Estimated inventory shrinkage is not a reserve - or is it?

• Author: Kempke, Robert E.

Taxpayers that maintain perpetual inventory systems and perform a physical inventory other than at the tax year-end may have an opportunity to make further adjustment for estimated shrinkage under a recent case. In Dayton Hudson Corp., 101 TC No. 30 (1993), the Tax Court, in a reviewed decision, concluded that a shrinkage estimate does not, as a matter of law, cause an accounting method to fail to clearly reflect income.

Dayton Hudson, engaged primarily in retail sales through various divisions and subsidiaries, maintained a perpetual inventory system. Physical inventories were performed at all of the stores, although not at its February 28 year-end. As a result of the physical inventory, adjustments were made to the books to record "shrinkage." At year-end, and estimate of shrinkage believed to occur subsequent to the physical inventories, but prior to year-end, was also recorded, based "on records of verified shrinkage in prior years and other information."

The IRS moved for summary judgment arguing that, as a matter of law, estimation of shrinkage was not in accordance with Regs. Sec. 1.471-2(d) and, accordingly, did not clearly reflect income. The taxpayer argued that the regulations do not prohibit an adjustment for estimated shrinkage and, therefore, whether the method clearly reflects income is a question of fact that may not be resolved by summary judgment.

Judge Halpern, writing for the majority, did not agree with the Service's argument that a physical inventory must be taken at year-end to make an adjustment for shrinkage. First, the regulations did not require that a taxpayer take a physical inventory at year-end, but only at "reasonable intervals." Second, the court looked to the history of the present regulation. The 1921 regulations explicitly required that physical inventories be taken at year-end. The 1922 regulations removed this year-end requirement and replaced it with "reasonable intervals." The court concluded that it was not the Treasury's intent to remove unambiguous language and replace it with an ambiguous requirement with precisely the same meaning.

In addition, the court did not agree that a physical count was the only way to adjust for shrinkage:

Moreover, the regulation appears to permit any means of adjusting book inventories for shrinkage, so long as (1) such book inventories are maintained in accordance with a sound accounting system, (2) such system values goods at actual cost, and (3) book inventories are...