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Petitioner estimated shrinkage factors for the periods
between physical inventories and, on a monthly basis, accrued
amounts on account thereof. At the time of each physical
inventory, petitioner would take account of any difference
between its accruals and the result of its physical inventory
(accrual error). For each taxable year, petitioner's total
adjustments for shrinkage factors would include (1) any accrual
for the period from the start of the year until the physical
inventory date, (2) any adjustment for an accrual error, and
(3) any accrual for yearend shrinkage (such accrual for yearend
shrinkage hereafter being referred to as shrinkage accrual).
Shrinkage accruals reduced yearend inventories, which had the
effect of increasing cost of goods sold and, as a result,
decreasing gross income. In the retail industry, the practice of
making shrinkage accruals, and of calculating such accruals as a
percentage of sales, is the prevalent, if not virtually universal
practice; it is the best practice in that industry.
Respondent disallowed petitioner's shrinkage accruals. That
had the consequence of decreasing cost of goods sold and, as a
result, increasing gross income. Respondent has proposed a
deficiency based upon that increased income.
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