Inventory shrinkage accrual method.

The Tax Court opened the new year by ruling in two separate decisions, Wal-Mart Stores Inc., TC Memo 1997-1, and Kroger Co., TC Memo 1997-2, that the taxpayers' methods of estimating inventory shrinkage clearly reflected income. The cases cite Dayton Hudson Corp., 101 TC 462 (1993) which held that, as a matter of law, Regs. Sec. 1.471-2(d) did not prohibit the use of a shrinkage estimate in computing year-end inventory. Because the issue of whether a method of estimating shrinkage clearly reflects income was a question of fact, the IRS's motion for summary judgment in Dayton was denied. As of this writing, the Dayton case, which is the oldest of the three cases, has not been decided on its facts.

Shrinkage is a term used to describe the discrepancy between the inventory records and the amount verified by a physical inventory. Causes of shrinkage include theft, damage, spoilage and bookkeeping errors. Estimated shrinkage is the amount of shrinkage estimated to have accrued between the last physical inventory and the taxpayers year-end.

Wal-Mart and Kroger are two very large retailers, each with hundreds of stores and billions of dollars in sales. The taxpayers maintained perpetual inventory systems and used cycle counting to conduct physical inventories. Wal-Mart counted each stores inventory approximately every 11 to 13 months and Kroger counted each stores inventory as often as twice a year. Cycle counting is a means of conducting physical inventories at each store, in rotation, throughout the year. Cycle counting is a widely accepted practice in the retail industry and is considered more accurate, less expensive and less disruptive than conducting a year-end physical inventory.

Both taxpayers used historical information to estimate the amount of shrinkage between the physical inventory date and the end of the tax year. In part due to their size, the taxpayers were able to compile statistical data that could accurately measure their rate of shrinkage as a percentage of sales. The taxpayers continuously updated the shrinkage percentage to reflect the latest trends based on the most recently completed physical inventories. Wal-Mart used a shrinkage rate based on a rolling average of the prior three inventories of the store. Wal-Marts internal audit department also calculated a ceiling and floor shrinkage rate limitation based on a five-year weighted average.

In the Service's opinion, the taxpayers, use of estimated shrinkage did not meet the two-prong test of Sec. 471(a) and Regs. Sec. 1.471-2(a). Sec. 471(a) provides that (1) inventories must conform to the best accounting practice in the trade or business and (2) the practice must clearly reflect income.

The court held that the use of estimated shrinkage met the first prong of the test for the following reasons: calculating estimated shrinkage as a percentage of sales is a widely accepted industry practice; it conformed to generally accepted accounting principles, the taxpayers used the same method for financial reporting purposes; and the method was consistently followed. As a practical matter, this part of the test should not create any problems for most taxpayers that are currently estimating shrinkage.

It is the clear-reflection-of-income requirement that causes problems. In Wal-Mart and Kroger, the taxpayers satisfied this test by developing shrinkage models through statistical analysis of historical data that proved to be more accurate than the method proposed by the Service. The taxpayers demonstrated to the satisfaction of the court that there was a direct correlation between sales and shrinkage. In Kroger, the taxpayer's expert also demonstrated to the satisfaction of the court that an alternative time-based method of deducting shrinkage was more accurate than the IRS's method.

The determination of the accuracy of a taxpayers method of estimating shrinkage is heavily dependent on the particular facts of each case. Clearly, the tremendous size of the operations provided Wal-Mart and Kroger with a wealth of statistical data from which to develop a strong linear relationship between sales and shrinkage. However, size alone should not prevent smaller retailers that use a sound accounting system from demonstrating to the satisfaction of the Tax Court that their shrinkage estimates dearly reflect income.