                     United States Court of Appeals
                           FOR THE EIGHTH CIRCUIT
                                   ___________

                                   No. 97-2693
                                   ___________

Wal-Mart Stores, Inc. & Subsidiaries, *
                                      *
          Appellees,                  *
                                      *
    v.                                *    Appeal from the United States
                                      *    Tax Court.
Commissioner of Internal Revenue,     *
                                      *
          Appellant.                  *
                                 ___________

                                 Submitted: March 10, 1998
                                     Filed: August 14, 1998
                                   ___________

Before BEAM and HEANEY, Circuit Judges, and WATERS,1 District Judge.
                            ___________

BEAM, Circuit Judge.

      This case presents the question whether a retailer may account for unverified
inventory shrinkage, and if so, whether the method used by Wal-Mart Stores, Inc. &
Subsidiaries is permissible. The Commissioner of Internal Revenue (Commissioner)




      1
        The Honorable Franklin H. Waters, United States District Judge for the Western
District of Arkansas, sitting by designation.
appeals from the tax court's2 decision reversing the Commissioner's determination of
federal tax deficiencies. We affirm the tax court.

I.    BACKGROUND

       The parties have stipulated the relevant facts. Wal-Mart Stores, Inc., was the
parent company of a group of affiliated corporations, including Kuhn's-Big K Stores
Corp. (Kuhn's), Big K Edwards, Inc. (Edwards), and Sam's Wholesale Clubs (Sam's).3
The Taxpayer filed consolidated tax returns for the fiscal years ending in late January
of 1984 (referred to herein as the 1983 taxable year), 1985, 1986, and 1987. The
Taxpayer's principal place of business was in Bentonville, Arkansas.

       During the taxable years at issue, Wal-Mart operated its stores as mass discount
retailers, carrying between 60,000 and 90,000 different merchandise items in each
store. Wal-Mart purchased more than $22 billion in merchandise, turning its inventory
over as often as 4.5 times per year. Sam's ran its stores as discount warehouses,
carrying between 3,500 and 5,000 different merchandise items, acquiring more than
$2.6 billion in merchandise. The Taxpayer's operations grew at a resounding pace from
1983 to 1986. For example, the number of Wal-Mart stores increased from 642 to 980
and the number of Sam's stores increased from 3 to 49. The Taxpayer utilized an
extensive distribution and tracking system to maintain optimal inventories at each store.
The Taxpayer's inventory system is commonly revered as the finest in the retail
industry.


      2
       The Honorable David Laro, United States Tax Court Judge.
      3
        Kuhn's and Edwards were subsidiaries of the parent and Sam's was a division
of the parent. Because Sam's used different accounting methods than the other entities,
we will use the name "Wal-Mart" to refer collectively to Kuhn's, Edwards, and the
parent company (excluding Sam's) and we will use the term "the Taxpayer" to refer
collectively to "Wal-Mart" and Sam's.

                                          -2-
        For both financial reporting and tax purposes, the Taxpayer used the accrual
method of accounting and maintained a perpetual inventory system. Under the
perpetual inventory system, the cost or quantity of goods sold or purchased is
contemporaneously recorded at the time of sale or purchase. The system continuously
shows the cost or quantity of goods that should be on hand at any given time. The
Taxpayer performed physical inventories to confirm the accuracy of the inventory as
stated in the books, and made adjustments to the books to reconcile the book inventory
with the physical inventory.4

       The Taxpayer's physical inventories were taken at its stores in rotation
throughout the year. The Taxpayer did not take physical inventories during the holiday
season (November, December, and the first week of January). The Taxpayer refers to
this technique, which is common in the retail industry, as cycle counting. Cycle
counting is necessitated by the difficulty in conducting physical inventories at every
store on the last day of the year. This technique also provides management with
feedback on the effectiveness of its inventory management and facilitates the use of
experienced personnel to conduct the physical inventories.

       Forty-five days prior to conducting a physical inventory in one of its stores, Wal-
Mart's internal audit department would send the store a preparation package, which
included instructions on how to prepare for the physical count. Each physical count
was then conducted by a team of independent counters (18 to 40 persons) and
representatives from Wal-Mart's loss prevention department (1 to 2 persons), internal


      4
        Wal-Mart used the Last-In, First-Out (LIFO) method of identifying items in
ending inventory and the retail method of pricing inventories. See Treas. Regs. §§
1.472-1 and 1.471-8. Wal-Mart determined the cost of the LIFO inventories using the
dollar value LIFO method and it valued any increase in inventory quantities based on
the cost of the earliest acquisitions during the year. See Treas. Regs. §§ 1.472-8 and
1.472-2. Sam's did not use the retail method. Sam's used the First-In, First-Out
(FIFO) method of identifying items in ending inventory.

                                           -3-
audit department (1 to 3 persons), and operations division (1 to 2 persons). Wal-Mart's
independent auditors, Ernst & Young, also sent representatives to randomly selected
physical counts to test their accuracy. The independent counters generally counted
every inventory item. The results of the physical count were then reconciled with the
book inventory. The reconciliations were reviewed by Wal-Mart's internal audit
department. Generally, Wal-Mart did not record the results of a physical inventory in
its books until the following month.5

      Sam's conducted its physical inventories in the same manner except that physical
counts were usually taken twice a year and recorded the very next day. Sam's also
periodically conducted item audits, counting the goods on hand for a particular
merchandise unit and recording those results the next day. The physical inventories of
both Wal-Mart and Sam's usually revealed shrinkage.

       Shrinkage (or overage) is the difference between the inventory determined from
the perpetual inventory records and the amount of inventory actually on hand. Because
shrinkage reduces profits, the Taxpayer has devoted extensive resources to monitoring
and mitigating shrinkage. There are many causes of shrinkage, including employee
theft, customer theft, vendor theft, damage, breakage, spoilage, accounting and
recording errors, errors in marking retail prices, cash register errors, markdowns taken
and not recorded, errors in accounting for customer returns, and errors in accounting
for vendor receipts and returns.



      5
       On occasion, the Taxpayer would immediately record physical inventories taken
in January, the last month of its fiscal year. In the 1983 taxable year, the Taxpayer
recorded in January all 39 of the physical inventories taken that month. In the 1984
taxable year, the Taxpayer recorded, in January, 9 of the 73 inventories taken. In the
1985 taxable year, the Taxpayer recorded, in January, only 1 of the 73 physical
inventories taken, while in the 1986 taxable year, the Taxpayer did not record in
January any of the 95 physical inventories taken.

                                          -4-
      Because the Taxpayer did not conduct a physical inventory at year-end, its
perpetual inventory records did not account for any shrinkage that may have occurred
during the period between the date of the last physical inventory and the taxable year-
end. The parties refer to this period as the stub period. Left unadjusted, the Taxpayer's
book records would overstate income because the stub period shrinkage results in a
decrease to ending inventory, thus increasing the cost of goods sold and reducing gross
income.6

        In adjusting its books to reflect stub period shrinkage, Wal-Mart estimated stub
period shrinkage for each store monthly by multiplying a retail shrinkage rate by the
store's sales during that month. At new stores, the retail shrinkage rate was fixed by
management at 3% of sales in the 1983 and 1984 taxable years and 2% of sales in the
1985 and 1986 taxable years. Wal-Mart used that fixed rate from the date the store
opened until its first physical inventory, which rarely took place less than six months
after opening. After taking the first physical inventory at a new store, Wal-Mart
computed a shrinkage rate for that store by dividing the store's shrinkage at retail, as
verified by the first inventory, by the store's sales for the period starting with the date the
store opened and ending on the inventory date. After Wal-Mart took a second inventory,
it computed the store's shrinkage rate by dividing the store's shrinkage, as verified by the
first two inventories, by the store's sales starting with the opening date and ending on the
second inventory date. After the third inventory, it computed the shrinkage rate by
dividing the store's shrinkage, as verified by the first three inventories, by the store's
sales starting with the opening date and ending on the third inventory date. After taking
a fourth and each subsequent inventory, the retail shrinkage rate was



       6
        Slightly simplified, gross income for most retailers means revenues less cost of
goods sold. The cost of goods sold is determined by subtracting ending inventory from
the goods available for sale during the year (opening inventory plus inventory purchases
during the period). See Rockwell Int'l Corp. v. Commissioner, 77 T.C. 780, 805 n.13
(1981), aff'd, 694 F.2d 60 (3d Cir. 1982).

                                             -5-
based on a rolling average of the historical shrinkage over the preceding three
inventories.

        The retail shrinkage rate was subject to certain floor and ceiling percentage
limitations that were set by Wal-Mart's management, based primarily on a weighted five-
year average of shrinkage. If the computed shrinkage rate was below the floor
limitation, or if it was an overage, the computed rate was replaced by the floor limitation.
Likewise, if the computed rate exceeded the ceiling limitation, it was replaced by the
ceiling limitation.

     Sam's consistently estimated the stub period shrinkage at .2% of sales. That rate
was determined by management based on their analysis of historical results from
warehouse operations.

         Each physical inventory would reveal a difference (estimation error) between the
estimated shrinkage, as reflected in the perpetual inventory records, and the verified
shrinkage. At that time, the Taxpayer would adjust its inventory records to reflect any
estimation error. Consequently, for each taxable year, the Taxpayer's total adjustments
to its inventory records for shrinkage would include (1) any shrinkage estimates for the
period from the start of the taxable year until the physical inventory date, (2) any
estimation error adjustment, and (3) any stub period shrinkage estimates. The Taxpayer
also recomputed the retail shrinkage rate for the store and used that new rate to estimate
shrinkage until the next physical inventory. Thus, if the Taxpayer overestimated or
underestimated a store's shrinkage in year one, it would adjust that store's shrinkage rate
in year two. In accordance with the cycle counting technique, this was a continuous
process throughout the year for each of the Taxpayer's stores.

      Wal-Mart estimated shrinkage for each store, but not for each department within
each store. It used a series of computations to allocate the estimated stub period
shrinkage to each department. Once these allocations were made, Wal-Mart used the

                                           -6-
adjusted ending inventory to make its LIFO computations, see Treas. Reg. § 1.472-1,
which were made on a division-wide basis and not at the individual store level.

       The Taxpayer reported shrinkage on an aggregate basis for both financial and tax
purposes. The practice of estimating shrinkage as a percentage of sales is prevalent in
the retail industry. Ernst & Young issued unqualified opinions to the effect that the
Taxpayer's financial statements for the subject years conformed with Generally Accepted
Accounting Principles (GAAP). Ernst & Young periodically reviewed the Taxpayer's
accounting method for estimating shrinkage during the stub period and never
recommended a change.

       The Commissioner disallowed the Taxpayer's use of shrinkage estimates. The
Commissioner issued the Taxpayer two notices of deficiency, one in the amount of
$9,937,544.68 for the 1983 taxable year and $4,084,255.28 for the 1984 taxable year
and the other in the amount of $9,381,626.40 for the 1985 taxable year and $8,206,962
for the 1986 taxable year.7 The Taxpayer filed a timely petition in the tax court seeking
redetermination of the resulting deficiencies.

       The tax court, following a prior decision, see Dayton Hudson Corp. and
Subsidiaries v. Commissioner, 101 T.C. 462, 465 (1993) (Dayton Hudson I) (12-5
reviewed decision), held that a method of computing shrinkage, including estimated
shrinkage, is permissible if "sound." Citing Treasury Regulation section 1.471-2(a), the
tax court defined a sound inventory method as one that (1) conforms to the best
accounting practice in the trade or business and that (2) clearly reflects income. The



      7
       The notice of deficiency for 1983 and 1984 disallowed shrinkage estimates for
Wal-Mart only. The notice for 1985 and 1986 disallowed shrinkage estimates for Wal-
Mart and Sam's. The Commissioner calculated that, as a result of disallowed inventory
shrinkage, the Taxpayer had understated its taxable income by $24,276,994 in 1983,
by $7,837,122 in 1984, by $20,394,840 in 1985, and by $1,196,045 in 1986.

                                          -7-
tax court then applied the two-part test to conclude that the Commissioner had abused
her discretion in finding that the Taxpayer's inventory methods were not sound.

       The Commissioner appeals, asserting that the regulations prohibit the reduction
of ending inventory by estimated shrinkage. The Commissioner further contends that,
even if shrinkage estimates are permissible, the Taxpayer's method of accounting did not
clearly reflect income.

II.   DISCUSSION

       We first address whether all shrinkage estimates are prohibited from being used
to reduce ending inventories and then turn to whether the Taxpayer's particular method
of accounting for estimated shrinkage is permissible.

      A.     Use of Shrinkage Estimates to Reduce Ending Inventories

      The general rule for inventory accounting is that:

      Whenever in the opinion of the [Commissioner] 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
      [Commissioner] 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.




                                         -8-
I.R.C. § 471(a).8 Determining the propriety of a taxpayer's reduction of ending
inventories by estimated shrinkage requires construction of the relevant sections of the
Internal Revenue Code (Code) and the regulations.9 Thus, this issue presents a question
of law subject to plenary review. See Musco Sports Lighting, Inc. v. Commissioner, 943
F.2d 906, 907 (8th Cir. 1991).

       It is undisputed that the use of inventories is necessary to determine income
because the Taxpayer is engaged in the sale of merchandise. See Treas. Reg. § 1.471-1.
An inventory method must (1) conform as nearly as may be to the best accounting
practice in the trade or business, and (2) clearly reflect income. See Treas. Reg. §
1.471-2(a). The tax court analyzed the Taxpayer's inventory method under this two-
prong test. The Commissioner contends that independent of this two-prong test,
Treasury Regulation section 1.471-(2)(d) precludes the use of all shrinkage estimates.
The regulation provides in relevant part:

      Where the taxpayer maintains book inventories in accordance with a sound
      accounting system in which the respective inventory accounts are charged
      with the actual cost of the goods purchased or produced and credited with
      the value of goods used, transferred, or sold, calculated upon the basis of
      the actual cost of the goods acquired during the taxable year (including the
      inventory at the beginning of the year), the net value as shown by such
      inventory accounts will be deemed to be the cost of the goods on hand.
      The balances shown by such book inventories should be


      8
       In 1997, Congress amended section 471, expressly providing that, in tax years
ending after August 5, 1997, ending inventories may be reduced by shrinkage
estimates. See Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 961, 111 Stat. 788,
891 (codified as amended at I.R.C. § 471(b)). The Taxpayer and the Commissioner
both argue that the change in law supports their position. We, however, find that the
recent amendment sheds little, if any, light on whether shrinkage estimates were
permissible under the earlier law. See H.R. Conf. Rep. No. 105-220, at 467 (1997).
      9
          The Taxpayer has not challenged the validity of the regulations.
                                           -9-
      verified by physical inventories at reasonable intervals and adjusted to
      conform therewith.

Treas. Reg. § 1.471-2(d).

        The Commissioner interprets the regulation to provide that (1) the Taxpayer's
book inventories, without adjustment for estimated shrinkage, will be deemed to reflect
the costs of goods on hand at year-end, and (2) book inventories may be adjusted to
reflect shrinkage only when a physical count is conducted. The Taxpayer contends that
adjusted book inventories are deemed to reflect the cost of the goods on hand at year-
end, if the adjustment is made in accordance with a sound accounting system.

       The regulatory scheme recognizes that shrinkage occurs, as it provides that book
inventories "should be verified by physical inventories at reasonable intervals and
adjusted to conform therewith." The Commissioner does not dispute that the proper way
to account for verified shrinkage is to reduce book inventories, resulting in an increase
to cost of goods sold. Nonetheless, the Commissioner asserts that book inventories may
be reduced only by verified shrinkage and not with estimates. Nothing in the text of the
regulation, however, distinguishes between estimated shrinkage and shrinkage that has
been verified by physical count. We will not read in such a distinction.

       Our reading comports with the background of the Commissioner's regulatory
scheme. Prior regulations construing the predecessor to section 471 provided that
physical inventories must be taken at year-end. See Regs. 45, art. 1588(3)(B) (1921).
The Commissioner dispensed with that requirement in 1922. See Regs. 45, art. 1582,
as amended by T.D. 3296, I-1 C.B. 40 (1922) (providing that physical inventories need
not be taken at year-end, but only at reasonable intervals). In removing the burdensome
year-end physical inventory requirement, the Commissioner opened the door to the
industry practice of estimating shrinkage during the stub period. Nothing in the



                                         -10-
Commissioner's regulatory scheme, which provides that book inventories may substitute
for year-end physical inventories, prohibits the reduction of ending inventories to account
for estimated inventory shrinkage. Moreover, the accrual method of accounting
contemplates the use of estimates. See, e.g., Treas. Reg. § 1.461-1(a)(2)(ii).
Accordingly, we construe Treasury Regulation section 1.471-2(d) to provide that book
inventories, as adjusted for estimated stub period shrinkage, are "deemed to be the cost
of the goods on hand" provided that (1) such inventories are maintained in accordance
with a sound accounting system; (2) goods are valued at actual cost; and (3) physical
inventories are taken at reasonable intervals.

       Here, the second and third criteria are not at issue. The only controversy is
whether the Taxpayer "maintain[ed] book inventories in accordance with a sound
accounting system." The regulations do not define "sound accounting system," and we
find no plausible construction of the phrase that would exclude the use of shrinkage
estimates. See Dayton Hudson I, 101 T.C. at 468. In mandating a "sound accounting
system," we find that the regulation prescribes no higher standard than that of section
471(a), which requires that an inventory method must conform "to the best accounting
practice in the industry" and result in a clear reflection of income.10 I.R.C. § 471(a).
       The phrase "best accounting practice in the industry" is synonymous with GAAP.
See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979). The tax court
found, and the Commissioner concedes on appeal, that the Taxpayer's use of shrinkage
estimates conformed to GAAP. We thus conclude that Treasury Regulation section
1.471-2(d) permits the Taxpayer's method of estimating shrinkage provided that such




      10
        We need not address the Taxpayer's argument that the all events test, see Treas.
Reg. § 1.461-1(a)(2)(ii), permits the estimation of shrinkage, in part because it was
raised for the first time on appeal, and in part because we hold that the inventory
regulations permit the use of shrinkage estimates.

                                          -11-
method resulted in a clear reflection of income. We will analyze the Taxpayer's
particular method in Part IIB.

       We reject the Commissioner's argument that permitting the reduction of ending
inventories by estimated shrinkage runs afoul of the Supreme Court's decision in Thor
Power Tool. In Thor Power Tool, the taxpayer, in accordance with GAAP, wrote-down
certain "excess inventory" to its net realizable value, which in most cases was its scrap
value. 439 U.S. at 530. However, despite taking the inventory write-down, the taxpayer
continued to offer the inventory for sale at full price. See id. at 529. The Court applied
the regulations to the facts and held that the Commissioner properly disallowed the
taxpayer's write-down as not clearly reflecting income because the taxpayer's method
"was plainly inconsistent with the Regulations." Id. at 538. In Thor Power Tool, the
regulations clearly articulated when a taxpayer could value inventory below its market
value, which is distinct from the present situation because, here, the Taxpayer's method
is not clearly covered by the relevant regulations.

       The Commissioner additionally contends that the Taxpayer's reduction of ending
inventories for estimated shrinkage was actually a deduction for a reserve, which may
not be taken unless Congress has specifically so provided. See id. at 541-44. A reserve
is used to set aside funds for an "estimated future loss" or expense. Id. at 542. Here, the
Taxpayer estimated the amount of shrinkage that had actually occurred during the stub
period, not a loss that may occur in the future. Therefore, estimated shrinkage is not an
impermissible reserve.

      In sum, the Commissioner's arguments are unavailing, and we find nothing within
the relevant statutes, regulations, or case law that prohibits the use of shrinkage
estimates.




                                          -12-
      B.     Taxpayer's Method of Accounting for Shrinkage

       The general rule for methods of accounting provides, "Taxable income shall be
computed under the method of accounting on the basis of which the taxpayer regularly
computes his income in keeping his books." I.R.C. § 446(a). For all relevant years, the
Taxpayer has used the same method of accounting for book and tax purposes.
Nonetheless, "if the method used does not clearly reflect income," the Commissioner has
broad authority to prescribe a method that "does clearly reflect income." I.R.C. §
446(b). In the two notices of deficiency issued to the Taxpayer, the Commissioner
prescribed a method that does not account for shrinkage until verified by a physical
count.11 The tax court determined that the Commissioner had abused her discretion in
acting under section 446(b), because the Taxpayer's method reflected income clearly.

       The "clearly reflect income" standard is a technical standard which is not easily
resolved by resorting to "experience with the mainsprings of human conduct."
Commissioner v. Duberstein, 363 U.S. 278, 289 (1960). Consequently, we find that the
tax court's conclusion that a particular method of accounting resulted in a clear reflection
of income is a conclusion of law, or at least a mixed question of law and fact, subject to
de novo review. See, e.g., Black Hills Corp. v. Commissioner, 73 F.3d 799, 804 (8th
Cir. 1996); cf. Ford Motor Co. v. Commissioner, 71 F.3d 209, 212 (6th Cir. 1995)
(holding that the clear reflection of income standard presents a question of ultimate fact,
which is reviewed de novo). Nonetheless, we respect the tax court's purely factual
findings unless they are clearly erroneous, and we accord the Commissioner's
determination the same discretion. See Black Hills Corp., 73 F.3d at 804.




      11
        The Commissioner also determined that the Taxpayer's understatement of
income was partially caused by a miscalculation of a cost complement. The parties
have resolved their disagreements with respect to this issue.

                                           -13-
       The Commissioner's discretion to prescribe a method that clearly reflects income
cannot be disturbed unless it is clearly unlawful or plainly arbitrary. See Thor Power
Tool, 439 U.S. at 532-33. However, the Commissioner may not require a taxpayer to
change from an accounting method that reflected income clearly, merely because the
Commissioner believes that her method more clearly reflects income. See, e.g.,
Louisville and Nashville R.R. v. Commissioner, 641 F.2d 435, 438 (6th Cir. 1981). We
find that the Taxpayer's method resulted in a clear reflection of income because it
complied with GAAP, it was consistent, and it produced accurate results.

        The Code does not define the phrase "clearly reflect income." The regulations,
however, provide some guidance. Treasury Regulation section 1.446-1(a)(2) states that
an accounting method "which reflects the consistent application of generally accepted
accounting principles in a particular trade or business in accordance with accepted
conditions or practices in that trade or business will ordinarily be regarded as clearly
reflecting income." Here, the tax court found that the Taxpayer's method of accounting
for stub period shrinkage consistently applied GAAP and was in accordance with the
best accounting practice in the retail industry.

       The Commissioner does not dispute that finding, but instead asserts that the tax
court placed undue emphasis on financial accounting principles. We disagree.
Compliance with GAAP will ordinarily "pass muster for tax purposes," though it does
not create a presumption of validity. See Thor Power Tool, 439 U.S. at 540. The tax
court did not grant the Taxpayer an improper presumption. After stating that the
Taxpayer's compliance with GAAP is not dispositive, the tax court carefully examined
the Taxpayer's method. We will do the same.

       Wal-Mart's accounting method resulted in a consistent estimation of stub period
shrinkage. Treasury Regulation section 1.471-2(b) provides that "[i]n order clearly to
reflect income, the inventory practice of a taxpayer should be consistent from year to
year, and greater weight is to be given to consistency than to any particular method of

                                         -14-
inventorying or basis of valuation." Wal-Mart's estimated shrinkage rates were generally
based on objective factors—historical shrinkage averages—that did not leave room for
manipulation from year-to-year. Other than setting new store rates, Wal-Mart had no
discretion in calculating estimated shrinkage.

       Moreover, Wal-Mart, an industry leader in inventory management and shrinkage
control, used the same accounting method for taxes, financial reporting, and evaluations
of daily operations. Although Wal-Mart made minor alterations to its method of
estimating shrinkage during the years in issue, we find no clear error in the tax court's
factual finding that Wal-Mart consistently calculated shrinkage estimates.

       Accuracy is also indicative of an accounting system that clearly reflects income.
See Caldwell v. Commissioner, 202 F.2d 112, 115 (2d Cir. 1953) (stating that "income
should be reflected with as much accuracy as standard methods of accounting practice
permit"). Obviously, in permitting cycle counting, the regulations do not require absolute
accuracy. See Treas. Reg. § 1.471-2(d) (providing for verification and adjustment of
book inventories). We agree with the tax court's finding that Wal-Mart's method of
estimation produced reasonably accurate results. In reaching that conclusion, the tax
court analyzed the overall accuracy of Wal-Mart's method by considering the testimony
of the various expert witnesses presented by the parties.

      We note that it is difficult, if at all possible, to devise an infallible method of
comparing estimated shrinkage to what actually transpired. The only verified calculation
of shrinkage is for the physical inventory period. However, because each physical
inventory period covers two different tax years, there is no direct proof available to show
exactly what proportion of the shrinkage occurred during the stub period and what
proportion occurred during the year-end-to-physical-inventory period. Consequently,
we must rely on indirect proof.




                                          -15-
       The tax court first compared the total amount of booked shrinkage as a percentage
of sales for the taxable year to the total amount of verified shrinkage as a percentage of
sales during the physical inventory period:

                         Shrinkage as a Percentage of Sales


       Taxable Year                     Booked                        Verified
            1983                          1.47                          1.48
            1984                          1.11                          1.06
            1985                          1.36                          1.37
            1986                          1.00                          1.00

       The figures for booked shrinkage consist of both the amount of estimated
shrinkage recorded by Wal-Mart for the taxable year and the estimation error adjustment
for the just-concluded physical inventory period. The figures for verified shrinkage are
for the physical inventory period.

       As the tax court recognized, this comparison has its limitations in that it compares
shrinkage from two different time frames. Nonetheless, the comparison is useful because
these periods overlap. Moreover, the inclusion of the estimation error adjustment in the
figures for booked shrinkage shows the effect that Wal-Mart's adjustments for physical
inventories had on book inventories. This reconciliation was a fundamental part of Wal-
Mart's inventory method. The Commissioner argues that the inclusion of adjustments
for overestimates from the previous year masks the true extent of an overestimate of
shrinkage in the current year, potentially resulting in a perpetual tax deferral if the
taxpayer consistently overestimates shrinkage. But this argument assumes that there is
a stub period shrinkage estimation error in each succeeding year that is at least equal to
the original error. This is unlikely considering that Wal-Mart's


                                          -16-
estimated shrinkage rate is self-adjusting in accordance with prior verified shrinkage.
        In an attempt to demonstrate the inaccuracy of Wal-Mart's method, the
Commissioner compares estimated shrinkage, without adjustment for prior estimation
errors, to verified shrinkage. The comparison is limited to the physical inventory period
only. The Commissioner's analysis again ignores the estimation error adjustment, which
is a fundamental part of Wal-Mart's accounting method. Nevertheless, even if we
accepted the Commissioner's flawed analysis, it would not persuade us that Wal-Mart's
method was inaccurate. If prior estimation errors were excluded from the calculation of
estimated shrinkage, the difference between verified and estimated shrinkage during the
physical inventory period follows:

     Comparison of Verified Shrinkage to Unadjusted Estimated Shrinkage
                       Stated as a Percentage of Sales


            Estimated Shrinkage          Verified Shrinkage            Difference
  1983               1.72                       1.48                       .24
  1984               1.58                       1.06                       .52
  1985               1.52                       1.37                       .15
  1986               1.46                       1.00                       .46

      The Commissioner conducted the above comparison for the taxable years from
1983 through 1993. For that entire period, the difference between verified shrinkage and
estimated shrinkage was .22% of sales, while the estimation error in any given year
ranged from an underestimate of .14% to an overestimate of .52% of sales. These small
percentage errors do not support the Commissioner's position that Wal-Mart's method
did not produce accurate results. This is especially true when we consider the




                                         -17-
fact that any estimation errors are accounted for in the succeeding year with both the
estimation error adjustment and the adjustment to the estimated shrinkage rate.

       In sum, we find that the tax court's "Shrinkage as a Percentage of Sales"
comparison, although not perfect, shows that Wal-Mart's method of accounting for
shrinkage produced accurate results. The tax court articulated an additional comparison
of estimated shrinkage to verified shrinkage. We do not, however, rely on this
comparison, in part because it does not add much to the previous comparison, and in part
because the appellate record is not adequately developed to reconstruct it.

       We recognize that Wal-Mart's method of estimating stub period shrinkage was not
flawless. Wal-Mart estimated shrinkage at the store level and then allocated that
shrinkage to each department or LIFO pool. Accordingly, the valuation of an individual
LIFO pool was potentially distorted because of changes in LIFO pool attributes. See
Dayton Hudson Corp. and Subsidiaries. v. Commissioner, 71 T.C.M. (RIA) 260, 97-
1665 (1997) (Dayton Hudson II). This same flaw, however, is also attributable to the
Commissioner's method, and any other method that uses cycle counting. See id. In the
final analysis, we agree with the tax court that Wal-Mart's accounting method resulted
in a clear reflection of income.12

      The tax court also found that the method of accounting for shrinkage that Sam's
used resulted in a clear reflection of income. In addition to consistently applying the
same method, which did in fact comply with GAAP, Sam's experienced a shrinkage rate
of .27% of sales for the 2-year period at issue. During those years, Sam's


      12
         We note that for taxable years ending after August 5, 1997, the Commissioner
has promulgated, as encouraged by the legislative history to I.R.C. § 471(b), a retail
safe harbor method of accounting for estimating shrinkage. See Rev. Proc. 98-29,
1998-15 I.R.B. 22. Use of the safe harbor method will presumably result in a clear
reflection of income, provided that the taxpayer consistently applies the method and the
taxpayer's other inventory methods satisfy the clear reflection of income standard.

                                         -18-
estimated its shrinkage to be .2% of sales. This estimate was based on historical
shrinkage results for warehouse operations. We find no error in the tax court's
conclusion that the accounting method used by Sam's resulted in a clear reflection of
income.

       We have carefully reviewed the remainder of the parties' submissions and hold
that the Commissioner abused her discretion in changing the Taxpayer's method of
accounting—a method that resulted in a clear reflection of income—to a method that
does not account for shrinkage until it is verified by physical count.13 The record simply
does not provide adequate support for the Commissioner's determination.

III.   CONCLUSION

       The Code and the regulations permit the use of an inventory accounting method
that includes estimates of shrinkage during the stub period, if the method is sound. The
Taxpayer's method is sound because it clearly reflects income and conforms to the best
accounting practice in the retail industry. Accordingly, the decision of the tax court is
affirmed.

       A true copy.

             Attest:

                      CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.




       13
         Even if the Taxpayer's method did not result in a clear reflection of income, the
Commissioner may not change a taxpayer's method to one that fails to reflect income
clearly. See Harden v. Commissioner, 223 F.2d 418, 421 (10th Cir. 1955). In light of
our holding that the Taxpayer's method reflected income clearly, we need not decide
whether the Commissioner's proposed method failed to reflect income clearly.

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