Teresa Rivas

With the trade war likely averted -- for now -- investors don't have to worry about many more surprises from retailers right?

Wrong, says Bernstein analyst Zhihan Ma. Now it's time to worry about accounting.

The past few years have brought a number of relatively obscure retail practices and jargon to investors' attention. First it was supply chains during the pandemic; then shrink, i.e. inventory lost to theft. Next up: Retail Inventory Method $(RIM.AU)$ of accounting.

Walmart highlighted the issue on its first-quarter-earnings call, noting that RIM -- which most U.S. retailers use -- could potentially cause unusually big fluctuations because of tariff-related costs and pricing.

"The magnitude of these swings both positive and negative given the level of additional costs that could be applied to the inventory that we're purchasing right now are unprecedented in our business and could result in swings in margin and earnings by quarter," said Chief Financial Officer John David Rainey. "[T]he range of outcomes for the quarter is so wide that it would be impractical to provide a range of operating income guidance that investors could credibly rely upon."

RIM is usually innocuous for retailers, but it isn't well suited to big swings in costs and selling prices in the face of on-and-off-again tariffs. As Ma explains, RIM reduces accounting complexity by not tallying the exact cost of every item a store sells, but an average-cost-to-retail-price ratio (called the cost complement) to estimate inventory. "This makes practical sense but could introduce a lot more volatility in gross margin when the cost-to-retail ratio changes rapidly," she writes.

Consider this example Ma provides: Costs go up due to tariffs, and retailers pass that increase onto consumers. However because the higher costs only apply for newly purchased inventory while price increases are across the board, the cost complement goes down. Gross margin, which moves inversely to cost complement, goes up.

So far, so good. However if costs go down again later on and retailers lower prices, under RIM accounting those markdowns don't apply to the cost complement (because that could make inventory look artificially inflated), but instead are subtracted from the total value of unsold products held by the company at the end of an accounting period (the ending inventory). Suddenly, inventory goes way down and the cost of goods sold jumps.

If that all sounds too wonky, the real takeaway is that RIM accounting can cause margins to whipsaw. Last in, first out, and first in, first out accounting aren't perfect on this point, either, but RIM exacerbates the swings in margins.

"The real world implications could be material," Ma writes. "Given tariff-led cost increases, many retailers will need to start raising prices in certain categories in the second quarter. At first, this will result in increased gross margins. If, after cost deflation or tariff mitigation, retailers mark prices down, we can expect a sharp downturn in margins."

Walmart has been the only company to warn about this problem so far, but since many retailers use RIM, it isn't an isolated problem. Ma notes that other retailers in her coverage could be affected by the issue as well, highlighting Dollar Tree. (Target, too, though she notes that it's "more concerned about permanent gross-margin headwinds." Ouch).

Dollar General, which has less import exposure, and Costco Wholesale, whose U.S. business primarily uses LIFO accounting, should be somewhat more insulated, she writes.

Of course, margins are just one metric for retailers. However they have been in focus in recent years -- consider the hits Walmart and Target took in 2022 when consumers quickly pulled back after pandemic-era stimulus ended and inflation was soaring, leading to heavy discounting to clear too-high inventory levels. At a time when consumer confidence looks shaky and tariffs remain a wild card, the last thing retailers need is another monkey wrench thrown into the mix.

Write to Teresa Rivas at teresa.rivas@barrons.com

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May 23, 2025 11:50 ET (15:50 GMT)

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