Retail Accounting: Inventory, Leases and Gift Cards

Introduction

Target reported net sales of $104.8 billion in its fiscal year to January 2026, 1.7% less than the year before. Comparable sales, the growth measure retailers use for stores and digital channels open at least a year (13 months at Target), fell 2.6%, as the number of transactions dropped 2.2% and the average basket shrank. Its gross margin slipped from 28.2% to 27.9% of sales and its operating income fell 8.1% to $5.1 billion, a margin of 4.9%, helped by $593 million of gains from settling litigation over card fees. Behind those figures sit accounting judgments specific to retail: the method used to value $12.3 billion of inventory, the estimate of goods lost to theft and damage, the payments Target receives from its suppliers, and the $1.2 billion it owed customers holding unused gift cards, all disclosed in its 2025 annual report.

Retailers operate on thin margins, so small accounting choices move profits by large percentages: Target estimates that a 10% change in its year-end shrink reserve would move cost of sales by about $110 million, roughly 2% of its operating income.

Inventory is usually a retailer's largest current asset and cost of sales its largest expense. Many large retailers value inventory using the retail inventory method, which converts the retail price of goods on hand into cost using a ratio of cost to retail for each department. Target applies it with last-in, first-out (LIFO) costing for the vast majority of its inventory; others use first-in, first-out (FIFO) or average cost. The method affects gross margin when costs change, as explained in inventory costing: FIFO, LIFO and weighted average.

Retail inventory method

A method of estimating the cost of inventory by applying a cost-to-retail ratio, calculated for groups of similar merchandise, to the retail value of goods on hand. It is widely used by retailers with large numbers of products, and it automatically reflects markdowns, because inventory valued at a reduced retail price is converted to a reduced cost.

Two estimates reduce inventory further. Shrink, the loss of goods to theft, damage and errors, is estimated between physical counts from past experience; Target counts each location about once a year and adjusts its estimate as counts come in. Markdowns reduce the carrying value of goods whose selling prices have been cut, under the lower of cost or market test that still applies to inventory measured with LIFO or the retail method, explained in inventory write-downs. Both depend on judgment, and changes in either move gross margin directly.

Vendor Income

Retailers receive substantial payments from their suppliers: volume rebates, promotional and advertising support and allowances to cover markdowns. Under Accounting Standards Codification (ASC) 705-20, this vendor income is presumed to be a reduction in the price of the goods bought, so most of it reduces the cost of the inventory and reaches the income statement as lower cost of sales when the goods are sold. The exceptions, set out in PwC's presentation guide, are narrow: a payment for a distinct service the retailer provides, such as advertising, can be revenue, and a payment that reimburses specific, incremental and identifiable costs offsets those costs. Target records a receivable for vendor income earned but not yet received, estimated from historical patterns. Because vendor income can be large relative to profit, changes in purchasing volumes or promotional terms can move gross margin, and agreements recognized in the wrong period are a known source of accounting problems.

Most retailers lease many of their stores, and since the leasing standard, ASC 842, took effect, those leases appear on the balance sheet as right-of-use assets and lease liabilities. Most are operating leases, whose cost appears as a single rent expense within operating costs, as described in operating vs finance lease classification. Target carried $3.8 billion of operating lease liabilities at the end of its 2025 fiscal year, and it includes them in invested capital when it calculates its own return on invested capital of 13.8%.

Because retailers differ in how much they lease and how much they own, bankers adjust for leases when comparing them. EBITDAR, earnings before interest, taxes, depreciation, amortization and rent, removes the effect of the choice from earnings, and lease-adjusted leverage adds lease liabilities to debt. The Valuation guide's article on EBITDAR and retail unit economics explains how both are used. Store closures bring a further judgment: underperforming stores are tested for impairment, often at the level of the individual store, and closing them can trigger write-downs of leasehold improvements and right-of-use assets.

Gift Cards

When a customer buys a gift card, the retailer has received cash but not yet made a sale, so it records a contract liability and recognizes revenue when the card is redeemed. Some cards are never used. Under the revenue standard's breakage rule, a retailer that expects to keep such balances recognizes the expected breakage as revenue in proportion to the pattern of redemptions, rather than waiting for the cards to lapse, unless unclaimed property laws require the balances to be paid to a state, in which case they stay a liability. Target's gift card liability, net of estimated breakage, was $1.2 billion at the end of its 2025 fiscal year: it added $849 million of cards issued and not yet redeemed during the year and recognized $861 million of revenue from the opening balance.

Loyalty Programs and Returns

Loyalty points or rewards earned on a purchase give the customer a material right to future discounts or goods, which the revenue standard treats as a separate performance obligation. Part of the sale price is allocated to the reward and deferred until it is redeemed or expires. Programs that offer immediate discounts, by contrast, simply reduce the price of the sale. Expected returns are handled in a similar spirit: revenue is recorded net of the returns expected, with a refund liability for the amount to be paid back and an asset for the goods expected to come back, the treatment under revenue recognition under ASC 606.

Target's income statement brings these elements together:

Retail analysis starts with comparable sales, split into traffic and average transaction, and by channel: Target's store comparable sales fell 4.0% while its digitally originated comparable sales rose 3.1%. Definitions differ between retailers, for example in how long a store must be open and how digital sales are counted, so comparisons need care. Gross margin and its drivers, from markdowns and shrink to vendor income and freight, come next, followed by inventory turnover and the relationship between inventory growth and sales growth, a classic early warning of markdowns ahead.

Newer revenue streams add their own classification questions. Retailers increasingly sell advertising to their suppliers on their websites and apps, a business known as retail media, and earn a share of the profits on co-branded credit cards. Target's advertising business, Roundel, is classified either as net sales or as a reduction of cost of sales or of selling, general and administrative expenses depending on the arrangement, so part of a high-margin business shows up as a better gross margin rather than as revenue. Separating these streams helps explain margins that look unusually resilient, the kind of question the analysis in profitability margins is built to ask.

Valuation follows the same lines. Retailers are compared on enterprise value to EBITDA or EBITDAR, on price to earnings and, for growing chains, on new store economics: sales per square foot, the investment per store and the time each new store takes to pay back. In buyouts and acquisitions, the lease commitments, the real estate a retailer owns and the treatment of vendor terms after a change of control are often as important as the earnings.