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2.2 Challenges in the application of the retail inventory method
Publication date: 31 Dec 2021
us Inventory guide
2.2.1 Accounting for markups and markdowns
Markups and markup cancellations generally should be accounted for “above the line” (i.e., as an adjustment to retail value in the calculation of the cost complement percentage). If a markup is reflected below the line (i.e., excluded from the cost complement calculation), the retail value used in the cost complement percentage calculation would be understated, resulting in a higher cost complement percentage and an overstated ending inventory balance.
On the other hand, markdowns and markdown cancellations should not be included in the computation of the FIFO RIM cost complement percentage. If included, the retail value used to compute the cost complement will be understated, resulting in a higher cost complement percentage and an overstated ending inventory balance.
The improper accounting for markups and markdowns can have a significant effect on the profit of a retailer. Some of the more common problems in this area include:
- The determination of whether a reduction in retail price is a markup cancellation or a markdown affects the computation of the cost complement percentage. Entities should have clearly defined policies and procedures for how to determine the appropriate classification.
- Improper cutoff in the recording of markdowns may lead to markdowns being deferred to the next accounting period, and ending inventory at retail and cost being overstated.
- Failure to account for point-of-sale markdowns recorded in the retailer's point-of-sale system that are not captured in the retail inventory ledger may lead to ending inventory at retail and cost being overstated.
- Failure to record markdowns taken on the floor may lead to ending inventory at retail and cost being overstated. At the physical inventory count, the error will appear as a shortage.
2.2.2 Averaging of high markon and low markon goods
Since RIM is an averaging method, variations in the data can result in distortions of inventory amounts. Having high markon goods or low markon goods can overstate or understate inventory cost, respectively, if there is a disparity between the proportions of high and low markon goods used in the determination of the cost complement percentage as compared to the proportion of such goods in ending inventory.
Low markon goods tend to turn over at a faster rate than high markon goods, resulting in a higher proportion of low markon goods in the cost complement percentage calculation than represented in ending inventory. The resulting higher cost complement percentage will be too high, resulting in an overstatement of ending inventory and an understatement of cost of goods sold.
In determining inventory groupings, similar markon percentages and turnover characteristics should be considered to mitigate the averaging effect inherent in the retail inventory method and ultimately report accurate ending inventory balances and costs of goods sold. Inaccuracies can be reduced by applying RIM at the departmental level; however, it may be necessary to further subdivide departments into classes of goods for purposes of computing retail inventory. In particular, tax rules in the US state that a retailer maintaining more than one department or dealing in classes of goods carrying different percentages of gross profit should not use a percentage of profit based upon an average of the entire business, but should compute and use the proper percentages for the respective departments or classes of goods when determining inventory.
Depending on the facts and circumstances, a change in the inventory groupings may be considered a change in accounting principle for book purposes, subject to the requirements of ASC 250, Accounting Changes and Error Corrections, and an accounting method change for tax purposes, subject to Section 446 of the Internal Revenue Code.
2.2.3 Seasonality and the significance of accumulation periods
Similar to the averaging of high markon and low markon goods, seasonality of margins can also result in inventory distortions. Markon percentages may fluctuate significantly from month to month and progressively throughout a season. These fluctuations could result in an overall cost complement percentage that is not representative of the ending inventory on hand.
In determining the cost complement accumulation period, consideration should be given to the rate of turnover and the consistency of markons over time. If inventory turns quickly (within 3 months or less), shorter accumulation periods may be appropriate. In these instances, the more recent months’ markons will be more representative of the markons in the ending inventory. On the other hand, if inventory turns at a slower rate, a longer accumulation period may be reasonable. Judgment is involved in determining an appropriate accumulation period and different accumulation periods can be selected for inventory in different departments based on the rate of turnover and seasonal variability of merchandise within each department. For tax purposes, the IRS requires the use of annual accumulation periods.
Similar to a change in inventory groupings, a change in the accumulation period may be considered a change in accounting principle (for book purposes) or a change in accounting method (for tax purposes), subject to the requirements of ASC 250 and Section 446 of the Internal Revenue Code, respectively.
2.2.4 Retail inventory method — vendor allowances
The following summarizes the effect of vendor allowances on RIM.
- Vendor allowances for overcharges – credited directly to the purchases account, reducing the cost of inventory and, as a result, the cost complement percentage.
- Advertising allowances – those meeting the criteria to be credited to advertising expense would not impact the inventory accounts or the cost complement percentage in accordance with ASC 705‑20. Advertising allowances that are not reimbursements of specific, incremental, identifiable costs incurred by the retailer represent a reduction of the purchase price of the goods acquired from the vendor and, accordingly, should be credited to the purchases account.
- Price protection allowances (also known as markdown allowances) – credited directly to the purchases account at cost, reducing the cost of inventory. If a corresponding reduction in the marked retail price is made, a reduction should also be made to the retail amount of the purchase in the retail inventory ledger (i.e., perpetual inventory records). However, if the actual retail price reduction by the retailer exceeds the retail amount of the vendor’s allowance, a markdown should be recorded for the excess, which would have no effect on the inventory cost used in the cost complement percentage.
A markdown allowance should reduce markdowns in the period described in the vendor allowance agreement. Such allowances are often negotiated with vendors after a designated selling season (e.g., the fall season) and an issue can arise with respect to the timing of recognition of these allowances. To the extent that the merchandise inventory to which the allowances relate has been sold through, and the allowances are obtained through the reduction of purchase price on the next season's purchases, we generally expect the allowances to be recognized in the following season as a reduction to the cost complement (resulting in an increase to gross profit) because the retailer would likely not have obtained such allowances without the actual or expected future purchases from the vendor.
Finally, “scan-down” or “scan-back” arrangements also warrant consideration under ASC 705, Costs of Sales and Services. Under these arrangements, retailers earn allowances (consideration) from the vendor when a product is scanned (sold) at the store. ASC 705‑20 provides guidance on accounting for consideration received from vendors.
- Non-compliance charges – a charge back to vendors for non-compliance with retailer’s procurement rules (e.g., early/late shipments) generally credited to distribution costs.
2.2.5 Retail inventory method — cash discounts
Cash discounts may be offered by vendors on an ad hoc basis or as part of a volume discount program. Cash discounts should be credited directly to the purchases account at cost, reducing the cost of inventory and the cost complement percentage. If quantity discounts are received based on purchases for an entire season or year, an estimate should be made of the discount to be received and the purchases account at cost should be credited for the estimated allowance.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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