The Honorable Franklin H. Waters, United States District Judge for t he Western 1 District of Arkansas, sitting by designation.



## United States Court of Appeals FOR THE EIGHTH CIRCUIT

___________ No. 97-3027

___________ Dayton Hudson Corporation and * Subsidiaries, * * Petitioner, * * Appeal from the United States v. * Tax Court. * Commissioner of Internal Revenue, * * Respondent. *

___________ Submitted: March 10, 1998 Filed: August 14, 1998

___________ Before BEAM and HEANEY, Circuit Judges, and WATERS, District Judge. 1

___________ BEAM, Circuit Judge. This case presents the ques tion whether the method of accounting for inventory shrink age used by a retailer, Dayton Hudson Corporation and Subsidiaries (Dayto n Hud son), is permissible. Dayton Hudson appeals from the tax court's decisio n upholding the Commissio ner of Internal Revenue's (Commissioner's) determination of tax deficiencies. We reverse.Dayton Hudson used the Last- In, First-Out (LIFO) method of identifying items 2 in ending inventory, a

nd the retail method of pricing inventories. See Treas. Regs. §§ 1.472-1 and 1.471-8. -2- I. BACKGROUND

The part ies have largely stipulated the facts. Dayton Hudson is a Minnesot a corpo ration with its principal place of business in Minneapolis, Minnesota. This case involves the accounting methods used by two of Day ton Hudson's divisions, Target and Dayton's, for the fiscal year ending on January, 2 8, 1984 (herein referred to as the 1983 taxable year). Together with its subsidiaries, Dayton Hudson filed a corporate federal income tax return for the 1983 taxable year.
By the end of the 1983 t axable year, Target operated a chain of 205 low-margin retail stores in 22 states, generating revenues of more than $3 billio n. Dayton's operated 16 traditional department stores, located in Minnesota, North Dakota, South Dakota , and Wisconsin. These stores generated revenues of approximately $488 million.
Dayton Hudson used the accrual method of accounting and maintained a perpetual inventory system for both financial reporting and tax purposes. Under th e perpetual inventory system, the cost or quantity of goods sold or purchased i s
con temporaneously recorded at the time of sale or purchase. Thus, the syste m continuously shows the cost or quantity of goods that should be on hand at any given tim e. Dayton Hudson performed physical inventories to confirm the accuracy of th e inventory as stated in the books, and made adjustments to the books to reconcile th e book inventory with the physical inventory. 2
Dayt on Hudson took physical inventories at its Target and Dayton's stores i n rotation throughout

the year. The parties refer to this technique, which is prevalent inDuring the months of December and January, Target also conducted physical 3 invento ries at each of its distribution centers and metro warehouses. The results o f the se inventories were taken into account in April of the following taxable year on a departmental basis by the Target stores serviced by each particular warehouse. -3- the ret ail industry, as cycle counting. This technique provides management with feedback on the effectiveness of its inventory management.
Target attemp ted to conduct physical inventories at its individual stores every 8 to 16 months. At times, however, as many as 18 months elapsed between physica l inventories. Physical inventories were not taken during the holiday season (November, December, and most of January). At new stores, Target did not perform physica l 3 inventorie s until their second year of operation because it believed that opening-year inve ntories produced meaningless results. Target generally employed an independent inventory service to perform the actual physical counts.
Dayton' s conducted its physical inventories on a departmental basis, countin g inventory items on the same day at e very store that maintained a particular department. Dayton's performed these counts at various times throughout the entire year. Generally, Dayton's regular employees conducted these physical inventories.

These physical inventories usually revealed shrinkage. Shrinkage (or overage) is the difference between the inventory determined from t he perpetual inventory records and the amo unt of inventory actually on hand. There are many causes of shrinkage , including theft, damage, and accounting and recording errors.

Because the physical inventories were not taken at year-end, Dayton Hudson' s perpetual inventory records di d not account for any shrinkage that had occurred during the period between the date of the last physical inventor y and the taxable year-end. We refer to this period as the stub period. Left unadjusted, Dayton Hudson's book recordsSlightly simplified, gross in come for most retailers means revenues less cost of 4 goods sold. The cost of goods sold is determined by subtra cting ending inventory from the goods available for sale during the year (opening inventory plus invent ory purchases during the period). Se e Rockwell Int'l Corp. v. Commissioner , 77 T.C. 780, 805 n.13 (1981), aff'd , 694 F.2d 60 (3d Cir. 1982). -4- would over state income because the stub period shrinkage results in a decrease t o ending inv entory, thus increasing the cost of goods sold and reducing gross income. 4 Accordingly, Dayton Hudson adjusted its book inventories to account for shrinkage. Da yton Hudson adjusted its book inventories in accordance with a corporat e policy, which was contained in th e "Controller's Manual." The policy provided that all companies must take at least one complete physical inventory every tax able year at each st ore, that book inventories should be reduced according to the "inventory shrinkag e
ac crual rate," which is stated as a percentage of net sales, and that "[e]ach Operatin g Company Controller is responsible for accounting for inventory shri nkage in accordance with the accrual basis of acco unting." Target and Dayton's each had different methods of setting the "inventory shrinkage accrual rate."
Target set "inventory shrinkage accrual rates" for every department in each store through a series of computations. It first developed an overall company rate b y reviewi ng the inventory results for the most recent three to five physical inventor y periods. It also considered a variety of other factors known to affect the rate o f shrinkage, including demographics, crime levels, management and pa perwork problems, shrinkage reduction measures, industry trends, warehouse performance, and stor e acquisitions. Next, after considering store-specific factors known to affect shrinkage rate s, Target determined preliminary shrinkage rates for each store. Target the n adjus ted the preliminary rates so that, in the aggregate, they equaled the compan y shrinkage as determined by the overall company rate. Last, Target determine d shrinkage rates at t

he departmental level, based on a three-year average shrinkage rate-5-

for the depa

rtment at each store. Those rates were further adjusted to accord with the shrinkage ra te for each store in proportion to each department's sales relative to th e store's totalsales during the most recent twelve-month period. For new stores, Target generally set shrinkage accrual rates by reference to the average shrinkage rate for the locality, the demographics, and the p lans of stores that are located in areas with similar demographics and m arketing plans (sister stores). Using these shrinkage rates, Target would c alculate and then record the estimated shrinkage in its perpetual inventor y records on a monthly basis.
Unlike Target, Dayton's directly determined shrin kage rates for each department. In setting a departmental rate, Dayton's considered numerous facto rs, including the most
rec ent shrinkage history and shrinkage trends of that particular department, th e
em ployment

of new marketing strategies, changes in demographics, trends that wer e developing in rela

ted departments, changes in security procedures, and particular theft problems. Dayton's did not set an overall company shrinkage rate. The estimate d shrinkage was calculated and rec orded in the perpetual inventory records on a monthly basis.

Each physical inventory would reveal a difference between the estimate d shrinkage as reflected in the perpetual inventory records and the shrinkage verified by the physical inventories (estimation error). Upon completion of a physical inventory, Dayto n Hudson would adjust its inventory records to reflect any estimation error

. Consequently, for each taxable year, Dayton Hudson's total adjustments to its inventory records for shrinkage would include (1) any sh rinkage estimates for the period from the start of the taxable year until the physical inventory date, (2) any estimation erro r adjustment, and (3) any stub period shrinkage estimates. Dayto n Hudson used the same shrinkage estimates for tax purposes as it used for financial reporting, determinin g budgets, evaluating employees, and determining the sources of shrinkage.-6-

The Commissioner issued Dayton Hudson a notice of deficiency in the amount of $17,384,314 for the 1983 taxable year. The notice of deficiency made cos t adju stments to the LIFO inventories of Target and Dayton's in the respective amounts of $36,339,217 and $2,440,127, reflecting a disallowance of the estimated shrinkage fo r the stub period. Dayton Hudson filed a timely petition in the tax court seekin g redetermination of the resulting deficiencies.

Prior to trial, the Commissioner moved for summary judgment, asserting tha t Treasury Regulation section 1.471-2(d) prohibits the use of estimated shrinkage as a matter of law. In a reviewed decision, the tax court held that a method of computin g shrinkage, including estimated shrinkage, is permissible if it is "so und." Dayton Hudson Corp. and Subsidiaries v. Commissioner , 101 T.C. 462, 465 (1993) ( Dayton Hudson I ) (12-5 d ecision). At trial, however, the tax court determined that Dayton Hudson' s method of computing shrinkage was not sound. The tax court defined a s ound inventory method as one that (1) conforms to the best a ccounting practice in the trade or business and that (2) clearly reflects income. The tax court found that, although Dayton Hudson's method conformed to the best accounting practice, the Commissioner acted within her discretion in d etermining that the method did not result in a clear reflection of income.

Dayton Hudson appeals, asserting that its method of estimating shrinkag e
res ultedin a clear reflection of income. Dayton Hudson also contends that th e Commis sioner's method does not reflect income clearly, and therefore, that th e Commis sioner

abused her discretion in changing Dayton Hudson's method

. Additio nally, the Commissioner continues to dispute the tax court's holding in Dayton Hud son I that the use of shrinkage estimates is permissible. The Commissione r
conce des, however, that Dayton Hudson's inventory method conformed to the bes t accounting practice within the meaning of I.R.C. § 471(a).-7-

II. DISCUSSION

The Commissioner's argument that Treasury Regulation section 1.471-2(d ) prohibi ts the use of shrinkage estimates is foreclosed by our recent decision in Wal

Mart Stores, Inc. & Subsidiaries v. Commissione r , No. 97-2693, slip op. (8th Cir. Aug. 14, 1998 ). Consequently, the only question remaining is whether the Commissione r abused her discretion in prescribing a new method of accounting for Dayton Hudson.

The general rule for accounting methods provides, "Taxable income shall b e computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books ." I.R.C. § 446(a). Dayton Hudson used the
sa me inventory accounting method for book and tax purposes. Nonetheless, "if th e method used does not clearly reflect in come," the Commissioner has broad authority to prescribe a method that "does clearly reflect income." I.R.C. § 446(b). In the notice of def iciency issued to Dayton Hudson, the Commissioner prescribed a method tha t does not account for shrinkage until it has been verified by a physical count. The tax court determined that the Commissioner had acted within her discretion.

We review de novo the tax court's conclusion that the Commissio ner acted within her discretion in di sallowing Dayton Hudson's method of accounting and prescribing a different method. See Wal-Mart Stores, Inc. , No. 97-2693, sli p op. at 13. Nonetheless, we review the tax court's findings of fact for clear error. See id.
The Commissioner's discretion to prescribe a method that clearly reflects income cannot be disturbed unless it is clearly unlawful or plainly arbitrary. See Thor Power Tool Co. v. Commissioner , 439 U.S. 522, 532 -33 (1979). The Commissioner may not, however, require a taxpayer to change from an accounting me thod that reflected income clearly, merely because the Commissioner believes that her method more c learly reflects income. See, e.g

. , Louisville and Nashville R.R. v. Commissioner , 641 F.2d 435, 438 (6th Cir. 1981). Likewise, even if the taxpayer's method does not result in a-8-

clear reflection of income, the Commissioner may not change a taxpayer's accounting method to a met

hod that fails to reflect income clearly. See Commissioner v. Hansen , 360 U.S . 446, 467 (1959); Harden v. Commissioner , 223 F.2d 418, 421 (10th Cir

. 1955) (holding that when a taxpayer's accounting meth od fails to reflect income clearly, the Commissioner's only remedy is to prescribe a method that clearly reflects income); Rotolo v. Commissioner , 88 T.C. 1500, 1514 (1987) (stating that "the Commissioner may not require a taxpayer to adopt an accounting method which does no t clearly reflect inc ome"). Thus, in order to prevail, Dayton Hudson must show either that it s accounting method resulted in a clear reflection of income or that the Commissioner's method does not.
In the absence of a statutory definitio n of the phrase "clearly reflect income," we turn to the regulations for meaning. Treasury Regulation section 1.446-1(a)(2) states that an accounting method "which reflects the consistent application of generall y
acc epted accounting principles in a particular trade or business in accordance wit h accepted conditions or practic es in that trade or business will ordinarily be regarded as clearly reflecting income." Treasury Regulation section 1.471- 2(b) further provides that "[i ]n order clearly to reflect income, the inventory practice of a taxpayer should b e consistent from year to year, and greater weight is to be given to cons istency than to any particular me thod of inventorying or basis of valuation." Against this background, we evaluate Dayton Hudson's accounting methods.

1. Dayton Hudson's Shrinkage Methods
At the outset, w e note that the tax court found, and the Commissioner concedes
on appea l, that Dayton Hudson's method of accounting for shrinkage consistentl y conformed to Generally Accepted Accounting Principles (GAAP) and was i n accord ance with the best accounting practice in the retail industry. Compliance with GAAP wil l ordinarily "pass muster for tax purposes," though it does not create a presumption of validity. Thor Power Tool , 439 U.S. at 540.To avoid aberrational results, Wal-Mart also applied certain ceiling and floo r 5 limitations to its calculated shrinkage rates. See Wal-Mart Stores, Inc. , No. 97-2693, slip op. at 6. These limitations were, however, also based on historical shrinkag e results. See id. -9- The method of accounting for shrinkage that Dayton Hudson used at Dayton' s differedslightly from what it used at Target. Dayton's directly set its estimate d shrinkage rates at the departmental level and Tar get determined departmental shrinkage rate s through a series of calculations. For both divisions, Dayton Hudson injecte d
numerous subjective factors, such as demographics, trends, and changes in securit y measures, into its method of establis hing shrinkage rates. They did not, however, have
a discernible method of quantifying these considerations, nor did they even bothe r keeping all the necessary work papers or documentation with respect to its shrinkage rate det erminations. The Commissioner's expert, Dr. David LaRue, testified tha t Tar get's method "is predicated on so many subjective processes, that a disintereste d p a rty with full knowledge of all relevant data, would not . . . be able to independently reconstruct the forecasted shrinkage derived under this procedure."
Dayton Hudson's method o f estimating shrinkage provided its management with a broad range of possible shrinkage rates, unlike the method used by Wal-Mart Stores, Inc., that resulted in a clear reflection of income. See Wal-Mart Stores, Inc. , No. 97- 2693, sli p op. at 13-19. Wal-Mart set shrinkage accrual rates for its existing store s based solely on well documented and objective f actors—a three-year rolling average of verified shrin

kage. Every year, Wal-Mart determined its estimated shrinkage rates in 5 the same fashion.
Dayton Hudson argues that de termining a reasonable shrinkage rate requires the use of judgment because circumstances which are known to affect shrinkage rates are always cha nging. We neither condemn nor approve the use of judgment in settin g shrinkage rates. However, the more a method is laden with considerations left to the-10-

unbridleddiscretion of a few individuals, the less conducive it is to consisten t appl ication. In the present case, Dayton Hudson's largely undocumented process o f ascertaining shri nkage rates entailed so many subjective considerations that consistent application of the process from year-to-year was difficult, if not impossible. See Treas. Reg. § 1.4 71-2(b) ("greater weight is to be given to consistency" from year-to-year)

. Consistency, however, is only one component of the clear reflection of income standard.

The sta ndard also includes an accuracy component. See Caldwell v

. Commissi oner , 202 F.2d 112, 115 (2d Cir. 1953) (stating that "income should b e refle cted with as much accuracy as standard methods of accounting practice permit"). Th e tax court found that Dayton Hudson failed to show that its method produce d accurate results. We review that factual finding for clear error.
Dayton Hudson's principal expert, Dr. W. Eugene Seago, testified to the accuracy of Target's method. Dr. Seago found a "nearly perfect" statistical correlation between sh rinkage and sales at the aggregate division level during the years ending in 198 0 through 198 9. Due to the absence of the necessary data, he did not conduct a correlation analysis at the departmental or store levels. Next, assuming a perfec t correlati on between shrinkage and sales, he conducted two analyses showing tha t Target's method produced accurate results.
The tax court rejected the significance of Dr. Sea go's correlation analysis, stating that:

Essent ially, Dr. Seago has not persuaded this Court that the stron g correla tion between sales and shrinkage derived from the 10-year correlat ion analysis is the product of the true relationship between sale s and shrinkage and not the product of the confluence of varying LIFO pool attributes. Dr. Seago has failed to explain that apparently fundamenta l flaw in the 10-ye ar correlation analysis. That is not to say that we would-11-

never accept statistical analyses demonstrating a correlation between sales a n d shrinkage; that is only to say that Dr. Seago, in this case, has simply failed to prove the significance of the c orrelation derived from the 10-year correlation analysis. Because the tax court did not accept the stati stical correlation between shrinkage and sales , it was equally unpersuaded by Dr. Seago's accuracy analyses, which wer e dependent on that correlation.

The tax court's finding that Dr. Seago failed to show the significance of hi s correlation analysis was not clearly erron eous. The record contains statistical evidence showing that the correlation between shrinkage and sales deteriorated at the store and departmental levels, where the degree of correlation, in Dr. Seago's words, is "highly relevant." The Commissioner's expert, Dr. LaRue, also questioned the significance of Dr. Seago's correlation a

nalysis. Although we may have concluded differently, we are not convinced that these findings are clearly erroneous.

After a review of the record and the tax court's f actual findings, we conclude that Dayton Hudson did not prove that the Commissioner abused her discretion in finding that its accounting method failed to reflect inc ome clearly. We next turn to whether the method prescribed by the Commissioner results in a clear reflection of income.

2. The Commissioner's Shrinkage Method

We re view the tax court's conclusion that the Commissioner's method clearl y reflects Dayton Hudson's income de novo. See Wal-Mart Stores, Inc. , No. 97- 2693, slip op. at 13.

The Commissioner's method does not accou nt for shrinkage until it is verified by phy sical count. The Commissioner accounts for shrinkage by reducing the curren t taxable year's ending inventories by the amount of verified shrinkage from the prior-12-

physical inventory period. The prior physical i nventory period begins with the physical inventory taken in the previous taxable year and concludes with the physical inventory ta ken in the current taxable year. Because shrinkage occurs in both the physica l inventory-to-year-endperiod and the year-end-to-physical-inventory period, th e Commissioner's method includes shrinkage that occurred during two taxable years.

The tax court characterized the Commissioner's method as one that "essentially estimates [year-end] shrinkage for the taxable year based on [year-end] shrinkage for the prior taxa ble year." This is simply not the case. The method prescribed by th e Co mmissioner

does not estimate the current taxable year's stub period shrinkage, i t merely delays the inclusion of stub period shrinkage until the following year.
Despi te rejecting Dr. Seago's sales-based correlation, the tax court found tha t shrinkage occurs during the entire year, including the stub period. The Commissioner
ca nnot seriously challenge that finding. Thus, the Commissioner's method alway s inclu des goods in ending inventory that were lost due to shrinkage during the stu b period

. For example, if Target suffered $65 million in shrinkage during the physica l inventor y period that ended in year 2, a significant portion of that shrinkage surel y occurred during the stub period of year 1. Under the Commissioner's method, that stub period shrinkage is not accounted for on Dayton Hudson's year 1 tax return, and thus the ending inventory on the year 1 tax return includes goods that are no longer i n inventory. On the year 2 tax return, the Commissioner's method includes year 1 stub perio d shrinkage and the shrinkage from the beginning of year 2 to the last physica l inve ntory, while ignoring year 2 stub period shrinkage. Thus, the Commissioner' s method does not

even attempt to reflect the shrinkage that occurred during the taxable year. Rather than propose her own method of estimatin g the stub period shrinkage, the Commissi oner

has instead adopted a method that does not account at all for th e shrinkage t

hat occurred during the stub period, penalizing those taxpayers that did not-13-

conduct a physical inventory at year-end. The Commissioner argues that her method is proper because verification is an ess ential aspect of inventory accounting. However,
we have previously held that by permitting cycle counting, the Commissioner ha s "opened the door to the industry practice of estimating shrinkage." Wal-Mart Stores, Inc. , No. 97- 2693, slip op. at 10. Dayton Hudson has an abundance of inventor y records and data, including historical shrinkage experiences, such that th e Commissioner could have construc ted a method of accounting for shrinkage during the stub period. Moreover, for businesses, such as Target, that are opening new store s every year, the Commissioner's method is p articularly distortive because the initial stub period at a new store tends to be l onger than that of an existing store. Finding no basis in law or fact for t

he Commissioner's method, we hold that Dayton Hudson has shown that the Commissioner's method does not ref lect income clearly and is plainly arbitrary. See Thor Power Tool , 439 U.S. at 533.
Congress apparently had the same trepidations about the Commissione r's method. In enacting I.R.C. § 471(b), Congress stated, "Whe re physical inventories are not taken at [year -end], the Committee believes that income will be more clearly reflected if the taxpayer makes a reasonable estimate of the shrinkage occurring through [year-end] , rather than simply ignoring it." H.R. Rep. No. 105-148, at 409 (1997); S. Rep. No

. 105-33, at 231 (1997).
The Commissioner argues that by rejecting her method, we are declaring that any inventor y method that does not estimate stub period shrinkage fails to reflect incom e clearly. Thi s is simply not the case. The Code provides that if the Commissione r desires to prescr

ibe an alternative accounting method, that method must clearly reflect the taxpayer' s income. See I.R.C. § 446(b). Here, we simply hold that the metho d prescribed for Dayton Hudson does not result in a clear reflection of income. W e express no opinion on the accounting methods of other taxpayers.-14-

III. CONCLUSION

We f ind no error in the tax court's conclusion that Dayton Hudson's method o f accounting for shrinkage did not reflect income clearly. However, we find that th e Com missioner

acted arbitrarily in prescribing a different method that does not reflec t income clearly. Accordingly, the judgment of the tax court is reversed.
A true copy.

Attest:
CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.