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the year, see sec. 1.472-2, Income Tax Regs. At the end of each
month, Wal-Mart applied a cost complement to convert its
inventory balances from retail to deemed cost. Wal-Mart's
internal monthly financial statements reported inventory
shrinkage (both estimated and verified) as an increase to cost of
goods sold.
Sam's did not use the retail method. Sam's used the First
In, First Out method of identifying items in ending inventory.
C. Cycle Counting
Petitioners did not count the actual yearend inventory at
each of their stores. They counted each store's inventory at
various times during the year (referred to as cycle counting).
The use of cycle counting, and the absence of a physical count at
yearend, is common in petitioners' industry. Petitioners used
this technique during the subject years because they were unable
to physically count the inventories at all of their stores/clubs
on the last day of the taxable year. Cycle counting was also
advantageous to them because it was less disruptive to business
operations, and it allowed management to receive information
throughout the year on the effectiveness of internal operations
and changes in external behavior. The continuous flow of
information facilitated management's response to shrinkage trends
on a timely basis.
During the subject years, petitioners' independent
auditors were Ernst & Young (E&Y). E&Y advised Wal-Mart that it
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