Year-end inventory shrinkage estimates.

• Author: St. Vincent, Gary
• Position: Taxation

Sec. 471 (a) states that, when inventories are necessary, they must be taken in a manner conforming "as nearly as may be to [1] the best accounting practice in the trade or business and [2] clearly reflecting the income." In 1997, Congress enacted Sec. 471(b), which specifically permits the use of inventory shrinkage estimates, provided they are confirmed by physical counts after year-end. In addition, the physical counts must be performed on a regular and consistent basis, and proper adjustments must be made to the inventories and estimating methods.

As discussed in Wal-Mart Stores, Inc., 153 F3d 650 (8th Cir. 1998) (Wal-Mart I), the IRS does not specifically require year-end physical inventories, but rather only requires physical inventories at reasonable intervals. This substitution of book inventories for year-end physical inventories, in effect, has led the way to the use of cycle counts. Current Regs. Sec. 1.471-2(d) states that, when a taxpayer maintains book inventories in accordance with a "sound accounting system," the net value of the inventory will be deemed to be its cost as long as the book inventories are "verified by physical inventories at reasonable intervals and adjusted to conform therewith."

Wal-Mart I concluded that an accounting system would be considered "sound" if it conformed to the Sec. 471 (a) standard explained above. In Wal-Mart Stores Inc., TC Memo 1997-1 (Wal-Mart II), the Tax Court found that the taxpayer's use of shrinkage estimates conformed to generally accepted accounting principles (GAAP), and that, accepting the phrase "best accounting practice in the industry" as synonymous with GAAP, the taxpayer in the II, Wal-Mart II case met the first test of Sec. 471 (a). The next step was to determine whether the taxpayer's method resulted in a clear reflection of income. Simply put, could the use of estimates in determining year-end inventory result in a dear reflection of income?

Regs. Sec. 1.461-1(a)(2)(ii) contemplates the use of estimates when it states "the fact that the exact amount of the liability cannot be determined does not prevent a taxpayer from taking into account that portion of the amount of the liability which can be computed with reasonable accuracy within the taxable year" The key is being able to compute the amount with reasonable accuracy. The court in the Wal-Mart II case continued its analysis by looking at the definition of "clear reflection of income" in the regulations. Regs. Sec...