In my search for stock market value, I normally avoid accounting issues. Most investors find them dry in the extreme. But in certain industries, it pays to understand what's going on. That's why I can't ignore two announcements in as many weeks relating to retailers accounting for rebates and allowances received from vendors.
In the past, CVS
And further, we're supposed to be well beyond this kind of nonsense. Late in 2002, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) issued EITF 02-16 -- "accounting by a reseller for consideration received from a vendor." I'm sorry to be throwing all these accounting abbreviations at you, but my point is that, by now, the rules should be perfectly clear. But perhaps I should step back a minute and clarify the problem before getting into the rules.
A vendor may have many reasons to offer a rebate or allowance to a retailer. Perhaps the retailer has prominently featured the merchandise at the end of an aisle -- valuable real estate that sells more product. The retailer might feature specific merchandise in its advertising, again of value to the vendor. Or if a product is not selling as anticipated, the vendor might offer markdown assistance to clear the floor. All of these practices are perfectly legitimate transfers between manufacturers and retailers, and they have been going on since the first storefront opened up back in the mists of time.
The issue is the timing of earnings recognition, which retailers once accounted for on a cash basis: get the check, count it as earnings. It's a method that leads to an enormous amount of potential abuse. Say you're a retailer and the quarter isn't looking so good. Call up your vendors, make buying commitments for the future, and get a check now. Your quarterly-earnings problem is solved. This practice has been rampant in retail for a few decades, and it results in what's called earnings "smoothing." The problem for investors is that we don't know whether earnings are real or "smoothed." And that's not a minor consideration.
EITF 02-16 was supposed to solve the problem by requiring retailers to account for this consideration by reducing the cost of product. That requires the income be recognized only when the merchandise sells or, in some cases, when the advertising is performed. But not at the discretion of the retailer.
The problem is, there are a lot of retail executives who have been in the business for a long time. Some of them have a tendency to revert back to the good old days. Fortunately for investors, those days are supposed to be gone. Anyone reading a retail financial statement today has reason to expect that vendor consideration is appropriately recognized and that the results are a true representation of the state of the business. If not, then what's a financial statement for?
I have no sympathy for retailers who won't follow the rules. My advice is to steer clear of retail stocks that are having issues with the SEC over EITF 02-16. If they're not prepared to honestly report quarterly results, they don't deserve your trust.
There . glad I got that off my chest.
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Fool contributor Timothy M. Otte welcomes comments on his articles and doesn't own the stock of any company mentioned in this article.