Anyone who has studied accounting knows that even when a management team is just trying to give the clearest possible depiction of how their business is doing (not massaging numbers or worse) there are a surprising number of judgment calls that can influence this quarter’s bottom line, and if investors don’t realize that two companies are making different choices they can be misled by a side-by-side comparison.
When deciding how to handle markdowns, for instance, big box department stores like J.C. Penney Company, Inc. (NYSE:JCP) normally use the retail method while specialty retailers normally use the cost method of accounting (though there are exceptions in both cases), and investors should understand the difference when deciding where to put their money.
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Citi prefers cost accounting in retail
“Our preference is that companies generally utilize the Cost method which we believe gives a fairer sense of matching expenses with revenues, has slightly less subjectivity as timing to markdown pressure is based on customer activity, & likely better aligns merchants with out the door price selling activity,” writes Citi analyst Oliver Chen in an April 9 report. “We acknowledge that Cost method could yield overstated inventory valuation on the balance sheet.”
Before the IT revolution, the retail accounting method was used as a matter of necessity. It tracks inventory and cost of goods sold (COGS), so when a markdown is made it immediately impacts COGS and gross margins, even if the item hasn’t actually been sold yet. Aside from being easier to implement, this has the advantage of giving a more accurate picture of the value of a companies’ current inventory, but it also gives executives more room to manage their earnings (thus the reason Chen isn’t a fan). Institutional inertia is likely part of the reason that department stores are much more likely to use retail accounting than specialty shops, but with so many struggling to keep their margins high the temptation to manage earnings must be high.
Tech makes item tracking, cost accounting feasible
Now that stores can track sales on an item-by-item basis it’s possible to do accounting according to the actual cost of each item as it’s sold. Cost accounting is less subjective, since it simply reports back what has happened the previous quarter, but it also means that markdowns taken this quarter can impact margins down the line as inventory clears out. It can also give investors a false sense of how much a companies’ inventory is actually worth.