T.C. Memo. 1997-2
UNITED STATES TAX COURT
THE KROGER COMPANY AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3358-94. Filed January 2, 1997.
P operated supermarkets and convenience stores.
P used “cycle counting” to conduct physical inventories
of merchandise throughout the year. P maintained book
inventory records from which inventory closing balances
could be determined at year’s end. P estimated losses
from shrinkage factors (e.g., theft and errors in
billing) occurring from the time of the last physical
count of inventory to year’s end and made an accrual of
the estimate. P calculated shrinkage accruals as a
percentage of gross sales.
Held: P’s systems of maintaining book inventories
(including the making of shrinkage accruals) conform to
the best accounting practice and clearly reflect
income. They are, thus, sound within the meaning of
sec. 1.471-2(d), Income Tax Regs.
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Frederick H. Robinson, Craig D. Miller, Patricia M.
Lacey, and Gary R. Vogel, for petitioner.
Reid M. Huey, Nancy B. Herbert, Robert J. Kastl,
Jennifer H. Decker, James E. Kagy, Timothy S. Sinnott, and
Richard G. Goldman, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: Respondent has determined deficiencies in
petitioner’s Federal income tax liabilities for the years 1984,
1985, and 1986 in the amounts of $7,152,527, $1,772,936, and
$1,668,392, respectively. The parties have reached agreement on
certain issues, and the only issue remaining for our
consideration is the soundness of certain of petitioner’s
accounting systems that allow for the accrual of an estimate of
losses from shrinkage factors (e.g., theft and errors in billing)
in determining book inventories.
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
FINDINGS OF FACT
Some facts have been stipulated and are so found. The
stipulations of fact filed by the parties and the accompanying
exhibits are incorporated herein by this reference. The parties
have made approximately 450 separate stipulations of fact,
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occupying over 100 pages, and there are 143 accompanying
exhibits. We will set forth only those stipulated facts that are
necessary to understand our report, along with other facts that
we find.
I. Background
A. Kroger
The Kroger Co. (Kroger) is an Ohio corporation, with its
principal place of business in Cincinnati, Ohio. Kroger is the
common parent corporation of an affiliated group of corporations
making a consolidated return of income. For itself, and as sole
agent for each member of the affiliated group, Kroger filed the
petition giving rise to this case. (In the papers filed in this
case, the convention of the parties has been to use the term
“petitioner” to refer to the affiliated group as a whole (as,
from time to time, it was constituted). We will adopt that
convention.)
Petitioner’s principal business activities are the operation
of supermarkets and convenience stores and the distribution and
sale of drug and general merchandise. During the years in issue,
petitioner operated one of the nation’s largest supermarket
chains, measured by total sales, and one of the nation’s largest
drug store chains. Kroger, itself, was in the retail food
business, operating numerous grocery product warehouses and
supermarkets. Kroger generated over $11 billion in annual sales
from its supermarkets during each of the years in issue. Superx,
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which operated a chain of drug and general merchandise stores
throughout the United States, was a wholly owned subsidiary
corporation of Kroger. Superx generated over $800 million in
annual sales during each of the years in issue. Florida Choice,
which operated a chain of supermarkets in Florida, was a division
of Superx. Florida Choice generated over $100 million in annual
sales during each of the years in issue. (Hereafter, for
convenience, we will refer to Kroger (but only with respect to
its retail operations), Superx, and Florida Choice, collectively,
as the retailers.)
B. Accounting Practices
Petitioner’s annual accounting period and taxable year was a
52/53-week year ending on the Saturday closest to December 31.
The retailers used the accrual method of accounting for both
Federal income tax and financial reporting purposes. Gross
income was calculated using inventories to account for the
purchase and sale of merchandise. Book inventories were
maintained to determine closing inventories for taxable years for
which no physical inventories were taken at year's end.
Gross income, in a merchandising business, means gross
receipts for the period in question less cost of goods sold, plus
any income from investments and from incidental or outside
sources. Cost of goods sold, slightly simplified, equals opening
inventory plus inventory purchased during the period minus
closing inventory.
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During the years in issue, the retailers used “cycle
counting” to conduct physical inventories of merchandise. Cycle
counting is a method of conducting physical inventories at
individual stores, in rotation, throughout the year. Most large
retail companies, including grocery and drug retailers, do not
perform a physical count of inventory on or near the last day of
the annual accounting period. Large retailers prefer cycle
counting to yearend counting because it is more accurate and
less expensive and provides better inventory control. Cycle
counting is also more efficient and practical in terms of the
availability of internal resources and outside services to
conduct physical inventories. With few exceptions, the retailers
took no physical inventories at the end of any of the years in
issue.
The retailers maintained “perpetual” or other book inventory
records (without distinction, book inventory records) from which
inventory could be determined without a physical count.
Inventory determined from book inventory records often differs
from inventory determined by physical count. When inventory is
determined from book inventory records (computed without any
accrual for estimated shrinkage), and the inventory so determined
exceeds inventory determined by physical count, the difference is
termed “shrinkage”. When book inventory so determined is
exceeded by inventory determined by physical count, the
difference is termed “overage”.
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Shrinkage and overage (hereafter, generally, shrinkage) are
attributable to a variety of factors, the total number of which
cannot be quantified, including the following:
1. theft of merchandise (by employees, customers, and
vendors);
2. unrecorded or improperly recorded losses of merchandise
due to spoilage, breakage, and other damage;
3. unit discrepancies in goods received from and/or
returned to vendors;
4. failure to ring or record the proper price upon sale of
merchandise;
5. errors in recording retail prices (including price
changes) on a taxpayer’s perpetual record;
6. errors in marking and changing prices on merchandise;
7. failure to properly record returns by customers;
8. errors in conducting the physical inventory (including
both unit errors and pricing errors);
9. errors in processing paper (including price-change
documents, invoices, and merchandise transfers); and
10. errors in billing and other computer systems.
The retailers experienced some or all of the factors listed
(shrinkage factors) during the years in issue. The occurrence of
shrinkage factors is not limited to particular times during the
year, but, generally, each of the factors occurs throughout the
year.
C. Accounting for Shrinkage
If inventory is not physically counted at the end of the
annual accounting period (year), shrinkage (as defined above)
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cannot be determined for the period from the last physical count
to the end of the year (the physical-to-yearend period). If
cycle counting is used, and the cycle for a particular store does
not end on the last day of the year, then losses from shrinkage
factors for the physical-to-yearend period (yearend shrinkage)
must be estimated if such yearend shrinkage is to be taken into
account.
For each of the years in issue, the retailers estimated and
accrued yearend shrinkage (that estimate and accrual hereafter
being referred to as shrinkage accrual). Such shrinkage accruals
were added to the other data constituting the retailers’ book
inventory records, which were used to determine yearend
inventories. Shrinkage accruals reduced yearend inventories,
which had the effect of increasing cost of goods sold and, as a
result, decreasing gross income.
In determining yearend inventories, the retailers would, in
addition to taking into account shrinkage as determined by
physical count of inventory during the year (1) subtract
shrinkage accrual as of that year’s end and (2) add shrinkage
accrual as of the prior year’s end. Errors in estimating
shrinkage accrual would be subject to correction in the
subsequent year because of the addition of the prior year’s
shrinkage accrual to the subsequent year’s ending inventory. The
retailers calculated shrinkage accrual as a percentage of gross
sales. In the retail industry, the practice of making shrinkage
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accruals, and of calculating such accruals as a percentage of
sales, is the prevalent, if not the virtually universal,
practice; it is the best practice in that industry.
Respondent disallowed the retailers’ shrinkage accruals.
That had the consequence of decreasing cost of goods sold and, as
a result, increasing gross income. Respondent has proposed
deficiencies based upon that increased income.
II. KFS Division of Kroger
A. General Operations
Kroger managed its grocery products warehouses and
supermarkets on a geographic basis as Kroger Marketing Areas
(KMAs). A KMA contained between 34 and 161 supermarkets. The
KMAs were part of the Kroger Food Stores Division of Kroger (the
KFS division). Altogether, the KFS division operated between
1,000 and 1,500 supermarkets between 1979 and 1992. Each KMA had
its own management organization, which was part of the Kroger
management structure. Management of each KMA reported to
corporate management in Kroger’s general office (the Kroger
general office). The Kroger general office set the policies that
governed the operation of the KMAs. After 1984, Florida Choice,
although a division of Superx, was treated as a KMA for certain
accounting purposes.
B. Accounting Methods and Procedures
The accounting methods and procedures used by each KMA were
prescribed by the Kroger general office. Pertinent aspects of
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those methods and procedures for the years in issue were as
follows.
1. Departments
Store inventories were divided into departments and
subdepartments. Shrinkage accrual was made only for the grocery,
drug/general merchandise, and cosmetics departments.
2. Retail Method of Inventory Valuation
The retail method of valuing inventory was used by the KFS
division for store inventories in the grocery, drug/general
merchandise, and cosmetics departments. Under the retail method,
the cost of goods sold is estimated by multiplying sales revenue
by the “cost complement”. That technique translates the retail
dollar value of the goods sold into its approximate cost dollar
value.
3. LIFO
Beginning with 1979, Kroger elected to use the last-in-
first-out (LIFO) method of accounting. Kroger valued its
inventories in stores and warehouses using the dollar value, link
chain method of implementing LIFO. The KFS division also elected
to use statistical sample techniques to determine the dollar
value indexes. The KFS division initially used a single LIFO
pool for all items in the grocery, drug/general merchandise, and
cosmetics departments. Beginning with 1986, the KFS division
allocated its single pool into nine pools.
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4. Shrinkage Accruals
The KFS division accounting policy for estimating shrinkage
accrual was as follows:
For each store in which no physical inventory is taken
during a period, a shrinkage and spoilage loss will be
accrued for each department:
a. At the beginning of each year determine the
KMA rate of shrinkage and spoilage, at
retail, for the previous year for each
department.
b. From this experience and evidence of trend,
estimate the percentage (to the nearest
hundredth of one percent) expected for the
KMA for the current year for each department.
c. Use the estimated percentages for all stores
for the current year. If a change in rate
appears desirable within the year request
approval of a change from the Corporate
Accounting Policy and Methods Department. No
approval is required to change the
percentages at the beginning of the year.
C. Management of Shrinkage
Minimization of shrinkage factors was a management goal
common to all KMAs. Detailed records were maintained in the KMAs
on the incidence (cost) of shrinkage factors. Records were
maintained by store and by store manager. Control (minimization)
of shrinkage factors was an important criterion in assessing the
performance of a store manager. A store manager could be fired
or might not be promoted for failure to minimize shrinkage
factors. Programs were continually developed and implemented to
control shrinkage factors.
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During the years in issue, the incidence of shrinkage
factors varied among stores, among departments within stores, and
among KMAs. Overages were, on occasion, recorded by individual
stores and, in some years, on a net basis by entire KMAs, but
never for the KMAs together. No accrual was made to reflect an
expectation of overage. From 1984 through 1987, in the face of
recurring overages, the Michigan KMA did not make shrinkage
accruals.
The management of each KMA determined shrinkage accrual
rates to be used throughout that KMA. Judgment played a large
role in determining shrinkage accrual rates. Factors that would
be taken into account included experience with shrinkage factors,
store sizes, merchandising techniques, regional differences, and
recent shrinkage trends. A separate percentage rate was
determined for each department for which a shrinkage accrual was
made.
D. Physical Inventories
From 1984 through 1992, the KFS division conducted an
average of 2.3 physical inventories a year in each store.
III. Florida Choice
Florida Choice, although a division of Superx, was operated
as if it were a part of the KFS division. During the years in
issue, Florida Choice’s chain of supermarkets grew from 22 to
30 stores.
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During the years in issue, Florida Choice followed the same
KFS division accounting methods and procedures utilized by the
KMAs. Florida Choice followed the shrinkage accrual practices
and procedures applicable to the KFS division to determine its
shrinkage accrual rate as if it were a KMA.
During 1984, Florida Choice conducted an average of three
physical inventories a store. In 1985 and 1986, the average was
two inventories a store.
IV. Superx
A. General Operations
During the years in issue, Superx operated between 185 and
621 drug and general merchandise stores.
Superx had its own management organization. Superx’s
management reported to corporate management in the Kroger general
office. The Kroger general office set the policies that governed
the general operations of Superx.
B. Accounting Methods and Procedures
1. Booking Rate Calculations
Inventory was reflected on Superx’s inventory accounts at
cost and not at retail.
To calculate gross income of each store (and each department
within a store) for the physical-to-yearend period, Superx
multiplied sales during that period by a percentage known as the
“booking rate”. That process was similar to Kroger’s retail
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method. Superx determined the booking rate by calculating a
company key rate from cost price data obtained from 80 selected
stores. The booking rate represented the percentage of each
dollar of sales that represented gross profit. Gross income was
further reduced by shrinkage accrual.
Cost of sales was computed by multiplying sales by the
percentage equal to (1) 100 percent less (2) the applicable
booking rate. That amount was used to reduce inventory.
2. LIFO
For its 1984 and 1985 years, Superx used the dollar value
LIFO method of calculating its inventories, using five LIFO
pools. It excluded optical centers, deli, restaurants, liquor,
and inventories maintained by Florida Choice from its LIFO
method. It discontinued the LIFO method for its 1986 tax year.
3. Shrinkage Accruals
Superx made shrinkage accruals for all of its departments
except its optical departments. Superx developed a single
shrinkage accrual rate, which was expressed as a percentage of
gross sales and used by all of Superx’s drug stores (and applied
uniformly, although yielding different shrinkage accruals
depending on a store’s sales).
Superx’s shrinkage accrual rate was determined at Superx
headquarters. Superx management primarily examined historical
shrinkage experience and recent shrinkage trends at the company
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level in determining Superx's shrinkage accrual rate. Individual
store managers could not use a different rate. Between 1981 and
1986, shrinkage accrual rates, as a percentage of gross sales,
varied between 2.1 percent and 2.5 percent.
C. Management of Shrinkage
Controlling shrinkage factors was a significant concern of
Superx management. Store managers could be fired, or their
compensation reduced, for failure to control shrinkage factors.
Superx maintained a risk management department, which performed
field audits to see that procedures to reduce shrinkage factors
were in place and performed analyses of shrinkage factors to aid
in control of such factors.
D. Physical Inventories
During 1983 and 1984, Superx conducted an average of 1.7
physical inventories a year in each store. In 1985, the average
was 1.6 inventories a store.
OPINION
I. Introduction
Petitioner’s principal business activities are the operation
of supermarkets and convenience stores and the distribution and
sale of drug and general merchandise. We are concerned here with
(1) the Kroger Food Stores Division of Kroger (the KFS division),
(2) Florida Choice, a division of Superx, which operated a chain
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of supermarkets, and (3) Superx, a subsidiary corporation of
Kroger, which operated a chain of drug and general merchandise
stores (collectively, the retailers).
During the years in issue, the retailers used cycle counting
to conduct physical inventories of merchandise. Under the cycle
counting method, physical inventories were taken in rotation, at
the various stores, throughout the year. Also, the retailers
maintained book inventory records from which inventories could be
determined without a physical count. The retailers estimated
losses from shrinkage factors (e.g., theft and errors in billing)
during the physical-to-yearend period (yearend shrinkage) and
made an accrual of that estimate (shrinkage accrual). That
practice had the effect of increasing cost of goods sold and
decreasing gross income.
Respondent disallowed the retailers’ shrinkage accruals, and
we must determine whether that disallowance was an abuse of
discretion.
II. Statute and Principal Regulation
Section 471(a) provides the following general rule:
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.[1]
1
The Tax Reform Act of 1986, Pub. L. 99-514, sec. 803(b)(4),
(continued...)
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As the regulations point out, section 471(a) establishes two
distinct tests to which an inventory must conform:
(1) It must conform as nearly as may be to the
best accounting practice in the trade or business, and
(2) It must clearly reflect the income.
Sec. 1.471-2(a), Income Tax Regs.
In accordance with the authority provided by section 471(a),
the Secretary has promulgated rules for taxpayers maintaining a
perpetual (book entry) system of keeping inventories. In
pertinent part, section 1.471-2(d), Income Tax Regs., reads as
follows:
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 * * * 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.
III. Dayton Hudson Corp. & Subs. v. Commissioner
In Dayton Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462
(1993), respondent determined a deficiency in the taxpayer’s
Federal income tax because, in computing its yearend book
(...continued)
100 Stat. 2356, designated the quoted language as sec. 471(a).
Before amendment, the quoted language was the entirety of sec.
471.
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inventories, the taxpayer made a shrinkage accrual. In the
Dayton Hudson case, which was before us on the Commissioner’s
motion for summary judgment, we held that section 1.471-2(d),
Income Tax Regs., as a matter of law, does not prohibit making a
shrinkage accrual in computing book inventories. We
acknowledged, however, that the Commissioner might yet argue that
the taxpayer’s accounting system, including the making of
shrinkage accruals, is not “sound” within the meaning of the
regulations, or fails to clearly reflect income. Id. at 468.
Here, respondent acknowledges our holding in the Dayton
Hudson case, but she does not agree that it is correct. We
adhere to that holding.
IV. Are the Retailers’ Systems of Accounting for Inventories,
Including the Use of Shrinkage Accruals, Sound?
Because the retailers used cycle counting to conduct
physical inventories of merchandise, and no count was taken at
year’s end, the retailers necessarily had to maintain book
inventory records to determine yearend inventories for purposes
of computing cost of goods sold. Those book inventories included
an entry for shrinkage accrual. We must determine whether those
book inventories were maintained in accordance with a “sound
accounting system”. Sec. 1.471-2(d), Income Tax Regs.
The question of what constitutes a “sound accounting system”
under section 1.471-2(d), Income Tax Regs., has not been answered
by the courts. Section 1.471-2(a), Income Tax Regs., however,
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provides two specific requirements with which acceptable
inventory practices must conform. First, such practices must
conform as nearly as may be to the best accounting practice in
the industry. Second, the practices must clearly reflect the
taxpayer’s income. Section 1.471-2(b), Income Tax Regs., adds
consistency of application from year to year as an important and
explicit element of inventory practices that clearly reflect
income. The use of the adjective “sound” in section 1.471-2(d),
Income Tax Regs., does not introduce an additional standard, but
only incorporates the previously articulated standards, with the
emphasis on the “system” or methodology employed to maintain book
inventories. Our inquiry, then, is, principally, whether the
retailers' systems of maintaining book inventories (including the
making of shrinkage accruals) conform to the best accounting
practice and clearly reflect income. Indeed, the principal point
relied on by respondent on brief is that “Petitioner’s methods of
estimating inventory shrinkage * * * failed to clearly reflect
income.”
V. Best Accounting Practice
The parties have stipulated that, for financial accounting
purposes, petitioner’s financial statements for the years in
issue were consistent with generally accepted accounting
principles (GAAP). In Thor Power Tool Co. v. Commissioner, 439
U.S. 522, 532 (1979), the Supreme Court stated that the phrase
“best accounting practice”, as it appears in section 471(a) (and
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section 1.471-2(a), Income Tax Regs.), is synonymous with GAAP.
Petitioner followed the same accounting practices for both
Federal income tax and financial reporting purposes. We find,
therefore, that the retailers’ systems of book inventories
conform to the best accounting practice within the meaning of
section 471(a) and section 1.471-2(a), Income Tax Regs.
VI. Clear Reflection of Income
A. Methods of Accounting and the Legal Requirement of
Clear Reflection of Income
The general rule for methods of accounting is set forth in
section 446(a):
Taxable income shall be computed under the method of
accounting on the basis of which the taxpayer regularly
computes his income in keeping his books.
A taxpayer has latitude, however, in selecting a method of
accounting. Section 1.446-1(a)(2), Income Tax Regs., provides:
It is recognized that no uniform method of accounting
can be prescribed for all taxpayers. Each taxpayer
shall adopt such forms and systems as are, in his
judgment, best suited to his needs. * * *
The accrual method is a permissible method of accounting.
Sec. 446(c). Section 1.446-1(c)(1)(ii)(A), Income Tax Regs.,
provides:
Generally, under an accrual method, income is to be
included for the taxable year when all the events have
occurred that fix the right to receive the income and
the amount of the income can be determined with
reasonable accuracy. Under such a method, a liability
is incurred, and generally is taken into account for
Federal income tax purposes, in the taxable year in
which all the events have occurred that establish the
fact of the liability, the amount of the liability can
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be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability.
* * *
The term “liability”, as used in section 1.446-1(c)(1)(ii)(A),
Income Tax Regs., is defined in section 1.446-1(c)(1)(ii)(B),
Income Tax Regs., to include “a cost taken into account in
computing cost of goods sold”.
Notwithstanding the latitude generally enjoyed by a taxpayer
in selecting a method of accounting, where inventories are
employed, accrual accounting is the general rule to account for
purchases and sales:
Where inventories are employed, purchases and sales
must be computed on the accrual method (unless another
method is authorized by the Commissioner) in order to
avoid the distortion of income. Sec. 1.446-1(c)(2),
Income Tax Regs.; Stoller v. United States, 162 Ct. Cl.
839, 845, 320 F.2d 340, 343 (1963).
Molsen v. Commissioner, 85 T.C. 485, 499 (1985).
In any event, a taxpayer’s right to adopt a method of
accounting is subject to the requirement that the method must
clearly reflect income. Section 446(b) states that, if the
method adopted “does not clearly reflect income, the computation
of taxable income shall be made under such method as, in the
opinion of the Secretary, does clearly reflect income.” See also
sec. 1.446-1(c)(1)(ii)(C), Income Tax Regs.
The term “clearly reflect income” is undefined in the Code.
In most cases, generally accepted accounting principles,
consistently applied, will pass muster for tax purposes. See,
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e.g., sec. 1.446-1(a)(2), (c)(1)(ii), Income Tax Regs. The
Supreme Court has made clear, however, that GAAP does not enjoy a
presumption of accuracy that must be rebutted by the
Commissioner. Thor Power Tool Co. v. Commissioner, supra at 540.
The Commissioner’s supervisory power under section 446(b),
permitting her to reject a taxpayer’s method if it “does not
clearly reflect income”, and to substitute a method that, “in the
opinion of the * * * [Commissioner], does clearly reflect
income”, was described by the Supreme Court in another case as
leaving “[m]uch latitude for discretion”, which “should not be
interfered with [by the courts] unless clearly unlawful.” Lucas
v. American Code Co., 280 U.S. 445, 449 (1930) (quoted with
approval in Thor Power Tool Co. v. Commissioner, supra at 532).
B. Standard of Review
When the Commissioner determines that a taxpayer's method of
accounting does not clearly reflect income, the taxpayer has a
heavy burden to show that the Commissioner abused her discretion.
E.g., Asphalt Products Co. v. Commissioner, 796 F.2d 843, 848
(6th Cir. 1986), affg. in part and revg. in part Akers v.
Commissioner, T.C. Memo. 1984-208, revd. per curiam on another
issue 482 U.S. 117 (1987). An appeal in this case will likely
lie in the Court of Appeals for the Sixth Circuit. That court
has said:
§ 446 gives the Commissioner discretion with respect to
two determinations. The Commissioner first determines
whether the accounting method chosen by a taxpayer
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clearly reflects income. If the Commissioner concludes
that the taxpayer's chosen method does not meet this
standard, he has the further discretion to require that
computations be made under the method which, in his
opinion, does clearly reflect income. It would be
difficult to describe administrative discretion in
broader terms.
Id. at 847.
Notwithstanding the authority conferred under section
446(b), the Commissioner cannot require a taxpayer to change to
another method where the taxpayer's method of accounting does
clearly reflect income, even if the method proposed by the
Commissioner more clearly reflects income. Ford Motor Co. v.
Commissioner, 71 F.3d 209, 213 (6th Cir. 1995), affg. 102 T.C. 87
(1994); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 371 (1995); Hospital Corp. of America v. Commissioner, T.C.
Memo. 1996-105. Nor will the courts approve the Commissioner's
change of a taxpayer's accounting method from an incorrect method
to another incorrect method. Harden v. Commissioner, 223 F.2d
418, 421 (10th Cir. 1955), revg. 21 T.C. 781 (1954); Prabel v.
Commissioner, 91 T.C. 1101, 1112 (1988), affd. 882 F.2d 820 (3d
Cir. 1989); see also Southern California Sav. & Loan v.
Commissioner, 95 T.C. 35, 44 (1990) (Wells, J., concurring)
("Section 446(b) authorizes respondent to require accounting
changes that produce clearer reflections of income, not greater
distortions of income"). Therefore, in order to prevail in a
case where the Commissioner determines that a taxpayer's method
of accounting does not clearly reflect income, the taxpayer must
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demonstrate either that his method of accounting clearly reflects
income or that the Commissioner's method does not clearly reflect
income. See Asphalt Products Co. v. Commissioner, supra at 847.
C. Retailers' Shrinkage Method
The retailers maintained book inventory records from which
yearend inventories could be determined. Losses for the taxable
year occasioned by shrinkage factors (taxable year shrinkage)
were reflected in the retailers’ book inventory records under a
method (the retailers’ shrinkage method) involving three
variables: (1) shrinkage verified by physical inventories during
the taxable year, (2) shrinkage accrual for the taxable year, and
(3) shrinkage accrual for the prior year. The retailers
calculated shrinkage accruals as a percentage of sales.
Shrinkage accrual rates for each department within a KMA and for
Florida Choice were based on a combination of factors including
experience with shrinkage factors, store sizes, merchandising
techniques, regional differences, and recent shrinkage trends.
Rates for Superx were primarily based on historical shrinkage
experience and recent shrinkage trends at the company level.
Prior year shrinkage accrual was subtracted from the amount of
shrinkage determined by the first physical inventory of the
taxable year; that adjustment purported to calibrate shrinkage
figures so as to provide an estimate of taxable year shrinkage.
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D. Petitioner’s Expert Testimony
1. Introduction
Petitioner relies on expert testimony to demonstrate that
the retailers' shrinkage method clearly reflects income. In
particular, petitioner relies on such testimony to demonstrate a
strong correlation between sales and shrinkage, which correlation
underlies the retailers’ shrinkage accruals. Petitioner presents
the expert testimony of Charles E. Bates, Ph.D. Dr. Bates is the
director of economic litigation services for the Economic
Consulting Services Group at KPMG Peat Marwick LLP. He is
experienced in statistics, econometric modeling, and economic
analysis.
2. Correlation Between Sales and Shrinkage
Statistical correlation is a measure of the degree to which
two variable quantities tend to change with respect to each
other. Correlations are expressed in a range between positive
one and negative one. A correlation of positive one indicates
that the two quantities change in exact proportion and in the
same direction, whether up or down. A correlation of zero
indicates that the two quantities change without reference to
each other. A correlation of negative one indicates that the two
quantities change in exact proportion, but in opposite
directions: When one goes up, the other goes down.
- 25 -
Dr. Bates is of the opinion that the correlation between
sales and shrinkage is strong. Dr. Bates is also of the opinion
that the “business level” is the appropriate level to test the
relationship of sales to shrinkage. Dr. Bates uses the term
“business level” to refer, individually, to the aggregate
operations of the KFS division, the aggregate operations of
Florida Choice, and the aggregate operations of Superx. Dr.
Bates acknowledges that correlation can be tested at other
levels, e.g., the department level within a store, the store
level, or, even, at the level of the “entire Kroger corporate
entity”. Dr. Bates believes that the business level is
appropriate because that is the level at which taxable income is
computed.
Dr. Bates bases his opinions of strong correlation on the
application of two methods to measure the correlation between
sales and shrinkage at the business level. The first method
derives the correlation between sales and shrinkage from
aggregate data at the business level. The second method derives
the correlation between sales and shrinkage from individual
inventory records at the store level. Dr. Bates is of the
opinion that, for the years he examined, the correlation between
sales and shrinkage is (1) at least 0.91 for the KFS division,
(2) at least 0.89 for Florida Choice, and (3) at least 0.94 for
Superx.
- 26 -
3. Yearend Shrinkage
Dr. Bates is of the opinion that losses from shrinkage
factors occur during the physical-to-yearend period. That
proposition is not as simple to demonstrate as one might think.
The problem, of course, is that, although losses on account of
shrinkage factors will be demonstrated by physical count at the
end of an accounting period, the lack of intervening physical
counts makes it impossible to demonstrate the distribution of
those losses within the period.
Dr. Bates primarily derives his opinion by deduction from
two premises: (1) sales occur during the physical-to-yearend
period and (2) there exists a strong correlation between sales
and shrinkage. In other words, he concludes that, because there
are sales during the physical-to-yearend period, and there is a
statistical relationship between sales and shrinkage, it is
likely that losses from shrinkage factors occur during the
physical-to-yearend period. He conducted two additional tests,
however, which gave him more evidence to support his conclusion.
First, he compared shrinkage among inventory cycles with
physical-to-yearend periods of differing lengths. Second, he
applied a conventional statistical analysis to test for the
occurrence of yearend shrinkage.
- 27 -
4. Shrinkage Accrual Accuracy Analysis
Dr. Bates is of the opinion that yearend shrinkage can
reasonably be estimated by allocating a portion of the shrinkage
revealed by the next physical count to the physical-to-yearend
period. Dr. Bates has made such estimates in order to test the
accuracy of the retailers’ shrinkage accruals. He concludes
that, for each of the retailers, annual losses, in the aggregate,
claimed on account of shrinkage factors are within 5 percent of
taxable year shrinkage based on an allocation of cross-year
inventory shrinkage as a function of both sales and time.
Dr. Bates knew the amount of losses from inventory cycles
wholly within a taxable year. To that sum he added (1) an
allocation of the shrinkage determined by the physical inventory
first taken during the taxable year and (2) an allocation of the
shrinkage determined by the physical inventory first taken during
the next taxable year. That calculation provided his estimate of
taxable year shrinkage. Dr. Bates calculated taxable year
shrinkage using sales to allocate shrinkage to the relevant
portions of cross-year inventory cycles (sales-based taxable year
shrinkage). To provide an alternative estimate of actual
shrinkage, Dr. Bates calculated taxable year shrinkage using a
time-based allocation method (time-based taxable year shrinkage).
That approach allowed him to have a second way to test the
accuracy of the losses from shrinkage factors that the retailers
reported for tax purposes.
- 28 -
Dr. Bates compared his estimates of taxable year shrinkage
with the losses claimed by the retailers for Federal income tax
purposes. He performed the same calculations to determine the
accuracy of respondent's method of reflecting shrinkage factors,
which would allow no shrinkage accrual, but would take account of
shrinkage only in the year when demonstrated by physical count.
Dr. Bates made these comparisons using estimates of taxable year
shrinkage based on both sales and time. The results of Dr.
Bates' calculations and analyses are set forth in an appendix to
this opinion.
Dr. Bates determined that the accounting system utilized by
the KFS division for Federal income tax purposes produced, in the
aggregate, a net underestimate for the years 1984 through 1991 of
1.8 percent of sales-based taxable year shrinkage and 1.7 percent
of time-based taxable year shrinkage. He determined that
respondent's method produced a net underestimate of 4.4 percent
of sales-based taxable year shrinkage and 4.3 percent of time-
based taxable year shrinkage. In addition, Dr. Bates determined
that the maximum error under respondent’s method was 15.6 percent
of sales-based taxable year shrinkage and 15.7 percent of time-
based taxable year shrinkage (compared to 11.4 percent and 11.2
percent, respectively, under the system utilized by the KFS
division). He concludes that respondent’s method is less
accurate than that used by the KFS division.
- 29 -
Dr. Bates determined that the accounting system utilized by
Florida Choice produced, in the aggregate, a net underestimate
for the years 1984 through 1988 of 3.9 percent of sales-based
taxable year shrinkage and 2.9 percent of time-based taxable year
shrinkage. He determined that respondent's method produced a net
underestimate of 6.1 percent of sales-based taxable year
shrinkage and 5.2 percent of time-based taxable year shrinkage.
Dr. Bates determined that the maximum error under respondent’s
method was 20.2 percent of sales-based taxable year shrinkage and
20.5 percent of time-based taxable year shrinkage (compared to
12.3 percent and 14.0 percent, respectively, under the system
utilized by Florida Choice). He concludes that respondent’s
method is less accurate than that used by Florida Choice.
Dr. Bates determined that the accounting system utilized by
Superx produced, in the aggregate, a net underestimate for the
years 1983 through 1985 of 4.7 percent of sales-based taxable
year shrinkage and 4.5 percent of time-based taxable year
shrinkage. He determined that respondent's method produced a net
underestimate of 7.1 percent of sales-based taxable year
shrinkage and 6.8 percent of time-based taxable year shrinkage.
Dr. Bates determined that the maximum error under respondent’s
method was 9.4 percent of sales-based taxable year shrinkage and
9.8 percent of time-based taxable year shrinkage (compared to 6.1
percent and 5.4 percent, respectively, under the system utilized
- 30 -
by Superx). Dr. Bates concludes that respondent’s method is less
accurate than that used by Superx.
E. Respondent's Expert Testimony
Respondent offered rebuttal expert testimony of Donald M.
Roberts, Ph.D., a professor of decision and information sciences
at the University of Illinois. Dr. Roberts had been asked to
examine the statistical basis of Dr. Bates’ conclusion that the
correlation between sales and shrinkage for the KFS division for
the period 1984 through 1992 was 0.91. Dr. Roberts confirmed
that the correlation was 0.91. In his rebuttal report, Dr.
Roberts does not offer any criticism of Dr. Bates’ opinion that
losses from shrinkage factors occur during the physical-to-
yearend period or undermine Dr. Bates' shrinkage accrual accuracy
analysis. Dr. Roberts’ own opinion is that the correlation
between sales and shrinkage is generally low and that sales do
not provide a reasonable basis for estimating inventory
shrinkage. Dr. Roberts had been asked to examine sales and
shrinkage only for the KFS division. He examined data at the
department level within stores in the KMAs. He computed
correlations for each department for the years 1984, 1985, and
1986. He also computed correlations for each department within
each KMA for the period 1984 through 1992.
Petitioner offered additional expert testimony of Dr. Bates
in rebuttal to Dr. Roberts’ opinion that the correlation between
sales and shrinkage is generally low and that sales do not
- 31 -
provide a reasonable basis for estimating inventory shrinkage.
Dr. Bates’ principal criticism of Dr. Roberts’ conclusion is that
Dr. Roberts’ correlations are not relevant to analyzing the
accuracy of the KFS division shrinkage accruals because Dr.
Roberts’ correlations measure the tendency of shrinkage to vary
in proportion to sales from inventory to inventory and store to
store within each department and KMA rather than the tendency of
annual shrinkage for the business to vary in proportion to annual
sales for the business. Dr. Bates is of the opinion that it is
correlation of year-to-year changes in business level shrinkage
and sales that is relevant to determining the accuracy of
shrinkage accruals. Dr. Bates states: “[Dr. Roberts’] more
restricted conclusion is technically correct, but irrelevant for
assessing the propriety of accruing shrinkage as a percentage of
sales for tax purposes.”
In his oral testimony, Dr. Roberts made clear to us the
limitations of any conclusions to be drawn from a consideration
of statistical correlation. A strong correlation between two
variables (e.g., shrinkage and sales) does not necessarily mean
that one can predict the value of one variable (e.g., shrinkage)
based on the value of the other (e.g., sales). To say that there
is a strong correlation between two variables means only that
there is a strong linear relationship between the two.
Neither Dr. Bates nor Dr. Roberts finds the other's
computation of correlation inconsistent with his own. That is
- 32 -
explained by the fact that they chose to correlate different
variables. Each, however, has gone another step (beyond
correlation) and ventures an opinion as to the predictability of
shrinkage based on sales. Not surprisingly, they have reached
different opinions. While we cannot fully reconcile those
different opinions, Dr. Bates, principally by way of his rebuttal
report, has persuaded us that the low correlations found by Dr.
Roberts are not inconsistent with Dr. Bates’ opinion as to the
accuracy of sales as a predictor of shrinkage at the business
level. More importantly, Dr. Roberts has not persuaded us that
the low department level correlations found by him are
determinative of the question of clear reflection of taxable
income. Moreover, Dr. Roberts has failed to rebut Dr. Bates’
opinion that losses from shrinkage factors occur during the
physical-to-yearend period or to undermine Dr. Bates’ shrinkage
accrual accuracy analysis.
At this point, it is sufficient to say that we attach
credence to Dr. Bates’ analysis and are convinced that, at the
business level, sales have value as a predictor of shrinkage. We
will consider the weight to be accorded to Dr. Bates' conclusions
infra.
- 33 -
F. Shrinkage Accruals and LIFO
The shrinkage accruals made by the retailers were only
estimates, and because they were estimates, they were subject to
error. We have found that errors in estimating shrinkage
accruals were subject to correction in the subsequent year
because of the addition of the prior year’s shrinkage accrual to
the subsequent year’s ending inventory. Respondent argues,
however, that the additional demands associated with the
retailers’ use of LIFO “compounds” the errors inherent in making
shrinkage accruals.
Respondent presents the expert testimony of David W. LaRue,
Ph.D., an associate professor of commerce at the University of
Virginia, who testified to, among other things, the “tax effects”
resulting from the accrual of erroneous estimates of undetected
shrinkage for the KFS division. Dr. LaRue examined the KFS
division’s practice of making shrinkage accruals. He designed
simulation models to analyze shrinkage estimation errors under
the retail dollar value LIFO method used by the KFS division. He
concluded that the process of making subsequent year corrections
was inadequate because of changes in factors such as LIFO
inflation adjustment factors and retail method cost complement
factors. Respondent also presented the report and testimony of
William R. Sutherland, Esq., an attorney and accountant.
Mr. Sutherland came to essentially the same conclusions for
Superx that Dr. LaRue came to for the KFS division.
- 34 -
Both Dr. LaRue and Mr. Sutherland concede, however, that
respondent’s adjustments--which disallow the retailers' shrinkage
accruals--would produce exactly the same types of errors if there
were undetected yearend shrinkage. Indeed, the magnitude of such
errors under respondent’s method might well be greater because of
respondent’s failure to account for trends or other factors
applicable to the taxable year.
In any event, respondent’s proposed adjustments will not
eliminate the flaws perceived by respondent’s experts. It
appears that only the practice of yearend physical inventories at
all stores could eliminate such errors. That, however, would not
be practical, nor is it required by the regulations. See sec.
1.471-2(d), Income Tax Regs.
G. Retailers' Shrinkage Method Compared to Respondent's
Method
Respondent's method would permit the retailers to account
for losses from shrinkage factors only when such losses are
verified by physical inventories. Respondent claims that her
"method is nothing more than the application of the principle
that taxpayers may not reduce income by unverified losses or
expenditures, or unreliable estimates." Respondent states that
"any alternative method of estimating shrinkage imposed by
Respondent would have been wholly arbitrary since it would not
clearly reflect income."
- 35 -
Upon closer analysis, we conclude that respondent's method
essentially estimates yearend shrinkage for the taxable year
based on yearend shrinkage for the prior taxable year.
Respondent's method would adjust the retailers' book inventories
by disallowing any shrinkage accrual. If we were to sustain
respondent's disallowance, the retailers would compute book
inventories much as they do now, except that they would neither
add to shrinkage as determined by physical count during the year
any shrinkage accrual for the physical-to-yearend period of that
year nor subtract from such shrinkage the shrinkage accrual for
the prior year's physical-to-yearend period. See sec. I.C.
(Findings of Fact), supra. The retailers’ cost of goods sold, as
determined by book inventories, would, therefore, include
shrinkage for all inventory cycles beginning and ending in the
taxable year, plus shrinkage for inventory cycles beginning in
the prior taxable year and ending in the taxable year, but not
any portion of the shrinkage determined for the inventory cycle
beginning within the taxable year and ending in the next taxable
year (i.e., yearend shrinkage). In sum, the retailers’ cost of
goods sold for a taxable year that included cross-year inventory
cycles would include shrinkage accurately measured (i.e.,
verifiable) for some period other than that taxable year (i.e.,
an inventory year).
If it is assumed that there is yearend shrinkage, then,
unless the amount of yearend shrinkage for the taxable year is
- 36 -
identical to the amount of yearend shrinkage for the previous
year, respondent’s method would produce only an estimate of the
loss from shrinkage factors for the taxable year. The facts
underlying that conclusion can be illustrated by the following
diagram, in which it is assumed that a physical inventory is
taken semiannually, on March 31 and September 30, and that the
taxpayer is a calendar year taxpayer.
1995 Taxable Year 1996 Taxable Year 1997 Taxable Year
Dec. 31 Dec. 31 Dec. 31
1995 Inventory Year 1996 Inventory Year 1997 Inventory Year
Sept.30 Mar. 31 Sept. 30 Mar. 31 Sept. 30 Mar. 31 Sept. 30
Under respondent’s method, the taxpayer’s cost of goods sold for
a taxable year would be computed by including shrinkage for the
taxpayer’s inventory year ending September 30. Shrinkage for the
inventory year might equal taxable year shrinkage, but the
occurrence of this remote possibility is impossible to verify.
What is likely (almost a certainty) is that the taxpayer,
computing his cost of goods sold under respondent's method, would
be making that computation using some figure for taxable year
shrinkage that was not the actual taxable year shrinkage. In
other words, the taxpayer would be forced to use what is almost
certainly no more than an estimate of taxable year shrinkage in
computing cost of goods sold.
- 37 -
Respondent does not seriously claim that losses from
shrinkage factors in a cross-year inventory cycle occur only in
the latter year. Nor does respondent claim that losses from
shrinkage factors do not occur generally throughout an inventory
cycle. On the record before us, we have no doubt that, on a
regular basis, the retailers experienced losses from theft,
billing errors, and other shrinkage factors. We also have no
doubt that some of those losses were experienced during the
physical-to-yearend period and gave rise to yearend shrinkage.
Therefore, the principal difference between the retailers’
shrinkage method and respondent’s method is that respondent,
without admitting it, accepts an estimate of yearend shrinkage
while the retailers, by making a shrinkage accrual, consciously
attempt to estimate that shrinkage.
H. Annual Accounting
It is well settled that the Federal income tax system is
based on annual accounting. E.g., Heiner v. Mellon, 304 U.S.
271, 275 (1938). "Inventories are intended to insure a clear
reflection of the year's income by matching sales during the
taxable year with the costs attributable to those sales". Rotolo
v. Commissioner, 88 T.C. 1500, 1515 (1987). Respondent's method,
in effect, substitutes yearend shrinkage of the prior year for
yearend shrinkage of the taxable year. Sales during the taxable
year are matched with losses verified to be both losses for that
year and losses for the end of the prior year. On its face,
- 38 -
respondent's method violates the principle of annual accounting.
Of course, under the retailers’ shrinkage method, the retailers’
estimates of shrinkage accruals are also based on information
gathered from prior years, since the retailers’ shrinkage rates
are dependent, in part, on historical data. The distinction,
however, is that the retailers’ shrinkage method utilizes prior
year information as a factor in calculating the current year’s
shrinkage rate, whereas respondent’s method plainly substitutes
yearend shrinkage of the prior year for yearend shrinkage of the
taxable year.
If physical inventories were required to be taken at year's
end, taxable year shrinkage would be known with certainty, and no
estimate of yearend shrinkage would be necessary. Physical
inventories, however, are not required to be taken at year's end.
Sec. 1.471-2(d), Income Tax Regs. Once the Secretary decided not
to require physical inventories at year’s end, see Dayton Hudson
Corp. & Subs. v. Commissioner, 101 T.C. at 467; sec. 1.471-2(d),
Income Tax Regs., and taxpayers began to exercise the privilege
of computing yearend inventories from book inventory records,
estimations of yearend shrinkage became inescapable, whether the
method of estimating yearend shrinkage involves calculation (the
retailers' shrinkage method) or substitution (respondent's
method). Respondent recognizes that fact. Respondent's
position, however, is that, unless a taxpayer can demonstrate the
accuracy of his calculation of yearend shrinkage, the taxpayer
- 39 -
must choose between yearend physical inventories and respondent's
substitution method of accounting for yearend shrinkage.
Respondent also recognizes, however, that, under the logic of
Dayton Hudson, if petitioner demonstrates the accuracy of the
retailers' shrinkage method, that method does clearly reflect
income. On brief, respondent states:
The crucial issue in determining whether
Petitioner’s methods of estimating shrinkage clearly
reflected income is whether the methods were designed
to produce accurate results. Clear reflection of
income means that income should be reflected with as
much accuracy as standard methods of accounting
practice permit. [Citing Caldwell v. Commissioner, 202
F.2d 112, 115 (2d Cir. 1953).]
We must determine the accuracy of the retailers' shrinkage method
to determine whether it clearly reflects income.
I. Accuracy
Absolute accuracy is not required. Indeed, respondent as
much as concedes that absolute accuracy is not required by
stating that clear reflection means reflection with as much
accuracy as standard methods of accounting practice permit.
Also, absolute accuracy is not the standard demanded of book
inventories by section 1.471-2(d), Income Tax Regs. That section
explicitly states that balances shown by book inventories “should
be verified by physical inventories at reasonable intervals and
adjusted to conform therewith.” (Emphasis added.) Both
verification and adjustment would be unnecessary if only absolute
accuracy were acceptable. Finally, section 1.446-1(c)(1)(ii)(A),
- 40 -
Income Tax Regs., which specifies when a liability is incurred
for purposes of the accrual method of accounting, requires only
reasonable accuracy in determining the amount of an established
liability. As noted previously, the term “liability”
specifically includes a cost taken into account in computing cost
of goods sold. Sec. 1.446-1(c)(1)(ii)(B), Income Tax Regs.
The accuracy of the retailers’ shrinkage method presents a
question of fact. Petitioner bears the burden of proving that
fact. Rule 142(a). Since, under the cycle method of counting
used by the retailers, yearend inventories are not ordinarily
taken, the accuracy of the retailers’ shrinkage method is not a
fact that petitioner can prove simply by comparing the retailers'
estimates (shrinkage accruals) to actual yearend shrinkage
figures. Petitioner must rely on an indirect method of proof.
That is why petitioner relies on the expert testimony of Dr.
Bates, whose expertise is in statistics, econometric modeling,
and economic analysis.
Dr. Bates was given the retailers' estimates of yearend
shrinkage based on sales. He hypothesized that he could prove
the accuracy of those estimates by showing that they did not
differ, or differed by only a small percentage, from amounts
determined on the basis of a sales-based allocation of the actual
shrinkage for the relevant inventory cycles. Dr. Bates’
conclusion is that, for each of the retailers, annual losses, in
- 41 -
the aggregate, claimed on account of shrinkage factors are within
5 percent of sales-based taxable year shrinkage.
Dr. Bates performed a similar analysis to determine the
accuracy of respondent’s method of accounting for losses from
shrinkage factors. He concluded that respondent’s method is less
accurate than the retailers’ shrinkage method and is subject to a
greater range of error.
Dr. Bates performed a second accuracy analysis, which was
independent of the correlation between sales and shrinkage and
apportioned actual shrinkage evenly over each inventory cycle
without regard to sales or any factor other than the passage of
time (i.e., a time-based allocation). For each of the retailers,
he found a level of accuracy similar to what he found using a
sales-based allocation. Applying a time-based allocation to
respondent’s method, he again concluded that respondent’s method
is less accurate than the retailers’ shrinkage method and is
subject to a greater range of error.
Dr. Bates has persuaded us that, assuming either a sales-
based or time-based allocation of losses from shrinkage factors,
the retailers’ shrinkage method is more accurate than
respondent’s method, and we so find.
J. Consistency of Retailers’ Inventory Practices
As stated in section IV, supra, section 1.471-2(b), Income
Tax Regs., makes consistency of application from year to year an
important and explicit element in determining whether the
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inventory practices of a taxpayer clearly reflect income.
Respondent argues that there are certain technical flaws in the
retailers' shrinkage accrual practices. We assume that
respondent wishes us to conclude that those flaws make the
practices inconsistent and, thus, inaccurate. Respondent cites
the failure of the Michigan KMA to accrue shrinkage for the
grocery or drug/general merchandise departments for the period
1984 through 1987 despite the general corporate policy of
shrinkage accrual. Respondent also cites the fact that one KMA
did not follow the standard procedure that, when a store was
transferred from one KMA to another, it was to use a combination
of the two KMAs' shrinkage accrual rates during the year of
transfer. One KMA permitted the stores transferred to its area
to continue to use the prior KMA's shrinkage rate during the year
of the transfer. We have considered those and other incidents
cited by respondent, and we cannot conclude that the retailers’
inventory practices were applied inconsistently from year to
year. Each of the retailers adopted accounting practices that
were to be applied uniformly and consistently. The scope of the
retailers' operations was enormous. The KFS division alone
operated between 1,000 and 1,500 supermarkets, with annual sales
in excess of $11 billion. Given the scope of the retailers’
operations, and the minor flaws cited by respondent, we believe
that there was consistency of application in inventory practices
from year to year, and we so find.
- 43 -
K. Did Respondent Abuse Her Discretion in Determining That
the Retailers’ Shrinkage Method Does Not Clearly Reflect
Income and That Respondent’s Method Does Clearly Reflect
Income?
We have found that the retailers’ shrinkage method was
applied consistently from year to year. We have also found that,
assuming either a sales-based or time-based allocation of losses
from shrinkage factors, the retailers’ shrinkage method is more
accurate than respondent’s method.
We consider whether respondent abused her discretion in
determining that the retailers' shrinkage method does not clearly
reflect income in light of section 1.471-2(d), Income Tax Regs.,
which allows for book inventories whose balances are verified by
physical inventories conducted at reasonable intervals.
Respondent has not challenged the intervals at which the
retailers verified their book inventories by physical count.
Indeed, during each of the years in question, the KFS division
and Florida Choice conducted an average of 2 or more physical
inventories a store, and Superx conducted an average of 1.5 or
more physical inventories a store. The retailers used cycle
counting to take physical inventories. Throughout the year,
cycles ended and physical inventories were taken. On average,
the physical-to-yearend period was no more than 3 months for both
the KFS division and Florida Choice. For Superx, the average
length of the physical-to-yearend period was 4 months. Of
course, since estimates were involved, there were bound to be
- 44 -
errors in the shrinkage accruals for those physical-to-yearend
periods. Those errors, however, were subject to correction
within the next taxable year and would, on average, involve no
more than 3 or 4 months of possible overestimates. The limited
potential for deferral is significant to us in deciding whether
income was clearly reflected.2
Respondent abused her discretion in determining that the
retailers’ shrinkage method does not clearly reflect income and
that her method does clearly reflect income. Taxable income must
be reflected with as much accuracy as standard methods of
accounting practice permit. Caldwell v. Commissioner, 202 F.2d
at 115. Because the retailers did not generally take physical
inventories at year’s end, no accounting method can state with
certainty either yearend shrinkage or the year’s taxable income.
In order to determine the accuracy of the retailers’ shrinkage
2
Shrinkage accruals are no more than estimates, and because
there are tax incentives for maximizing shrinkage accruals, the
potential for tax avoidance exists. That is so notwithstanding
that minimization of shrinkage factors was a management goal for
each of the retailers. Essentially, the determination of
shrinkage accrual rates by the management of each KMA (the
analysis is the same for Florida Choice and Superx) is not
dependent entirely on shrinkage factors, which individual store
and department managers have an incentive to minimize. The
potential for tax avoidance is one of respondent’s objections to
shrinkage accruals. On the record before us, however, we are
unconvinced that there was a significant potential for tax
avoidance or that, indeed, there was any tax avoidance. Any
potential overestimates were subject to correction within the
following taxable year and would, on average, involve no more
than 3 or 4 months of excess shrinkage accruals. We see no
pattern of overaccruals for tax avoidance purposes.
- 45 -
method, we must, therefore, hypothesize the taxable income for
each of the years in question. Although we accept Dr. Bates’
opinion as to the correlation between sales and shrinkage at the
business level, and we are impressed by Dr. Bates’ sales-based
accuracy analysis, we are hesitant to rest our conclusion as to
the accuracy of the retailers’ shrinkage method on a correlation
whose significance we may not fully appreciate. The assumption
underlying Dr. Bates’ time-based accuracy analysis, on the other
hand, is independent of any correlation between sales and
shrinkage. Indeed, it is independent of the correlation between
shrinkage and any particular factor. Moreover, respondent has
not argued that shrinkage is a function of any particular factor.
Thus, the hypothesis that taxable income reflects a ratable
allocation within cross-year inventory cycles of shrinkage
determined for those cycles provides a neutral guideline to judge
not only the accuracy of the retailers’ shrinkage method but also
the relative accuracy of that method compared to respondent’s
method. Based on Dr. Bates’ time-based comparison of the
retailers’ shrinkage method with respondent’s method, utilizing
KFS division, Florida Choice, and Superx data for various years
between 1983 and 1991, see sec. VI.D.4., supra, we are convinced
that respondent's method of estimating losses from shrinkage
factors is less accurate than the retailers' shrinkage method and
is subject to a greater range of error.
- 46 -
Respondent abused her discretion because petitioner has
convinced us that the retailers’ shrinkage method was more
accurate in reflecting taxable income than was respondent’s
method. If, indeed, shrinkage is a function of sales, our
conclusion would not change, because, on that basis also, the
retailers’ shrinkage method is more accurate than respondent’s
method.
In sum, we conclude that respondent abused her discretion in
determining that the retailers' shrinkage method does not clearly
reflect income because the retailers' shrinkage method more
clearly reflects income when compared to respondent's method
based on an allocation of cross-year inventory shrinkage losses
as a function of time. In addition, the frequency of the
retailers' physical inventories and the uniform and consistent
application of the retailers' shrinkage method insured correction
of overestimates on a regular basis and promoted the clear
reflection of income.
VII. Conclusion
The retailers’ systems of maintaining book inventories
(including the making of shrinkage accruals) conform to the best
accounting practice and clearly reflect income. They are, thus,
sound within the meaning of section 1.471-2(d), Income Tax Regs.
- 47 -
To reflect the foregoing, and to give effect to agreements
reached by the parties,
Decision will be entered
under Rule 155.
- 48 -
Appendix3
Sales-Based Accuracy Analysis for the KFS Division
KFS DIVISION - RETAILERS' METHOD
Sales-Allocated Difference As
Sales- Annual Shrinkage Percent Of
Allocated Actual KFS Minus Actual Annual Sales-
Annual Annual Tax KFS Annual Tax Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1984 $16,730,176 $16,152,686 $577,491 3.5%
1985 12,480,853 13,803,649 -1,322,796 -10.6%
1986 18,828,725 16,674,582 2,154,143 11.4%
1987 14,965,650 15,920,349 -954,699 -6.4%
1988 11,573,159 10,415,192 1,157,967 10.0%
1989 18,949,137 17,067,966 1,881,170 9.9%
1990 23,781,623 24,735,994 -954,371 -4.0%
1991 28,082,463 28,014,682 67,781 0.2%
1984- 145,391,786 142,785,100 2,606,686 1.8%
1991
KFS DIVISION - RESPONDENT'S METHOD
Sales-Allocated Difference As
Sales- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Sales-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1984 $16,730,176 $16,719,232 $10,944 0.1%
1985 12,480,853 13,166,875 -686,022 -5.5%
1986 18,828,725 16,541,601 2,287,124 12.1%
1987 14,965,650 15,066,016 -100,366 -0.7%
1988 11,573,159 9,763,096 1,810,063 15.6%
1989 18,949,137 16,497,880 2,451,257 12.9%
1990 23,781,623 24,409,148 -627,526 -2.6%
1991 28,082,463 26,868,966 1,213,498 4.3%
1984- 145,391,786 139,032,814 6,358,972 4.4%
1991
3
These tables contain a few immaterial computational errors.
- 49 -
Time-Based Accuracy Analysis for the KFS Division
KFS DIVISION - RETAILERS' METHOD
Time-Allocated Difference As
Time- Annual Shrinkage Percent Of
Allocated Actual KFS Minus Actual Annual Time-
Annual Annual Tax KFS Annual Tax Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1984 $16,804,512 $16,152,686 $651,826 3.9%
1985 12,417,480 13,803,649 -1,386,170 -11.2%
1986 18,667,248 16,674,582 1,992,666 10.7%
1987 15,153,369 15,920,349 -766,980 -5.1%
1988 11,585,858 10,415,192 1,170,666 10.1%
1989 18,930,812 17,067,966 1,862,846 9.8%
1990 23,843,933 24,735,994 -892,061 -3.7%
1991 27,847,797 28,014,682 -166,885 -0.6%
1984- 145,251,008 142,785,100 2,465,908 1.7%
1991
KFS DIVISION - RESPONDENT'S METHOD
Time-Allocated Difference As
Time- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Time-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1984 $16,804,512 $16,719,232 $85,280 0.5%
1985 12,417,480 13,166,875 -749,396 -6.0%
1986 18,667,248 16,541,601 2,125,647 11.4%
1987 15,153,369 15,066,016 87,353 0.6%
1988 11,585,858 9,763,096 1,822,762 15.7%
1989 18,930,812 16,497,880 2,432,932 12.9%
1990 23,843,933 24,409,148 -565,215 -2.4%
1991 27,847,797 26,868,966 978,831 3.5%
1984- 145,251,008 139,032,814 6,218,194 4.3%
1991
Sales-Based Accuracy Analysis for Florida Choice
FLORIDA CHOICE - RETAILERS' METHOD
Actual Sales-Allocated Difference As
Sales- Florida Annual Shrinkage Percent Of
Allocated Choice Minus Actual Florida Annual Sales-
Annual Annual Tax Choice Annual Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1984 $1,285,541 $1,189,507 $96,034 7.5%
1985 1,465,206 1,575,637 -110,430 -7.5%
1986 1,283,771 1,441,437 -157,666 -12.3%
1987 3,191,210 2,843,037 348,172 10.9%
1988 3,150,351 2,923,998 226,353 7.2%
1984- 10,376,079 9,973,616 402,463 3.9%
1988
- 50 -
FLORIDA CHOICE - RESPONDENT'S METHOD
Sales-Allocated Difference As
Sales- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Sales-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1984 $1,285,541 $1,025,390 $260,151 20.2%
1985 1,465,206 1,360,463 104,744 7.1%
1986 1,283,771 1,382,411 -98,640 -7.7%
1987 3,191,210 2,572,824 618,386 19.4%
1988 3,150,351 3,400,035 -249,684 -7.9%
1984- 10,376,079 9,741,123 634,956 6.1%
1988
Time-Based Accuracy Analysis for Florida Choice
FLORIDA CHOICE - RETAILERS' METHOD
Actual Time-Allocated Difference As
Time- Florida Annual Shrinkage Percent Of
Allocated Choice Minus Actual Florida Annual Time-
Annual Annual Tax Choice Annual Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1984 $1,289,498 $1,189,507 $99,991 7.8%
1985 1,471,431 1,575,637 -104,206 -7.1%
1986 1,264,544 1,441,437 -176,893 -14.0%
1987 3,171,919 2,843,037 328,881 10.4%
1988 3,076,645 2,923,998 152,647 5.0%
1984- 10,274,037 9,973,616 300,420 2.9%
1988
FLORIDA CHOICE - RESPONDENT'S METHOD
Time-Allocated Difference As
Time- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Time-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1984 $1,289,498 $1,025,390 $264,108 20.5%
1985 1,471,431 1,360,463 110,968 7.5%
1986 1,264,544 1,382,411 -117,867 -9.3%
1987 3,171,919 2,572,824 599,095 18.9%
1988 3,076,645 3,400,035 -323,390 -10.5%
1984- 10,274,037 9,741,123 532,914 5.2%
1988
- 51 -
Sales-Based Accuracy Analysis for Superx
SUPERX DIVISION - RETAILERS’ METHOD
Sales-Allocated Difference As
Sales- Actual Annual Shrinkage Percent Of
Allocated Superx Minus Actual Superx Annual Sales-
Annual Annual Tax Annual Tax Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1983 $15,786,221 $14,822,148 $964,073 6.1%
1984 19,940,756 19,004,471 936,285 4.7%
1985 23,163,483 22,272,344 891,139 3.8%
1983- 58,890,459 56,098,963 2,791,497 4.7%
1985
SUPERX DIVISION - RESPONDENT'S METHOD
Sales-Allocated Difference As
Sales- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Sales-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1983 $15,786,221 $14,498,732 $1,287,489 8.2%
1984 19,940,756 18,062,925 1,877,831 9.4%
1985 23,163,483 22,155,386 1,008,097 4.4%
1983- 58,890,459 54,717,043 4,173,416 7.1%
1985
Time-Based Accuracy Analysis for Superx
SUPERX DIVISION - RETAILERS' METHOD
Time-Allocated Difference As
Time- Actual Annual Shrinkage Percent Of
Allocated Superx Minus Actual Superx Annual Time-
Annual Annual Tax Annual Tax Allocated
Year Shrinkage Shrinkage Shrinkage Shrinkage
1983 $15,665,951 $14,822,148 $843,803 5.4%
1984 20,020,109 19,004,471 1,015,638 5.1%
1985 23,050,060 22,272,344 777,716 3.4%
1983- 58,736,119 56,098,963 2,637,157 4.5%
1985
- 52 -
SUPERX DIVISION - RESPONDENT'S METHOD
Time-Allocated Difference As
Time- Annual Shrinkage Percent Of
Allocated Minus Shrinkage Annual Time-
Annual IRS Based on IRS Allocated
Year Shrinkage Method Method Shrinkage
1983 $15,665,951 $14,498,732 $1,167,219 7.5%
1984 20,020,109 18,062,925 1,957,184 9.8%
1985 23,050,060 22,155,386 894,674 3.9%
1983- 58,736,119 54,717,043 4,019,076 6.8%
1985