Opinion ID: 757357
Heading Depth: 2
Heading Rank: 2

Heading: Taxpayer's Method of Accounting for Shrinkage

Text: 36 The general rule for methods of accounting provides, 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. 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 authority 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 Commissioner prescribed a method that does not account for shrinkage until verified by a physical count. 11 The tax court determined that the Commissioner had abused her discretion in acting under section 446(b), because the Taxpayer's method reflected income clearly. 37 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, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960). 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 factual findings unless they are clearly erroneous, and we accord the Commissioner's determination the same discretion. See Black Hills Corp., 73 F.3d at 804. 38 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, 439 U.S. at 532-33, 99 S.Ct. 773. However, the Commissioner may not require a taxpayer to change from an accounting method that reflected income clearly, merely because the Commissioner believes that her method more clearly reflects income. See, e.g., Louisville and Nashville R.R. v. Commissioner, 641 F.2d 435, 438 (6th Cir.1981). We find that the Taxpayer's method resulted in a clear reflection of income because it complied with GAAP, it was consistent, and it produced accurate results. 39 The Code does not define the phrase clearly reflect income. The regulations, however, provide some guidance. Treasury Regulation section 1.446-1(a)(2) states that an accounting method which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income. Here, the tax court found that the Taxpayer's method of accounting for stub period shrinkage consistently applied GAAP and was in accordance with the best accounting practice in the retail industry. 40 The Commissioner does not dispute that finding, but instead asserts that the tax court placed undue emphasis on financial accounting principles. We disagree. Compliance with GAAP will ordinarily pass muster for tax purposes, though it does not create a presumption of validity. See Thor Power Tool, 439 U.S. at 540, 99 S.Ct. 773. The tax court did not grant the Taxpayer an improper presumption. After stating that the Taxpayer's compliance with GAAP is not dispositive, the tax court carefully examined the Taxpayer's method. We will do the same. 41 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 to year, and greater weight is to be given to consistency than to any particular method of 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 manipulation from year-to-year. Other than setting new store rates, Wal-Mart had no discretion in calculating estimated shrinkage. 42 Moreover, Wal-Mart, an industry leader in inventory management and shrinkage control, used the same accounting method for taxes, financial reporting, and evaluations of daily operations. Although Wal-Mart made minor alterations to its method of 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. 43 Accuracy is also indicative of an accounting system that clearly reflects income. See Caldwell v. Commissioner, 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 require absolute accuracy. See Treas. Reg. § 1.471-2(d) (providing for verification and adjustment of book inventories). We agree with the tax court's finding that Wal-Mart's method of estimation produced reasonably accurate results. In reaching that conclusion, the tax court analyzed the overall accuracy of Wal-Mart's method by considering the testimony of the various expert witnesses presented by the parties. 44 We note that it is difficult, if at all possible, to devise an infallible method of comparing estimated shrinkage to what actually transpired. The only verified calculation of shrinkage is for the physical inventory period. However, because each physical inventory period covers two different tax years, there is no direct proof available to show exactly what proportion of the shrinkage occurred during the stub period and what proportion occurred during the year-end-to-physical-inventory period. Consequently, we must rely on indirect proof. 45 The tax court first compared the total amount of booked shrinkage as 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 46 Taxable Year Booked Verified 1983 1.47 1.48 1984 1.11 1.06 1985 1.36 1.37 1986 1.00 1.00 47 The figures for booked shrinkage consist of both the amount of estimated shrinkage recorded by Wal-Mart for the taxable year and the estimation error adjustment for the just-concluded physical inventory period. The figures for verified shrinkage are for the physical inventory period. 48 As the tax court recognized, this comparison has its limitations in that it compares shrinkage from two different time frames. Nonetheless, the comparison is useful because these periods overlap. Moreover, the inclusion of the estimation error adjustment in the figures for booked shrinkage shows the effect that Wal-Mart's adjustments for physical inventories had on book inventories. This reconciliation was a fundamental part of Wal-Mart's inventory method. The Commissioner argues that the inclusion of adjustments for overestimates from the previous year masks the true extent of an overestimate of shrinkage in the current year, potentially resulting in a perpetual tax deferral if the taxpayer consistently overestimates shrinkage. But this argument assumes that there is a stub period shrinkage estimation error in each succeeding year that is at least equal to the original error. This is unlikely considering that Wal-Mart's estimated shrinkage rate is self-adjusting in accordance with prior verified shrinkage. 49 In an attempt to demonstrate the inaccuracy of Wal-Mart's method, the Commissioner compares estimated shrinkage, without adjustment for prior estimation errors, to verified shrinkage. The comparison 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 we 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 between verified and estimated shrinkage during the physical inventory period follows: 50 Comparison of Verified Shrinkage to Unadjusted Estimated Shrinkage 51 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