A retailer's revenue is high volume and low risk per transaction. The judgment sits on the balance sheet: inventory is counted with error, and gift cards and loyalty points are liabilities the point-of-sale system does not value. This guide covers those areas.
Inventory: shrink, valuation and the retail method
Shrink is the difference between book inventory and what is on the shelf, from theft, damage, vendor error and process failure. Retailers either count every location at year end or run cycle counts with a reserve for the period after the last count.
The measurement rule depends on the costing method. Under ASC 330-10-35-1B, inventory measured with any method other than LIFO or the retail inventory method, such as FIFO or average cost, is measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation. Inventory on LIFO or the retail inventory method keeps the lower of cost or market approach under ASC 330-10-35-1C, because the FASB excluded those methods from the 2015 simplification. A retailer using the retail method needs the audit to test its markup and markdown inputs, since the cost-to-retail ratio drives the carrying amount. The costing mechanics are in the inventory costing guide.
Audit steps:
- Observe counts at a sample of stores and the distribution center, and test the count sheets to the perpetual record. See inventory observation procedures.
- Recompute the shrink accrual for the period after the last count using the shrink rate from completed counts, and compare the rate to prior years and across stores.
- Test inventory in transit and consignment, and cutoff on receiving and sales. See cutoff testing.
- Compare the markdown reserve to post year end clearance prices, with attention to seasonal goods.
- Test vendor allowances and rebates for whether they reduce inventory cost or are recorded as income, and for the period earned.
Gift cards: breakage and unclaimed property
A gift card sold is a contract liability. Revenue is recognized when the card is redeemed, and a retailer that expects breakage recognizes it in proportion to the pattern of redemptions. PwC's revenue guide states that if an entity expects to be entitled to breakage, it recognizes the expected amount in proportion to the pattern of rights exercised by the customer, that if it does not expect breakage it recognizes the amount when the likelihood of redemption becomes remote, and that a policy of recognizing breakage only when it occurs is not permitted. Estimates are updated each period.
Unclaimed property law changes the answer. The same guide says that where a jurisdiction requires unredeemed amounts to be remitted to the government, the entity does not recognize breakage on those amounts. The auditor needs the retailer's analysis of each state's rules on gift card escheat and the history of remittances.
Test the estimate against redemption history by card cohort, test the liability roll-forward from activations to redemptions to breakage, and agree the liability to the card system report.
Loyalty programs: a material right
When points give customers a discount they would not receive without a purchase, they are a material right and a separate performance obligation. The transaction price is allocated between the goods sold and the points based on relative standalone selling price, and the amount allocated to points is deferred until redemption or expiration. BDO describes the standard's example the same way: the points' standalone selling price reflects the expected redemption rate, and breakage is recognized in the pattern of redemption.
The audit tests the redemption rate against actual redemptions, the value per point against the discount actually given, and the liability against the loyalty system report.
Returns
Retailers with right-of-return policies recognize revenue only for goods not expected to be returned, with a refund liability and a return asset presented separately. Returns after year end for sales before year end are a cutoff test. The mechanics are covered in the ecommerce guide.
Worked example
An illustrative example for gift cards: a retailer sells $80,000 of cards in the fourth quarter and expects 8 percent breakage, which is $6,400, so expected redemptions are $73,600. By year end $36,800 has been redeemed, half of the expected total. Revenue is $36,800 for redemptions plus breakage of $6,400 × 36,800 / 73,600 = $3,200, a total of $40,000. The liability is $80,000 less $40,000 = $40,000. If the retailer instead recognized all $6,400 at activation, revenue would be overstated by $3,200 at year end.
For loyalty points, suppose $200,000 of sales earn 20,000 points, each redeemable for $1, and the retailer expects 90 percent redemption. Points have a standalone selling price of $18,000. Relative allocation gives the points $200,000 × 18,000 / 218,000 = $16,514, which is deferred, and $183,486 is recognized at sale.
For shrink, book inventory at cost is $2,400,000 and the count totals $2,316,000. Shrink is $84,000, which is 0.7 percent of the $12,000,000 of cost of sales since the prior count. If the count was taken November 30 and December cost of sales is $2,500,000, applying the same 0.7 percent rate gives an additional $17,500 accrual.
PBC list
- Count instructions, count sheets and perpetual inventory reconciliation
- Shrink history by store and the reserve calculation
- Markdown and clearance schedule with post year end sales
- Gift card liability roll-forward, redemption history and state unclaimed property filings
- Loyalty program terms, points issued and redeemed, and liability calculation
- Vendor allowance agreements and credits received
- Returns reserve calculation and post year end return report
Red flags
- Shrink rate that drops sharply in the year of a covenant test
- Gift card breakage recognized at sale or on a schedule unrelated to redemptions
- No loyalty liability for a program with points outstanding
- Large adjustments between the perpetual record and the count with no root cause
- Vendor allowances recorded as revenue
Sources
- FASB ASC 330-10-35-1B and 35-1C, and the Master Glossary definition of net realizable value, ASU 2015-11, text reproduced by PwC Viewpoint: https://viewpoint.pwc.com/dt/us/en/fasb_financial_accou/asus_fulltext/2015/asu_201511inventory_/asu_201511inventory__US/asu_201511inventory__US.html
- PwC Viewpoint, Revenue from Contracts with Customers, Customers' Unexercised Rights: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/revenue_from_contrac/revenue_from_contrac_US/chapter_7_options_to_US/74unexercised_rights_US.html
- PwC Viewpoint, Revenue from Contracts with Customers, Rights of Return: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/revenue_from_contrac/revenue_from_contrac_US/chapter_8_practical__US/82rights_of_return_US.html
- BDO, ASC 606's Impact on Loyalty Programs: https://www.bdo.com/insights/industries/restaurants/asc-606s-impact-on-loyalty-programs-redemption-is-key
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