How accounting could change profitability amid tariffs

As more tariffs take effect on goods imported into the U.S., a specific accounting method could have major implications for how American retailers calculate the impact.

A tariff adds to the cost of an imported item when it’s received and paid for when it crosses a border. While there’s debate over who pays that tariff — the manufacturer, the retailer, the consumer or some combination — the hit will likely show up in retailers’ bottom lines.

But a specific accounting practice, called retail inventory method accounting, or RIM, can make profitability appear stronger than it is in the short term.

“Retail inventory method accounting (RIM) is less responsive to initial product cost changes compared to cost accounting, and can initially overstate profitability,” said Ali Furman, PwC U.S. consumer markets industry leader. “This would normalize once tariffs stabilize, depending on how much of the cost retailers absorb.” 

Because RIM uses an average cost-to-retail price ratio across a broad group of items, rather than the actual cost of every item, like in cost accounting, RIM does not entirely capture the immediate impact of rising costs.   

Nearly a quarter of U.S. retailers use the retail inventory method of accounting, according to PwC. Walmart, Target and Home Depot are among them. All three retailers report quarterly earnings this week, and their results may not fully show how tariffs have cut into their profitability so far.

Take Walmart, the largest U.S. retailer, which will post fiscal second-quarter earnings Thursday.

TD Cowen analyst Oliver Chen estimated about half of Walmart’s quarter will include the impact of levies, as the company brought in inventory at different cost levels before and after new tariff rates took effect. That could temporarily distort gross margin profitability, Chen said.

Walmart’s accounting has in part informed its strategy in recent months as it navigates President Donald Trump’s unpredictable tariff policy.

A week after Trump’s April 2 announcement of so-called “reciprocal tariffs” on a wide swath of trade partners, Walmart withdrew its guidance for operating income in its first fiscal quarter. However, the company maintained its annual forecast, citing in part the influence of RIM accounting.

Then when it reported its fiscal first-quarter earnings in May, Walmart said it would mitigate higher costs as much as possible, but would likely have to increase some prices at the current tariff rates. 

In response, Trump wrote on his Truth Social platform that Walmart should “just eat” the tariffs.

Doing so could actually benefit a retailer’s bottom line, at least initially, according to Furman.

“The more costs retailers absorb in retail accounting, the greater the risk of overstating profitability during periods of increasing costs, such as tariff increases,” she said.

Walmart management briefed Trump this spring about the impact its accounting method may have on results in a high-tariff environment, according to a person familiar with the discussion, who asked to remain unnamed while speaking about private conversations.

Still, James Bowie, managing director in EY’s technical accounting advisory group, warned “all of the inventory costing methodologies will be affected in some ways.”

It typically takes a large, non-fast fashion retailer using RIM roughly two to four quarters for cost volatility to settle and profitability to get closer to its true level, according to PwC. The method could make profitability look higher initially, then lower in a subsequent quarter, before it has time to stabilize.

“It’s kind of like you’ve got a speed boat on the price,” he said. “I can turn pretty quickly, but I’ve got a cruise liner that is carrying all my average of my inventory. It takes a little longer for it to turn and so even though they might ultimately be able to go the same speed, it takes a little bit of time for that one turn to take place.”

While RIM is more likely to lead to a temporary overstating of profitability, it can also wind up understanding profits if tariffs are negotiated lower.

Bowie said if a retailer responds to lower tariff rates by cutting retail prices, under RIM accounting, “it looks like my margin has eroded, but it’s only because I now am waiting for the cost relationship to catch back up, so [it] might look like there’s margin compression even in a period of decreasing tariffs.”

Furman added that PwC is seeing “a clear disconnect” for companies that use RIM accounting.

“Companies might be doing all the right things: navigating sourcing challenges, managing suppliers, and even mitigating tariffs,” she said. “But, those efforts often aren’t reflected in the financials. That misalignment between operational execution and reporting for those using RIM is exacerbating the challenges retailers face.”  

The retail inventory method of accounting is an older method that was most useful for retailers when they had many items from a range of categories without an easy, or technological, way to track inventory. 

“Inventory accounting methods existed before this thing called Excel,” said Bowie. “[A retailer] had an abacus and a dream trying to figure out what you’re going to do.”

Over time, technology made it easy to use actual costs rather than averages, so cost accounting became more common.

As retailers grow and accounting methods become ingrained, it’s difficult, though not impossible, to switch tactics. Macy’s and Nordstrom recently made the change to cost accounting.

PwC said it takes an average of two to three years to make the transition from one accounting method to another and can require millions of dollars and a restatement of previous years’ financials to provide apples-to-apples comparisons. Still, the accounting firm said about half of retailers that use RIM have considered switching.

CNBC worked with PwC’s Furman and Suni Shamapande, the firm’s U.S. retail customer experience and operations leader, to develop a simplified example demonstrating the difference between RIM and weighted average cost accounting in how they affect gross profit margins.

The example demonstrates how RIM accounting can “overstate” true profitability at a moment in time when costs increase quickly.

For the purposes of this example, PwC and CNBC used weighted average cost accounting, which takes a SKU-level weight average and blends all costs together, regardless of purchase date. A SKU is a stock-keeping unit, which retailers use to track inventory of specific items.

Base case: No tariffs

The base case, which does not include tariffs, uses three different T-shirts types from three different countries. Each type of T-shirt, or individual SKU, has a different cost and is sold to consumers at a different retail price. The retailer bought each type of T-shirt in different quantities, as did consumers.

Here’s how the math differs to start.

The gross profit margin for the items calculated using weighted average cost accounting is 46%. Using RIM, it’s 53%.

Tariff case 1: Retailer’s costs increase, all else remains the same

If the retailer’s cost for each T-shirt goes up as a result of tariffs, but everything else — units bought, units sold and retail price — remains the same, gross margin falls if calculated using cost accounting and RIM. But it would still be higher under RIM than if the company used cost accounting.

Here’s the math for our simplified example:

Tariff case 2: Retailer raises prices to offset higher costs

If the retailer passes on the full dollar value of the tariff cost to the customer, and units bought and sold stay the same, gross margin improves under both accounting methods. 

In our example, it goes to 36% in cost accounting and 47% with RIM.

Both gross margin percentages are lower than the base case, which assumes no tariffs, but the percentage change is smaller under RIM than under cost accounting.

Tariff case 3: Retailer raises prices and units bought and sold both fall

Here’s where it gets interesting, and likely more realistic, to reflect supply and demand choices a retailer and consumer would likely make as costs rise.

If the retailer passes on the full dollar value of tariffs to the customer and also sells fewer items to consumers at the higher retail price, RIM makes profit margins look temporarily rosier.

Gross margin in our example falls to 27% under cost accounting, but holds steady under RIM at 47% even though units sold have changed.

Here’s where you see how the ratio of cost of goods sold to selling price hasn’t had time to adjust. 

— CNBC’s Jodi Gralnick contributed to this report.