I’ve heard dealers describe consigned inventory as “found money.” Items taken on consignment, they claim, reduce their investment in inventory and provide more choices for customers. Both perceptions are true. But, how you choose to account for consignment transactions can make your overall financial performance harder to analyze and ultimately may make your business worth less money.
My intent in this edition of Behind the Gavel is to lend a perspective on consignments that is rarely discussed. Whether or not you incorporate this information into your bookkeeping practices is between you and your accountant.
Typically, inventory is consigned by an owner-seller, and a dealer (you) acts as the agent for the seller. In exchange for a percentage of the sale price, you agree to clean, display, promote and sell the item (or to perform in whatever manner your consignment agreement dictates). Title to the merchandise stays with the seller, not you. When the item is sold, you deduct your commission from the proceeds and send the seller a check. Your portion of the sale gets booked as commission revenue. The consigned item never enters your balance sheet inventory because title never passes to you. Unlike inventory you own, consigned inventory is tracked separately.
This accounting method (booking only the commission) is called “tracking revenue at net,” and is commonly used by sales reps, service businesses and drop-shippers. When used in conventional retailing, however, this system makes it tougher to get an accurate measure of your company’s performance. The more consigned inventory you carry the worse the problem becomes. Here are some issues:
Because you’re booking only the commission from a sale rather than the entire amount, gross revenue will be lower. Top line revenue is an important consideration for a business; recording the entire sale amount rather than just the commission gives the appearance of a larger operation. When the time comes to sell your business, buyers pay more for higher sales volumes.
Since consigned items never enter your owned inventory, wholesale costs are not reflected when a sale is made. Consequently, your overall profit margin calculation is skewed and it becomes more difficult to analyze the financial return on your inventory (Gross Margin Return on Inventory). For a detailed discussion of the importance of GMROI, see Behind the Gavel from March 12, 2014 (http://bit.ly/1MwE0bx).
One of the best measures of the health of a retail business is how efficiently it turns inventory into sales. At any given sales level, the faster your inventory turns the more money you will make. This is called your “turn ratio.” When you are making sales but not recording the wholesale cost or the gross revenue from a sale, you don’t get a clear picture of how well (or poorly) your inventory is turning.
Shops that specialize in consignments find it difficult to gain significant increases in gross margin. If your consignment agreement offers a 50-50 split, your top margin is 50 percent (100 percent markup). Until you start buying inventory with which you can make three, five or 10 times what you paid at wholesale you will always struggle along with low margins.
There is another way to account for consigned inventory; it’s called “tracking revenue at gross.” When tracking revenue at gross, you record the entire amount of a sales transaction and at the same time record the wholesale cost of an item. By doing this, you avoid the problems listed above. Plus, since consigned items don’t linger in your inventory (they are in and out on the same day) you needn’t be concerned about excess personal property taxes. When I had my stores, I chose to track revenue at gross. Doing so enabled me to break the company down into profit centers and analyze the performance of each separately, comparing “apples to apples” from year to year.
Some accountants would have a hissy-fit over tracking consignment revenue at gross. Generally, commissions are reported at net. In truth, it’s a gray area. You have to make the decision on how you want to run your business. As I’ve said before, make your decision based on what you need and not what makes your accountant happy. I personally believe that the benefits of tracking at gross outweigh the benefits of tracking at net.
The Emerging Issue Task Force (EITF) established some guidelines handling consignments, etc. in their issue No. 99-19 “Reporting Revenue Gross as a Principal Versus Net as an Agent” [http://bit.ly/1UfHKRy]. You are allowed to report income at gross if:
• You are the primary obligor in the sales transaction. In a consignment transaction, you bear the risk for checks, credit cards, returns, shipping, warranty (if offered) and in some cases pickup and delivery. Once an item leaves your store, you owe the consignor. Getting paid is up to you.
• You have general inventory risk. As a dealer, you bear the risk for theft, returns and damage.
• You have varied suppliers.
• You get to set the selling price.
On-site estate sales and auctions don’t meet enough of the above criteria to qualify for booking revenue at gross, so commissions should always be booked at net. In such cases items are sold “as-is, where-is, with all faults.”
If you sell consigned goods on eBay, however, you can’t get around being the “primary obligor,” so income should be booked at gross. If an eBay item arrives damaged or there is some other customer problem, then eBay or PayPal will force a return regardless of your stated terms and conditions. In fact, PayPal keeps you on the hook for up to six months. In other words, you have general inventory risk despite the items being sold on consignment.
EITF concludes their analysis by stating: “It is possible that you could have two companies in the same industry with identical business models, and one records revenue at gross and the other at net – and they may both able to justify their positions to their auditors. Consequently, this is one of those odd topics that can go in either direction.”
Whichever method you decide to use, it’s important to establish a good paper trail. Should you decide to sell your business, nothing will confuse an auditor more than “changing horses mid-stream” without an addendum stating what changes you made.