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Year-end inventory shrinkage estimates.

Sec. 471 (a) states that, when inventories are necessary, they must be taken in a manner conforming "as nearly as may be to [1] the best accounting practice in the trade or business and [2] clearly reflecting the income." In 1997, Congress enacted Sec. 471(b), which specifically permits the use of inventory shrinkage estimates, provided they are confirmed by physical counts after year-end. In addition, the physical counts must be performed on a regular and consistent basis, and proper adjustments must be made to the inventories and estimating methods.

As discussed in Wal-Mart Stores, Inc., 153 F3d 650 (8th Cir. 1998) (Wal-Mart I), the IRS does not specifically require year-end physical inventories, but rather only requires physical inventories at reasonable intervals. This substitution of book inventories for year-end physical inventories, in effect, has led the way to the use of cycle counts. Current Regs. Sec. 1.471-2(d) states that, when a taxpayer maintains book inventories in accordance with a "sound accounting system," the net value of the inventory will be deemed to be its cost as long as the book inventories are "verified by physical inventories at reasonable intervals and adjusted to conform therewith."

Wal-Mart I concluded that an accounting system would be considered "sound" if it conformed to the Sec. 471 (a) standard explained above. In Wal-Mart Stores Inc., TC Memo 1997-1 (Wal-Mart II), the Tax Court found that the taxpayer's use of shrinkage estimates conformed to generally accepted accounting principles (GAAP), and that, accepting the phrase "best accounting practice in the industry" as synonymous with GAAP, the taxpayer in the II, Wal-Mart II case met the first test of Sec. 471 (a). The next step was to determine whether the taxpayer's method resulted in a clear reflection of income. Simply put, could the use of estimates in determining year-end inventory result in a dear reflection of income?

Regs. Sec. 1.461-1(a)(2)(ii) contemplates the use of estimates when it states "the fact that the exact amount of the liability cannot be determined does not prevent a taxpayer from taking into account that portion of the amount of the liability which can be computed with reasonable accuracy within the taxable year" The key is being able to compute the amount with reasonable accuracy. The court in the Wal-Mart II case continued its analysis by looking at the definition of "clear reflection of income" in the regulations. Regs. Sec. 1.446-1(a)(2) states that a "method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income." Regs. Sec. 1.471-2(b) provides that "to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation." Accordingly, if the method used (1) is based on objective factors that do not leave room for manipulation from year to year, (2) complies with GAAP, (3) is consistently applied from year to year and (4) produces accurate results, it should be considered as clearly reflecting income. In Wal-Mart II, the Service took the position that book inventories could be adjusted to reflect shrinkage only in the year the physical count was conducted. Both the Tax Court and the Eighth Circuit disagreed, and allowed the use of estimated shrinkage.

From another point of view, in Dayton Hudson Corp., 153 F3d 660 (8th Cir. 1998) (issued on the same date as Wal-Mart I), the IRS prescribed a method believed to clearly reflect income that did not allow shrinkage estimates. It was determined that the Service's method did not clearly reflect income because it did not consider an estimate for shrinkage during the period from the last physical inventory to the year-end. There are other cases in which physical counts were not taken for several years and the taxpayer tried to take the entire related deduction in the year of the physical count; in other instances, the courts required that the deduction be spread over several years, in effect requiring the use of estimates (Rhinelander Paper Co., 16 AFTR 1041 (1935), or Swinehart Tire & Rubber Co., 2 BTA 223 (1925)).

When Congress enacted Sec. 471(b), it also provided that certain taxpayers should be allowed to change their inventory accounting method to one using shrinkage estimates. Currently, Rev. Proc. 98-29 provides guidance for changing accounting methods and identifies a retail safe harbor method. Taxpayers within the scope of Rev. Proc. 98-29 that want to make an automatic change must follow Rev. Proc. 98-60.

This can be carried a step further, when considering the following: (1) nowhere in the Code or regulations is "physical inventory count" defined, (2) a "sound accounting system" for tax purposes is closely aligned with GAAP, (3) sound accounting systems are more accepting of estimates, (4) perpetual inventory methods are becoming more accurate, (5) Sec. 471 (b) is not limited to the retail trade and (6) most taxpayers are now allowed to use the automatic change provisions to change their inventory accounting method to a method allowing shrinkage estimates.

As perpetual inventories become more sophisticated, they may be considered a part of the physical count process. By direct entry on receipt (either through bar-coding or from shipping invoices appropriately confirmed), the items are initially counted and maintained through the perpetual inventory system. If this initial counting process is combined with appropriate statistical sampling techniques (expanded for tolerance-level violations) and acceptable internal controls, statistical sampling may be an acceptable substitute for a physical inventory when combined with perpetual counts. In addition, inventories could be segmented in some logical manner for cycle-counting purposes. If accepted as GAAP, the concept could be considered a "sound accounting system." Shrinkage losses in the manufacturing industry are often attributable to process rejection due to damage or errors, theft and so on. When shrinkage is identified from the sampling, more complete follow-up counts on the affected segments could be required, allowing the establishment of an estimation method designed to satisfy the historical tests associated with Sec. 471.

The benefits of a system using physical counts that embrace a combination of statistical sampling with perpetual counts provide substantial time and monetary savings over traditional physical counts. If segment shortages can be identified from a statistical sampling and verified through expanded counts of those segments, and a method of estimating those shortages during the period from the last count to the year-end can be established, a taxpayer may be able to protect his actual shrinkage deduction and continue to qualify for the shrinkage estimate deduction.

It appears that this proposed procedure for taking "physical inventory counts" has not been tested. It may even be considered a change in accounting in itself, but as perpetual inventories become more sophisticated and increasing pressures to improve productivity continue, some taxpayers may find the concept worth testing.

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Article Details
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Title Annotation:taxation
Author:St. Vincent, Gary
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 1999
Previous Article:WIP and raw materials inventories.
Next Article:Recent developments in farm taxation.

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