Home Depot 2006 Annual Report Download - page 39

points. We do not believe that changing prices for commodities have had a material effect on our Net
Sales or results of operations. Although we cannot precisely determine the overall effect of inflation
and deflation on operations, we do not believe inflation and deflation have had a material effect on our
results of operations.
Critical Accounting Policies
Our significant accounting policies are disclosed in Note 1 of our Consolidated Financial Statements.
The following discussion addresses our most critical accounting policies, which are those that are both
important to the portrayal of our financial condition and results of operations and that require
significant judgment or use of complex estimates.
Revenue Recognition
We recognize revenue, net of estimated returns, at the time the customer takes possession of the
merchandise or receives services. We estimate the liability for sales returns based on our historical
return levels. We believe that our estimate for sales returns is an accurate reflection of future returns.
We have never recorded a significant adjustment to our estimated liability for sales returns. However, if
these estimates are significantly below the actual amounts, our sales could be adversely impacted. When
we receive payment from customers before the customer has taken possession of the merchandise or
the service has been performed, the amount received is recorded as Deferred Revenue in the
accompanying Consolidated Balance Sheets until the sale or service is complete.
Merchandise Inventories
Our Merchandise Inventories are stated at the lower of cost (first-in, first-out) or market, with
approximately 80% valued under the retail inventory method and the remainder under the cost
method. Retailers like The Home Depot, with many different types of merchandise at low unit cost and
a large number of transactions, frequently use the retail inventory method. Under the retail inventory
method, Merchandise Inventories are stated at cost, which is determined by applying a cost-to-retail
ratio to the ending retail value of inventories. As our inventory retail value is adjusted regularly to
reflect market conditions, our inventory valued under the retail method approximates the lower of cost
or market. We evaluate our inventory valued under the cost method at the end of each quarter to
ensure that it is carried at the lower of cost or market. The valuation allowance for Merchandise
Inventories valued under the cost method was not material to the Consolidated Financial Statements of
the Company as of the end of fiscal 2006 and fiscal 2005.
Independent physical inventory counts or cycle counts are taken on a regular basis in each store,
distribution center and HD Supply location to ensure that amounts reflected in the accompanying
Consolidated Financial Statements for Merchandise Inventories are properly stated. During the period
between physical inventory counts in our stores, we accrue for estimated losses related to shrink on a
store-by-store basis. Shrink (or in the case of excess inventory, ‘‘swell’’) is the difference between the
recorded amount of inventory and the physical inventory. Shrink may occur due to theft, loss,
inaccurate records for the receipt of inventory or deterioration of goods, among other things. We
estimate shrink as a percent of Net Sales using the average shrink results from the previous two
physical inventories. The estimates are evaluated quarterly and adjusted based on recent shrink results
and current trends in the business.
Self-Insurance
We are self-insured for certain losses related to general liability, product liability, automobile, workers’
compensation and medical claims. Our liability represents an estimate of the ultimate cost of claims
incurred as of the balance sheet date. The estimated liability is not discounted and is established based
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