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. 97-2693

___________ Wal-Mart Stores, Inc. & Subsidiaries, * * Appellees, * *
v. * Appeal from the United States * Tax Court. Commissioner of Internal Revenue, * * Appellant. *

___________ 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 question whether a retailer may account for unverifie d inventory shrinkage, and if so, whether the method used by Wal-Mart Stores, Inc. & Subsidiaries is permissible. The Commissioner of Internal Revenue (Commissioner)The Honorable David Laro, United States Tax Court Judge. 2 Kuhn's and Edwards were subsidiaries of the parent and Sam's was a division 3 of the parent. Because Sam's used different accounting me thods than the other entities, we will use the name "Wal-Mart" to refer collectively to Kuhn's, Edwards, and th e parent company (excluding Sam's) and we will use the term "the Taxpayer" to refe r collectively to "Wal-Mart" and Sam's.
-2- appeals from the tax court's decision reversing the Commissioner's determination o f 2 federal tax deficiencies. We affirm the tax court.

I. BACKGROUND

The parties have stipulated the relevant facts. Wal-Mart Stores, Inc., was th e parent company of a group of affiliated corporations, including Kuhn's-Big K Store s Corp. (Kuhn's), Big K Edwards, Inc. (Edwards), and Sam's Wholesale Clubs (Sam's). 3 The Taxpayer filed consolidated tax returns for the fiscal years ending in late January of 1984 (referred to herein as the 1983 taxable year), 1985, 1986, and 1987. Th e Taxpayer's principal place of business was in Bentonville, Arkansas.
During the taxable years at issue, Wal-Mart op erated its stores as mass discount retailers , carrying between 60,000 and 90,000 different merchandise items in eac h store. Wal-Mart purchased more than $22 billion in merchandise, turning its inventory
over as of

ten as 4.5 times per year. Sam's ran its stores as discount warehouses , ca rrying between 3,500 and 5,000 different merchandise items, acquiring more tha n $2.6 billion in merchandise. The Taxpayer's operations grew at a reso unding pace from 1983 to 1986. For example, the number of Wal-Mart sto res increased from 642 to 980 and the number of Sam's stores increased from 3 to 49. The Taxpayer utilized a n extensive distribution and tracking system to maintain optimal inv entories at each store. The Taxpa yer's inventory system is commonly revered as the finest in the retai l industry.Wal- Martused the Last-In, First-Out (LIFO) method of identifying items i n 4 ending inven tory and the retail method of pricing inventories. See Treas. Regs. § § 1.472-1 and 1.471-8. Wal-Mart determi ned the cost of the LIFO inventories using the dollar value LIFO method and it valued any increase in inventory quantities based on the cost of the earl iest acquisitions during the year. See Treas. Regs. §§ 1.472-8 and 1.472-2. Sam's did not use the retail method. Sam's used the First-In, First-Ou t (FIFO) method of identifying items in ending inventory. -3- For both financial reporting and tax purposes, the Taxpayer used the accrua l metho d of accounting and maintained a perpetual inventory system. Under th e perpetual inventory system, the cost or quantity of goods sold or purchased i s contemporaneously recorded at the time of sale or purc hase. The system continuously sh ows the cost or quantity of goods that should be on hand at any given time. Th e Taxpayer performed physical inventories to confirm the accuracy of the inventory as stated in the books, and made adjustments to the books t o reconcile the book inventory with the physical inventory. 4

The Taxp ayer's physical inventories were taken at its stores in rotatio n throughout the year. The Taxpayer did not take physical inventories during the holiday season (November, December, and the first week of January). The Taxpayer refers to this tech nique, which is common in the retail industry, as cycle counting. Cycl e
coun ting is necessitated by the difficulty in conducting physical inventories at every sto re on the last day of the year. This technique also provides management with feed back on the effectiveness of its inventory management and facilitates the use o f experienced personnel to conduct the physical inventories.
Forty-five days prior to conducting a physical inventory in one o f its stores, WalMart's in ternal audit department would send the store a preparation package, whic h inclu ded instructions on how to prepare for the physical count. Each physical coun t
was then co nducted by a team of independent counters (18 to 40 persons) an d representativ es from Wal-Mart's loss prevention department (1 to 2 persons), internalOn occasion, the Taxpayer would immediately record physical inventories taken 5 in January , the last month of its fiscal year. In the 1983 taxable year, the Taxpaye r recorded in January all 39 of the physical inventories taken that month. In the 198 4 taxable ye ar, the Taxpayer recorded, in January, 9 of the 73 inventories taken. In the 1985 ta xable year, the Taxpayer recorded, in January, only 1 of the 73 physica l inventories taken, while in the 1986 taxable year, the Taxpayer did not record i n January any of the 95 physical inventories taken.
-4- audit department (1 to 3 persons), and operation s division (1 to 2 persons). Wal-Mart's independent

auditors, Ernst & Young, also sent representatives to randomly selected physi cal counts to test their accuracy. The independent counters generally counte d every invento ry item. The results of the physical count were then reconciled with the book inve ntory. The reconciliations were reviewed by Wal-Mart's internal audi t department. Generally, Wal-Mart did not record the results of a physical inventory in its books until the following month. 5
Sam's conducted its physical inventories in the same manner except that physical counts were usually taken twice a year and recorded the very next day. Sam's als o periodi cally conducted item audits, counting the goods on hand for a particular merchandise unit and recording those res ults the next day. The physical inventories of both Wal-Mart and Sam's usually revealed shrinkage.
Shrinkage (or overage) is the diff erence between the inventory determined from the perpetual inventory records and the amount of inventory actually on hand. Because shrinkage reduces profits, the Taxpayer has devoted extensive resources to monitoring
an d mitigating shrinkage. There are many causes of shrinkage, including employe e theft, customer theft, vendor theft, damage, breakage, spoilage, accounting an d recording errors, errors in marking re tail prices, cash register errors, markdowns taken andnot recorded, errors in accounting for customer returns, and errors in accounting for vendor receipts and returns.Slightly simplified, gross in come for most retailers means revenues less cost of 6 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 inventory 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). -5- Be cause the Taxpayer did not conduct a physical inventory at year-end, it s perpetual inventory records did not account for any shrinkage that may have occurred during the period between the date of the last physical inventory and the taxable yearend. The parties refer to this perio d as the stub period. Left unadjusted, the Taxpayer's book rec ords would overstate income because the stub period shrinkage results in a decrease to ending invent ory, thus increasing the cost of goods sold and reducing gross income. 6

In adjusting its books to reflect stub period shrinkage, Wal-Mart estimated stub period sh rinkage for each store monthly by multiplying a retail shrinkage rate by th e store's sal es during that month. At new stores, the retail shrinkage rate was fixed b y management

at 3% of sales in the 1983 and 1984 taxable years and 2% of sales in the 1985 and 1 986 taxable years. Wal-Mart used that fixed rate from the date the stor e opened u ntil its first physical inventory, which rarely took place less than six month s af ter opening. After taking the first physical inventory at a new store, Wal-Mar t computed a s hrinkage rate for that store by dividing the store's shrinkage at retail, a s verified by the first inventory, by the store's sales for the p eriod starting with the date the store opened and ending on the inventory date. After Wal-Mart took a sec ond inventory, it computed the store's shrinkage rate by dividing the stor e's shrinkage, as verified by the first two inventories, by the store's sales starting with the opening date and ending on the second i nventory date. After the third inventory, it computed the shrinkage rate b y dividing the store's shrinkage, as verified by the first three inventories, by the store' s sales starting with the opening date and e nding on the third inventory date. After taking a fourth and each subsequent inventory, the retail shrinkage rate was-6-

based on a rolling average of the historical shrinkage over the preceding thre e inventories.

The retail shrinkage rate was subject to certain floor and ceiling percentag e limitations that were set by Wal-Mart's management, based primarily on a weighted fiveyear average of shrinkage. If the computed shrinkage rate was below the floo r limitation, or if it was an overage, the computed rate was replaced by t he floor limitation. Likewise, if the computed rate exceeded the ceiling limitation, it was replaced by th e ceiling limitation.
Sam's consistently estimate d the stub period shrinkage at .2% of sales. That rate
was determined by management based on their analysis of historical results fro m warehouse operations.
Each physical inventory would re veal a difference (estimation error) between the estim ated shrinkage, as reflected in the perpetual inventory records, and the verifie d shrinkag e. At that time, the Taxpayer would adjust its inventory records to reflect any estimation error. Consequ ently, for each taxable year, the Taxpayer's total adjustments to its inventory reco rds for shrinkage would include (1) any shrinkage estimates for the period fro m the start of the taxable year until the physical inventory date, (2) an y estimation error adjustment, and (3) any stub p eriod shrinkage estimates. The Taxpayer also recomputed the retail shrinkage rate for th e store and used that new rate to estimate shrinka ge until the next physical inventory. Thus, if the Taxpayer overestimated o r underestimated a store's shrinkage in year one, it would adjust that store's shrinkage rate in year two. In accordance with the cycle counting technique, this was a continuou s process throughout the year for each of the Taxpayer's stores.

Wal-Mart estimated shrink age for each store, but not for each department within each store. It used a series of computations to allocate the estimated stub perio d shrinkage to each department. Once these allocations were made, Wal-Mart used theThe notice of deficiency for 1983 and 1984 disallowed shrinkage estimates for 7 Wal-Mart only. The notice for 1985 and 1986 disallowed shrinkag e estimates for WalMart and Sam's. The Commissioner calculated that, as a res ult of disallowed inventory shrinkage, the Taxpayer had understated its taxable income by $24,276,994 in 1983, by $7,837,122 in 1984, by $20,394,840 in 1985, and by $1,196,045 in 1986.
-7- ad justed ending inventory to make its LIFO computations, see Treas. Reg. § 1.472-1 , which were made on a division-wide basis and not at the individual store level.
The Taxpayer reported shrinkage on an aggregate basis for both financial and tax purpose s. The practice of estimating shrinkage as a percentage of sales is prevalent in the ret ail industry. Ernst & Young issued unqualified opinions to the effect that th e Taxpayer's financial statements for the subject years conformed with Generally Accepted Accounting Principles (GAAP). Ernst & Young periodically reviewed the Taxpayer's
accou nting method for estimating shrinkage during the stub period and neve r recommended a change.

The Com missioner disallowed the Taxpayer's use of shrinkage estimates. Th e Com missioner

issued the Taxpayer two notices of deficiency, one in the amount o f $9,937,544.68 for the 1983 taxable year and $4,084,255.28 for the 1984 taxable year and the other in the amount of $9,381,626.40 for the 1985 taxable year and $8,206,962 for the 1986 taxable year. The Taxpayer filed a timely petition in the tax court seeking 7 redetermination of the resulting deficiencies.

The tax co urt, following a prior decision, see Dayton Hudson Corp. an d Subsi diaries v. Commissioner , 101 T.C. 462, 465 (1993) ( Dayton Hudson I ) (12- 5 revie wed decision), held that a method of computing shrinkage, including estimate d shrinkage, is permissible if "sound." C iting Treasury Regulation section 1.471-2(a), the tax court d efined a sound inventory method as one that (1) conforms to the bes t accounting practice in the trade or business and that (2) clearly reflects income. The-8-

t a x court then applied the two-part test to conclude that the Commissioner had abused her discretion in finding that the Taxpayer's inventory methods were not sound.

The Commissioner appeals, asserting that the regulations prohibit the reduction of ending inventory by estimated shrinkage. The Commissioner further contends that, even if shrinkage estimates are permissible, the Taxpayer's method of accounting did not clearly reflect income.

II. DISCUSSION

We fir st address whether all shrinkage estimates are prohibited from being used to reduce ending inventories and then turn to whether the Taxpayer's particular method of accounting for estimated shrinkage is permissible.

A. Use of Shrinkage Estimates to Reduce Ending Inventories
The general rule for inventory accounting is that:
Whenever i n the opinion of the [Commissioner] the use of inventories i s nec essary in order clearly to determine the income of any taxpayer , inventori es shall be taken by such taxpayer on such basis as th e [Commi ssioner] may prescribe as conforming as nearly as may be to th e best acc ounting practice in the trade or business and as most clearl y reflecting the income.In 1997, Congress amended section 471, expressly providing that, in tax years 8 ending after August 5, 1997, ending inventories may be reduced by shrinkag e estimates. SeeTaxpayer Relief Act of 1997, Pub. L. No. 105-34 , § 961, 111 Stat. 788, 891 (codified as amended at I.R.C. § 471(b)). The Taxpayer and the Commissione r bo th argue that the change in law supports their position. We, however, find that the recent ame ndment sheds little, if any, light on whether shrinkage estimates wer e permissible under the earlier law. See H.R. Conf. Rep. No. 105-220, at 467 (1997). The Taxpayer has not challenged the validity of the regulations. 9
-9- I.R.C. § 4 71(a). Determining the propriety of a taxpayer's reduction of endin g 8 inventori es by estimated shrinkage requires construction of the relevant sections of the Internal Revenue Code (Code) and the regulations. Thus, this issue presents a question 9 of law subject to plenary review. See Musco Sports Lightin g, Inc. v. Commissioner , 943 F.2d 906, 907 (8th Cir. 1991).

It is und isputed that the use of inventories is necessary to determine incom e because the Taxpayer is engaged in the sale of merchandise

. See Treas. Reg. § 1.471-1. An invent ory method must (1) conform as nearly as may be to the best accountin g practice in the trade or business, and (2) clearly reflect income. See Treas. Reg. § 1.471-2(a). The tax court analyzed the Taxpayer's inventory method under this two

prong tes t. The Commissioner contends that independent of this two-prong test , Treasury Regulation section 1.471-(2)(d) precludes the use of all shrinkage estimates. The regulation provides in relevant part: Where the taxpayer maintains book inventories in accordance with a sound accounting system in w hich the respective inventory accounts are charged with the actual cost of the goods purchased or produced and credited with th e value of goods used, transferred, or sold, calculated upon the basis of the actual cost of the goods acquired during the taxable year (including the inven tory at the beginning of the year), the net value as shown by suc h inve ntory accounts will be deemed to be the cost of the goods on hand

. The balances shown by such book inventories should be-10-

verified by physical inventories at reasonable intervals and adjusted t o conform therewith. Treas. Reg. § 1.471-2(d).

The Commissioner interprets the regulation to provide that (1) the Taxpayer' s book inventories, without adj ustment for estimated shrinkage, will be deemed to reflect the costs of goods on hand at year-end, and (2) book inventories may be adjusted t o reflect shrinkage only when a physica l count is conducted. The Taxpayer contends that adjusted book inventories are deemed to reflect the cost of the goods on hand at yearend, if the adjustment is made in accordance with a sound accounting system.
The regulatory scheme recogniz es that shrinkage occurs, as it provides that book inv entories "should be verified by physical inventories at reasonable intervals an d adjusted to conform therewith." The Commissioner does not dispute th at the proper way to accou nt for verified shrinkage is to reduce book inventories, resulting in an increase to cost of goods sold. Nonetheless, the Commissioner ass erts that book inventories may be reduced only by verified shrinkage and not with estimates. Nothing in the text of the regulation, h owever, distinguishes between estimated shrinkage and shrinkage that has been verified by physical count. We will not read in such a distinction.

Our reading comports with the background of the Commissioner's regulator y sch eme. Prior regulations construing the predecessor to section 471 provided tha t physical inventories must be taken at year-end. See Regs. 45, art. 1588(3)(B) (1921). The Commissioner dispensed with that requirement in 1922. See Regs. 45, art. 1582, as amended by T.D. 3296, I-1 C.B. 40 (1922) (providing that physical inventories need not be taken at year-end, but only at reasonab le intervals). In removing the burdensome ye ar-end physical inventory requirement, the Commissioner opened the door to th e industry practice of estimating shrinkage during the stub period. Nothing in theWe need not address the Taxpayer's argument that the all events test, s ee Treas. 10 Reg. § 1.46 1-1(a)(2)(ii), permits the estimation of shrinkage, in part because it wa s raise d for the first time on appeal, and in part because we hold that the inventor y regulations permit the use of shrinkage estimates.
-11- Commissioner's regulatory scheme, which provides that book inventories may substitute for year-end physical inventories, prohibits the reduction of ending inventor ies to account for estimated inventory shrinkage. Moreover, the accrual method of accountin g contempl ates the use of estimates. See, e.g. , Treas. Reg. § 1.461-1(a)(2)(ii)

. Accordingly, we c onstrue Treasury Regulation section 1.471-2(d) to provide that book inventories, as adjusted for estimated stub period shrinkage, are "deemed to be the cost of the goods on hand" provided that (1) such inventories are maintained in accordance with a sou nd accounting system; (2) goods are valued at actual cost; and (3) physica l inventories are taken at reasonable intervals.

Here, the se cond and third criteria are not at issue. The only controversy i s whether the Taxpayer "maintain[ed] book inventories in accordance with a soun d accounting system." The regulations do not define "sound accounting system," and we find n o plausible construction of the phrase that would exclude the use of shrinkag e estimates. See Dayton Hudson I , 101 T.C. at 468. In mandating a "sound accounting syste m," we find that the regulation prescribes no higher standard than that of sectio n 47 1(a), which requires that an inventory method must conform "to the best accounting practice in the industry" and result in a clear reflection of income. I.R.C. § 471(a). 10 The phrase "best accounting practice in the industry" is synonymous with GAAP. See Thor Power Tool Co. v. Commissioner , 439 U.S. 522, 532 (1979). The tax court found, and the Comm

issioner concedes on appeal, that the Taxpayer's use of shrinkage estimate s conformed to GAAP. We thus conclude that Treasury Regulation sectio n 1.471-2(d) permits the Taxpayer's method of estimating shrinkage provided that such-12-

method resul ted in a clear reflection of income. We will analyze the Taxpayer' s particular method in Part IIB.

We r eject the Commissioner's argument that permitting the reduction of endin g inventories by estimated shrinkage runs afoul of the Supreme Court's decision in Thor Power Tool . In Thor Power Tool , the taxpayer, in accordance with G AAP, wrote-down certain "excess inventory" to its net realizable value, which in most cases was its scrap value. 439 U.S. at 530. However, despite taking the inventory write- down, the taxpayer continued to offer the inventory for sale at full price. See id. at 529. The Court applied the regulat ions to the facts and held that the Commissioner properly disallowed th e taxpayer' s write-down as not clearly reflecting income because the taxpayer's metho d "was plai nly inconsistent with the Regulations." Id. at 538. In Thor Power Tool , th e regu lations clearly articulated when a taxpayer could value inventory below its market value, which is distinct fro m the present situation because, here, the Taxpayer's method is not clearly covered by the relevant regulations.

The Commissioner additio nally contends that the Taxpayer's reduction of ending inventories for estimated shrinkage was actually a deduction for a reserve, which may not be taken unless Congress has specifically so prov ided. See id. at 541-44. A reserve is used to set aside funds for an "estimated future loss" or expense

. Id. at 542. Here, the Taxpayer e stimated the amount of shrinkage that had actually occurred during the stub period, not a loss that may occur in the future. Therefore, estimated shrinkage is not an impermissible reserve.
In sum, the Commissioner's arguments are u navailing, and we find nothing within the rele vant statutes, regulations, or case law that prohibits the use of shrinkag e estimates.The Commissioner also determined that the Taxpayer's understatement o f 11 inco mewas partially caused by a miscalculation of a cost complement. The partie s have resolved their disagreements with respect to this issue. -13- B. Taxpayer's Method of Accounting for Shrinkage

Th e general rule for methods of accounting provides, "Taxable income shall b e computed u nder the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." I.R.C. § 446(a). For all relevant years, the Taxpayer has used the same method of accounting for book and tax purposes

. Nonetheless, "if the method used does not clearly reflect income, " the Commissioner has broad auth ority to prescribe a method that "does clearly reflect income." I.R.C. § 446(b). In the two notices of deficiency issued to the Taxpayer, the Commissione r prescribed a method that does not account for shrinkage until verified by a physica l count. The tax court determined that the Commissioner had abused her discretion in

11 acting under section 446(b), because the Taxpayer's method reflected income clearly.

The "clearly reflect income" standard is a technical standard which is not easily resolved by resorting to "experience with the mainsprings of human conduct. " Commissioner v. Duberstein , 363 U.S. 278, 289 (196 0). Consequently, we find that the tax court's conclusion that a particular method of accounting resulted in a clear reflection of income is a conclusion of law, or at least a mixed question of law and fact, subject to de novo review. See, e.g. , Black Hills Corp. v. Commissioner , 73 F.3d 799, 804 (8th Cir. 1996) ; cf. Ford Motor Co. v. Commissioner , 71 F.3d 209, 212 (6th Cir. 1995 ) (holding that the clear reflection of income standard presents a question of ultimate fact, which is reviewed de novo). Nonetheless, we respect the tax court's purely factua l finding s unless they are clearly erroneous, and we accord the Commissioner' s determination the same discretion. See Black Hills Corp. , 73 F.3d at 804.-14-

The Commissioner's discretion to prescribe a method that clearly reflects income cannot b e disturbed unless it is clearly unlawful or plainly arbitrary. See Thor Powe r Tool , 439 U.S. at 532-33. However, the Commissioner may not require a taxpayer to change from an accounting method that reflected income clearly, merely because th e Commissioner believes that her method more clearly reflects income. See, e.g. , Louisville and Nashville R.R. v. Commissioner , 6 41 F.2d 435, 438 (6th Cir. 1981). We find that the Taxpayer's method resulted in a clear reflection of income because i t complied with GAAP, it was consistent, and it produced accurate results.

The Code does not define the phrase "clearly reflect income." The regulations, however, provide some guidance. Treasury R egulation section 1.446-1(a)(2) states that
an accounting method "which reflects the consistent application of generally accepted account ing principles in a particular trade or business in accordance with accepte d conditio ns or practices in that trade or business will ordinarily be regarded as clearl y reflecting income." Here, the tax court found that the Taxpayer's method of accounting for stub p eriod shrinkage consistently applied GAAP and was in accordance with th e best accounting practice in the retail industry.

The Commissioner does not dispute that finding, but instead asserts that the tax court p laced undue emphasis on financial accounting principles. We disagree

. Compliance with GAAP will ordinarily "pass muster for tax purposes," though it does not cre ate a presumption of validity. See Thor Power Tool , 439 U.S. at 540. The tax court did not grant the Taxpayer an improper presumption. After stating that th e Taxpayer 's compliance with GAAP is not dispositive, the tax court carefully examined the Taxpayer's method. We will do the same.

Wal-Mart' s accounting method resulted in a consistent estimation of stub period shrinkage. Treasury Regulation section 1.471-2(b) provides that "[i]n order clearly to reflect income, the inventory practice of a taxpayer should be consistent from year t o year, and greater weight is to be given to consistency than to any particular method of-15-

inventorying or basis of valuation." Wal-Mart's estimated shrinkage rates were generally based on objective factors—historical shrinkage averages—that did not leave room for
ma nipulationfrom year-to-year. Other than setting new store rates, Wal-Mart had n o discretion in calculating estimated shrinkage.
Moreover, Wal-Mart, an indu stry leader in inventory management and shrinkage control, used the same accounting method for taxes, financial reporting, and evaluations of daily o perations. Although Wal-Mart made minor alterations to its method o f estimating shrinkage during the years in issue, we find no clear error in the tax court's factual finding that Wal-Mart consistently calculated shrinkage estimates.
Accuracy is also indicative of an accounting system that clearly reflects income. See Caldwell v. Commiss ioner , 202 F.2d 112, 115 (2d Cir. 1953) (stating that "income should be reflected with as much accuracy as standard methods of accounting practice permit"). Obviously, in permitting cycle counting, the regulations do not re quire absolute accuracy. See Treas. Reg. § 1.471-2(d) (providing for verification and adjustment o f book inv entories). We agree with the tax court's finding that Wal-Mart's method o f est imationproduced reasonably accurate results. In reaching that conclusion, the ta x court analyzed the overall accuracyof Wal-Mart's method by considering the testimony of the various expert witnesses presented by the parties.

We note that i t is difficult, if at all possible, to devise an infallible method o f comparing estimated shrinkage to what actually transpired. The onl y verified calculation of shrinka ge is for the physical inventory period. However, because each physica l inventory period covers two different tax years, there is no direct proo f available to show exactly what proportion of the shrinkage occurred during the stub period and wha t propo rtion occurred during the year-end-to-physical-inventory period. Consequently , we must rely on indirect proof.-16-

The tax court first compared the total amount of booked shrinkage a s a percentage of sales for the taxable year to the total amount of verified shrinkage as a percentage of sales during the physical inventory period:

Shrinkage as a Percentage of Sales

Taxable Year Booked Verified 1983 1.47 1.48 1984 1.11 1.06 1985 1.36 1.37 1986 1.00 1.00

The figures for booked shrinkage consist of both the amount of estimate d shrinkage recorded by Wal-Mart for the taxable year and the esti mation error adjustment for the just-concluded p hysical inventory period. The figures for verified shrinkage are for the physical inventory period.
As the tax court recognized, this comparison has its lim itations in that it compares shrinkage from two different time frames. Nonetheless, the comparison is use ful because these periods overlap. Moreover, the inc lusion of the estimation error adjustment in the figures for booked shr

inkage shows the effect that Wal-Mart's adjustments for physical inventories had on book inventories. This reconciliation was a fundamental part of WalMart's inventory method. The Commissioner argues that the inclusion of adjustment s for o verestimates from the previous year masks the true extent of an overestimate o f shrinkag e in the current year, potentially resulting in a perpetual tax deferral if th e taxpayer consisten tly overestimates shrinkage. But this argument assumes that there is a stub period shrinkage estim ation error in each succeeding year that is at least equal to the original error. This is unlikely considering that Wal-Mart's-17-

estimatedshrinkage rate is self-adjusting in accordance with prior verified shrinkage. Inan attempt to demonstrate the inaccuracy of Wal-Mart's method, th e Commissioner compa

res estimated shrinkage, without adjustment for prior estimation errors, to verified shrinkage. The compariso n is limited to the physical inventory period only. The Commissioner's analysis again ignores the estimation error adjustment, which is a fundamental part of Wal-Mart's accounting method. Nevertheless, even if w e accepted the Commissioner's flawed analysis, it would not persuade us that Wal-Mart's method was inaccurate. If prior estimation errors were excluded from the calculation of estimated shrinkage, the difference bet ween verified and estimated shrinkage during the physical inventory period follows:
Comparison of Verified Shrinkage to Unadjusted Estimated Shrinkage

Stated as a Percentage of Sales

Estimated Shrinkage Verified Shrinkage Difference 1983 1.72 1.48 .24 1984 1.58 1.06 .52 1985 1.52 1.37 .15 1986 1.46 1.00 .46

The Commissioner conducted the above comparison for the taxable years fro m 1983 through 1993. For that entire period, the difference between ver ified shrinkage and estimated shrinkage was .22% of sales, while the estimation error in any given year ranged from an underestimate of .14% to an overe stimate of .52% of sales. These small percentage errors do not support the Commissioner's position that Wal-Mart's method did not produce accurate results. This is especially true when we consider theWe note that for taxable years ending after August 5, 1997, the Commissioner 12 ha s promulgated, as encouraged by the legislative history to I.R.C. § 471(b), a retai l safe harb or method of accounting for estimating shrinkage. See Rev. Proc. 98-29 , 1998- 15 I.R.B. 22. Use of the safe harbor method will presumably result in a clear reflection of income, provided that the taxpayer consistently app lies the method and the taxpayer's other inventory methods satisfy the clear reflection of income standard. -18- fact that any estimation errors are accounted for in the succeeding year with both th e estimation error adjustment and the adjustment to the estimated shrinkage rate.

In sum, we find that the tax court's "Shrinkage as a Percentage of Sales " compari son, although not perfect, shows that Wal-Mart's method of accounting fo r shrinkage produced accurate results. The tax co urt articulated an additional comparison of estimated shrinkage to verified shrinkage. We do not, however, rely on thi s comparison, in part because it does not add much to the previous compariso n, and in part because the appellate record is not adequately developed to reconstruct it.
We recognize that Wal-Mart's method of estimating stub period shrink age was not flawless. Wal-Mart estimated shrinkage at the store level and then allocated tha t shrinkage to each department or LIFO pool. Ac cordingly, the valuation of an individual LIFO poo l was potentially distorted because of changes in LIFO pool attributes. Se e Da yton Hudson Corp. and Subsidiaries. v. Commissioner , 71 T.C.M. (RIA) 260, 97

- 1665 (1997) ( Dayton Hudson II ). This same flaw, however, is also attributable to the Commissioner's method, and any other method that uses cycle counting. See id. In the final analysis, we agree with the tax court that Wal-Mart's accounting method resulted in a clear reflection of income. 12

The tax court also found that the method of accounting for shrinkage that Sam's used r esulted in a clear reflection of income. In addition to consistently applying th e same method, which did in fact comply with GAAP, Sam's experienced a shrinkage rate of .27% of sales for the 2-year period at issue. During those years, Sam'sEven if the Taxpayer's method did not result in a cl ear reflection of income, the 13 Commi ssioner may not change a taxpayer's method to one that fails to reflect income clearly. See Harden v. Commissioner , 223 F.2d 418, 421 (10th Cir. 1955). In light of
our holding that the Taxpayer's method reflected income clearly, we need not decide whether the Commissioner's proposed method failed to reflect income clearly. -19- estimated its shrinkage to be .2% of sales. This estimate was based on historica l shr inkage results for warehouse operations. We find no error in the tax court' s conclusion that the accounting method used by Sam's resulted in a clear reflection o f income.

We have c arefully reviewed the remainder of the parties' submissions and hol d tha t the Commissioner abused her discretion in changing the Taxpayer's method o f
acco unting—a

method that resulted in a clear reflection of income—to a method tha t does not account for shrinkage until it is verified by physical count. The record simply 13 does not provide adequate support for the Commissioner's determination.

III. CONCLUSION

Th e Code and the regulations permit the use of an inventory accounting method that includes estimates of shrin kage during the stub period, if the method is sound. The Taxpayer's method is so und because it clearly reflects income and conforms to the best accounting practice in the retail industry. Accordingly, the decision of the tax court is affirmed.
A true copy.

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