Gabi Ledesma, Principal, Capgemini

gabriel.ledesma@capgemini.com
Anil Das, Senior Manager, Capgemini
anil.das@cagpemini.com
International Financial Reporting Standards (IFRS)
Cost Method of Accounting: Can Retail Companies Really Afford Not to Adopt It?
Retail companies have traditionally used the Retail Method of Accounting (RMA) to avoid the costs
associated with tracking inventory at the unit level in a perpetual basis. New International Financial
Reporting Standards (IFRS) supported by the U.S. Securities and Exchange Commission (SEC) will
require the adoption of item-location inventory accounting by 2016. Even if this requirement does not
become mandatory, those retail companies continuing to use RMA will be missing the business and
managerial opportunities offered by tracking inventory more accurately and being able to better
understand true profitability at stores and product category levels. More than 113 countries and 12,000
companies around the world have adopted the IFRS standard for financial reporting. In a global economy,
where investors can place their money in any country, the ability to be able to compare financial
statements in a simple and transparent manner will benefit the companies that have adopted the new
standards. And should IFRS become a mandate in the U.S. in 2011, retail companies still using RMA will
be faced with transitioning to a new system in a shorter, possibly more expensive, timeframe.
Business Benefits of Cost Method of Accounting
RMA was developed before the advent of computerized inventory tracking systems. It is a year-to-date
system that tracks inventory valuation at an aggregated level, usually class level. Under this method, the
purchase costs are accumulated for the year-to-date period at the class level and the value of the
merchandise acquired is determined at the retail price. The ratio of accumulated cost to the value at retail
price is the cost factor that is applied to derive the Cost of Goods Sold at the end of the period. A change
to price - which happens often in retail - results in a change to the inventory valuation.
Cost Method of Accounting (CMA) manages inventory at item-location level and tracks its cost using a
moving average. The moving average cost is computed every time a goods receipt occurs. The move to
item/location inventory costing provides the powerful ability to understand item-location profitability. With
this method merchandise planners have the ability to target assortments to stores based on the products
profitability at each store or store group. In addition, inventory valuation is straightforward: true revenues
less true costs provides gross margin. Under RMA, the revaluation necessary when a price changes
requires cumbersome additional analysis by experienced merchants to understand what caused the shifts
in gross margin.
That being said, there are challenges that have to be addressed under the cost method related to delayed
costs. The cost method of accounting is built around moving average cost that is based on perpetual
tracking of units. Computation logic for moving average requires that most of the procurement costs are
available at the time of receipt. This does not always happen. So the delayed costs are not absorbed in
the moving average cost because the goods have often moved from the distribution center to the stores
or have been actually sold to customers. Application developers are addressing this in a number of ways,
including use of analytics.

Finally, U.S. retailers planning expansions into other countries, either organically or via mergers and
acquisitions, will need to adopt IFRS standards if they plan to work in the European Union countries,
where the standards have been mandatory since 2005.
How new technologies can help
Over the past few years, Enterprise Resource Planning (ERP) systems have begun to deliver the
functionality required to run a retail business, including proper valuation of inventory at all nodes of the
supply chain. These systems provide an all-in-one inventory management platform, from purchasing to
store sales. Inventory transactions are immediately posted to the financial ledgers as they are performed,
resulting in a perpetual accounting of inventory. Inventory is valued at its true cost at any given time
including purchase, costs of conversion and other costs incurred in bringing items to their present location
and condition. The IFRS requirement to move to CMA can serve as a trigger to change current obsolete
legacy systems to new retail ERP systems that deliver integrated merchandising, supply chain, and
financial solutions.
Case study
We helped a large fashion retail company in the U.S. move from RMA to CMA. The biggest challenge in
this transformation was to align the organization with the new financial reporting structure. Merchants, as
much as accountants, needed to understand the implications of item-location inventory valuation. The
decision was not solely made on accounting terms. The company also understood the additional
opportunity to:
-

Achieve competitive advantage from item-location inventory management

Integrate planning, execution and financial functions
Replace aging legacy systems and consolidate applications
Move to leading practice driven packages from in-house custom applications

The solution implemented was SAP IS Retail. SAP Retail has the advantage of offering cost method of
accounting as well as report functionality using the older retail method. This is very important for
transitional purposes since people need to still be able to make sense of historical sales and revenue
data until CMA is fully adopted.
Citigroup Global Markets recent evaluation of the company specifically mentioned their new SAP-based
supply chain implementation as a reason for improved sales and margins since it will allow them to
manage inventory on a store by store basis and flow goods based on store specific needs. The report
goes on to say that the new systems allows visibility all the way up the supply chain, ensuring that each
store has the proper stock for key items, especially important during the high volume holiday selling
period.