T.C. Memo. 1997-260
UNITED STATES TAX COURT
DAYTON HUDSON CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21217-91. Filed June 11, 1997.
P operated department 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 yearend. 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 yearend and made an accrual of
the estimate. P calculated shrinkage accruals as a
percentage of sales.
Held: P's systems of maintaining book inventories
do not clearly reflect income. They are, thus, not
sound within the meaning of sec. 1.471-2(d), Income Tax
Regs.
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David R. Brennan and Walter A. Pickhardt, for petitioner.
Reid M. Huey, John C. Schmittdiel, Robert J. Kastl, and
Robin L. Herrell, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: Respondent has determined a deficiency in
petitioner's Federal income tax for its 1984 taxable year in the
amount of $17,384,314, and petitioner has claimed an overpayment
of income tax for that taxable year in the amount of $180,375.1
Previously, on respondent's motion for summary judgment, we
addressed one of the issues presented in this case. In Dayton
Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462 (1993), we
held that section 1.471-(2)(d), Income Tax Regs., as a matter of
law, does not prohibit petitioner from making a shrinkage accrual
in computing book inventories. The 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 year in issue, and all
1
The claim for overpayment contests the disallowance of
shrinkage accruals in computing the tax consequences of a prior
settlement between the parties for the taxable year in issue.
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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 facts filed by the parties, with accompanying
exhibits, are incorporated herein by this reference. The parties
have made approximately 180 separate stipulations of fact,
occupying 50 pages, and there are 120 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. Petitioner
Petitioner is a Minnesota corporation with its principal
office in Minneapolis, Minnesota. Petitioner makes its Federal
income tax return on the basis of a fiscal year ending during
January of each year (we shall refer to petitioner's taxable year
ending within a year simply by referring to that year, e.g.,
“1984” for petitioner's taxable year ending January 28, 1984).
During 1984, petitioner was a retailer operating 1,075
stores in 47 States, the District of Columbia, and Puerto Rico.
Petitioner's operations included a rapidly growing low margin
department store chain in 22 States called Target and a regional
department store company called Dayton's.
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Target and Dayton's were divisions of petitioner. Target
offered a merchandise mix of two-thirds convenience-oriented
hardlines and one-third fashion softgoods. Target has had
significant growth in the number of stores it has operated; in
1980, Target operated 80 stores, in 1984, it operated 205 stores,
and, in 1993, it operated 506 stores. Dayton's included
13 stores, generally referred to as department stores, and
3 “Home” stores specializing in furniture, carpeting, and
draperies; all 16 stores were located in Minnesota, North Dakota,
South Dakota, and Wisconsin. In 1984, Target had gross receipts
of $3,098,325,882, and Dayton's had gross receipts of
$488,375,001.
B. Accounting Procedures
Petitioner's annual accounting period and taxable year was a
52/53-week year ending on the Saturday closest to January 31.
Petitioner 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 the taxable yearend.
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
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inventory plus inventory purchased during the period minus
closing inventory.
Both Target and Dayton's used the “cycle counting” method of
conducting physical inventories. Cycle counting is a method of
conducting physical inventories at individual stores or
departments within stores, in rotation, throughout the year.
Most large retail companies 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.
Generally, petitioner did not conduct physical inventories on the
last day of the taxable year in issue.
During 1983 and 1984, and for a number of years prior
thereto, petitioner maintained a “perpetual”, or book, inventory
system for its divisions and subsidiaries, including Target and
Dayton's. Under its perpetual inventory system, petitioner
debited its inventory or stock accounts with the cost of goods
purchased and credited those accounts with the cost of goods
sold. The perpetual inventory system also showed the sales
proceeds from goods sold.
During 1984, physical inventories were conducted on a store-
by-store basis within the Target division and on a departmental
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basis within the Dayton's division. Physical inventories were
not taken in Target stores commencing operations during 1984.
The results of a physical inventory often would indicate that
inventory shrinkage had occurred. Inventory shrinkage is the
difference between the amount of inventory the stock account
shows as being on hand and the amount of inventory that is
actually on hand. 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”. Factors that contribute to shrinkage and overage
(hereafter, generally, shrinkage) include theft by employees,
customers, and vendors, and paperwork, billing, and other systems
errors. Both Target and Dayton's experienced some or all of the
listed shrinkage factors during the year 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)
cannot be determined for the period from the last physical count
to the end of the year (the physical-to-yearend period). If
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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.
Petitioner maintained a “Controller's Manual” containing a
standard control procedure to set forth corporate policy for
accounting for inventory shrinkage and for planning and reporting
physical inventory results. That manual provided that all
companies must take at least one complete physical inventory a
year. It further provided that “[e]ach Operating Company
Controller is responsible for accounting for inventory shrinkage
in accordance with the accrual basis of accounting.” The manual
defined the term “inventory shrinkage accrual rate” as “[t]he
rate at which inventory is written off to cost of sales to
provide for inventory shrinkage. The rate is stated as a
percentage of net sales.” The manual further provided for the
adjustment of physical inventory results as follows:
When physical inventory shortage is less than the
provision [i.e., the accrual] for inventory shrinkage,
cost of sales should be reduced for the calculated
difference between the physical inventory shortage and
the provision for inventory shrinkage.
When physical inventory shortage is more than the
provision for inventory shrinkage, cost of sales should
be increased for the calculated difference between the
physical inventory shortage and the provision for
inventory shrinkage.
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Petitioner estimated shrinkage factors for the periods
between physical inventories and, on a monthly basis, accrued
amounts on account thereof. At the time of each physical
inventory, petitioner would take account of any difference
between its accruals and the result of its physical inventory
(accrual error). For each taxable year, petitioner's total
adjustments for shrinkage factors would include (1) any accrual
for the period from the start of the year until the physical
inventory date, (2) any adjustment for an accrual error, and
(3) any accrual for yearend shrinkage (such accrual for yearend
shrinkage hereafter being referred to as shrinkage accrual).
Shrinkage accruals reduced yearend inventories, which had the
effect of increasing cost of goods sold and, as a result,
decreasing gross income. In the retail industry, the practice of
making shrinkage accruals, and of calculating such accruals as a
percentage of sales, is the prevalent, if not virtually universal
practice; it is the best practice in that industry.
Respondent disallowed petitioner's shrinkage accruals. That
had the consequence of decreasing cost of goods sold and, as a
result, increasing gross income. Respondent has proposed a
deficiency based upon that increased income.
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II. Target
A. Accounting Methods and Procedures
1. In General
Target comprised 205 stores that were organized into
91 separate departments. Target maintained its inventory records
by department and by store.
2. LIFO Retail Method
Beginning in 1963 and continuing through 1984, petitioner
elected to value Target's inventories using the LIFO Retail
Method of inventory valuation pursuant to section 1.471-8, Income
Tax Regs. Pursuant to sections 1.472-1(k) and 1.472-8(c), Income
Tax Regs., petitioner elected to use department store indexes
prepared by the U.S. Bureau of Labor Statistics (BLS).
Petitioner aggregated Target's departments into 17 LIFO pools
that corresponded to merchandise groups as established by BLS.
3. Accrual Rate for Shrinkage
Target accounted for its inventory shrinkage on the accrual
method, by department and by store. Target accrued shrinkage as
a percentage of sales using rates (accrual rates) that were set
for each department in each store. The accruals were posted
directly to the perpetual inventory system on a monthly basis,
and adjustments were made to account for accrual errors.
Target developed a companywide accrual rate for each taxable
year by reviewing the inventory results for prior physical
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inventory periods. Target generally reviewed the most recent 3
to 5 years of store and company experience in arriving at a
companywide rate. Target also considered a variety of other
factors known to affect the rate of shrinkage (shrinkage rate),
including demographics, crime levels, management problems,
paperwork problems, measures to improve shrinkage, industry
trends, performance of warehouses, and store acquisitions.
The next step in the process was the determination of
accrual rates for each store. After considering store-specific
information, Target would assign a preliminary accrual rate to
each store. Target then adjusted those rates so that the sum of
the individual store rates multiplied by each store's projected
sales figures would equal the projected shrinkage dollars at the
company level as determined from the companywide accrual rate.
The adjustment for a specific store's accrual rate would not
exceed 0.1 percent of its projected annual sales.
Lastly, Target adjusted accrual rates at the department
level within each store, based upon a 3-year average shrinkage
rate for the department on a companywide basis. Those department
rates were further adjusted to accord with the shrinkage rate for
each store in proportion to each department's sales relative to
the store's total sales during the most recent 12-month period.
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4. Application of Accruals for Shrinkage
Target used its accruals for shrinkage for the following
purposes: (1) financial and tax reporting, (2) to determine the
budget that would be available for the purchase of inventory in a
particular department, (3) to set goals for and to evaluate the
performance of store managers and buyers, and (4) to determine
the sources of shrinkage.
B. Target's Physical Inventories
1. In General
Target employed an outside inventory service to conduct
physical inventories of stores generally during the period
beginning with the first weekend in February and ending in
mid-October. Each store had its own physical inventory period.
Target attempted to conduct a physical inventory at each store
every 8 to 16 months; however, in rare instances, as many as
18 months elapsed between physical inventories. Except for
stores opened during the year, Target usually inventoried every
store once each year.
2. New Stores
Target generally did not conduct physical inventories of new
stores in the year that they were opened because Target believed
that such inventories produced meaningless results. Instead,
Target conducted physical inventories of new stores in the year
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following the year of opening. In most cases, Target set accrual
rates for new stores by considering the average shrinkage rate
for the district in which the new store was being opened. Target
also considered the demographics of that district, as well as the
marketing plan of “sister stores”--stores that are located in
areas with similar demographics and have merchandise mixes
similar to that anticipated for the new store--in setting accrual
rates for new stores.
3. Warehouses
During 1979 through 1984, physical inventories were
performed at Target's distribution centers and metro warehouses
(hereafter, collectively referred to as “warehouses”) once each
year prior to the close of the taxable year, during the months of
December or January. The results of the physical inventories at
the warehouses were taken into account in April of the subsequent
taxable year on a departmental basis by the Target stores
serviced by each particular warehouse. The amount of shrinkage
was allocated to the Target stores based upon the store's use of
a particular warehouse. That practice reflected the
determination that the warehouses' shrinkage generally reflected
billing errors to stores.
C. Proposed Deficiencies With Respect to Target
In the notice of deficiency, respondent disallowed shrinkage
accruals for 1984. The LIFO cost adjustment was $36,339,217,
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which reflected a disallowance of shrinkage at retail for the
post-physical inventory periods in the amount of $57,621,019.
Target had sales for 1984 in the amount of $3,045,802,000.
During the periods between the dates of the physical inventories
of Target's stores and the end of 1984, Target's sales were
$2,370,786,576, or 77.8 percent of all sales for 1984.
III. Dayton's
A. Accounting Methods and Procedures
1. In General
Dayton's comprised 16 stores, and each store had in excess
of 400 departments. Dayton's maintained its inventory records by
department.
2. LIFO Retail Method
Petitioner elected to value the inventories of Dayton’s
using the LIFO Retail Method of inventory valuation pursuant to
section 1.471-8, Income Tax Regs. Pursuant to sections 1.472-
1(k) and 1.472-8(c), Income Tax Regs., petitioner elected to use
department store indexes prepared by BLS. Petitioner aggregated
the departments of Dayton's into 20 LIFO pools that corresponded
to merchandise groups as established by BLS.
3. Accrual Rate for Shrinkage
Dayton's accounted for its inventory shrinkage on the
accrual method, by department. Dayton's accrued shrinkage as a
percentage of sales using rates (accrual rates) that were set for
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each department for each taxable year. The accruals were posted
directly to the perpetual inventory system on a monthly basis,
and adjustments were made to account for accrual errors.
Dayton's established accrual rates as a percentage of sales
on a departmental basis. The department rate was applied
throughout the Dayton's division. In setting a department
accrual rate, Dayton's considered numerous factors including the
most recent shrinkage history and shrinkage trends of the
particular department, the employment of new marketing
strategies, changes in demographics, trends that were developing
in related departments, changes in security procedures, and
particular theft problems.
Dayton's did not set a companywide accrual rate. The
companywide accrual figure was simply the aggregate of the
accruals for all of the departments.
4. Application of Accruals for Shrinkage
Dayton's used its accruals for shrinkage for the following
purposes: (1) financial and tax reporting, (2) to determine the
budget that would be available for the purchase of inventory in a
particular department, (3) to evaluate the performance of
department heads, and (4) to determine the sources of shrinkage.
B. Dayton's Physical Inventories
Dayton's conducted its physical inventories of its
departments by counting inventory on the same day at every store
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that maintained a particular department. In conducting physical
inventories, Dayton's used its own employees, and, at times,
those employees were assisted by outside personnel. The physical
inventories of the departments were performed at various times
throughout the year, and, during the year in issue, they were
performed as early as February 1983 and as late as January 1984.
After a physical inventory was taken, the perpetual inventory
system would be adjusted as necessary, and, generally, Dayton's
adjusted the department accrual rate for the balance of the
taxable year to reflect the most recent shrinkage experience.
C. Proposed Deficiencies With Respect to Dayton's
In the notice of deficiency, respondent disallowed shrinkage
accruals for 1984. The LIFO cost adjustment was $2,440,127,
which reflected a disallowance of shrinkage at retail for the
post-physical inventory periods in the amount of $4,625,877.
Dayton's had sales for 1984 in the amount of $415,467,423.
During the periods between the dates of the physical inventories
of the departments of Dayton's and the end of 1984, sales for
Dayton's were $254,488,635, or 61.3 percent of all sales for
1984.
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OPINION
I. Introduction
Petitioner's principal business activities are the operation
of department stores. We are concerned here with petitioner's
Target division (Target) and its Dayton's division (Dayton's)
(together, the Divisions).
During the taxable year in issue, the Divisions used cycle
counting to conduct physical inventories of merchandise. Under
the cycle counting method, physical inventories were taken in
rotation, at the various stores or departments within stores,
throughout the year. Also, the Divisions maintained book
inventory records from which inventories could be determined
without a physical count. The Divisions 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 Divisions’ shrinkage accruals, and
we must determine whether that disallowance is an abuse of
discretion.
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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.[2]
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
2
The Tax Reform Act of 1986, Pub. L. 99-514, sec. 803(b)(4),
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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verified by physical inventories at reasonable
intervals and adjusted to conform therewith.
III. Prior Proceedings
Previously, on respondent's motion for summary judgment, we
addressed one of the issues presented in this case. In Dayton
Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462 (1993), we
held that section 1.471-(2)(d), Income Tax Regs., as a matter of
law, does not prohibit petitioner from making a shrinkage accrual
in computing book inventories. We acknowledged, however, that
respondent might yet argue that petitioner'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.
Respondent acknowledges our holding in the earlier opinion,
but does not agree that it is correct. We adhere to that
holding.
IV. Are the Divisions' Systems of Accounting for Inventories,
Including the Making of Shrinkage Accruals, Sound?
Because the Divisions used cycle counting to conduct
physical inventories of merchandise, and generally no count was
taken at yearend, the Divisions 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.
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We have recently addressed the question of what constitutes
a “sound accounting system” under section 1.471-(2)(d), Income
Tax Regs. In Kroger Co. & Subs. v. Commissioner, T.C. Memo.
1997-2, we noted that section 1.471-(2)(a), Income Tax Regs.,
provides two specific requirements with which acceptable
inventory practices must conform. We then stated:
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. * * * [Id.]
Therefore, our inquiry is, principally, whether the Divisions'
systems of maintaining book inventories (including the making of
shrinkage accruals) conform to the best accounting practice and
clearly reflect income.
V. Best Accounting Practice
The parties have stipulated that, for financial accounting
purposes, petitioner’s financial statements for the taxable year
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 Divisions' systems of maintaining 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
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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
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.
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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,
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 the rejection of a taxpayer’s method if it “does not
clearly reflect income”, and its substitution with 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 an abuse of discretion. E.g., Asphalt
Prods. 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).
The Court of Appeals for the Sixth Circuit has stated:
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§ 446 gives the Commissioner discretion with respect to
two determinations. The Commissioner first determines
whether the accounting method chosen by a taxpayer
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 Am. 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 Cal. 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
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Commissioner determines that a taxpayer's method of accounting
does not clearly reflect income, the taxpayer must demonstrate
either that his method of accounting clearly reflects income or
that the Commissioner's method does not clearly reflect income.
See Asphalt Prods. Co. v. Commissioner, supra at 847; Kroger Co.
& Subs. v. Commissioner, T.C. Memo. 1997-2.
C. The Divisions' Shrinkage Methods
The Divisions 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 Divisions' book inventory records under
methods (individually, Target's shrinkage method and Dayton's
shrinkage method; together, when no distinction is intended, the
Divisions' shrinkage methods) that essentially involved three
variables: (1) an estimate of losses from shrinkage factors for
the portion of the taxable year preceding the date of the
physical inventory (preinventory accrual), (2) the accrual error
(a measure of error in both the prior year's shrinkage accrual
and the preinventory accrual), and (3) the shrinkage accrual for
the taxable year.
Target accounted for shrinkage as a percentage of sales
using rates (accrual rates) that were set for each department in
each store for each taxable year. Those rates were derived from
a companywide accrual rate that was based on a combination of
factors including historical shrinkage experience, demographics,
- 25 -
crime levels, management problems, measures to improve shrinkage,
industry trends, performance of warehouses, and store
acquisitions. Except for stores opened during the year, Target
generally conducted a complete physical inventory of an entire
store on a particular day once each year.
Dayton's accounted for shrinkage as a percentage of sales
using rates (accrual rates) that were set for each department for
each taxable year. Companywide, department accrual rates were
based on a combination of factors including the most recent
shrinkage history and shrinkage trends of the particular
department, the employment of new marketing strategies, changes
in demographics, trends that were developing in related
departments, changes in security procedures, and particular theft
problems. Dayton's conducted its physical inventories of its
departments by counting inventory on the same day at every store
that maintained a particular department. The physical
inventories of the departments were performed at various times
throughout the year, and, during the year in issue, they were
performed as early as February 1983 and as late as January 1984.
In sum, both Target and Dayton's estimated losses from
shrinkage factors as a percentage of sales, using methods that
essentially reflected (1) verified shrinkage for the preinventory
period, (2) an estimate of yearend shrinkage (shrinkage
accruals), and (3) accrual error attributable to the shrinkage
accrual for the prior taxable year.
- 26 -
D. Respondent's Method
Respondent would permit the Divisions to account for losses
from shrinkage factors only when such losses are verified by
physical inventories (respondent's method). Respondent claims
that that “method is nothing more than application of the
principle that taxpayers may not reduce income by unverified
losses or expenditures, or unreliable estimates”. 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 Divisions' book
inventories by disallowing any shrinkage accrual. The Divisions'
cost of goods sold, as determined by book inventories, would
essentially include shrinkage for inventory cycles beginning in
the prior taxable year and ending in the taxable year and not any
portion of the shrinkage determined for inventory cycles
beginning within the taxable year and ending in the next taxable
year (i.e., yearend shrinkage). In sum, the Divisions’ 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
identical to the amount of yearend shrinkage for the previous
- 27 -
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 that 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.
- 28 -
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 Divisions 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 Divisions’
shrinkage methods and respondent’s method is that respondent,
without admitting it, accepts an estimate of yearend shrinkage
while the Divisions, by making shrinkage accruals, consciously
attempt to estimate that shrinkage.3
3
Petitioner attempts to distort our understanding of
respondent's method by stating that, for Target, “[r]espondent
allows shrinkage at retail of $6,152,381 or 0.202 percent of
sales.” Petitioner also states that “[r]espondent has not even
allowed the shrinkage verified by physical inventories during the
year of $51,323,565.” That characterization of respondent's
method is misleading because it fails to recognize that
respondent's adjustments for the year in issue are not isolated
determinations, but, rather, reflect a method change. Indeed, in
the petition, petitioner alleges, alternatively, that a sec. 481
adjustment would be required in the event that respondent's
adjustments are sustained. At trial, however, petitioner's
counsel acknowledged that no evidence was submitted on that issue
and that petitioner intended to rely on defeating respondent's
determination of deficiency. On brief, petitioner's counsel
cites respondent's failure to make an adjustment to opening
inventory as evidence of the arbitrariness of respondent's
method. Adjustments to opening inventory are the province of
sec. 481; petitioner having abandoned its sec. 481 argument, we
(continued...)
- 29 -
E. Petitioner's Expert Testimony
1. Introduction
Petitioner relies on expert testimony to demonstrate that
(1) the Divisions' shrinkage methods clearly reflect income,
(2) respondent's method does not clearly reflect income, or
(3) the Divisions' shrinkage methods more clearly reflect income
when compared to respondent's method. In particular, petitioner
relies on such testimony to demonstrate a strong correlation
between sales and shrinkage, which correlation underlies the
Divisions' shrinkage accruals and petitioner's contention that
respondent's method does not clearly reflect income. Petitioner
presents principally the expert testimony of W. Eugene Seago,
Ph.D. Dr. Seago is a certified public accountant and a professor
of accounting at Virginia Polytechnic Institute and State
University.
2. Correlation Between Sales and Shrinkage
Statistical correlation (R) is a measure of the degree to
which two variable quantities tend to change with respect to each
other. R is 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
3
(...continued)
believe that it cannot show arbitrariness based on respondent's
failure to make an adjustment to opening inventory, and we reject
petitioner's attempt to distort respondent's method.
- 30 -
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. In addition, the square of the
correlation coefficient is termed the coefficient of
determination (R2). Generally, R2 measures the predictive power
of one variable with respect to another variable. The principal
experts in this case do not limit their use of the term
“correlation” to represent R in the technical sense, but rather,
use that term to signify R2 at times and also to signify the
general relationship between two variables. We shall conform,
for purposes of this report, to the experts’ broad usage of the
term “correlation”.
Dr. Seago states in his rebuttal report that “[t]he purpose
of ascertaining whether shrinkage correlates to sales is to test
whether Target's use of sales to estimate shrinkage is
appropriate.” Dr. Seago acknowledges that testing the
correlation of sales and shrinkage at the LIFO pool level for
Target would be highly relevant because tax effects occur at that
level, but, since data to test that correlation does not exist,
he concludes that the “next best thing” is to examine correlation
at the aggregate division level. Dr. Seago is of the opinion
- 31 -
that the correlation between sales and shrinkage at the aggregate
Target-wide level is strong.
Dr. Seago conducted a regression analysis of the
relationship between sales and shrinkage at the aggregate Target-
wide level during the years 1979 through 1988 (the 10-year
correlation analysis). For each Target store, he paired actual
sales figures between inventory dates with verified shrinkage
figures for the same period. Dr. Seago then aggregated the data
according to the taxable year in which the closing inventory was
taken. He is of the opinion that, for the years examined, “[t]he
change in sales each year explained over 97% of the change in
shrinkage.” Dr. Seago concludes that, “according to the
statistical evidence, sales is a nearly perfect predictor of the
loss from shrinkage.” He did not conduct a similar analysis with
respect to Dayton's.
To compensate for the absence of data to test correlation
at the LIFO pool level, Dr. Seago randomly placed individual
Target stores into 21 “surrogate pools” and examined the
correlation between sales and shrinkage for the fiscal years 1979
through 1988. Dr. Seago concludes that the correlation between
sales and shrinkage at the surrogate pool level is strong and
that “comparable results would be achieved if sales and shrinkage
for the actual LIFO pools were available.”
- 32 -
3. Shrinkage Accrual Accuracy Analysis
Dr. Seago believes that the 10-year correlation analysis
demonstrating a correlation between sales and shrinkage with
respect to Target leads to the conclusion that the Divisions'
shrinkage methods4 are theoretically correct methods. Dr. Seago
acknowledges, however, that the next step is to determine whether
those methods were properly applied. He recognizes that a
comparison of the shrinkage verified by physical count with the
shrinkage claimed by petitioner for the taxable year is of
limited significance because the comparison would be of figures
for two different periods. In an attempt to analyze the accuracy
of the Divisions' shrinkage methods and to compare those methods
with respondent's method, Dr. Seago developed a model to
determine taxable year shrinkage. He applied that model to data
for Target during the taxable years that ended in 1983 through
1986.
Dr. Seago believes that, when a physical inventory is taken
at the close of a period that includes portions of 2 taxable
4
It should be noted that Dr. Seago refers to both Target's
shrinkage method and Dayton's shrinkage method as Dayton Hudson's
method, without distinction. Although there are many significant
similarities between the two methods, this Court will evaluate
the two methods independently and refer to the two methods as the
Divisions' shrinkage methods only for convenience and when there
are no relevant distinctions.
- 33 -
years, and an accrual error is detected, some portion of that
error is attributable to each of the taxable years. With support
from the results of the 10-year correlation analysis, Dr. Seago
assumed that sales and shrinkage were perfectly correlated
throughout the year and, thus, determined that any accrual error
should be allocated according to the relative sales between the
two relevant taxable years to arrive at a figure for taxable year
shrinkage. Dr. Seago examined Target's sales figures for the
taxable years ending in 1984, 1985, and 1986, and determined that
approximately 75 percent of sales between physical inventory
dates are allocable to the taxable year prior to the taxable year
in which the physical inventory is taken. As a result, Dr. Seago
allocated 75 percent of the applicable accrual error to the
taxable year prior to the taxable year in which the physical
inventory was taken and 25 percent to the taxable year in which
the physical inventory was taken. Dr. Seago compared his
resulting figures for taxable year shrinkage (sales-allocated
taxable year shrinkage) with the shrinkage claimed by Target for
tax purposes and the shrinkage that would be allowed under
respondent's method. Dr. Seago's analysis produced the following
results:5
5
These tables contain a few minor computational errors, and
we have taken the liberty of calculating the aggregate percentage
difference using Dr. Seago's numbers.
- 34 -
TARGET'S SHRINKAGE METHOD
Target Book
Taxable Sales- Shrinkage Minus Difference as
Year Target Allocated Sales-Allocated Percent of
Ending Book Taxable Year Taxable Year Sales-Allocated
In Shrinkage Shrinkage Shrinkage Shrinkage
1983 $54,175,800 $48,257,951 $5,917,849 12.26%
1984 63,773,400 63,217,484 555,916 0.88%
1985 66,205,504 73,483,645 -7,278,141 -9.90%
1986 82,227,200 81,441,206 785,994 0.97%
1983- 266,381,904 266,400,286 -18,382 -0.01%
1986
RESPONDENT'S METHOD - TARGET DIVISION
Verified
Taxable Loss Sales- Loss Minus Difference as
Year Verified by Allocated Sales-Allocated Percent of
Ending Physical Taxable Year Taxable Year Sales-Allocated
In Inventory Shrinkage Shrinkage Shrinkage
1983 $41,733,212 $48,257,951 -$6,524,739 -13.52%
1984 51,323,565 63,217,484 -11,893,929 -18.81%
1985 65,194,206 73,483,645 -8,289,439 -11.28%
1986 80,248,800 81,441,206 -1,192,406 -1.46%
1983- 238,499,783 266,400,286 -27,630,152 -10.37%
1986
Dr. Seago determined that Target's estimates of taxable year
shrinkage produced, in the aggregate, a net underestimate in the
amount of $18,382 for the taxable years ending in 1983 through
1986 when compared to sales-allocated taxable year shrinkage. He
also determined that the maximum error under Target's shrinkage
method was 12.26 percent of sales-allocated taxable year
shrinkage. From that analysis, Dr. Seago concludes that the
Divisions' shrinkage methods produced “a reasonably accurate
measure of the loss” occasioned by shrinkage factors. Dr. Seago
notes that, in contrast, respondent's method yields a cumulative
overstatement of income in the amount of $27,630,152. Dr. Seago
- 35 -
concludes that respondent's method “contains a systematic bias
towards the understatement of losses during periods when sales
are increasing.”
4. Sales Percentage Shrinkage Analyses
To further examine the accuracy of Target's shrinkage
method, Dr. Seago computed for each Target store during the
taxable years ending in 1980 through 1989 (1) the verified
shrinkage between physical inventory dates as a percentage of
sales for that period (actual shrinkage), (2) the shrinkage
estimates accrued in book inventory as a percentage of sales for
the same period (estimated shrinkage), and (3) the difference
between (1) and (2). Dr. Seago hypothesized that, if Target
could accurately predict shrinkage between physical inventory
dates, i.e., the difference between actual and estimated
shrinkage is small, Target should likewise accurately predict
shrinkage for the taxable year.
Dr. Seago's calculations revealed that, over the period
examined, the simple average difference between actual and
estimated shrinkage was 0.12 percent of sales and the weighted
average (weighted by sales) difference was 0.16 percent of sales.
That difference represents approximately 7 percent of actual
shrinkage. In addition, Dr. Seago performed a regression
analysis comparing sales and shrinkage for each Target store
- 36 -
during the taxable years ending in 1980 through 1989.6 He
determined an R2 of 0.367. Dr. Seago explains that finding by
stating, “while an accrual based solely on the historical
relationship between sales and shrinkage would result in
substantial errors in predictions * * *, Target personnel are
able to significantly reduce the error by adjusting the accrual
factor to take into account factors known to contribute to
shrinkage in the particular store.” Dr. Seago asserts that the
demonstrated success of Target in predicting store shrinkage
suggests that Target likewise accurately predicts shrinkage at
the department level.
Dr. Seago also presents a sales percentage shrinkage
analysis for Target at the aggregate division level. He states
that, from 1979 through 1988, verified shrinkage has averaged
2.102 percent of sales, with a range of 1.90 percent to 2.30
percent. Dr. Seago states that Target's estimates of shrinkage
as a percentage of sales, when compared to the verified
percentage, showed that the estimates deviated from the actual
figures by no more than 25 percent.
6
That analysis of the relationship between sales and
shrinkage at the individual store level appears in Dr. Seago's
rebuttal report and is distinct from the 10-year correlation
analysis.
- 37 -
5. Dr. Seago's Criticism of Respondent's Method
Dr. Seago states that the shortcomings of respondent's
method are that (1) the loss for the taxable year is dependent on
the date of the physical inventories and (2) losses actually
attributable to a prior taxable year are included in the loss for
the current year and losses attributable to the current taxable
year are deducted in the following taxable year. Dr. Seago
asserts that respondent's method contains a systematic bias
towards understating losses when sales are increasing.
F. Respondent's Expert Testimony
1. Introduction
Respondent presents the testimony of two experts, Dennis J.
Gaffney, Ph.D., a professor of accounting at the University of
Toledo, and David W. LaRue, Ph.D., an associate professor of
commerce at the University of Virginia.
2. Dr. Gaffney
Dr. Gaffney was requested to render an opinion as to whether
the Divisions' shrinkage methods were appropriate for financial
accounting and reporting purposes and, if so, the degree of error
in estimating shrinkage that could be tolerated for those
purposes. Although Dr. Gaffney's opinions on those issues are
not relevant with respect to the issue of clear reflection of
income for tax purposes, we believe that Dr. Gaffney's comparison
of Target's verified and accrued shrinkage in retail sales
- 38 -
figures for inventory periods that ended in taxable years ending
in 1980 through 1993, nevertheless, provides an important
perspective on sales and shrinkage data for Target. That
comparison produced the following results:
TARGET - COMPARISON OF VERIFIED AND ACCRUED SHRINKAGE FOR INVENTORY PERIODS7
Verified Shrinkage Accrued Shrinkage Accrued Minus Verified
TYE in $000 %Sales $000 %Sales $000 %Sales %Difference
1980 17,513 1.94 20,689 2.29 3,175 0.35 18.04
1981 25,608 2.25 25,763 2.27 156 0.02 0.89
1982 37,186 2.21 36,605 2.18 -580 -0.03 -1.36
1983 41,733 2.15 43,983 2.26 2,250 0.11 5.12
1984 51,324 2.02 61,464 2.42 10,141 0.40 19.80
1985 65,194 2.00 76,076 2.33 10,882 0.33 16.50
1986 80,249 2.20 81,370 2.23 1,121 0.03 1.36
1987 91,512 2.30 85,749 2.15 -5,763 -0.15 -6.52
1988 87,816 2.05 91,068 2.12 3,252 0.07 3.41
1989 115,560 1.90 145,048 2.38 29,488 0.48 25.26
1990 97,610 1.57 147,806 2.37 50,196 0.80 50.96
1991 148,717 1.92 169,731 2.19 21,014 0.27 14.06
1992 130,260 1.59 163,944 2.00 33,683 0.41 25.79
7
Dr. Gaffney notes that the columns “may not foot and
crossfoot due to rounding.” In addition, he notes that the data
for 1981, which was provided by petitioner, do not appear
mathematically correct, and the 1993 data include warehouse
shrinkage that was computed separately in that year. Lastly, we
have taken the liberty of deleting Dr. Gaffney's aggregate
calculations because those calculations did not take into account
the adjustment to book inventories following physical
inventories.
- 39 -
1993 162,692 1.70 188,526 1.98 25,834 0.28 16.47
Dr. Gaffney observed that out of the 14 years considered by him,
an overaccrual of shrinkage was made in 12 of those years.
3. Dr. LaRue
Dr. LaRue testified to, among other things, the “tax
effects” resulting from the accrual of erroneous estimates of
unverified shrinkage (shrinkage estimation errors). He designed
simulation models to analyze shrinkage estimation errors that
result from the use of cycle counting in conjunction with the
LIFO Retail Method. Dr. LaRue believes that the LIFO Retail
Method imposes certain additional demands on any method of
shrinkage estimation. To better appreciate Dr. LaRue's
assertion, we must acquire a basic understanding of the LIFO
Retail Method. See secs. 1.471-8, 1.472-1(k), 1.472-8(c), Income
Tax Regs.
The LIFO Retail Method is a method of inventory valuation
designed to meet the special needs of high volume retailers
dealing in a wide variety of merchandise. In general terms, the
sales at retail for an accounting period are subtracted from the
retail value of goods available for sale during that period to
produce a figure for the retail value of ending inventory. That
figure for the retail value of ending inventory must be converted
into a figure for cost of ending inventory, which can be
- 40 -
subtracted from cost of goods available for sale during that
period to produce a figure for cost of goods sold.
In simplified terms, the process of converting the current
year retail value of ending inventory to cost of ending inventory
involves dividing the current year retail value of ending
inventory by the current retail price index (which, for retailers
using U.S. Bureau of Labor Statistics (BLS) indexes, is the
current BLS price index for the particular inventory pool divided
by the BLS price index for the year in which that pool was
adopted (base year)) to yield a figure for current year retail
value of ending inventory expressed in base year dollars.
Comparing that result to a similar figure computed as of the end
of the immediately preceding accounting period reveals whether an
increment or decrement in the quantity of goods has occurred as
of the end of the period, as opposed to mere changes in retail
price levels. If there has been no decrement in the quantity of
goods as of the end of the period, cost of ending inventory is
the sum of the prior year's cost of ending inventory plus the
cost of the quantity of inventory in the current increment (if
any). The retail value of the increment expressed in base year
dollars is multiplied by the current year's retail price index
and then multiplied by the cost complement8 to arrive at the cost
8
Generally, the cost complement is the weighted average
relationship between the cost of current year purchases and the
(continued...)
- 41 -
of the increment in the quantity of goods. In the event of a
decrement, the decrease is subtracted from the annual layers of
the period's beginning inventory in reverse chronological order.
Those procedures are applied to each LIFO pool, which generally
maintains its own set of BLS indexes, cost complement, layer
structure, and other pool attributes.
Having acquired a basic understanding of the LIFO Retail
Method, we can better analyze Dr. LaRue's criticism of the
Divisions' shrinkage methods. Dr. LaRue believes that the
process of making corrections to shrinkage estimates in the
subsequent year is inadequate because changes in LIFO pool
attributes, such as BLS indexes and cost complements, prevent
corrections from accurately offsetting previous shrinkage
estimation errors in the earlier year. In addition, Dr. LaRue
asserts that the varying tax effects of shrinkage estimation
errors among LIFO pools, which is a product of differing pool
attributes, even undermines the validity of a methodology that,
in the aggregate, produces an accurate estimate of taxable year
shrinkage. In sum, Dr. LaRue believes that cycle counting and
the LIFO Retail Method impose “significant additional demands on
the design and implementation of a methodology that might be
8
(...continued)
retail value assigned to those purchases.
- 42 -
considered capable of producing sound accruals of shrinkage
losses.”
In addition, Dr. LaRue considered Target's shrinkage method
and concluded as follows:
In my opinion, the “methodology” employed by Target to
forecast its shrinkage experience and to then allocate
that forecast to each of the departments in each of its
stores for the purpose of accruing these losses in its
books and records fails to evidence the objectivity and
verifiability required to establish the overall process
as a sound method that can be expected to clearly
reflect its income.
That opinion, according to Dr. LaRue, is based on Target's
failure to “directly” consider a department's actual shrinkage
experience in setting that particular department's shrinkage rate
coupled with the inability of “a disinterested party with full
knowledge of all relevant data * * * to independently reconstruct
the forecasted shrinkage derived” by Target's shrinkage method.
Dr. LaRue disagrees with Dr. Seago's conclusion that the
Divisions' shrinkage methods produce reasonably accurate
estimates of losses from shrinkage factors. Dr. LaRue believes
that the tax effects of shrinkage estimation errors are not the
result of errors at the aggregate level because shrinkage is
accrued at the store and department levels, and, therefore,
minimal errors at the aggregate level are misleading. Dr. LaRue
states:
I think he [Dr. Seago] is looking at the wrong
phenomena. I think it doesn't matter a whole lot. It
matters, but it doesn't matter a whole lot whether our
- 43 -
shrinkage estimation methodology produces very small or
very large errors at the aggregate level. Shrinkage is
not accrued at the aggregate level.
Dr. LaRue believes that, notwithstanding a net figure of zero at
the aggregate level, the fact that retail dollars of shrinkage
have to be converted into cost dollars among the various LIFO
pools, which pools utilize diverse conversion processes (i.e.,
differing BLS indexes and cost complements), undermines the
significance of Dr. Seago's shrinkage accrual accuracy analysis.
Dr. LaRue acknowledges, however, that a finding of low shrinkage
estimation error at the aggregate level is not irrelevant.
Indeed, he believes that such a finding creates a presumption of
a “pretty good model”.
In addition, Dr. LaRue, although in agreement with
Dr. Seago's mathematics, questioned the significance of the high
correlation between sales and shrinkage derived from the 10-year
correlation analysis. Dr. LaRue conducted his own analysis of
Target data and concludes that the correlation between sales and
shrinkage disintegrates as the level of analysis moves from the
Target-wide level to the department and store levels.
G. Evaluation of Expert Testimony
1. Origin of Shrinkage Estimation Errors
An inquiry into the origin of shrinkage estimation errors
provides the proper perspective to evaluate Dr. LaRue's criticism
that the Divisions' shrinkage methods are inherently flawed
- 44 -
because the additional demands of the LIFO Retail Method prevent
accurate, subsequent year corrections of shrinkage estimation
errors. If physical inventories were required to be taken at
yearend, 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
yearend. Sec. 1.471-2(d), Income Tax Regs. Once the Secretary
decided not to require physical inventories at yearend, 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 Divisions' shrinkage methods) or
substitution (respondent's method).
The realization that estimates of yearend shrinkage are an
inescapable byproduct of cycle counting reveals that Dr. LaRue's
criticisms are, in fact, a condemnation of cycle counting by
means of highlighting the additional demands of the LIFO Retail
Method, which are just as applicable to respondent's method. In
other words, errors resulting from respondent's method of
substituting yearend shrinkage for the taxable year with yearend
shrinkage for the prior taxable year are subject to the same
problems of varying tax effects arising from changing LIFO pool
- 45 -
attributes and dissimilar pool attributes among pools.
Respondent’s proposed adjustments will not eliminate the flaws
perceived by Dr. LaRue. It appears that only the practice of
yearend physical inventories at all stores or departments 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. In sum, we consider Dr. LaRue's objection as an
inherent component of all estimates of yearend shrinkage.
2. Dr. Seago
As a preliminary matter, Dr. Seago, in his report and in his
testimony at trial, made clear that his opinions regarding clear
reflection of income were made in the context of financial
accounting principles and not tax accounting principles. In
addition, Dr. Seago, at trial, acknowledged that he had not
reviewed directly any taxpayer's method of accounting for
inventory shrinkage other than the Divisions' shrinkage methods.
Although we consider Dr. Seago's concessions in evaluating the
weight of his testimony, this Court will focus on the substance
of his analyses.
We first consider Dr. Seago's shrinkage accrual accuracy
analysis. Under the cycle method of counting used by the
Divisions, yearend inventories are not ordinarily taken, and,
thus, whether the Divisions’ shrinkage methods clearly reflect
income is not a fact that petitioner can prove simply by
- 46 -
comparing the shrinkage claimed by Target and by Dayton's for the
taxable year to actual taxable year shrinkage figures.
Petitioner must rely on an indirect method of proof. That is why
petitioner relies on the expert testimony of Dr. Seago.
Dr. Seago developed a model for determining taxable year
shrinkage. First, Dr. Seago assumed that sales and shrinkage are
“perfectly correlated”, based on his findings in the 10-year
correlation analysis, supra section VI.E.2. As we have stated,
Dr. Seago allocated 75 percent of any accrual error to the
taxable year prior to the taxable year in which the physical
inventory was taken and 25 percent to the taxable year in which
the physical inventory was taken. That allocation of the accrual
error in conjunction with the aggregate of monthly accruals for
shrinkage for the relevant taxable years yielded, in Dr. Seago's
opinion, the best estimate of taxable year shrinkage (i.e.,
sales-allocated taxable year shrinkage).
Dr. LaRue criticizes Dr. Seago for aggregating sales and
shrinkage figures at the Target-wide level. Dr. LaRue believes
that variances in LIFO pool attributes and discontinuities in the
timing of the physical inventories throughout the taxable year
render the aggregate data virtually meaningless. Although we
appreciate Dr. LaRue's criticism, we believe that an analysis of
divisionwide or companywide data is not necessarily without
merit, especially when an analysis of such data exposes relative
- 47 -
differences between methods at the aggregate level. See Kroger
Co. & Subs. v. Commissioner, T.C. Memo. 1997-2 (accepting the
taxpayer's presentation of an aggregate analysis, which compared
the taxpayer's method with the Commissioner's method based on an
allocation of cross-year inventory shrinkage as a function of
time; this Court found the aggregate analysis dispositive of
whether there was an abuse of discretion by the Commissioner).
Taxable year shrinkage estimates derived by a taxpayer's
shrinkage method and by the Commissioner's method must be
subjected to the same indexes and cost complements when
converting from retail to cost, and, thus, relative differences
between two methods at the aggregate level may be significant.
This Court, however, agrees with Dr. LaRue when aggregate
data is used for other purposes. In particular, we have
difficulty accepting the significance of Dr. Seago's 10-year
correlation analysis, which found a strong correlation between
sales and shrinkage for Target during the years 1979 through
1988, and which underlies Dr. Seago's shrinkage accrual accuracy
analysis. At the most basic level, it appears that changes in
the Divisions’ LIFO pool attributes from year to year,
differences in attributes among pools, and discontinuities in the
timing of physical inventories from year to year combine to
produce sales and shrinkage figures that represent different
variables from year to year. We understand correlation, for
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present purposes, as a measure of the degree to which two
variable, but consistently constituted, quantities tend to change
with respect to each other and not as a measure of the degree to
which two inconsistently constituted quantities change with
respect to each other. Essentially, Dr. Seago has not persuaded
this Court that the strong correlation between sales and
shrinkage derived from the 10-year correlation analysis is the
product of the true relationship between sales and shrinkage and
not the product of the confluence of varying LIFO pool
attributes. Dr. Seago has failed to explain that apparently
fundamental flaw in the 10-year correlation analysis. That is
not to say that we would never accept statistical analyses
demonstrating a correlation between sales and shrinkage; that is
only to say that Dr. Seago, in this case, has simply failed to
prove the significance of the correlation derived from the
10-year correlation analysis.9 Dr. Seago recognizes that an
9
It should be noted that, in Kroger Co. & Subs. v.
Commissioner, T.C. Memo. 1997-2, we stated:
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. * * *
Similarly, in this case, although we accept Dr. Seago's opinion
that the data he examined in the 10-year correlation analysis
revealed a strong correlation, Dr. Seago has not demonstrated the
(continued...)
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analysis of the correlation between sales and shrinkage at the
LIFO pool level would produce a more meaningful correlation and
attempts to examine that correlation by the creation of surrogate
pools in the absence of such data. We are not convinced by
Dr. Seago's analysis of hypothetical pools of data derived from
randomly placing individual Target stores into 21 pools because
that approach divorces particular sales and shrinkage figures for
each actual pool from the corresponding pool attributes; the
preservation of that relationship is precisely the purpose of
analyzing sales and shrinkage data at the LIFO pool level.
Because we are reluctant to accept Dr. Seago's 10-year
correlation analysis, his shrinkage accrual accuracy analysis
does not persuade us that Target's shrinkage method clearly
reflects income, that respondent's method does not clearly
reflect income, or that Target's shrinkage method more clearly
reflects income when compared to respondent's method. Dr. Seago
allocated accrual errors under the assumption, which was derived
from the 10-year correlation analysis, that sales and shrinkage
are perfectly correlated. In addition, Target's monthly accruals
for shrinkage were made as a percentage of sales. Therefore,
Dr. Seago's estimate of the actual taxable year shrinkage--sales-
allocated taxable year shrinkage--relies entirely on the critical
9
(...continued)
significance of that finding to the issue of clear reflection of
income.
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assumption that sales and shrinkage are sufficiently correlated
so that the sum of aggregate monthly shrinkage accrued as a
percentage of sales for the taxable year, adjusted for an
allocation of any accrual error based on a ratio of relative
sales between the relevant taxable years, yields a figure for
taxable year shrinkage that would clearly reflect income.10
Although we believe that sales have some value as a predictor of
shrinkage at the Target-wide level, we simply cannot accept the
critical assumption that underlies Dr. Seago's shrinkage accrual
accuracy analysis.
Dr. Seago did not conduct an analysis of the correlation
between sales and shrinkage or a shrinkage accrual accuracy
analysis for data derived from the operations of Dayton’s. We
assume that petitioner wishes that we infer both a strong
correlation between sales and shrinkage and a favorable shrinkage
10
In addition, this Court has difficulty with Dr. Seago's
shrinkage accrual accuracy analysis for other reasons. Target's
shrinkage method results in the accrual of shrinkage based on a
rate set at the beginning of the taxable year for each department
within each store. Thus, conceivably, a department within a
store could accrue shrinkage at two different rates during the
cross-year inventory period, e.g., 2 percent of sales during the
taxable year's physical-to-yearend period and 2.5 percent of
sales during the period prior to the physical inventory in the
next taxable year. An allocation of any accrual error only, as
opposed to an allocation of total verified shrinkage, is
inconsistent with the underlying assumption that sales and
shrinkage are perfectly correlated. In the same vein, Dr. Seago
allocates accrual error based on a 75/25 ratio that is an
approximation of the relative sales between the relevant taxable
years and not the actual cross-year sales percentages.
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accrual accuracy analysis for Dayton's based on the analyses of
Target data. Even if this Court were to engage in that type of
speculation, our rejection of the analyses with respect to Target
renders that method of proof ineffectual. In addition,
petitioner presents evidence demonstrating that the aggregate
estimated shrinkage rates of Dayton’s for inventory periods
spanning the taxable year in issue are less than the verified
rates of shrinkage for the same periods. That evidence, without
more, does not provide a basis to evaluate clear reflection of
income for the taxable year in issue for the reasons set forth in
our discussion that follows of Dr. Seago's sales percentage
shrinkage analyses based on Target data.
Dr. Seago presents analyses that compare actual and
estimated shrinkage rates as a percentage of sales for physical
inventory periods (sales percentage shrinkage analyses). See
supra sec. VI.E.4. Those analyses were conducted at both the
store and Target-wide levels. Not only are we unimpressed by
Dr. Seago's results, we have reservations about his assumptions.
Dr. Seago's analyses compare results for inventory periods and
not the taxable year or any other taxable year. An identity of
results between actual and estimated shrinkage rates as a
percentage of sales for inventory periods does not tell us
anything about the relative distribution of losses from shrinkage
factors within those inventory periods. Thus, unless sales and
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shrinkage are correlated, evidence of an identity between actual
and estimated shrinkage rates for an inventory period is no
evidence that the shrinkage estimation rate for the inventory
period is accurate for that portion of a taxable year that falls
within (but is not identical to) the inventory period.11 We
rejected above a general correlation between sales and shrinkage
based on the 10-year correlation analysis. In addition,
Dr. Seago derived only an R2 of 0.367 from his disaggregated
analysis of Target stores during the taxable years ending in 1980
through 1989. In sum, we cannot accept Dr. Seago's assumption of
a strong correlation between sales and shrinkage, and, therefore,
Dr. Seago's sales percentage shrinkage analyses do not persuade
us that the Divisions' shrinkage methods clearly reflect income.
11
The requirement of the assumption that sales and shrinkage
are correlated is illustrated by the following example. Assume
that X Co. (1) is a calendar year taxpayer; (2) has an inventory
period from Apr. 1 to Mar. 31; (3) has no sales from Jan. 1,
1990, to Mar. 31, 1990, and $1 of shrinkage for that period;
(4) has $100 of sales from Apr. 1, 1990, to Dec. 31, 1990, and no
shrinkage for that period; (5) has no sales from Jan. 1, 1991, to
Mar. 31, 1991, and $2 of shrinkage for that period; and
(6) accrued shrinkage at a rate of 2 percent of sales for all
relevant periods. Upon the physical inventory on Mar. 31, 1991,
X Co.'s records would indicate $100 of sales and $2 of shrinkage
during the inventory period. Thus, verified shrinkage of
2 percent of sales would correspond to accrued shrinkage of
2 percent of sales. The identity of results for the inventory
period does not correspond to an identity of results for the
taxable year because actual shrinkage for the taxable year was
1 percent of sales. That discrepancy exists because the example
did not assume that sales and shrinkage are correlated.
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Lastly, Dr. Seago criticizes respondent's method as
containing a systematic bias towards understating losses when
sales are increasing. The validity of that assertion also relies
on a strong correlation between sales and shrinkage. Although
respondent's method is merely another method of estimating losses
from shrinkage factors for the taxable year, see supra section
VI.D., Dr. Seago's unproven assertion, however, does not convince
us that respondent's method does not clearly reflect income.
H. Is Respondent's Determination That the Divisions'
Shrinkage Methods Do Not Clearly Reflect Income and That
Respondent's Method Does Clearly Reflect Income an Abuse
of Discretion?
Petitioner has a heavy burden to prove that respondent's
determination that Target's shrinkage method and Dayton's
shrinkage method do not clearly reflect income and that
respondent's method does clearly reflect income is an abuse of
discretion. See supra sec. VI.B. We find no such abuse of
discretion here. But cf. Kroger Co. & Subs. v. Commissioner,
T.C. Memo. 1997-2 (finding an abuse of discretion); Wal-Mart
Stores, Inc. v. Commissioner, T.C. Memo. 1997-1 (same).
Petitioner relies on the testimony of Dr. Seago who asserts
that both Target's shrinkage method and Dayton's shrinkage method
produce reasonably accurate shrinkage accruals and that those
methods clearly reflect income. Dr. Seago also asserts that
respondent's method does not clearly reflect income. The
critical assumption upon which all of Dr. Seago's conclusions
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rely is the existence of a strong correlation between sales and
shrinkage derived from the 10-year correlation analysis. We
cannot take the inferential leap that is required to accept that
assumption. In light of respondent's broad discretion to
determine clear reflection of income, this Court cannot accept
the significance of Dr. Seago's 10-year correlation analysis
because we cannot overlook the fact that aggregate sales and
shrinkage data at the Target-wide level consist of sales and
shrinkage figures from numerous LIFO pools, which each have
different pool attributes that vary from year to year. In
addition, we are not persuaded by any of the other evidence
presented by petitioner in this case. Therefore, respondent's
determination that the Divisions' shrinkage methods do not
clearly reflect income and that respondent's method does clearly
reflect income is not an abuse of discretion.
VII. Conclusion
The Divisions' systems of maintaining book inventories do
not clearly reflect income. They are, thus, not sound within the
meaning of section 1.471-2(d), Income Tax Regs. To reflect the
foregoing,
Decision will be entered
for respondent.