Estimating inventory shrinkage.

• Author: Bayles, Cristy M.

For more than a decade, taxpayers and the IRS have disagreed as to whether inventory shrinkage (primarily resulting from theft, damage and accounting errors) that occurs between the last physical inventory during the year and the taxpayer's year-end may be estimated. The Service has taken the position that shrinkage is a Sec. 165 loss that must be verified before the amount is removed from inventory and included in cost of goods sold (COGS). Taxpayers, however, have insisted that Sec. 471 and Regs. Sec. 1.471-2(d) allow them to estimate inventory shrinkage, as long as the inventory accounts are "verified by physical inventories at reasonable intervals and adjusted to conform therewith."

Earlier this year, the Tax Court released two memorandum opinions upholding the use of estimates of inventory shrinkage at year-end. The decisions in Wal-Mart, TC Memo 1997-1, and Kroger, TC Memo 1997-2, concluded that each company's use of estimates of inventory shrinkage conformed to the best accounting practice in the trade or business and clearly reflected income. The Tax Court rejected an IRS request to reconsider its holding in Dayton Hudson, 101 TC 462 (1993), that a taxpayer may estimate year-end shrinkage if its method of accounting for its inventory is sound.

During the years involved, both Kroger and Wal-Mart took physical inventories on a cyclical basis (a common practice in the retail industry). Both companies estimated shrinkage using similar methodologies, generally multiplying a shrinkage rate based on experience by the amount of sales for the period between the physical inventory and year-end.

The opinion in Wal-Mart stated that a taxpayer may estimate year-end shrinkage if the estimate methodology (1) conforms to the best accounting practice in the trade or business and (2) clearly reflects income. The Tax Court found that Wal-Mart met both requirements, and that, when viewed as a percentage of sales, there were only modest differences between the estimated and verified shrinkages. The court noted that the Service's position...