Estimating inventory shrinkage.
For more than a decade, taxpayers and the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. have disagreed as to whether inventory shrinkage Shrinkage
The amount by which inventory on hand is shorter than the amount of inventory recorded.
The missing inventory could be due to theft, damage, or book keeping errors. (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 Cost of goods sold
The total cost of buying raw materials, and paying for all the factors that go into producing finished goods.
cost of goods sold (COGS These are all the Cogs found in Disney's Toontown Online. Names that are moved forward are leaders of the HQ of that specific Cog type. Bossbots
1. With that, this, or it.
2. In addition to that.
3. Archaic Immediately thereafter.
Adv. 1. ."
Earlier this year, the Tax Court released two memorandum opinions A memorandum opinion or memorandum decision is a judicial opinion which does not create precedent, persuasive or mandatory. A memorandum is often brief and written only for the purpose for announcing judgment in a particular case. 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 cyclical
Of or relating to a variable, such as housing starts, car sales, or the price of a certain stock, that is subject to regular or irregular up-and-down movements. 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 Relating to appeals; reviews by superior courts of decisions of inferior courts or administrative agencies and other proceedings. review or possible IRS guidance providing a limited number of acceptable "safe-harbor" shrinkage methodologies.
Pursuant to the Sec. 446 regulations, accrual accrual,
n continually recurring short-term liabilities. Examples are accrued wages, taxes, and interest. 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 de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. 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.