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Respondent does not seriously claim that losses from
shrinkage factors in a cross-year inventory cycle occur only in
the latter year. Nor does respondent claim that losses from
shrinkage factors do not occur generally throughout an inventory
cycle. On the record before us, we have no doubt that, on a
regular basis, the retailers experienced losses from theft,
billing errors, and other shrinkage factors. We also have no
doubt that some of those losses were experienced during the
physical-to-yearend period and gave rise to yearend shrinkage.
Therefore, the principal difference between the retailers’
shrinkage method and respondent’s method is that respondent,
without admitting it, accepts an estimate of yearend shrinkage
while the retailers, by making a shrinkage accrual, consciously
attempt to estimate that shrinkage.
H. Annual Accounting
It is well settled that the Federal income tax system is
based on annual accounting. E.g., Heiner v. Mellon, 304 U.S.
271, 275 (1938). "Inventories are intended to insure a clear
reflection of the year's income by matching sales during the
taxable year with the costs attributable to those sales". Rotolo
v. Commissioner, 88 T.C. 1500, 1515 (1987). Respondent's method,
in effect, substitutes yearend shrinkage of the prior year for
yearend shrinkage of the taxable year. Sales during the taxable
year are matched with losses verified to be both losses for that
year and losses for the end of the prior year. On its face,
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