. Such arrangements may be seen as ways to hit sales targets and improve financial performance in a period, but when the excess product may be returned or discounted in the next period, the recognition of revenue may be inappropriate.

Outside of the sales process, side arrangements are often used to clarify contractual terms or to modify contracts for last minutes changes. For instance, in an acquisition of another business, a side agreement may adjust the primary contract for changes that happened immediately before closing on the acquisition without having to revise the entire contract. Side agreements may also occur because they cannot be included in an original contract, such as when the original contract involves multiple parties and two of the parties have additional business to contract that does not involve the other parties to an arrangement.

Steps to Minimize Risk

The use of side letters for legitimate business purposes isn't the core problem. Rather, it is the absence of internal control over their use that is the core issue. Internal controls that fail to communicate the side letter to the appropriate people responsible for accounting and financial reporting can lead to accounting errors and reporting irregularities. They also expose an organization to potential avenues for fraud to occur.

The challenges in establishing effective internal control and the risk of side letters lead some companies to simply prohibit the use of side agreements and sales inducements, and this policy is often the best protection that can be afforded. Whether your company chooses to engage in these practices, it should have clear policies and procedures in place to describe if and how side letters can be used. Organizations that have been operating without clear-cut policies face the risk that a side letter will become an off-the-record arrangement. When the arrangements become "off-the-record," errors or even fraud may occur. The first step in mitigating the underlying risk associated with such sales practices is assessing the level of risk and designing effective internal control to mitigate the risk.

When determining controls, first consider who in the organizations is most susceptible to making side letter arrangements. Commission-based compensation for sales teams means sales staff may be more willing to offer incentives to get customers to purchase goods or services. Companies that provide market guidance and identify goals and benchmarks to hit each quarter may find side letters offering sales inducements more appealing than comparable companies that don't publish such information. Consider not only those with the incentive to issue side arrangements, but also the types of relevant authority that may be required. For instance, some sales inducements may require the involvement of senior management given the decision-making authority typically required to move large amounts of product.

To strengthen controls on side letter arrangements, companies should train staff on when it's appropriate to enter into an arrangement without putting it into the contract. Ensure that staff is aware of how, and to whom, to report side arrangements and regularly remind them of their obligations. If you want to avoid the complications that can arise from side letter arrangements with sales, make a clear policy that any changes to the price, volume, delivery method or other elements associated with the sale are made in the contract. If your organization chooses to allow side letter arrangements, there should be a system of approval in place before a side letter arrangement is entered. Also, consider creating regular interaction between the sales team and the accounting team members responsible for properly recording revenues, in particular when operating in an industry, such as software, that has more complex accounting rules for recognition of revenue. The interaction and dialogue between the two groups may help prevent a "silo" mentality that can result in errors being introduced because of a lack of communication.

Placing controls on arrangements that may result in channel stuffing requires organizations to educate their management teams about when or if to engage in the practice. There should also be defined limits on what amount of excess products can be shifted to related parties and how to account for those scenarios.

Besides putting rules into place for managing side letter arrangements, policies can also help minimize your liability for these types of transactions. Should the company have accounting complications related to side letter arrangements, it can demonstrate to regulators or auditors why the organization entered into the arrangement and what monitoring was in place to minimize the risk of erroneous financial reporting.

Use Judgment

Keep in mind that any off-the-record arrangements warrant a caveat emptor. When transactions and other decisions that have a monetary impact on transactions occur apart from a contract, the company's risk of error, misunderstanding its legal rights and obligations, regulatory scrutiny or other missteps greatly increases. Controls can help mitigate some of these concerns and limit the use of side letter arrangements.

Published on March 29, 2016