The opinion
T.C. Memo. 1997-1
UNITED STATES TAX COURT
WAL-MART STORES, INC. AND SUBSIDIARIES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 27022-93. Filed January 2, 1997.
Ps operate retail department stores and clubs.
Ps' accounting records set forth each store/club's
inventory, and Ps count each store/club's inventory
during the year to verify the records' accuracy. In
order to reflect the "shrinkage" of inventory at
yearend caused by theft, breakage, and clerical errors
occurring after a count, Ps estimate this shrinkage
based on gross sales. Ps' inclusion of the estimates
in costs of goods sold reduces their gross income.
Held: Ps' method of estimating inventory
shrinkage at yearend is permissible because the method:
(1) Conforms as nearly as may be to the best accounting
practice in the trade or business and (2) clearly
reflects income.
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Alexander Zakupowsky, Jr., Frederick Brook Voght, Jean Ann
Pawlow, and Carol Ann Johnson, for petitioners.
Albert L. Sandlin, Jr., Thomas R. Ascher, James P. Dawson,
and Martin L. Osborne, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Wal-Mart Stores, Inc., & Subsidiaries,
petitioned the Court to redetermine respondent's determination of
deficiencies in their Federal income tax. Respondent determined
the following deficiencies:
Taxable Year Ended Deficiency
Jan. 31, 1984 (1983 taxable year) $9,937,545
Jan. 31, 1985 (1984 taxable year) 4,084,255
Jan. 31, 1986 (1985 taxable year) 9,381,626
Jan. 31, 1987 (1986 taxable year) 8,206,962
Following concessions by the parties, we must decide whether
petitioners' estimates of inventory shrinkage at yearend are
permissible. We hold they are. Section references are to the
Internal Revenue Code in effect for the subject years. Rule
references are to the Tax Court Rules of Practice and Procedure.
Dollar amounts are rounded to the nearest dollar. The term
"shrinkage" refers to the excess value of book inventory over
actual inventory. The term "overage" refers to the excess value
of actual inventory over book inventory. The term "physical
inventory" refers to the counting of the goods that are actually
in inventory.
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FINDINGS OF FACT
I. Background
A. General Information
Some of the facts have been stipulated and are so found.
The stipulated facts and exhibits submitted therewith are
incorporated herein by this reference. Petitioners comprise an
affiliated group of corporations that use an accrual method of
accounting for financial accounting and tax purposes. They filed
Federal consolidated income tax returns and amended Federal
consolidated income tax returns for the subject years. Their
common parent is Wal-Mart Stores, Inc. (Parent). Parent's
principal place of business was in Bentonville, Arkansas, when it
petitioned the Court.
At all relevant times, Kuhn's-Big K Stores Corp. (Kuhn's)
and Big K Edwards, Inc. (Edwards), were two of Parent's
subsidiaries, and Sam's Wholesale Clubs (Sam's) was one of
Parent's divisions. (We hereinafter use the name "Wal-Mart" to
refer collectively to Parent (without regard to Sam's), Kuhn's,
and Edwards. We hereinafter use the term "petitioners" to refer
collectively to Wal-Mart and Sam's.)
Sam's operated its stores (clubs) on a discount warehouse
basis. Wal-Mart operated its stores as mass discount retailers.
Each Wal-Mart store contained up to 37 departments, and, in the
aggregate, these departments carried a wide range of merchandise,
including home furnishings, electrical appliances, automotive and
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hardware items, electronics, toys, candy, and pet supplies, as
well as apparel for men, women, boys, and girls.
Inventory is petitioners' most essential and valuable asset,
and it is critical to their success. Petitioners strive to
maintain enough inventory to satisfy their customers' needs,
while at the same time minimizing the dollar amount of their
inventories. One measure of the effectiveness of Wal-Mart's
inventory management is its impressive rate of inventory turnover
(sales/inventory). Wal-Mart's inventory turned over 4.5 times in
its 1983 taxable year, while the average turnover for Wal-Mart's
competitors was approximately 2.8 times. Another indication of
the effectiveness of Wal-Mart's inventory management was that
many other companies (both domestic and foreign) sought advice
from Wal-Mart on inventory management.
B. Respondent's Adjustments
Respondent issued petitioners two notices of deficiency, one
for their 1983 and 1984 taxable years and the other for their
1985 and 1986 taxable years. Both notices reflected an increase
to petitioners' ending inventories on account of respondent's
disallowance of their estimated inventory shrinkage.1 Respondent
1
The notice for 1983 and 1984 disallowed shrinkage
estimates for Wal-Mart only. The notice for 1985 and 1986
disallowed shrinkage estimates for Wal-Mart and Sam's.
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determined that petitioners' ending inventories as reported
understated their taxable income by the following amounts:2
Taxable Year Understatement
1983 $24,276,994
1984 7,837,122
1985 20,394,840
1986 1,196,045
The shrinkage disallowed by respondent relates to the period
of time referred to by the parties as the "stub period". In
general, the stub period is the time between the date of the last
physical inventory prior to the taxable yearend and the taxable
yearend. In some cases, Wal-Mart took a physical inventory in
January and booked the inventory in February of the next year.
In those cases, the stub period is the time between the date of
the physical inventory immediately prior to the January physical
inventory and the taxable yearend. In other cases, Wal-Mart
booked two consecutive January inventories in February. In those
cases, the stub period is the time between the first January
inventory and the taxable yearend following the second January
inventory. In the case of a new store for which a physical
inventory was not taken before the taxable yearend, the stub
period is the period beginning with the date of the store opening
and ending with the taxable yearend.
2
Respondent also determined that part of these
understatements stemmed from petitioners' miscalculation of a
cost complement. The parties have settled their disagreements
with respect to this calculation, and it is not at issue herein.
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C. Scope of Petitioners' Operations
Wal-Mart is one of the largest operators of mass merchandise
retail stores in the United States. During the subject years,
the numbers of Wal-Mart's stores and Sam's clubs were as follows:
Taxable Year Wal-Mart Sam's
1983 642 3
1984 745 11
1985 859 23
1986 980 49
Many of these stores were open to the public 24 hours a day.
During the subject years, Wal-Mart purchased and sold
products labeled with the manufacturer's name (name brands), as
well as products with its own name brand. The dollar amounts of
petitioners' purchases and the retail values of its net sales
were as follows:
Purchases Sales
Year Wal-Mart Sam's Wal-Mart Sam's
1983 $3,543,245,308 $41,192,081 $4,566,514,170 $37,364,011
1984 4,808,957,832 232,156,657 6,068,673,313 221,585,916
1985 5,855,108,264 749,927,690 7,501,658,005 776,483,444
1986 8,037,262,151 1,608,040,382 9,933,879,035 1,670,806,324
A typical Wal-Mart store averaged 53,000, 55,000, 57,000,
and 59,000 square feet in the respective taxable years, and
petitioners' total square footage of retail space increased from
27.7 million in the 1983 taxable year to 63 million in the 1986
taxable year. Wal-Mart's stores carried between 60,000 and
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90,000 specific types of merchandise (stock keeping units or
SKU's).3 Sam's clubs carried between 3,500 and 5,000 SKU's.
Wal-Mart received approximately 80 percent of its
merchandise through petitioners' distribution system. Wal-Mart's
distribution centers increased from 6 in 1984 to 10 in 1987.
In the later year, petitioners' total distribution center space
was over 7 million square feet, and each distribution center
received and shipped in excess of 30 million cases of merchandise
a year, the equivalent of 96 trailer loads per working day.
II. Petitioners' Inventory Practice
A. Inventory Systems in General
Inventory accounting requires allocating each period's
cost of goods available for sale between: (1) Cost of goods sold
and (2) the value of ending inventory. Taxpayers may use either
the perpetual or periodic inventory system for this allocation.
Under both systems, the cost of each purchase is recorded
contemporaneously with the purchase, and the revenue from each
sale is recorded contemporaneously with each sale. But for these
similarities, recording differs depending on whether the taxpayer
uses a periodic or a perpetual system.
Under the periodic system, an entry is not made to record
the quantity or cost of an item of merchandise when it is sold.
A physical count is generally performed at yearend to ascertain
3
In general, identical units are one SKU's, and each
different size and brand is a different SKU.
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the items in and value of the ending inventory. The cost of
goods sold is the residual amount. No distinction is made
between the cost of the goods that were actually sold during the
period and the expense of shrinkage.
Under the perpetual system, the cost and/or quantity of
goods sold are contemporaneously recorded at or about the time of
sale. Thus, the perpetual system continuously reveals the cost
and/or quantity of goods sold since the beginning of the current
period and the cost and/or quantity of goods that are (or should
be) on hand at any given time. Physical inventory counts are
performed periodically to confirm the accuracy of the inventory
as stated in the taxpayer's books, and adjustments are made to
the books to reconcile the inventory stated therein with the
actual inventory.
B. Petitioners' Inventory Accounting Method
Petitioners maintained a perpetual inventory system.
Wal-Mart used the Last In, First Out (LIFO) method of identifying
items in ending inventory, see sec. 1.472-1, Income Tax Regs.,
and the retail method of pricing inventories, see sec. 1.471-8,
Income Tax Regs.4 Wal-Mart determined the cost of the LIFO
inventories using the dollar value LIFO method, see sec. 1.472-8,
Income Tax Regs., and it valued any increase in inventory
quantities based on the cost of the earliest acquisitions during
4
Many of Wal-Mart's competitors also used the retail
inventory method to account for their inventories.
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the year, see sec. 1.472-2, Income Tax Regs. At the end of each
month, Wal-Mart applied a cost complement to convert its
inventory balances from retail to deemed cost. Wal-Mart's
internal monthly financial statements reported inventory
shrinkage (both estimated and verified) as an increase to cost of
goods sold.
Sam's did not use the retail method. Sam's used the First
In, First Out method of identifying items in ending inventory.
C. Cycle Counting
Petitioners did not count the actual yearend inventory at
each of their stores. They counted each store's inventory at
various times during the year (referred to as cycle counting).
The use of cycle counting, and the absence of a physical count at
yearend, is common in petitioners' industry. Petitioners used
this technique during the subject years because they were unable
to physically count the inventories at all of their stores/clubs
on the last day of the taxable year. Cycle counting was also
advantageous to them because it was less disruptive to business
operations, and it allowed management to receive information
throughout the year on the effectiveness of internal operations
and changes in external behavior. The continuous flow of
information facilitated management's response to shrinkage trends
on a timely basis.
During the subject years, petitioners' independent
auditors were Ernst & Young (E&Y). E&Y advised Wal-Mart that it
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could use cycle counting because: (1) Wal-Mart had accurate
retail accounting records, (2) Wal-Mart had retained independent
counting services to work with Wal-Mart's internal audit
department, and (3) Wal-Mart's previous physical inventories had
not required significant changes to the retail records. E&Y
certified that petitioners' financial statements for the subject
years (which included the shrinkage estimates) conformed with
Generally Accepted Accounting Principles (GAAP), issuing
unqualified opinions to that effect for each of the years. E&Y
had been periodically reviewing petitioners' methodology for
accounting for shrinkage, including the accrual of the shrinkage
estimate during the stub period, and E&Y had never recommended
that petitioners change their method of accounting for shrinkage.
D. Physical Counts
The amount of shrinkage or overage was verified by
petitioners when the inventory on hand was counted. In general,
Wal-Mart counted each store's inventory approximately every 11 to
13 months. In the case of new stores, petitioners did not count
the inventory until the store had been open for at least
6 months. Petitioners also did not count inventory in the months
of November, December, and the first week in January. During
November and December, Wal-Mart was focusing on the Christmas
season, which is one of the busiest times of the year, and its
inventory was at a maximum. During the first week of January,
Wal-Mart's employees were recuperating from the Christmas season,
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and they were responding to the return of merchandise from
customers. Wal-Mart's inventory was generally at its lowest
during the month of January.
Wal-Mart counted the inventory at some of its stores
during the last 3 weeks in January. The results of some of these
inventories were posted in January of the same taxable year,
while the results of most of these inventories were posted in
February of the subsequent taxable year. The ending inventory
for the year of the counts was not corrected for verified
shrinkage for those stores inventoried in January and posted in
February. The following chart shows the number of inventories
taken in January, the number of January inventories posted in
January, and the number of January inventories posted in
February for the taxable years at issue:
Number of
January Posted in Posted in
Year Inventories January February
1983 39 39 - 0 -
1984 73 9 64
1985 73 1 72
1986 93 or 95 - 0 - 93 or 95
During the subject years, the highest percentages of physical
inventories took place from March through September.
In general, it takes 4 to 6 weeks to prepare a store for
inventory. Forty-five days prior to a scheduled count,
Wal-Mart's internal audit department would send a preparation
package to the store for completion before the inventory was
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taken. Completion of the package by the store was designed to
ensure accuracy and consistency in the count and reconciliation
with book inventory. The package included detailed instructions
for store preparation to ensure an efficient count. The package
included 13 schedules that were reviewed or completed prior to
the day of the count.
Persons involved in a count included a team of independent
counters (18 to 40 individuals) and representatives from
Wal-Mart's loss prevention department (one to two individuals),
internal audit department (one to three individuals), and
operations division (one to two individuals). E&Y was also
present at the inventories of randomly selected stores to test
the count's accuracy by recounting results. All salable
merchandise in a store was counted by the independent counters on
the day of the physical inventory, and they based the count on
the inventory's retail value.
Wal-Mart took inventory while the stores were open to
customers. Each store count took a full day, commencing at
approximately 8 a.m. and concluding at approximately 6 p.m.
Thereafter, while still at the store, the physical count team
reconciled the physical count to the book inventory. These
reconciliations were reviewed by petitioners' internal audit
department on a future date. Due to the time necessary to review
the reconciliations, petitioners did not book the results of a
physical inventory until the next month.
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Sam's physical inventory procedure was essentially the
same as Wal-Mart's procedure, except that Sam's conducted its
inventories before business hours and the physical count was
completed within 4 to 5 hours. In addition, two inventories were
usually taken during the taxable year at each of Sam's clubs, and
the items, rather than retail values, were counted. Physical
counts were sometimes taken at Sam's in January, and the results
of physical inventories at Sam's were booked the day after the
physical inventory. Unlike the records of Wal-Mart, petitioners
kept records for Sam's that listed the quantity and cost of items
in inventory on any given date.
In addition to the physical inventories performed at each
club, Sam's personnel routinely performed item audits on specific
products held in inventory. In an item audit, Sam's personnel
counted the goods on hand for a particular SKU's, and they
reconciled the count with the club's stock status report. Any
discrepancy was immediately booked. Item audits were performed
daily or weekly at the club manager's discretion.
III. Accounting for Shrinkage
A. Shrinkage in General
Inventory shrinkage occurs daily and is an inherent cost
of the retail business. Causes of shrinkage include theft,
damage, breakage, spoilage, and bookkeeping errors. Although
shrinkage cannot be eliminated entirely, it can be minimized
through methods that include the use of loss prevention
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equipment, employee involvement and screening, prosecutions for
theft, security devices, training of security personnel, and
effective control systems for paperwork, bookkeeping, and
accounting. Shrinkage is particularly high around the holiday
seasons such as Christmas and Easter.
B. Wal-Mart's Response to Shrinkage
In the early 1980's, prior to the subject years, Wal-Mart
modified its computer system to improve the accuracy of its
inventory accounting. Wal-Mart employed various other techniques
to reduce shrinkage and overage during the subject years, such as
closed-circuit camera systems, burglar alarms, and close scrutiny
over the hiring and performance of employees.5 In the latter
regard, Wal-Mart tried not to hire applicants who might be
inclined to commit theft, and Wal-Mart focused on employee
training to reduce bookkeeping errors. Each store manager was
also evaluated in part on his or her ability to reduce shrinkage,
and employees at stores that reported excessive shrinkage or
overages were not eligible for a bonus. Store managers with
higher than expected shrinkage were required to attend internal
seminars on shrinkage, and they were subject to demotion or
termination if the high shrinkage continued.
Shrinkage reduces profits and was viewed by petitioners
during the subject years as reflecting poor management and
5
Sam's employed similar measures.
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adversely affecting employee morale. Petitioners aimed to reduce
shrinkage, and they devoted extensive resources to the mitigation
and monitoring of it. Petitioners' management discussed
shrinkage weekly among themselves, and they regularly discussed
the subject with the audit committee of the board of directors,
as well as the regional managers, district managers, and store
managers.
C. Petitioners' Monthly Shrinkage Estimates
Wal-Mart estimated shrinkage for each store for the period
between the physical inventory and the end of the taxable year by
multiplying a retail shrinkage rate (stated as a percentage of
sales) by the store's sales for the period between the physical
inventory and the end of the taxable year. For new stores,
Wal-Mart estimated shrinkage based on a fixed rate established by
its senior management. In the 1983 and 1984 taxable years, the
retail shrinkage rate for new stores was 3 percent of sales. In
the 1985 and 1986 taxable years, the rate was 2 percent of sales.
Wal-Mart used the fixed rate from the date the store opened until
the date that the first inventory was taken at the store.
After Wal-Mart took the first inventory at a store, it
computed a shrinkage rate for that store by dividing the store's
shrinkage at retail, as verified by the first inventory, by the
store's sales for the period starting with the date the store
opened and ending on the inventory date. The shrinkage rate, as
computed, was subjected to the imposition and application of
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certain floor and ceiling percentage limitations that were
established by Wal-Mart's senior management, and that are
discussed further below. After Wal-Mart took a second inventory
at the store, it computed the shrinkage rate for that store
similarly to the method described above, except that it used the
shrinkage as verified by both the first and second inventories,
and it used the sales for the period starting with the date the
store opened and ending on the date of the second inventory. The
floor and ceiling limitations described below were also applied
to this rate. After Wal-Mart took a third inventory at the
store, it computed a shrinkage rate for that store in a fashion
similar to that of the first 2 years, except that it used the
shrinkage as verified by the first, second, and third
inventories, and it used the sales for the period commencing with
the date the store opened and ending on the date of the third
inventory. This shrinkage rate, as computed, was subjected to
the floor and ceiling limitations described below.
After Wal-Mart took the fourth and each subsequent
inventory, the retail shrinkage rate was based on a rolling
average of the historical shrinkage over the last three
inventories of the store. The rate was computed by dividing the
amount of shrinkage at retail, as verified by the current
inventory and the preceding two inventories, by the sales for the
period commencing with the date of the third preceding inventory
and ending on the current inventory date. This shrinkage rate,
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as computed, was subjected to the floor and ceiling limitations
described below.
The floor and ceiling percentage limitations mentioned
above were internal guidelines set forth in memoranda prepared by
Wal-Mart's senior management. These guidelines were followed by
all of Wal-Mart's stores. Wal-Mart's internal audit department
recommended the amount of a ceiling and floor limitation to the
controllers and vice presidents of the respective operating
divisions based on a weighted 5-year average, and they, in turn,
recommended the guidelines for these limitations to Wal-Mart's
president. Wal-Mart's president was the ultimate setter of these
guidelines, and, once set and implemented, these guidelines were
effective until revised through the procedure used to establish
them. The floor and ceiling percentage limitations were applied
as follows: (1) If the computed shrinkage rate was below the
floor, the rate was adjusted upward to equal the floor; (2) if
the computed shrinkage rate exceeded the ceiling, it was adjusted
downward to equal the ceiling; (3) if the computed shrinkage rate
was an overage, the rate was replaced by the floor. In practice,
the ceiling was seldom applied, and the floor was applied more
often. As one example of the application of the floor and
ceiling percentage limitations, the following table contains
information from the 1986 taxable year that illustrates how a
computed average shrinkage rate was adjusted:
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Store Computed % Applied % % Applied
201 -1.08 shrinkage -1.08 Computed
397 -3.90 shrinkage -3.85 Ceiling
531 -0.27 shrinkage -1.00 Floor
782 +0.32 overage -1.40 Floor
Sam's consistently determined shrinkage projections for
its clubs by multiplying a fixed rate of .2 percent by monthly
sales. None of the clubs, including new clubs, applied a floor
or ceiling percentage limitation to the .2-percent rate. The
.2-percent rate was determined by petitioner's senior management
on the basis of their analysis of historical results from
warehouse operations. Sam's shrinkage estimates are a smaller
part of overall annual shrinkage because Sam's warehouse format
allows it to continuously take item physical inventories in
addition to taking complete physical inventories twice a year.
Sam's underestimated shrinkage. Sales during the physical
inventory cycle for Sam's, expressed in thousands of dollars,
were $597,954 for 1985 and $1,314,344 for 1986. Shrinkage during
the physical inventory cycle for Sam's, expressed in thousands of
dollars, was $567 for 1985 and $4,669 for 1986. Sam's shrinkage
as a percentage of sales for the physical inventories taken
during 1985 and 1986 was .27% (($567 + $4,669)/($597,954 +
$1,314,344)).
D. Adjustment of Monthly Estimates
Petitioners adjusted their inventory accounts to reflect
the results of each physical count of a store or club. Each time
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petitioners took a physical count, they adjusted any over- or
under-estimate of shrinkage, so that their books and records
reflected inventories on hand as verified by the physical count.
This was a continuous process throughout the year, as stores and
clubs were physically counted in the cycle procedure.
E. Yearend Allocations and LIFO Effects
Wal-Mart estimated shrinkage for each store, not for each
department within each store. At the end of each subject year,
Wal-Mart aggregated the estimate for shrinkage for the stub
period as reported in its records for all of its stores.
Wal-Mart then allocated this aggregate estimated shrinkage to
each department on the basis of the relative amount of all
shrinkage verified during the year for each department as
reported in the December purchase recap report.6 At the end of
each taxable year, Wal-Mart allocated the consolidated ending
inventory (net of shrinkage), as reported in the general journal,
among each of its departments.7 For the 1984, 1985, and 1986
6
Purchase recap reports were prepared monthly, and they
listed beginning inventory at retail, purchases at cost and
retail, sales at retail, markdowns at retail, and ending
inventory at retail. The inventory amounts shown in the monthly
purchase recap reports were stated net of shrinkage (overage) as
determined from physical inventories taken from the beginning of
the year to date. The shrinkage (overage) determined from the
physical inventory was included in the purchase recap report when
the inventory was completed, including verification and recording
in the books. The shrinkage (overage) reported in the purchase
recap report was reported on a departmental basis from the
physical counts of the departments.
7
Wal-Mart recorded purchases, sales, and related
(continued...)
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taxable years, the allocation was made on the basis of the
relative value of ending inventory in each department (net of
shrinkage as allocated) as reported in the yearend purchase recap
report. In petitioners' 1983 taxable year, the allocation was
made on the basis of the results of physical inventories taken
during the month of January 1984. A separate allocation in the
same manner was made for the stores of Parent, Kuhn's, and
Edwards.
Parent, Kuhn's, and Edwards each had its own LIFO pools.
Petitioners made separate LIFO computations for each of these
entities. Petitioners separately recorded shrinkage as verified
by physical counts by department for Parent, Kuhn's, and Edwards.
Petitioners also allocated aggregate estimated stub period
shrinkage separately to each of the entity's departments.
Petitioners did not allocate an estimate of shrinkage to pools at
the individual store level. Petitioners did not make yearend
allocations and reconciliations or LIFO computations for
individual stores. Yearend allocations and LIFO computations
were performed on a division-wide basis.
Petitioners reported the same shrinkage for both financial
and tax purposes. For purposes of preparing financial statements
7
(...continued)
information in the general journal. The general journal
contained information on a store basis and contained basically
the same accounts for each store. The general journal contained
the records of the total shrinkage as verified by physical count
and estimated shrinkage by store, but not by department.
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and the Federal income tax return, petitioners reported shrinkage
on an aggregate basis. Other large retail businesses, in
addition to Wal-Mart, estimate shrinkage for the stub period.
The practice of estimating shrinkage as a percentage of sales is
prevalent in the retail industry.
OPINION
I. Overview
We must decide whether petitioners' estimates of inventory
shrinkage at yearend are permissible. In Dayton Hudson Corp. &
Subs. v. Commissioner, 101 T.C. 462 (1993), we held that a
taxpayer was entitled to use an estimate of yearend shrinkage if
the taxpayer's method of accounting for its inventory was
"sound". In the instant case, respondent asks us to reconsider
our holding in Dayton Hudson. We will not do so. We adhere to
our opinion in Dayton Hudson Corp. & Subs. v. Commissioner,
supra, for the reasons stated therein. We will not disturb
petitioners' method of accounting for their inventories,
including their estimates of shrinkage at yearend, if the method
is "sound". Stated differently, petitioners will prevail if they
prove that their inventory method meets the following two-prong
test: (1) It conforms as nearly as may be to the best accounting
practice in the trade or business and (2) it clearly reflects
income. Sec. 471(a);8 see also Thor Power Tool Co. v.
8
Sec. 471(a) provides:
(continued...)
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Commissioner, 439 U.S. 522, 531-532 (1979); Dayton Hudson Corp. &
Subs. v. Commissioner, supra; sec. 1.471-2(a)(1) and (2), Income
Tax Regs. We analyze these prongs seriatim, and we set forth our
analysis below. Before doing so, however, we pause to summarize
the qualifications of the experts.
During the cases in chief, petitioners called two
witnesses whom the Court recognized as experts, and respondent
called three. We are given broad discretion to evaluate the
cogency of each expert's analysis and to weigh it accordingly.
See Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 301
(1996). We must evaluate and weigh each expert's opinion in
8
(...continued)
Whenever, in the opinion of the Secretary the use of
inventories is necessary in order clearly to determine
the income of any taxpayer, inventories shall be taken
by such taxpayer on such basis as the Secretary may
prescribe as conforming as nearly as may be to the best
accounting practice in the trade or business and as
most clearly reflecting the income.
The Commissioner has prescribed rules under sec. 471(a) for
taxpayers like petitioners that employ a perpetual inventory
system. In pertinent part, sec. 1.471-2(d), Income Tax Regs.,
provides:
Where the taxpayer maintains book inventories in
accordance with a sound accounting system in which the
respective inventory accounts are charged with the
actual cost of the goods purchased or produced and
credited with the value of goods used, transferred, or
sold, calculated upon the basis of the actual cost of
the goods acquired during the taxable year (including
the inventory at the beginning of the year), the net
value as shown by such inventory accounts will be
deemed to be the cost of the goods on hand. The
balances shown by such book inventories should be
verified by physical inventories at reasonable
intervals and adjusted to conform therewith.
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light of his or her qualifications and with regard to all other
evidence in the record. Id.; IT&S of Iowa, Inc. v. Commissioner,
97 T.C. 496, 508 (1991); Parker v. Commissioner, 86 T.C. 547, 561
(1986). We are not bound by an expert’s opinion, especially when
it is contrary to our own judgment. Trans City Life Ins. Co. v.
Commissioner, supra at 302. If we believe it is appropriate to
do so, we may adopt an expert’s opinion in its entirety, or we
may reject it in its entirety. Helvering v. National Grocery
Co., 304 U.S. 282, 294-295 (1938); see Buffalo Tool & Die
Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980).
We may also choose to adopt only parts of an expert’s opinion.
Parker v. Commissioner, supra at 562.
The Court recognized Robert M. Zimmerman, petitioners'
first expert, as an expert on shrinkage in the retail industry,
as well as on matters of GAAP. Mr. Zimmerman has been a
certified public accountant (C.P.A.) since 1959, and he has
worked for a national accounting firm for 15 years as a partner
and/or director, specializing in the retail industry and
directing the firm's operations therein. Mr. Zimmerman consults
currently in the retail industry, and he has written repeatedly
on the subject of retail accounting and financial control.
Mr. Zimmerman holds an undergraduate degree in accounting and a
master's degree in taxation, both from New York University.
The Court recognized petitioners' second expert,
Thomas E. Doerfler, as an expert on statistics. Dr. Doerfler has
- 24 -
consulted on the subject of statistics for over 25 years, and he
is currently employed as a senior consultant in that area at a
diversified international management and technology consulting
firm. Dr. Doerfler holds an undergraduate degree in mathematics
from the University of Dayton and two graduate degrees (M.S. and
Ph.D) in statistics from Iowa State University. He has
previously appeared before this and other Courts as an expert on
statistical issues involving sampling and estimation.
Respondent's first expert, Steven Elliott Fienberg, was
recognized by the Court as an expert on statistics. Dr. Fienberg
is a professor at Carnegie-Mellon University, where he teaches
statistical science at both the undergraduate and graduate level.
Dr. Fienberg holds a Ph.D in statistics from Harvard University,
and he has previously testified as an expert in Federal, State,
and local courts. Dr. Fienberg is currently the president of the
international society for Bayesian analysis, and he chairs the
committee of presidents of statistical sciences.
The Court recognized respondent's second expert,
David W. LaRue, as an expert in financial, tax, and inventory
accounting. Dr. LaRue, an associate professor at the University
of Virginia, holds a Ph.D in taxation and accounting from the
University of Houston. He specializes in the fields of Federal
taxation and accounting, and he has written repeatedly on those
subjects.
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Respondent's third expert, James Earnest Wheeler, was
recognized by the Court as an expert in financial and tax
accounting. Dr. Wheeler is a professor of accounting at the
University of Michigan, and he holds a Ph.D. in accounting from
the University of Illinois. Dr. Wheeler specializes and teaches
in the fields of Federal taxation and accounting, and he has
written frequently on those subjects.
The Court also recognized as experts two other witnesses
called by petitioner during rebuttal; namely, Charles Bates and
James Bradow. Both of these witnesses were qualified as experts
for the sole purpose of rebuttal. Dr. Bates was recognized as an
expert on tax accounting for purposes of rebutting Dr. Fienberg.
He is a principal with KPMG Peat Marwick, heading its economic
analysis group with a particular focus on statistical application
to the field of economics (econometrics). He has a master's and
a Ph.D in economics from the University of Rochester. Mr. Bradow
was recognized as an expert in econometrics for purposes of
rebutting Dr. Wheeler. Mr. Bradow is a C.P.A. and a partner of
E&Y.
II. Best Accounting Practice
Petitioners contend that their method of estimating
shrinkage conforms to the best accounting practice in the
industry. Respondent alleges to the contrary. Respondent argues
that the retail industry does not have "one per se industry
standard for estimating shrinkage" because other retailers use
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variations of petitioners' method, rather than strictly following
it. According to respondent, Wal-Mart's competitors in the
retail industry use different historic periods to ascertain their
shrinkage rates, and they adjust these rates differently than the
ceiling and floor levels used by Wal-Mart. Respondent also
argues that petitioners' shrinkage estimates do not conform to
GAAP for the reasons stated by Dr. Wheeler. Respondent adds that
petitioners' financial statements as a whole may have satisfied
GAAP, but that their estimates of shrinkage do not. Respondent
contends that E&Y was able to certify the subject statements
without qualification because petitioners' shrinkage estimates
were immaterial from a financial point of view. Respondent
alleges that materiality is a financial accounting concept that
does not apply to tax accounting.
The Supreme Court has indicated that the phrase "best
accounting practice in the trade or business" is synonymous with
GAAP. Thor Power Tool Co. v. Commissioner, 439 U.S. at 531; see
also Hachette USA, Inc. v. Commissioner, 105 T.C. 234, 247
(1995), affd. 87 F.3d 43 (2d Cir. 1996). Thus, petitioners'
method of accounting for their inventories will satisfy the first
prong of our two-prong test if it conforms to GAAP. We believe
it does. Petitioners' estimate of stub period shrinkage as a
percentage of sales is a widely accepted industry practice.
Petitioners consistently followed this practice, and they
utilized the estimates resulting therefrom in their financial
- 27 -
statements. Petitioners' financial statements were certified by
E&Y as conforming to GAAP without qualification.
Respondent challenges the accuracy of petitioners'
financial statements and contends that E&Y's certification does
not pertain to the estimates of shrinkage. We disagree. Each of
the statements is accompanied by E&Y's unqualified certification
that E&Y has examined the financial statements in accordance with
generally accepted auditing principles, and that the statements
present the financial position of petitioners in conformance with
GAAP. Respondent invites the Court to focus on the accounting
concept of materiality and conclude that E&Y was able to render
an unqualified opinion even though petitioners' estimates of
inventory shrinkage were improper. We will not do so. We do not
find that petitioners' inventory accounting method was out of
compliance with GAAP. Petitioners' witness James A. Walker, Jr.,
a C.P.A. and Wal-Mart's current senior vice
president/comptroller, testified that Wal-Mart's method of
accounting for shrinkage conformed with GAAP. Respondent did not
persuasively challenge Mr. Walker's testimony, and we find that
his testimony was consistent with the testimony of
Robert Lundgren. Mr. Lundgren is also a C.P.A, and he is the
partner of E&Y who directed the audit of Wal-.Mart for the
relevant years and gave the approval for the firm's opinion on
the financial statements. To the extent that Dr. Wheeler
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testified that petitioners' inventory method did not comply with
GAAP, we are unpersuaded by that testimony.
Petitioners' shrinkage methodology is supported by FASB
Statement of Concepts No. 6 (Statement No. 6). In relevant part,
Statement No. 6 states:
26. An asset has three essential characteristics:
(a) it embodies a probable future benefit that
involves a capacity * * * to contribute directly or
indirectly to future net cash inflows, (b) a
particular entity can obtain the benefit and control
others' access to it, and (c) the transaction or
other event giving rise to the entity's right to or
control of the benefit has already occurred.
* * * * * * *
33. Once acquired, an asset continues as an asset
of the entity until the entity collects it,
transfers it to another entity, or uses it up, or
some other event or circumstance destroys the future
benefit or removes the entity's ability to obtain
it.
Petitioners' method of accounting for shrinkage comports with
Statement No. 6 because petitioners adjusted their inventories,
which were their largest asset, to reflect the value of the
merchandise that was on hand at yearend. If petitioners had not
made these adjustments, the value of their ending inventories
would have been overstated by the value lost through shrinkage.
Merchandise that is not available for sale to customers does not
"contribute * * * to future net cash inflows" or provide a
"benefit".
We also are guided by the retail industry's accounting
practice. In the absence of specific guidance, the generally
- 29 -
accepted standard for a trade or industry may be established by
reference to a common practice followed by members of that trade
or industry. See sec. 1.471-2(a)(1), Income Tax Regs.
(inventories must conform to the best accounting practice in the
trade or business). Petitioners' methodology for estimating stub
period shrinkage is consistent with and comparable to the best
practice used in the retail industry. Like most major retailers,
petitioners use cycle counting, which is widely accepted in the
retail industry. Petitioners' physical inventory process is
strictly and carefully conducted and reviewed by independent
counting services, petitioners' internal auditors and loss
prevention department, and independent auditors. Petitioners'
competitors also estimate shrinkage as a percentage of sales.
Estimating shrinkage for the stub period as a percentage of sales
is the best practice available in the industry. It is also
relevant that petitioners used the same shrinkage estimates for
reports issued to the Securities Exchange Commission.
We conclude that petitioners' method of accounting for
their inventories, including their estimates of shrinkage at
yearend, conforms as nearly as may be to the best accounting
practice in the trade or business. We so hold, and we turn to
the second prong.
III. Clear Reflection of Income
Inventory accounting is governed by sections 446 and 471.
Section 471 prescribes the general rule for inventories. The
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regulations thereunder follow the statutory text in stating that
a method of accounting for inventory "must conform as nearly as
may be to the best accounting practice in the trade or business,"
and "must clearly reflect the income." Sec. 1.471-2(a)(1) and
(2), Income Tax Regs.
Section 446(a) contains the general rule for tax
accounting. Section 446(a) states that the accounting method
used to compute taxable income generally must be based on the
method of accounting used to compute book income. When the
accounting method used to compute taxable income does not clearly
reflect income, section 446(b) gives the Commissioner broad
authority to prescribe a method that does clearly reflect income.
Thor Power Tool Co. v. Commissioner, supra at 532; Commissioner
v. Hansen, 360 U.S. 446, 467 (1959); Ford Motor Co. v.
Commissioner, 71 F.3d 209 (6th Cir. 1995), affg. 102 T.C. 87
(1994); see also sec. 1.446-1(a)(2), Income Tax Regs. ("no method
of accounting is acceptable unless, in the opinion of the
Commissioner, it clearly reflects income"). The Commissioner's
exercise of authority under section 446(b) is given "much
latitude" and cannot be disturbed unless "clearly unlawful".
Thor Power Tool Co. v. Commissioner, 439 U.S. at 532-533; Lucas
v. American Code Co., 280 U.S. 445, 449 (1930); see also United
States v. Catto, 384 U.S. 102 (1966); Schlude v. Commissioner,
372 U.S. 128, 133-134 (1963); American Auto. Association v.
United States, 367 U.S. 687, 697-698 (1961); Automobile Club of
- 31 -
Mich. v. Commissioner, 353 U.S. 180, 189-190 (1957); Brown v.
Helvering, 291 U.S. 193, 203 (1934). Taxpayers challenging the
Commissioner's authority must prove that the Commissioner's
determination is "clearly unlawful" or "plainly arbitrary".
Thor Power Tool Co. v. Commissioner, supra at 532-533. The
Commissioner's authority under section 446(b) encompasses overall
methods of accounting, as well as specific methods utilized to
report any item of income or expense. Id. at 531; Ford Motor Co.
v. Commissioner, 102 T.C. at 100; Prabel v. Commissioner, 91 T.C.
1101, 1112-1113 (1988), affd. 882 F.2d 820 (3d Cir. 1989); sec.
1.446-1(a), Income Tax Regs.
The fact that the Commissioner possesses broad authority
under section 446(b) does not mean that the Commissioner can
change a taxpayer's method of accounting with impunity. See,
e.g., Prabel v. Commissioner, supra at 1112-1113. Thus, for
example, if a taxpayer uses a method of accounting that clearly
reflects income, the Commissioner may not require a change to
another method merely because the Commissioner believes that the
latter method will reflect income more clearly. Ansley-Sheppard-
Burgess Co. v. Commissioner, 104 T.C. 367 (1995); Auburn Packing
Co. v. Commissioner, 60 T.C. 794 (1973); Garth v. Commissioner,
56 T.C. 610 (1971); see also St. James Sugar Co-op, Inc. v.
United States, 643 F.2d 1219 (5th Cir. 1981); Photo-Sonics, Inc.
v. Commissioner, 357 F.2d 656, 658 (9th Cir. 1966), affg. 42 T.C.
926 (1964); Bay State Gas Co. v. Commissioner, 75 T.C. 410, 417
- 32 -
(1980), affd. 689 F.2d 1 (1st Cir. 1982). Likewise, we have
allowed the use of an accounting method that was challenged by
the Commissioner, when the taxpayer's method clearly reflected
income and the Commissioner's method did not. See Rotolo v.
Commissioner, 88 T.C. 1500, 1514 (1987). We also have allowed
the consistent application of accounting methods that were
authorized by the Code or the underlying regulations. See RLC
Indus. Co. & Subs. v. Commissioner, 98 T.C. 457, 491-492 (1992),
affd. 58 F.3d 413 (9th Cir. 1995).
When a taxpayer challenges the Commissioner's authority
under section 446(b), we inquire whether the accounting method in
issue clearly reflects income. The answer to this question does
not hinge on whether the taxpayer's method is superior to the
Commissioner's method, or vice versa. Id. at 492; see also Brown
v. Helvering, supra at 204-205. Instead, the answer must be
found by analyzing the unique facts and circumstances of the
case. Ansley-Sheppard-Burgess Co. v. Commissioner, supra;
Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78 T.C.
1029, 1045 (1982).
Although it is not dispositive of our analysis, we believe
that a critical fact to consider is whether the taxpayer is
consistently utilizing a recognized method of accounting that
comports with GAAP, and that is prevalent in the industry.
See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354
(1st Cir. 1970), affg. T.C. Memo. 1969-79; RLC Indus. Co. & Subs.
- 33 -
v. Commissioner, supra at 490. We recognize that the treatment
of an item for financial accounting and Federal income tax
purposes does not always mesh, and that an accounting method that
is acceptable under GAAP may be unacceptable for Federal income
tax purposes because it does not clearly reflect income. Thor
Power Tool Co. v. Commissioner, supra at 538-544; see also
Hamilton Indus., Inc. v. Commissioner, 97 T.C. 120, 128 (1991);
UFE, Inc. v. Commissioner, 92 T.C. 1314, 1321 (1989); Sandor v.
Commissioner, 62 T.C. 469, 477 (1974), affd. 536 F.2d 874 (9th
Cir. 1976); Peninsula Steel Prods. & Equip. Co. v. Commissioner,
supra. All the same, the regulations under section 446(b)
contemplate that a method of accounting "ordinarily" will clearly
reflect income when it "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". Sec. 1.446-1(a)(2), Income Tax Regs.
In this regard, we believe that the instant case falls
within the contemplation of section 1.446-1(a)(2), Income Tax
Regs. Petitioners consistently calculated their shrinkage
estimates under a methodology that comported with GAAP. Under
this methodology, they generally estimated shrinkage every month
based on a 3-year rolling average, which was revised after every
actual count. They adjusted any prior under- or over-estimate of
shrinkage each time they counted their inventory so that their
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books and records reflected the amount of inventory on hand as
verified by the count.
A comparison of the total annual shrinkage recorded in
petitioners' books (booked shrinkage) to the total shrinkage
verified by actual count (verified shrinkage) during each of the
years demonstrates that petitioners' method of estimation was
reasonable. The following table compares booked shrinkage as a
percentage of sales for the annual accounting period to verified
shrinkage as a percentage of sales for the period between the
physical inventory and the immediately preceding physical
inventory.
Shrinkage as a Percentage of Sales
Year Booked Verified
1983 1.47 1.48
1984 1.11 1.06
1985 1.36 1.37
1986 1.00 1.00
Although this comparison matches shrinkage for the physical
inventory cycle to shrinkage for the taxable year, which is a
different period, we believe that this comparison is appropriate
under the facts herein. Both periods cover the period from the
beginning of the taxable year to the physical inventory dates,
and both amounts of shrinkage relate to sales for the period over
which the shrinkage is measured. Moreover, the combination of
the monthly estimates for the period from the beginning of the
taxable year to the physical inventory date, taking into account
the adjustments made at the time of the physical counts, reflects
- 35 -
the actual shrinkage for the year through the physical inventory
date. For the period from the beginning of the year to the date
of the physical inventory, the estimated shrinkage combined with
the part of the physical inventory adjustment attributable to the
current year was the amount of actual shrinkage for that period
as verified by the physical count. This was so without regard to
any difference between the shrinkage estimate and the actual
shrinkage for the period.
We recognize that the period over which petitioners'
shrinkage can be known with a higher degree of certainty is the
period from physical inventory to physical inventory; i.e., this
is the period over which the amount of shrinkage can be verified
by physical count. Any analysis of this period alone, however,
is inappropriate because it ignores an important part of
petitioners' method of accounting; namely, the adjustment that is
made on the last day of that cycle when the book inventory is
adjusted to the physical count. Yet, if this adjustment is made,
the analysis is unhelpful to us in determining the reasonableness
of the stub period shrinkage estimate because, at the time of the
physical count, petitioners' method of accounting is as precise
as the physical count. Accordingly, any analysis of the physical
inventory cycle alone either ignores a fundamental part of
petitioners' method of annual accounting (i.e., the reconciling
adjustment booked at the time of the physical count) or shows
that the method is accurate at the time of the physical count.
- 36 -
Neither of these analyses properly evaluates the stub period
estimate.
By comparing the unadjusted results from physical
inventories to the adjusted book amounts, the verification
provided by the physical counts helps test the overall accuracy
of petitioners' entire method of accounting for shrinkage, as it
affects petitioners' inventory balances and annual determination
of income. As shown in the above table, petitioners' shrinkage
adjustment to inventories for each taxable year reasonably
represents the amount of shrinkage verified by physical counts
taken in the same year. In the 1986 taxable year, the numbers
are the same. In the 1983 and 1985 taxable years, the numbers
are within .0001 percent. In both 1983 and 1985, the amounts
booked were less than the amount verified by the physical counts.
Only in the 1984 taxable year did the amount booked exceed the
amount verified by physical count, and that overstatement was
only .0005 percent. These modest differences indicate that
petitioners' method of accounting for shrinkage produced
reasonable results. Respondent's determination, by contrast,
would have petitioners omit shrinkage estimates for the subject
years in the respective amounts of $33.6 million, $40.2 million,
$62.1 million, and $67.9 million.
The second way in which the reasonableness of petitioners'
shrinkage estimates can be seen is by understanding the
relationship between shrinkage and sales. Respondent relies on
- 37 -
Dr. Fienberg's testimony to argue that such a relationship does
not exist. We do not find this testimony to be persuasive. We
read the record to support a finding of a relationship between
shrinkage and sales under which a store's shrinkage will increase
or decrease in accordance with its sales. An increase in sales,
for example, results in an increase in purchases, and, as
purchases rise, so do the goods lost in shipment or through
paperwork errors. An increase in sales results in more inventory
being placed on the shelves for sale, and, as the shelf inventory
increases, so do the goods lost through breakage, theft, and
erroneous price changes. An increase in sales results in greater
customer traffic in the store, and, as more customers enter the
store, the ratio of sales personnel to customers declines, making
it more difficult to detect theft. An increase in sales results
in the employment of additional sales personnel, and, as sales
personnel increase, so does employee theft.
With this relationship in mind, we find that the
reasonableness of petitioners' shrinkage estimates is seen
further by comparing: (1) The retail value of shrinkage
estimates for the stub period to the verified shrinkage for the
same period and (2) the individual stub period estimates to the
shrinkage that was attributable to the stub period and that was
verified by a physical count in the next year.9 The verified
9
We compare the following year's physical inventory because
stub period shrinkage is verified through physical inventories
(continued...)
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shrinkage in the stub period can be fairly approximated by
multiplying the verified shrinkage by the ratio of (i) stub
period sales to (ii) sales for the entire physical inventory
cycle. The following table shows this analysis:
Verified Shrinkage Allocable to Stub Period
(in thousands of dollars)
Stub period sales
1983 1984 1985 1986 Total
Parent $2,394,894 $3,207,316 $4,147,484 $5,457,379 $15,207,073
Kuhn's 230,542 299,992 353,714 424,967 1,309,215
Edwards 112,265 150,491 157,650 182,945 603,351
Total 2,737,701 3,657,799 4,658,848 6,065,291 17,119,639
Sales between physical inventories that include stub period
1983 1984 1985 1986 Total
Parent $4,084,989 $5,063,087 $6,951,462 $8,908,722 $25,008,260
Kuhn's 389,005 465,129 551,540 656,671 2,062,345
Edwards 190,890 244,489 266,793 296,036 998,208
Total 4,664,884 5,772,705 7,769,795 9,861,429 28,068,813
Stub period sales as percent of sales between physical inventories
1983 1984 1985 1986 Total
Parent 58.6 63.3 60.0 61.3 60.8
Kuhn's 59.3 64.5 64.1 64.7 63.5
Edwards 58.8 61.6 59.1 61.8 60.4
Overall 58.7 63.4 60.0 61.5 61.0
Total verified shrinkage
1983 1984 1985 1986 Total
Parent $40,663 $67,543 $68,542 $ 99,253 $276,001
Kuhn's 5,532 8,159 6,100 7,302 27,093
Edwards 3,298 3,558 3,353 4,312 14,521
Total 49,493 79,260 77,995 110,867 317,615
9
(...continued)
taken in the following period. For example, the physical
inventory results for the stub period that ended Jan. 31, 1984,
were reflected in the physical inventories taken in the 1984
taxable year.
- 39 -
Verified shrinkage allocated to stub period on basis of percent of sales in stub
period
1983 1984 1985 1986 Total
Parent $23,829 $42,755 $41,125 $60,842 $168,551
Kuhn's 3,280 5,263 3,910 4,724 17,177
Edwards 1,939 2,191 1,982 2,665 8,777
Total 29,048 50,209 47,017 68,231 194,505
We now compare the stub period estimates for each year to the
verified shrinkage allocable to the stub period as it was
reflected in the previous table.
Comparison of Verified Shrinkage to Shrinkage Estimates
(in thousands of dollars)
Verified shrinkage allocated to stub period on basis of percent of sales in stub
period
1983 1984 1985 1986 Total
Parent $23,829 $42,755 $41,125 $60,842 $168,551
Kuhn's 3,280 5,263 3,910 4,724 17,177
Edwards 1,939 2,191 1,982 2,665 8,777
Total 29,048 50,209 47,017 68,231 194,505
Stub period shrinkage estimated
1983 1984 1985 1986 Total
Parent $27,983 $33,996 $54,178 $60,197 $176,354
Kuhn's 4,059 4,056 5,777 5,339 19,231
Edwards 1,556 2,151 2,185 2,364 8,256
Total 33,598 40,203 62,140 67,900 203,841
Over (Under) Estimated
1983 1984 1985 1986 Total
Parent $4,154 $(8,759) $13,053 $(5,707) $2,741
Kuhn's 779 (1,107) 1,867 615 2,154
Edwards (383) (40) 203 (301) (521)
Total 4,550 (9,906) 15,123 (5,393) (4,374)
As illustrated in the second table, our retrospective
allocation of the shrinkage verified by physical count results in
higher or lower shrinkage for each stub period than the shrinkage
estimates at issue herein. We believe that this should be
expected, however, because Wal-Mart did not have the benefit of
- 40 -
hindsight in estimating shrinkage. It also did not have the
results of the subsequent inventories that are used in this
comparison when it made its estimates. All the same, we believe
that our comparison of Wal-Mart's estimates with those made with
the benefit of hindsight helps demonstrate that Wal-Mart's method
is reasonable. Wal-Mart's estimation procedure resulted in
Parent's stores underestimating shrinkage in 2 years (1984 and
1986) and overestimating shrinkage in 2 years (1983 and 1985).
Similarly, Kuhn's and Edwards underestimated shrinkage in some
years and overestimated shrinkage in other years.
We conclude that Wal-Mart's shrinkage estimates clearly
reflect income, and that Wal-Mart has met the second prong of our
two-prong test. We so hold.10 Because respondent has determined
to the contrary, we reverse her determination.
IV. Sam's
The correlation of shrinkage to sales supports Sam's use
of estimates. The reasonableness of Sam's shrinkage estimates
for the 1985 and 1986 taxable years is evident from the data.
During those years, petitioners verified shrinkage through the
physical inventories of Sam's in the amount of $5.236 million.
Over the same period, Sam's recorded sales of $1.912 billion.
Thus, Sam's shrinkage for the 2-year period was approximately
.27 percent of sales, or slightly higher than the .2-percent rate
10
We note that Dr. LaRue has not persuaded us that we
should hold otherwise.
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actually used. We conclude that Sam's shrinkage estimates were
permissible, and we so hold.
In reaching all of our holdings herein, we have considered
all arguments made by respondent for contrary holdings and, to
the extent not discussed above, find them to be irrelevant or
without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.