Estimating inventory shrinkage.

For more than a decade, taxpayers and the IRS have disagreed as to whether inventory shrinkage (primarily resulting from theft, damage and accounting errors) that occurs between the last physical inventory during the year and the taxpayer's year-end may be estimated. The Service has taken the position that shrinkage is a Sec. 165 loss that must be verified before the amount is removed from inventory and included in cost of goods sold (COGS). Taxpayers, however, have insisted that Sec. 471 and Regs. Sec. 1.471-2(d) allow them to estimate inventory shrinkage, as long as the inventory accounts are "verified by physical inventories at reasonable intervals and adjusted to conform therewith."

Earlier this year, the Tax Court released two memorandum opinions upholding the use of estimates of inventory shrinkage at year-end. The decisions in Wal-Mart, TC Memo 1997-1, and Kroger, TC Memo 1997-2, concluded that each company's use of estimates of inventory shrinkage conformed to the best accounting practice in the trade or business and clearly reflected income. The Tax Court rejected an IRS request to reconsider its holding in Dayton Hudson, 101 TC 462 (1993), that a taxpayer may estimate year-end shrinkage if its method of accounting for its inventory is sound.

During the years involved, both Kroger and Wal-Mart took physical inventories on a cyclical basis (a common practice in the retail industry). Both companies estimated shrinkage using similar methodologies, generally multiplying a shrinkage rate based on experience by the amount of sales for the period between the physical inventory and year-end.

The opinion in Wal-Mart stated that a taxpayer may estimate year-end shrinkage if the estimate methodology (1) conforms to the best accounting practice in the trade or business and (2) clearly reflects income. The Tax Court found that Wal-Mart met both requirements, and that, when viewed as a percentage of sales, there were only modest differences between the estimated and verified shrinkages. The court noted that the Service's position disallowing any estimated shrinkage also resulted in an estimate of year-end inventory.

The decision in Kroger followed similar lines. Given that no year-end physical inventory was taken, the taxpayer's estimate reflected its inventory with reasonable accuracy. Thus, the Tax Court concluded, the IRS abused its discretion in insisting that no estimated shrinkage be allowed, since that would result in a less accurate measurement of inventory and reflection of income.

The ultimate impact of these decisions may depend on future developments, such as appellate review or possible IRS guidance providing a limited number of acceptable "safe-harbor" shrinkage methodologies.

Pursuant to the Sec. 446 regulations, accrual of shrinkage is a method of accounting, since it affects the timing of the inclusion of an amount in COGS. Taxpayers that currently count inventory at year-end and are considering a change to cycle counting may be able to accrue shrinkage without IRS permission if the change is considered to be a change in underlying facts. However, before proceeding, taxpayers should discuss the merits of such a position with their tax advisers.

Taxpayers that currently cycle count but do not deduct estimated shrinkage probably must file Form 3115, Application for Change in Accounting Method, requesting IRS permission to change their accounting method to begin accruing shrinkage. Although it is anticipated that no changes will be granted until any appeals from the Tax Court cases are resolved, a current filing could protect the earliest application of accruing shrinkage. Since this approach likely would involve direct conflict with the Service, taxpayers should consult their advisers.