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From the annual reports we can conclude that Wal-Mart operates its stores as mass discount retailers, carrying between 60,000 and 90,000 different merchandise items in each store. Wal-Mart purchases more than $22 billion in merchandise, turning its inventory over as often as 4.5 times per year. Sam Club carries between 3,500 and 5,000 different merchandise items, acquiring more than $2.6 billion in merchandise. Wal Marts operations grew from 2003 to 2005. For example, the number of Wal-Mart stores increased and the number of Sam’s stores increased. WalMart utilized an extensive distribution and tracking system to maintain optimal inventories at each store. They use the retail last-in, first-out (LIFO) inventory accounting method for the Wal-Mart Stores segment, cost LIFO for the SAM’S CLUB segment.
For both financial reporting and tax purposes, Wal Mart used the accrual method of accounting and maintained a perpetual inventory system. Under the perpetual inventory system, the cost or quantity of goods sold or purchased is contemporaneously recorded at the time of sale or purchase. The system continuously shows the cost or quantity of goods that should be on hand at any given time. WalMart performed physical inventories to confirm the accuracy of the inventory as stated in the books, and made adjustments to the books to reconcile the book inventory with the physical inventory.
WalMart’s physical inventories were taken at its stores in rotation throughout the year. They did not take physical inventories during the holiday season (November, December, and the first week of January). WalMart refers to this technique, which is common in the retail industry, as cycle counting. Cycle counting is necessitated by the difficulty in conducting physical inventories at every store on the last day of the year. This technique also provides management with feedback on the effectiveness of its inventory management and facilitates the use of experienced personnel to conduct the physical inventories.
Forty-five days prior to conducting a physical inventory in one of its stores, Wal-Mart’s internal audit department sends the store a preparation package, which included instructions on how to prepare for the physical count. Each physical count is then conducted by a team of independent counters (18 to 40 persons) and representatives from Wal-Mart’s loss prevention department (1 to 2 persons), internal audit department (1 to 3 persons), and operations division (1 to 2 persons). Wal-Mart’s independent auditors, Ernst & Young, also sent representatives to randomly selected physical counts to test their accuracy. The independent counters generally counted every inventory item. The results of the physical count were then reconciled with the book inventory. The reconciliations is reviewed by Wal-Mart’s internal audit department. Generally, Wal-Mart does not record the results of a physical inventory in its books until the following month.
Sam’s Club conducs its physical inventories in the same manner except that physical counts are usually taken twice a year and recorded the very next day. Sam’s also periodically conducted item audits, counting the goods on hand for a particular merchandise unit and recording those results the next day. The physical inventories of both Wal-Mart and Sam’s usually revealed shrinkage.
Shrinkage (or overage) is the difference between the inventory determined from the perpetual inventory records and the amount of inventory actually on hand. Because shrinkage reduces profits, WalMart has devoted extensive resources to monitoring and mitigating shrinkage. There are many causes of shrinkage, including employee theft, customer theft, vendor theft, damage, accounting and recording errors, errors in marking retail prices, cash register errors, markdowns taken and not recorded, errors in accounting for customer returns, and errors in accounting for vendor receipts and returns.
Because Wal Mart does not conduct a physical inventory at year-end, its perpetual inventory records do not account for any shrinkage that may have occurred during the period between the date of the last physical inventory and the taxable year-end. The parties refer to this period as the stub period. Left unadjusted, the book records could overstate income because the stub period shrinkage results in a decrease to ending inventory, thus increasing the cost of goods sold and reducing gross income.
In adjusting its books to reflect stub period shrinkage, Wal-Mart estimates stub period shrinkage for each store monthly by multiplying a retail shrinkage rate by the store’s sales during that month. At new stores, the retail shrinkage rate fixed by management at 2% of sales. Wal-Mart used that fixed rate from the date the store opened until its first physical inventory. After taking the first physical inventory at a new store, Wal-Mart computed a shrinkage rate for that store by dividing the store’s shrinkage at retail, as verified by the first inventory, by the store’s sales for the period starting with the date the store opened and ending on the inventory date.
Sam’s consistently estimates the stub period shrinkage at .2% of sales. That rate was determined by management based on their analysis of historical results from warehouse operations.
Wal-Mart estimates shrinkage for each store, but not for each department within each store. It used a series of computations to allocate the estimated stub period shrinkage to each department. Once these allocations were made, Wal-Mart used the adjusted ending inventory to make its LIFO computations, which were made on a division-wide basis and not at the individual store level. The practice of estimating shrinkage as a percentage of sales is prevalent in the retail industry. A company may estimate year-end shrinkage if the estimate methodology (1) conforms to the best accounting practice in the trade or business and (2) clearly reflects income.
There is nothing in WalMarts accounting for inventory that raise suspicion about their inventory not reflecting true numbers. Inventories are not recorded in excess of market value. Historically, they have rarely experienced significant occurrences of obsolescence or slow moving inventory. However, future changes in circumstances, such as changes in customer merchandise preference or unseasonable weather patterns, could cause the Company’s inventory to be exposed to obsolescence or be slow moving.
The inventory system is commonly revered as the finest in the retail industry and WalMart is perhaps the best example of the importance of a high inventory turnover rate to succeed in this industry. Increased turnover and increased sales at the same time — that’s great inventory management.