Retail & Distribution Industry:

Inventory Valuation: Risk Assessment

Considerations — Illustrative Example
Introduction
This illustrative example outlines how we may
evaluate potential considerations to support a
fact-based risk assessment for retail inventory
market valuation adjustments, including how to
support our identification of risks of misstatement
(RoM) and assessment of risks of material
misstatement (RoMMs), significant accounts and
disclosures, and further risk assessment. This
example does not illustrate potential
documentation to support our risk assessment
conclusions; rather, it provides matters for us to
consider in risk assessment, the most important
of which will be supplemented by documented
facts.

U.S. GAAP requires that in situations in which the

value of inventory goods are no longer as great as
their cost, a loss shall be recognized on the
inventory in the current accounting period. Identifying and estimating adjustments required to
appropriately account for the value of inventory involves varying degrees of complexity, judgement,
and estimation that will require thorough fact-based risk assessment, application of professional
judgement, and appropriate audit documentation to support such judgements.

An appropriate risk assessment begins with a thorough understanding of the nature of inventory items
and identification of inventory goods for which cost has deteriorated over time, requiring a loss to be
recognized. Those responsible for performing the risk assessment need to have a deep knowledge of
ASC 330-10-35.
See Factors and Assumptions below for further details regarding factors for engagement teams to
consider while evaluating the risk associated with a retail entity’s inventory valuation. It is imperative
that engagement teams consider the risk at a
sufficiently granular level to appropriately
assess and respond to the RoMMs.

As depicted in the image to the right, the

discussions in this document fit in the general
framework set forth in Risk Assessment: A
Practical Guide to Auditing — particularly with
respect to identifying risks of misstatement
and determining how to evaluate which of
those rise to a RoMM.

To assist engagement teams in performing

their risk assessment, we have (1) highlighted
various factors and assumptions that can
influence our risk assessment, (2) set forth
examples of situations with varying levels of
risk and the underlying drivers of those risks,
and (3) identified certain other available resources. The ultimate objective of this process is to
establish what the specific RoMMs are so that focused audit responses
can be developed.

Use of Deloitte Audit Innovation Tools

Engagement teams may find that the use of Audit Analytics and
Visualization tools significantly increases the effectiveness and
efficiency of risk assessment procedures and assists in documenting
risk assessment conclusions in a clear and concise manner. Teams can
use Data Analytics to obtain visualizations of trends that may affect
our assessment of the inherent risk related to retail inventory
valuation. See the U.S. Audit Analytics Resource Center and the Data
Analytics in the Audit Guide for further details.

Teams can also use the data analytics tools like Power BI to help
analyze large data sets and quickly visualize trends and outliers to
inform our risk assessment process. For example, illustrated at right is
an analysis of realized margin percentage based on actual sales and
costs data by SKU/category which teams can utilize to assess valuation risks by identifying changes in
product margins. This visual highlights potential SKUs/categories that have a realized margin at or
below zero indicating a possible higher risk for valuation.

Factors and Assumptions

While not exhaustive, the following table contains factors and assumptions that most commonly give
rise to risks and have an effect on our assessment of risk related to retail inventory valuation. The
table also presents the underlying drivers that can vary the level of risk associated with each factor or
assumption. This table has intentionally excluded broader factors (e.g., whether the entity is public or
private, whether the entity is operating in a stable environment). Refer to Risk Assessment: A

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Practical Guide to Auditing for considerations pertaining to such broader factors. As a reminder, we are
required to obtain a sufficient understanding of internal control as part of our base of knowledge from
which we identify risks of misstatements and ultimately assess which are RoMMs (see AS 2110.18-20
(previously AS 12.18-20), AICPA AU-C 315.13 and 315.A49, and ISA 315.12 and 315.A49).
Factors and Less Risk
Assumptions
Company-Specific Factors
Nature of Inventory Inventory has a history of
selling above cost for moderate
to long periods (e.g.,
automotive parts may not see
price declines for one year or
even multiple years).
History of strong margins.
Entity has not historically sold
inventory for less than cost,
and no indicators they will in
the future.
Changes in The average days of sales of
Inventory Days inventory on hand has stayed
consistent with the entity’s
historical amounts.
Entity Performance Comparable and total sales
have remained stable. Entity
has strong margins, and has
not historically sold inventory
for less than cost with no
indication they will in the
future.
Inventory turns many times per
year and has stayed consistent
or increased in recent years.
Variability in Low level of recorded
Inventory Reserves adjustments to the reserve in $
and/or as a percentage of
inventory historically.
Consistent year-round
inventory items.
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More Risk Drivers
Inventory has a history of Inventory useful
heavy discounts and quickly lives
becomes obsolete (e.g.,
seasonal fashion apparel or
perishable grocery items may
quickly lose their value if not
sold).
History of realizing margins Business pricing
below target, and using and promotional
significant mark-downs, strategies
promotion, and/or disposals
of aged inventory.
The average days of sales of Levels of inventory
inventory on hand has sold below cost or
increased significantly disposed of
Type of retailer
will affect the
average days of
sales of inventory
Entity has seen volatility in Merchandise
sales in recent periods, decisions
encountered tight margins,
Pricing decisions
and has a history of selling a
portion of their inventory Competitive
below cost and/or material pressures on price
inventory write-offs. and mix
Inventory turns few times per
year or has seen a slowdown
in recent years.
Moderate to high level of Variability in
recorded variability in the promotional,
inventory valuation reserve pricing and costing
historically. processes
Highly seasonal inventory Ability to job out
items throughout the year unwanted
requires forecasted sales. inventory vs.
continued store
mark-downs
Business and Economic Considerations
Industry Conditions Based on IBIS Industry Reports
(i.e., women’s apparel, auto
parts stores, consumer
electronics, etc.), industry is
well-established with no
anticipated market disruptors
on the horizon and expects
normal growth in the near term
indicating stability in the
economy and industry.
Company’ historical and
projected revenue and growth
are in line with industry
projections.
General Economic General economy is performing
Conditions well (e.g., low unemployment,
high growth, positive market
returns), which affects business
drivers in positive manner.
Regulatory or Political Stable regulatory or political
Environment environment, regulatory or
political environment has little
impact on business.
Company Process
Level of Judgement Little to no judgement or
and Estimation estimation.
Formalized effective
methodology used to determine
reserve and consistently
applied.
Valuation performed at a low
level of disaggregation (e.g.,
department, sku, etc.)
IPE and GITCs Low risk related to the
completeness and accuracy of
information used in the
valuation analysis (e.g.,
system-generated data, well-
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New industry with few Industry specific
barriers to entry. Analyst
reports for anticipated growth
vary significantly indicating
instability in the industry.
General economy is not Economic
performing well (e.g., high conditions
unemployment, low growth
or contraction, negative
market returns), unless the
entity typically performs well
under such conditions
(defensive companies).
Volatile regulatory or political Change in
environment, business is political or
highly affected by regulatory regulatory
or political environment. landscape, new
regulations or
laws, changes to
existing
regulations or
laws
Moderate to high level of Level of judgement
judgement or estimation.
Changes in methodology Consistency of
from prior year or methodology and
methodology is not application
consistently applied.
Valuation performed at a high
level of aggregation (e.g., in
total)
Moderate to high risk related Management
to the completeness and operating
accuracy of information used decisions and
in the valuation analysis information
(e.g., high degree of manual
 established and mature GITCs
in place, low level of manual
manipulation of data).
manipulation of data, or high technology
reliance on nonsystem-
generated data, or GITCs
new, not well-established or
known to have issues, which
impact the integrity and flow
of data).

Nature of the Highly automated, including
Process automated interface of input
data, calculations, and
reporting. Stable process and
personnel.
Low level of automation, The entity’s
manual interface of input processes
data, calculations, and
reporting; high use of
spreadsheets.

Examples of Varying Levels of Risk

The examples illustrate how factors and assumptions similar to those listed above may influence our
identification and assessment of risks of both misstatement and material misstatement.

The example contains three sections:

• Case facts
− This section includes case facts for the fictional audit used in the examples.
• Risk assessment
− This section includes risk toggles that provide us a way to visually document our overall
thought process as we identify and assess the level of risk based on facts uncovered from our
risk assessment procedures. They match up to the broad categories noted above and may
represent the types of factors we may discuss as an engagement team while sitting around a
table together during the planning process. That information is later synthesized into risks and
risk factors relative to an account — and those risks and risk factors are then narrowed down
further to the RoMMs that we identify and to which we ultimately assign an inherent risk level.
− The toggles are not required to be included as part of our risk assessment documentation —
however, they may be helpful to us as we analyze the facts obtained from our risk assessment
procedures.
• Identifying and assessing risks
− Within the risk assessment section we have listed and analyzed above a number of different
risk factors that could have an effect on the accounts and disclosures related to inventory
valuation. The identifying and assessing risks section demonstrates how we may identify more
detailed items under the broad risk category headings in the risk assessment section that may
constitute RoMMs. It also demonstrates factors that we may consider as we assess the level of
RoMM (e.g., lower, higher, significant).
− These considerations generally do not represent separate processes or activities that we
perform; rather, they are part of an interconnected process that underpins the identification
and assessment of risks.
− This section does not include all possible RoMMs. Rather, it demonstrates a sample of risks
related certain broad risk categories.

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ABC, Inc. (ABC or the “Company”)

Case facts:
• ABC entity is clothing retailer which specializes in professional dress wear.
• Management prepares a quarterly assessment of the inventory reserve disaggregated by product
category.
• Based on our preliminary analytics performed, total inventory represents 30 percent of the entity’s
assets.

Example 1
Additional Case Facts:
• The quarterly reserve analysis is prepared using a consistent methodology with system-generated
reports for each product category detailing the balance of inventory items sold below cost during
the previous quarter. This information helps determine the percentage decline in each inventory
product category. The company applies this percentage to amounts remaining in inventory. In our
experience, we have not seen significant variability and or evidence of management bias.
• Inventory consistently turns three times per year and inventory gross margin has remained stable
at 50 percent. LCM/LCNRV reserve has remained between 5 percent and 7 percent of gross
inventory.
• The reserve fluctuates throughout the year by approximately 10 percent of materiality, driven by
the seasonality of inventory levels and changes in product mix. Overall there is a low level of
recorded adjustments to the reserve.
• ABC’s offers professional dress wear which is not impacted by short-term fashion trends. The
Company’s aging is consistent with prior years.
• Management uses system-generated reports that detail the balance of inventory sold below cost
during the previous quarter in order to perform a retrospective review. In our historical
experience, we have not seen significant variability and or evidence of management bias.
• Based on historical trend analyses, the ratio of LCM/LCNRV reserve-to-gross inventory and to
revenues has remained consistent with prior periods. Comp store sales and comp inventories are
both up approximately 1 percent from the prior year. The average days of sales of inventory on
hand has stayed consistent with prior years.
• There is no history of errors associated with the reserve, nor have there been any changes to the
calculation methodology or related IT systems.
• Retailer operates in a well-established industry and normal growth for the industry and ABC
Company is expected in the future. The Company’s historical and project growth is in line with the
industry growth rates.
• General economy in the U.S. and abroad is performing well and there are no new regulatory or
political environmental changes that would affect the business.

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Risk Assessment:

Summary
With the case facts presented, it may be appropriate to conclude that, while there are RoMMs, they are
RoMMs that may be assessed as lower. The key elements in the case facts leading to a lower risk
assessment include less management judgment, consistent performance, and high degree of automation
in the process.
Rationale for Toggle Placement
In this example, the ratios of LCM/LCNRV reserve-to-gross inventory and to revenues as well as average
days of sales of inventory on hand have remained consistent with prior periods indicating less variability
and thus less risk in the account balance. Further inventory only represents 30 percent of the entity’s
assets, inventory consistently turns, and gross margins have remained stable further indicating a lower
risk of misstatement.
In addition, the industry is well-established and the Company has mirrored industry growth historically
and is projecting to do so in the future. The general economy in the U.S. and abroad is performing well
with no disruptors anticipated for the industry or the Company. Finally there are no new regulatory or
political changes that are expected to alter the industry or the Company. All these macroeconomic factors
lead to a reduced risk of misstatement for inventory valuation.
Regarding management’s process, management uses system-generated reports for their inventory
analysis. There has been no history of errors or changes to the methodology or the related systems. There
has not been any significant variability or evidence of management bias in management’s retrospective
review of inventory selling below cost. All these factors result in less risk associated with the valuation of
inventory.

Identifying and Assessing Risks:

The following risks may be identified related to inventory valuation:

Risk A
Inventory records include inventory that is not in saleable condition. (Valuation)

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The facts presented for this example indicate that we would expect the assessed level of risk as lower.
There are various qualitative factors that decrease the inherent level of risk.

The facts presented for this example indicate that we may (1) not identify any RoMMs or (2) identify a
RoMM(s) and assess the level of risk as lower. As discussed above, the case factors along with other
qualitative factors appear to indicate lower risk.

Example 2
Additional Case Facts:
• In the current year, inventory turnover has decreased to 2.75 times and gross margin is
approximately 45 percent lower than the Company’s historical margins of 50 percent.
• Preparation of the quarterly reserve analysis is a manual process in which management compares
inputs from multiple sources and/or reports to generate an estimate. In addition, we have noted
instances in which the entity has inconsistently applied their valuation methodology. However, the
entity uses the same preparer, reviewer, and calculation inputs each quarter in preparing this
analysis.
• There is a greater level of management judgement involved in determining the market value and
carrying cost due to consistently changing floor sets and high inventory turnover. However,
through performance of retrospective reviews and historical audit experience, we have not seen
significant variability and or evidence of management bias.
• Based on historical trend analyses, the ratio of LCM/LCNRV reserve to gross inventory has
remained consistent with prior periods. However, entity sales have declined in the current year
(compared to prior periods) by approximately 10 percent and comp inventory at cost (the cost of
inventory at stores included in comp sales calculation) has increased 1.5 percent from the prior
year.

• In the prior year, we identified an error in the calculation not identified through management’s
review, which resulted in an understatement of the reserve by approximately $3 million (greater
than CTT, but less than PM). In the current year, management has implemented an additional
review step to prevent similar errors going forward.

• The general economy in the U.S. and abroad is not performing well (i.e., high unemployment, low
growth).
• The Company’s sales are below industry average and based on the economic conditions are not
expected to grow.
• New regulatory changes may increase the costs of operations for the Company in the future.

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Risk Assessment:

Summary
There is an overall higher level of risk associated with this example. Several of the specific facts in this
example increase the overall level of risk associated with the valuation of inventory. For example, the
decrease in inventory turnover coupled with the decrease in gross margin and decline in entity sales
increases the risk associated with inventory valuation. Further, the quarterly reserve analysis is a
manual process, with a greater level of management judgment involved. The inconsistent application of
the Company’s valuation methodology and errors identified in the prior year further increase the risk
associated with the valuation of inventory.

Rationale for Toggle Placement

In comparison to the first example, the inventory turnover and gross margin have decreased compared
to historical amounts. Further Company sales have declined by 10 percent and comp inventory at cost
(the cost of inventory at stores included in comp sales calculation) has increased 1.5 percent from the
prior year. These company-specific factors may indicate a higher level of risk in the current year.

In addition, the Company’s sales are below industry average and the Company is not expecting to grow
sales in the future due to economic conditions. The general economy in the U.S. and abroad are
experiencing high unemployment and low growth. Further on the horizon are potential regulatory
changes that may increase operating costs for the Company in the future. All these macroeconomic
factors lead to a higher risk level compared to the first example.

Finally, management’s process to review the reserve is manual with multiple sources of reports for
information. Further we have noticed an inconsistent application of their valuation methodology. In
addition, there is a greater level of judgment involved in determining market value and carrying cost
due to consistently changing floor sets and high inventory turnover. These factors may indicate a higher
risk that is partially offset as we have not noticed significant variability or evidence of management
bias. We have identified an error in the calculation which resulted in an understatement of the reserve
of about $3M which is higher than CTT but less then PM. Management has implemented additional steps
in the current year to prevent similar errors.

These factors combined may indicate a higher level of risk associated with inventory valuation in the
current year.

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Identifying and Assessing Risks:

The following risks may be identified related to inventory valuation:

Risk A
Inventory may be recorded at the incorrect cost under the entity’s costing method. (Valuation)

Risk B
Management’s method for determining the E&O reserve is inappropriate or has not been applied
consistently, or the estimate is based on assumptions that are unreasonable, lack sufficient basis, or
lack sufficient support. (Valuation)

Due to the facts for this particular example, we would expect assessed level of risk as higher. There
are various qualitative factors discussed above that raise the inherent level of risk.

Other Available Resources

We have listed and analyzed above a number of different risk factors that could have an effect on risk
assessment related to inventory valuation. These considerations generally do not represent a separate
process or activities that we perform; rather, they are part of an interconnected process that
underpins the identification and assessment of risks of misstatement and RoMMs. Other illustrative
examples and guides can assist us in performing risk assessment, including the following:

• Guides:

− Inventory — Select Topics: A Practical Guide to Auditing

In Summary
As described above, inventory valuation testing has many variables associated with it. It is important
that we understand management’s policy for identifying and calculating instances of inventory carried
and sold at amounts below cost, the process for calculating such valuation adjustments, and various
other factors in assessing inherent risk so that we may make appropriate risk assessment decisions.

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