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of supermarkets, and (3) Superx, a subsidiary corporation of
Kroger, which operated a chain of drug and general merchandise
stores (collectively, the retailers).
During the years in issue, the retailers used cycle counting
to conduct physical inventories of merchandise. Under the cycle
counting method, physical inventories were taken in rotation, at
the various stores, throughout the year. Also, the retailers
maintained book inventory records from which inventories could be
determined without a physical count. The retailers estimated
losses from shrinkage factors (e.g., theft and errors in billing)
during the physical-to-yearend period (yearend shrinkage) and
made an accrual of that estimate (shrinkage accrual). That
practice had the effect of increasing cost of goods sold and
decreasing gross income.
Respondent disallowed the retailers’ shrinkage accruals, and
we must determine whether that disallowance was an abuse of
discretion.
II. Statute and Principal Regulation
Section 471(a) provides the following general rule:
Whenever in the opinion of the Secretary the use of
inventories is necessary in order clearly to determine
the income of any taxpayer, inventories shall be taken
by such taxpayer on such basis as the Secretary may
prescribe as conforming as nearly as may be to the best
accounting practice in the trade or business and as
most clearly reflecting the income.[1]
1 The Tax Reform Act of 1986, Pub. L. 99-514, sec. 803(b)(4),
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