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Retail Industry ATG - Chapter 1: Description of the Retail Industry

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

 


Table of Contents / Chapter 2
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Chapter 1: Description of the Retail Industry

 


Purpose for the Audit Technique Guide

The purpose of this Audit Technique Guide is to provide guidance on conducting income tax examinations in the retail industry. It incorporates procedures and techniques that have been shown to be practical or unique to the retail industry, that will be combined with the examiner’s good judgment, skill and experience to complete the examination within the shortest possible time with the least burden possible to the taxpayer. Use of these techniques does not imply that the object of the examination is to find a deficiency, but rather to determine whether the reported income and expenses have been accurately reported.

Because the facts and circumstances of each taxpayer are unique, the procedures applied will be slightly different in every examination, and the strategy will remain dynamic. The examiner will combine the techniques that apply to each specific case and apply his or her basic knowledge to the practical situation at hand.

Description of the Retailer

Retailers purchase items from a supplier or wholesaler for re-sale at a profit. The retailer earns his living by making a profit on the re-sale. To do this the retailer may offer only one type of product, where there is little competition, and use a substantial markup (such as an auto dealership), or the retailer may offer many different products or models, so customers will be certain to find an item to buy in this store and not in a competitor’s store (such as a convenience store). Some retailers earn a small profit on many items and rely on the volume of sales (such as grocery stores), or turnover, to account for their profits. For these reasons, the retailer will constantly assess whether items for sale are turning over properly, and if necessary, will retire an item or product and introduce new items or products for sale.

What Retailers Do

Retailers purchase a product, mark up its cost, and advertise it for sale. The mark-up process is the key to the retailer’s business, because, if the product is marked up too high, consumers will not buy it; if it is too low, the retailer will have lost profits and the supply may be quickly exhausted.

Another key to the retail business is knowing what the customer needs or wants and when, how much the customer is willing to pay for the product, what the competition is charging, and where to find the product at the best possible cost to make a profit.

These items and products held in the retailer’s possession are called inventory. Inventory is money out of the retailer’s pocket, so the retailer tries to keep available only the amount that is needed. The retailer only makes money when inventory is sold, and business profitability is measured by inventory turnover rates.

All decisions made in this process, finding the product to sell, marking up its cost and placing it for sale, are made with the expectation of earning a greater profit.

Demographics of the Retail Industry

Retailing is one of the largest industries in the United States and accounts for approximately 10 percent of our gross national product. Retail business covers many different areas, including auto dealerships, bars, convenience stores, restaurants, gift shops, clothing stores, merchandise stores, etc.

There has been enormous growth and innovation in American retailing in this century. Neighborhood markets and drugstores of the early 1900’s have succumbed to population growth and demographic shifts to become department stores and grocery stores in the 1950’s. As cities became crowded, families continued to move and the interstate road system improved, suburban shopping centers and malls were created. Chains, franchises and catalogs have built them into national brands today. Retail warehouse concepts continue to increase. Technology has enabled product scanning, sophisticated marketing techniques and Internet shopping. 

During the past 2 decades the retail industry has been a leader in the number of mergers and acquisitions.  During the 1980’s the Wall Street Journal stated that the retail industry was “percolating with mergers and acquisitions.”   In recent years the retail grocery industry has been involved in numerous acquisitions.

Technology has played a significant role in acquiring and maintaining inventory.  It has allowed a “partnership” between vendors and retailers in quick response replenishment of inventories.  Point-of-sale terminals, bar coding, customer credit cards, etc., have led to better, more accurate recordkeeping by retailers.

Retail Entities

Small retailers are sometimes called ‘mom and pop’ stores because they are family owned and operated.  An example of this might be a generic convenience store or a boutique in a strip mall.  This type of business may be a sole proprietorship.  Even if both spouses work in the store, only one may be the proprietor.  Only the proprietor spouse may pay self-employment tax.

It is not unusual for ‘mom and pop’ stores to enter into a partnership, or for family members to form a partnership.  This might be done to give each member a share in profits or it might be formed because the business is growing.

Large retailers may include many store locations and hundreds of employees.  Both small and large retailers might include activities reported as sole proprietors on Form 1040, Schedule C, as partnerships on Form 1065, or as corporations on Form 1120 or Form 1120S.

Useful Retail Web Sites

Some useful web sites we recommend looking at include:

Unique General Industry Terminology

There is some terminology and practices unique to the industry.  It is recommended that examiners familiarize themselves with the terms unique to this industry prior to the initial interview in order to facilitate the examination. Each Retail sub-industry will also have it’s own unique terminology. See the particular industry section.

 

Industry Term Definition or Explanation

Bar Code

A series of vertical or horizontal parallel lines forming a code that is optically read and interpreted by a bar code scanner.  Used on envelopes and forms for rapid entry of data and for sorting.  Bar coding may be an indication that the inventory is computerized. 

Chargebacks

The retailer’s invoice for claims against a vendor resulting from items such as damaged merchandise, cooperative advertising costs, adjustments, and the recovery of transportation charges for improperly routed merchandise.  Chargebacks are usually shown on the vendor’s invoices.

Cooperative Advertising

Advertising paid for jointly by the advertiser and its wholesalers or retailers. For example, the landlord of a strip mall may collect a percentage of advertising from each tenant.  This is used for advertising that will benefit all of the tenants.

Cost Complement

The average relationship existing between the cost of merchandise and the retail value of the items handled during an accounting period. The dollar value of the inventory at cost is divided by the dollar value of the inventory at retail. 

Layaway

A method of deferring payments whereby goods are retained by the store until the customer has completed payments for them.

Markdown

A reduction of an originally established selling or previous retail price.

Markup

The difference between cost price of goods and their retail price. The initial margin between the selling price and cost.  It also is referred to as mark-on or gross margin.

Additional markup: An increase above the original selling price.

Markup Cancellations

A reduction in the price of an item after it has been subject to an additional markup.  Markup cancellation never exceeds the amount of additional markup applied to an item.

A reduction in the selling price after there has been an additional markup.  The reduction does not reduce the selling price below the original selling price. 

Markdown Cancellations

The increase in the retail price of an item that has been reduced.

An increase in the selling price, following a markdown, which does not raise the new selling price above the original selling price.

Promotional Markdowns

A lowering of the retail price hoping to encourage greater store traffic.  Unlike clearance markdowns, promotional markdowns are regarded as an integral part of some retailer’s offensive strategy calculated to increase sales.  Frequently the promotional markdowns are temporary.

Push Money

Bonus money paid by a vendor or a retailer to sales people for selling specially designated merchandise. 

Quick Response (QR) Inventory System

A cooperative effort between retailers and their suppliers aimed at reducing retail inventory while providing a merchandise supply that more closely addresses the actual buying patterns of consumers.

Retail Method of Inventory

An accounting technique for recording all inventory inputs, including sales, purchases, markdowns, and so on, at their retail values.  Purchased items are recorded at cost.

Shrinkage

The gradual loss of inventory over time due to damage, misplacement, or theft. 

Specialty Stores

Retail outlets that maintain a large selection in a limited line of merchandise.

Stock Book

A book, maintained by the buyer, in which are entered additions to stock (inventory) in the form of merchandise received from vendors, and merchandise deductions which represent sales to customers.

Stock Keeping Unit (SKU)

A measure of an item of merchandise for inventory management.  In inventory control and identification systems the (SKU) represents the smallest unit for which sales and stock records are maintained.

Stock Overage

A condition where the actual items on hand, as determined by physical inventory is greater than the amount indicated in the stock (inventory) records.

Trade Discount

A deduction from the agreed price, usually expressed as a percentage or a series of percentages that is used in commerce to encourage prompt payment of bills; should not be entered in the books of account, nor should it be considered to be a type of earnings.

Workroom

In retailing, a non-selling area devoted to such support services as apparel alterations, etc. 

Universal Product Code (UPC)

UPC is a categorization where each item is given a ten-digit number, pre-marked on the package by the producer in the form of a bar code over ten corresponding numbers. 

Retail Price

The price at which goods originally are offered for sale.

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Page Last Reviewed or Updated: 21-Jul-2014