Pottery Barn 2006 Annual Report Download - page 47

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IMPACT OF INFLATION
The impact of inflation on our results of operations for the past three fiscal years has not been significant.
CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our
consolidated financial statements, which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial statements requires us to make
estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and
related disclosures of contingent assets and liabilities. These estimates and assumptions are evaluated on an
ongoing basis and are based on historical experience and various other factors that we believe to be reasonable
under the circumstances. Actual results could differ from these estimates.
We believe the following critical accounting policies affect the significant estimates and assumptions used in the
preparation of our consolidated financial statements.
Merchandise Inventories
Merchandise inventories, net of an allowance for excess quantities and obsolescence, are stated at the lower of
cost (weighted average method) or market. We estimate a provision for damaged, obsolete, excess and slow-
moving inventory based on inventory aging reports and specific identification. We generally reserve, based on
inventory aging reports, for 50% of the cost of all inventory between one and two years old and 100% of the cost
of all inventory over two years old. If actual obsolescence is different from our estimate, we will adjust our
provision accordingly. Specific reserves are also recorded in the event the cost of the inventory exceeds the fair
market value. In addition, on a monthly basis, we estimate a reserve for expected shrinkage at the concept and
channel level based on historical shrinkage factors and our current inventory levels. Actual shrinkage is recorded
at year-end based on the results of our physical inventory count and can vary from our estimates due to such
factors as changes in operations within our distribution centers, the mix of our inventory (which ranges from
large furniture to small tabletop items) and execution against loss prevention initiatives in our stores, off-site
storage locations, and our third party transportation providers.
Advertising and Prepaid Catalog Expenses
Advertising expenses consist of media and production costs related to catalog mailings, e-commerce advertising
and other direct marketing activities. All advertising costs are expensed as incurred with the exception of prepaid
catalog expenses. Prepaid catalog expenses consist primarily of third party incremental direct costs, including
creative design, paper, printing, postage and mailing costs for all of our direct response catalogs. Such costs are
capitalized as prepaid catalog expenses and are amortized over their expected period of future benefit. Such
amortization is based upon the ratio of actual revenues to the total of actual and estimated future revenues on an
individual catalog basis. Estimated future revenues are based upon various factors such as the total number of
catalogs and pages circulated, the probability and magnitude of consumer response and the assortment of
merchandise offered. Each catalog is generally fully amortized over a six to nine month period, with the majority
of the amortization occurring within the first four to five months. Prepaid catalog expenses are evaluated for
realizability on a monthly basis by comparing the carrying amount associated with each catalog to the estimated
probable remaining future profitability (remaining net revenues less merchandise cost of goods sold, selling
expenses and catalog related-costs) associated with that catalog. If the catalog is not expected to be profitable, the
carrying amount of the catalog is impaired accordingly.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the
estimated useful lives of the assets. Any reduction in the estimated lives would result in higher depreciation
expense in a given period for the related assets.
For any store closures where a lease obligation still exists, we record the estimated future liability associated with
the rental obligation on the date the store is closed in accordance with SFAS No. 146, “Accounting for Costs
Associated with Exit or Disposal Activities.” However, most store closures occur upon the lease expiration.
35
Form 10-K