Accounting Principles and Disclosures

Learning Outcomes

  • Discuss common financial statement disclosures with regard to inventory

Let’s revisit actual financial statements from The Home Depot, Inc. annual report. Here is a partial balance sheet for the fiscal year ended February 2, 2020:

in millions, except per share data Fiscal 2019 Fiscal 2018 Fiscal 2017
Net sales $     110,225 $     108,203 $     100,904
Cost of sales 72,653 71,043 66,548
          Gross Profit Single line37,572 Single line37,160 Single line34,356
Subcategory, Operating expenses: Single line Single line Single line
     Selling, general and administrative 19,740 19,513 17,864
     Depreciation and amortization 1,989 1,870 1,811
     Impairment loss 247
          Total operating expenses Single line21,729 Single line21,630 Single line19,675
Operating income Single line15,843 Single line15,530 Single line14,681
Subcategory, Interest and other (income) expenses: Single line Single line Single line
     Interest and investment income (73) (93) (74)
     Interest expense 1,201 1,051 1,057
     Other 16
          Interest and other, net Single line1,128 Single line974 Single line983
Earnings before provision for income taxes Single line1,128 Single line974 Single line983
Provision for income taxes 3,473 3,435 5,068
Net earnings Single line$     11,242Double line Single line$     11,121Double line Single line$     8,630Double line

Inventory makes up a substantial portion of total assets, second only to property, plant, and equipment. But the number on the face of the financials is only part of the story. GAAP requires additional disclosures with regard to inventory that cover the following financial accounting principles and policies:

  • Conservatism (using LCM or LCNRV)
  • Estimates
  • Internal controls
  • Materiality

Below is the complete disclosure regarding inventory from The Home Depot, Inc. Annual Report for the fiscal year ended February 2, 2020, found on page 38.

Note the following:

ASU 2015-11 requires that the term market should no longer be used in accounting policy or other disclosures in reference to inventories, except in transition or when inventory is priced on a LIFO or a retail method basis. Instead, the term should be replaced with NRV. Because of the complexity of The Home Depot’s operations, they actually use both systems.

Merchandise Inventories

The substantial majority of our merchandise inventories are stated at the lower of cost (first-in, first-out) or market, as determined by the retail inventory method, which is based on a number of factors such as markups, markdowns, and inventory losses (or shrink). As the inventory retail value is adjusted regularly to reflect market conditions, inventory valued using the retail method approximates the lower of cost or market. Certain subsidiaries, including retail operations in Canada and Mexico, and distribution centers, record merchandise inventories at the lower of cost or net realizable value, as determined by a cost method. These merchandise inventories represent approximately 29% of the total merchandise inventories balance. We evaluate the inventory valued using a cost method at the end of each quarter to ensure that it is carried at the lower of cost or net realizable value. The valuation allowance for merchandise inventories valued under a cost method was not material to our consolidated financial statements at the end of fiscal 2019 or fiscal 2018.

Independent physical inventory counts or cycle counts are taken on a regular basis in each store and distribution center to ensure that amounts reflected in merchandise inventories are properly stated. Shrink (or in the case of excess inventory, swell) is the difference between the recorded amount of inventory and the physical inventory. We calculate shrink based on actual inventory losses occurring as a result of physical inventory counts during each fiscal period and estimated inventory losses occurring between physical inventory counts. The estimate for shrink occurring in the interim period between physical inventory counts is calculated on a store-specific basis based on recent shrink results and current trends in the business.

Home Depot includes a standard disclaimer about the use of estimates, and this too is required by GAAP with regard to inventory (also on page 38):

Use of Estimates

We have made a number of estimates and assumptions relating to the reporting of assets and liabilities, the disclosure of contingent assets and liabilities, and reported amounts of revenues and expenses in preparing these financial statements in conformity with GAAP. Actual results could differ from these estimates.

Now that you are more familiar with the types of accounting used for inventory, and have become more familiar with publicly traded corporations, you’ll be able to search out your favorite corporation’s financial statements and discover what they disclose in regard to their inventory.

Practice Question