                   T.C. Memo. 1997-260



                 UNITED STATES TAX COURT



DAYTON HUDSON CORPORATION AND SUBSIDIARIES, Petitioner v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



 Docket No. 21217-91.                      Filed June 11, 1997.



       P operated department stores. P used “cycle
 counting” to conduct physical inventories of
 merchandise throughout the year. P maintained book
 inventory records from which inventory closing balances
 could be determined at yearend. P estimated losses
 from shrinkage factors (e.g., theft and errors in
 billing) occurring from the time of the last physical
 count of inventory to yearend and made an accrual of
 the estimate. P calculated shrinkage accruals as a
 percentage of sales.
       Held: P's systems of maintaining book inventories
 do not clearly reflect income. They are, thus, not
 sound within the meaning of sec. 1.471-2(d), Income Tax
 Regs.
                                 - 2 -


     David R. Brennan and Walter A. Pickhardt, for petitioner.

     Reid M. Huey, John C. Schmittdiel, Robert J. Kastl, and

Robin L. Herrell, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     HALPERN, Judge:   Respondent has determined a deficiency in

petitioner's Federal income tax for its 1984 taxable year in the

amount of $17,384,314, and petitioner has claimed an overpayment

of income tax for that taxable year in the amount of $180,375.1

     Previously, on respondent's motion for summary judgment, we

addressed one of the issues presented in this case.    In Dayton

Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462 (1993), we

held that section 1.471-(2)(d), Income Tax Regs., as a matter of

law, does not prohibit petitioner from making a shrinkage accrual

in computing book inventories.    The issue remaining for our

consideration is the soundness of certain of petitioner's

accounting systems that allow for the accrual of an estimate of

losses from shrinkage factors (e.g., theft and errors in billing)

in determining book inventories.

     Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the year in issue, and all



1
     The claim for overpayment contests the disallowance of
shrinkage accruals in computing the tax consequences of a prior
settlement between the parties for the taxable year in issue.
                               - 3 -

Rule references are to the Tax Court Rules of Practice and

Procedure.



                         FINDINGS OF FACT

      Some facts have been stipulated and are so found.   The

stipulations of facts filed by the parties, with accompanying

exhibits, are incorporated herein by this reference.   The parties

have made approximately 180 separate stipulations of fact,

occupying 50 pages, and there are 120 accompanying exhibits.     We

will set forth only those stipulated facts that are necessary to

understand our report, along with other facts that we find.

I.   Background

      A.   Petitioner

      Petitioner is a Minnesota corporation with its principal

office in Minneapolis, Minnesota.   Petitioner makes its Federal

income tax return on the basis of a fiscal year ending during

January of each year (we shall refer to petitioner's taxable year

ending within a year simply by referring to that year, e.g.,

“1984” for petitioner's taxable year ending January 28, 1984).

      During 1984, petitioner was a retailer operating 1,075

stores in 47 States, the District of Columbia, and Puerto Rico.

Petitioner's operations included a rapidly growing low margin

department store chain in 22 States called Target and a regional

department store company called Dayton's.
                                   - 4 -

     Target and Dayton's were divisions of petitioner.      Target

offered a merchandise mix of two-thirds convenience-oriented

hardlines and one-third fashion softgoods.      Target has had

significant growth in the number of stores it has operated; in

1980, Target operated 80 stores, in 1984, it operated 205 stores,

and, in 1993, it operated 506 stores.      Dayton's included

13 stores, generally referred to as department stores, and

3 “Home” stores specializing in furniture, carpeting, and

draperies; all 16 stores were located in Minnesota, North Dakota,

South Dakota, and Wisconsin.    In 1984, Target had gross receipts

of $3,098,325,882, and Dayton's had gross receipts of

$488,375,001.

     B.    Accounting Procedures

     Petitioner's annual accounting period and taxable year was a

52/53-week year ending on the Saturday closest to January 31.

     Petitioner used the accrual method of accounting for both

Federal income tax and financial reporting purposes.      Gross

income was calculated using inventories to account for the

purchase and sale of merchandise.      Book inventories were

maintained to determine closing inventories for taxable years for

which no physical inventories were taken at the taxable yearend.

     Gross income, in a merchandising business, means gross

receipts for the period in question less cost of goods sold, plus

any income from investments and from incidental or outside

sources.    Cost of goods sold, slightly simplified, equals opening
                               - 5 -

inventory plus inventory purchased during the period minus

closing inventory.

     Both Target and Dayton's used the “cycle counting” method of

conducting physical inventories.   Cycle counting is a method of

conducting physical inventories at individual stores or

departments within stores, in rotation, throughout the year.

Most large retail companies do not perform a physical count of

inventory on or near the last day of the annual accounting

period.   Large retailers prefer cycle counting to yearend

counting because it is more accurate and less expensive and

provides better inventory control.     Cycle counting is also more

efficient and practical in terms of the availability of internal

resources and outside services to conduct physical inventories.

Generally, petitioner did not conduct physical inventories on the

last day of the taxable year in issue.

     During 1983 and 1984, and for a number of years prior

thereto, petitioner maintained a “perpetual”, or book, inventory

system for its divisions and subsidiaries, including Target and

Dayton's.   Under its perpetual inventory system, petitioner

debited its inventory or stock accounts with the cost of goods

purchased and credited those accounts with the cost of goods

sold.   The perpetual inventory system also showed the sales

proceeds from goods sold.

     During 1984, physical inventories were conducted on a store-

by-store basis within the Target division and on a departmental
                               - 6 -

basis within the Dayton's division.    Physical inventories were

not taken in Target stores commencing operations during 1984.

The results of a physical inventory often would indicate that

inventory shrinkage had occurred.    Inventory shrinkage is the

difference between the amount of inventory the stock account

shows as being on hand and the amount of inventory that is

actually on hand.   When inventory is determined from book

inventory records (computed without any accrual for estimated

shrinkage), and the inventory so determined exceeds inventory

determined by physical count, the difference is termed

“shrinkage”.   When book inventory so determined is exceeded by

inventory determined by physical count, the difference is termed

“overage”.   Factors that contribute to shrinkage and overage

(hereafter, generally, shrinkage) include theft by employees,

customers, and vendors, and paperwork, billing, and other systems

errors.   Both Target and Dayton's experienced some or all of the

listed shrinkage factors during the year in issue.    The

occurrence of shrinkage factors is not limited to particular

times during the year, but, generally, each of the factors occurs

throughout the year.

     C.   Accounting for Shrinkage

     If inventory is not physically counted at the end of the

annual accounting period (year), shrinkage (as defined above)

cannot be determined for the period from the last physical count

to the end of the year (the physical-to-yearend period).     If
                               - 7 -

cycle counting is used, and the cycle for a particular store does

not end on the last day of the year, then losses from shrinkage

factors for the physical-to-yearend period (yearend shrinkage)

must be estimated if such yearend shrinkage is to be taken into

account.

     Petitioner maintained a “Controller's Manual” containing a

standard control procedure to set forth corporate policy for

accounting for inventory shrinkage and for planning and reporting

physical inventory results.   That manual provided that all

companies must take at least one complete physical inventory a

year.   It further provided that “[e]ach Operating Company

Controller is responsible for accounting for inventory shrinkage

in accordance with the accrual basis of accounting.”   The manual

defined the term “inventory shrinkage accrual rate” as “[t]he

rate at which inventory is written off to cost of sales to

provide for inventory shrinkage.   The rate is stated as a

percentage of net sales.”   The manual further provided for the

adjustment of physical inventory results as follows:

     When physical inventory shortage is less than the
     provision [i.e., the accrual] for inventory shrinkage,
     cost of sales should be reduced for the calculated
     difference between the physical inventory shortage and
     the provision for inventory shrinkage.

     When physical inventory shortage is more than the
     provision for inventory shrinkage, cost of sales should
     be increased for the calculated difference between the
     physical inventory shortage and the provision for
     inventory shrinkage.
                               - 8 -

     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.
                                   - 9 -

II.   Target

      A.   Accounting Methods and Procedures

            1.    In General

      Target comprised 205 stores that were organized into

91 separate departments.       Target maintained its inventory records

by department and by store.

            2.    LIFO Retail Method

      Beginning in 1963 and continuing through 1984, petitioner

elected to value Target's inventories using the LIFO Retail

Method of inventory valuation pursuant to section 1.471-8, Income

Tax Regs.      Pursuant to sections 1.472-1(k) and 1.472-8(c), Income

Tax Regs., petitioner elected to use department store indexes

prepared by the U.S. Bureau of Labor Statistics (BLS).

Petitioner aggregated Target's departments into 17 LIFO pools

that corresponded to merchandise groups as established by BLS.

            3.    Accrual Rate for Shrinkage

      Target accounted for its inventory shrinkage on the accrual

method, by department and by store.         Target accrued shrinkage as

a percentage of sales using rates (accrual rates) that were set

for each department in each store.         The accruals were posted

directly to the perpetual inventory system on a monthly basis,

and adjustments were made to account for accrual errors.

      Target developed a companywide accrual rate for each taxable

year by reviewing the inventory results for prior physical
                                - 10 -

inventory periods.   Target generally reviewed the most recent 3

to 5 years of store and company experience in arriving at a

companywide rate.    Target also considered a variety of other

factors known to affect the rate of shrinkage (shrinkage rate),

including demographics, crime levels, management problems,

paperwork problems, measures to improve shrinkage, industry

trends, performance of warehouses, and store acquisitions.

     The next step in the process was the determination of

accrual rates for each store.    After considering store-specific

information, Target would assign a preliminary accrual rate to

each store.   Target then adjusted those rates so that the sum of

the individual store rates multiplied by each store's projected

sales figures would equal the projected shrinkage dollars at the

company level as determined from the companywide accrual rate.

The adjustment for a specific store's accrual rate would not

exceed 0.1 percent of its projected annual sales.

     Lastly, Target adjusted accrual rates at the department

level within each store, based upon a 3-year average shrinkage

rate for the department on a companywide basis.    Those department

rates were further adjusted to accord with the shrinkage rate for

each store in proportion to each department's sales relative to

the store's total sales during the most recent 12-month period.
                                - 11 -

            4.   Application of Accruals for Shrinkage

     Target used its accruals for shrinkage for the following

purposes:    (1) financial and tax reporting, (2) to determine the

budget that would be available for the purchase of inventory in a

particular department, (3) to set goals for and to evaluate the

performance of store managers and buyers, and (4) to determine

the sources of shrinkage.

     B.   Target's Physical Inventories

            1.   In General

     Target employed an outside inventory service to conduct

physical inventories of stores generally during the period

beginning with the first weekend in February and ending in

mid-October.     Each store had its own physical inventory period.

Target attempted to conduct a physical inventory at each store

every 8 to 16 months; however, in rare instances, as many as

18 months elapsed between physical inventories.    Except for

stores opened during the year, Target usually inventoried every

store once each year.




            2.   New Stores

     Target generally did not conduct physical inventories of new

stores in the year that they were opened because Target believed

that such inventories produced meaningless results.      Instead,

Target conducted physical inventories of new stores in the year
                                - 12 -

following the year of opening.     In most cases, Target set accrual

rates for new stores by considering the average shrinkage rate

for the district in which the new store was being opened.    Target

also considered the demographics of that district, as well as the

marketing plan of “sister stores”--stores that are located in

areas with similar demographics and have merchandise mixes

similar to that anticipated for the new store--in setting accrual

rates for new stores.

          3.   Warehouses

     During 1979 through 1984, physical inventories were

performed at Target's distribution centers and metro warehouses

(hereafter, collectively referred to as “warehouses”) once each

year prior to the close of the taxable year, during the months of

December or January.    The results of the physical inventories at

the warehouses were taken into account in April of the subsequent

taxable year on a departmental basis by the Target stores

serviced by each particular warehouse.     The amount of shrinkage

was allocated to the Target stores based upon the store's use of

a particular warehouse.     That practice reflected the

determination that the warehouses' shrinkage generally reflected

billing errors to stores.



     C.   Proposed Deficiencies With Respect to Target

     In the notice of deficiency, respondent disallowed shrinkage

accruals for 1984.   The LIFO cost adjustment was $36,339,217,
                                  - 13 -

which reflected a disallowance of shrinkage at retail for the

post-physical inventory periods in the amount of $57,621,019.

       Target had sales for 1984 in the amount of $3,045,802,000.

During the periods between the dates of the physical inventories

of Target's stores and the end of 1984, Target's sales were

$2,370,786,576, or 77.8 percent of all sales for 1984.

III.    Dayton's

       A.   Accounting Methods and Procedures

             1.    In General

       Dayton's comprised 16 stores, and each store had in excess

of 400 departments.      Dayton's maintained its inventory records by

department.

             2.    LIFO Retail Method

       Petitioner elected to value the inventories of Dayton’s

using the LIFO Retail Method of inventory valuation pursuant to

section 1.471-8, Income Tax Regs.       Pursuant to sections 1.472-

1(k) and 1.472-8(c), Income Tax Regs., petitioner elected to use

department store indexes prepared by BLS.       Petitioner aggregated

the departments of Dayton's into 20 LIFO pools that corresponded

to merchandise groups as established by BLS.

             3.    Accrual Rate for Shrinkage

       Dayton's accounted for its inventory shrinkage on the

accrual method, by department.      Dayton's accrued shrinkage as a

percentage of sales using rates (accrual rates) that were set for
                                - 14 -

each department for each taxable year.    The accruals were posted

directly to the perpetual inventory system on a monthly basis,

and adjustments were made to account for accrual errors.

     Dayton's established accrual rates as a percentage of sales

on a departmental basis.    The department rate was applied

throughout the Dayton's division.    In setting a department

accrual rate, Dayton's considered numerous factors including the

most recent shrinkage history and shrinkage trends of the

particular department, the employment of new marketing

strategies, changes in demographics, trends that were developing

in related departments, changes in security procedures, and

particular theft problems.

     Dayton's did not set a companywide accrual rate.    The

companywide accrual figure was simply the aggregate of the

accruals for all of the departments.

            4.   Application of Accruals for Shrinkage

     Dayton's used its accruals for shrinkage for the following

purposes:    (1) financial and tax reporting, (2) to determine the

budget that would be available for the purchase of inventory in a

particular department, (3) to evaluate the performance of

department heads, and (4) to determine the sources of shrinkage.

     B.   Dayton's Physical Inventories

     Dayton's conducted its physical inventories of its

departments by counting inventory on the same day at every store
                              - 15 -

that maintained a particular department.   In conducting physical

inventories, Dayton's used its own employees, and, at times,

those employees were assisted by outside personnel.   The physical

inventories of the departments were performed at various times

throughout the year, and, during the year in issue, they were

performed as early as February 1983 and as late as January 1984.

After a physical inventory was taken, the perpetual inventory

system would be adjusted as necessary, and, generally, Dayton's

adjusted the department accrual rate for the balance of the

taxable year to reflect the most recent shrinkage experience.

     C.   Proposed Deficiencies With Respect to Dayton's

     In the notice of deficiency, respondent disallowed shrinkage

accruals for 1984.   The LIFO cost adjustment was $2,440,127,

which reflected a disallowance of shrinkage at retail for the

post-physical inventory periods in the amount of $4,625,877.

     Dayton's had sales for 1984 in the amount of $415,467,423.

During the periods between the dates of the physical inventories

of the departments of Dayton's and the end of 1984, sales for

Dayton's were $254,488,635, or 61.3 percent of all sales for

1984.
                               - 16 -

                               OPINION

I.   Introduction

      Petitioner's principal business activities are the operation

of department stores.    We are concerned here with petitioner's

Target division (Target) and its Dayton's division (Dayton's)

(together, the Divisions).

      During the taxable year in issue, the Divisions used cycle

counting to conduct physical inventories of merchandise.      Under

the cycle counting method, physical inventories were taken in

rotation, at the various stores or departments within stores,

throughout the year.    Also, the Divisions maintained book

inventory records from which inventories could be determined

without a physical count.    The Divisions 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 Divisions’ shrinkage accruals, and

we must determine whether that disallowance is an abuse of

discretion.
                              - 17 -

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.[2]

As the regulations point out, section 471(a) establishes two

distinct tests to which an inventory must conform:

           (1) It must conform as nearly as may be to the
      best accounting practice in the trade or business, and

           (2) It must clearly reflect the income.

Sec. 1.471-2(a), Income Tax Regs.

      In accordance with the authority provided by section 471(a),

the Secretary has promulgated rules for taxpayers maintaining a

perpetual (book entry) system of keeping inventories.   In

pertinent part, section 1.471-2(d), Income Tax Regs., reads as

follows:

      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 * * * 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

2
     The Tax Reform Act of 1986, Pub. L. 99-514, sec. 803(b)(4),
100 Stat. 2356, designated the quoted language as sec. 471(a).
Before amendment, the quoted language was the entirety of sec.
471.
                                 - 18 -

       verified by physical inventories at reasonable
       intervals and adjusted to conform therewith.

III.    Prior Proceedings

       Previously, on respondent's motion for summary judgment, we

addressed one of the issues presented in this case.      In Dayton

Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462 (1993), we

held that section 1.471-(2)(d), Income Tax Regs., as a matter of

law, does not prohibit petitioner from making a shrinkage accrual

in computing book inventories.      We acknowledged, however, that

respondent might yet argue that petitioner's accounting system,

including the making of shrinkage accruals, is not “sound” within

the meaning of the regulations, or fails to clearly reflect

income.    Id. at 468.

       Respondent acknowledges our holding in the earlier opinion,

but does not agree that it is correct.      We adhere to that

holding.

IV.    Are the Divisions' Systems of Accounting for Inventories,
       Including the Making of Shrinkage Accruals, Sound?

       Because the Divisions used cycle counting to conduct

physical inventories of merchandise, and generally no count was

taken at yearend, the Divisions necessarily had to maintain book

inventory records to determine yearend inventories for purposes

of computing cost of goods sold.      Those book inventories included

an entry for shrinkage accrual.      We must determine whether those

book inventories were maintained in accordance with a “sound

accounting system”.      Sec. 1.471-(2)(d), Income Tax Regs.
                                - 19 -

     We have recently addressed the question of what constitutes

a “sound accounting system” under section 1.471-(2)(d), Income

Tax Regs.   In Kroger Co. & Subs. v. Commissioner, T.C. Memo.

1997-2, we noted that section 1.471-(2)(a), Income Tax Regs.,

provides two specific requirements with which acceptable

inventory practices must conform.    We then stated:

      First, such practices must conform as nearly as may be
      to the best accounting practice in the industry.
      Second, the practices must clearly reflect the
      taxpayer’s income. Section 1.471-2(b), Income Tax
      Regs., adds consistency of application from year to
      year as an important and explicit element of inventory
      practices that clearly reflect income. The use of the
      adjective “sound” in section 1.471-2(d), Income Tax
      Regs., does not introduce an additional standard, but
      only incorporates the previously articulated standards,
      with the emphasis on the “system” or methodology
      employed to maintain book inventories. * * * [Id.]

Therefore, our inquiry is, principally, whether the Divisions'

systems of maintaining book inventories (including the making of

shrinkage accruals) conform to the best accounting practice and

clearly reflect income.

V.   Best Accounting Practice

      The parties have stipulated that, for financial accounting

purposes, petitioner’s financial statements for the taxable year

in issue were consistent with generally accepted accounting

principles (GAAP).   In Thor Power Tool Co. v. Commissioner, 439

U.S. 522, 532 (1979), the Supreme Court stated that the phrase

“best accounting practice”, as it appears in section 471(a) (and
                                 - 20 -

section 1.471-2(a), Income Tax Regs.), is synonymous with GAAP.

Petitioner followed the same accounting practices for both

Federal income tax and financial reporting purposes.       We find,

therefore, that the Divisions' systems of maintaining book

inventories conform to the best accounting practice within the

meaning of section 471(a) and section 1.471-2(a), Income Tax

Regs.

VI.   Clear Reflection of Income

        A.   Methods of Accounting and the Legal Requirement of
             Clear Reflection of Income

        The general rule for methods of accounting is set forth in

section 446(a):

        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.

A taxpayer has latitude, however, in selecting a method of

accounting.      Section 1.446-1(a)(2), Income Tax Regs., provides:

        It is recognized that no uniform method of accounting
        can be prescribed for all taxpayers. Each taxpayer
        shall adopt such forms and systems as are, in his
        judgment, best suited to his needs. * * *

        The accrual method is a permissible method of accounting.

Sec. 446(c).      Section 1.446-1(c)(1)(ii)(A), Income Tax Regs.,

provides:

        Generally, under an accrual method, income   is to be
        included for the taxable year when all the   events have
        occurred that fix the right to receive the   income and
        the amount of the income can be determined   with
        reasonable accuracy. Under such a method,    a liability
                              - 21 -

     is incurred, and generally is taken into account for
     Federal income tax purposes, in the taxable year in
     which all the events have occurred that establish the
     fact of the liability, the amount of the liability can
     be determined with reasonable accuracy, and economic
     performance has occurred with respect to the liability.
     * * *

The term “liability”, as used in section 1.446-1(c)(1)(ii)(A),

Income Tax Regs., is defined in section 1.446-1(c)(1)(ii)(B),

Income Tax Regs., to include “a cost taken into account in

computing cost of goods sold”.

     Notwithstanding the latitude generally enjoyed by a taxpayer

in selecting a method of accounting, where inventories are

employed, accrual accounting is the general rule to account for

purchases and sales:

     Where inventories are employed, purchases and sales
     must be computed on the accrual method (unless another
     method is authorized by the Commissioner) in order to
     avoid the distortion of income. Sec. 1.446-1(c)(2),
     Income Tax Regs.; Stoller v. United States, 162 Ct. Cl.
     839, 845, 320 F.2d 340, 343 (1963).

Molsen v. Commissioner, 85 T.C. 485, 499 (1985).

     In any event, a taxpayer’s right to adopt a method of

accounting is subject to the requirement that the method must

clearly reflect income.   Section 446(b) states that, if the

method adopted “does not clearly reflect income, the computation

of taxable income shall be made under such method as, in the

opinion of the Secretary, does clearly reflect income.”   See also

sec. 1.446-1(c)(1)(ii)(C), Income Tax Regs.
                               - 22 -

     The term “clearly reflect income” is undefined in the Code.

In most cases, generally accepted accounting principles,

consistently applied, will pass muster for tax purposes.    See,

e.g., sec. 1.446-1(a)(2), (c)(1)(ii), Income Tax Regs.   The

Supreme Court has made clear, however, that GAAP does not enjoy a

presumption of accuracy that must be rebutted by the

Commissioner.   Thor Power Tool Co. v. Commissioner, supra at 540.

The Commissioner’s supervisory power under section 446(b),

permitting the rejection of a taxpayer’s method if it “does not

clearly reflect income”, and its substitution with a method that,

“in the opinion of the * * * [Commissioner], does clearly reflect

income”, was described by the Supreme Court in another case as

leaving “[m]uch latitude for discretion”, which “should not be

interfered with [by the courts] unless clearly unlawful.”      Lucas

v. American Code Co., 280 U.S. 445, 449 (1930) (quoted with

approval in Thor Power Tool Co. v. Commissioner, supra at 532).

     B.   Standard of Review

     When the Commissioner determines that a taxpayer's method of

accounting does not clearly reflect income, the taxpayer has a

heavy burden to show an abuse of discretion.   E.g., Asphalt

Prods. Co. v. Commissioner, 796 F.2d 843, 848 (6th Cir. 1986),

affg. in part and revg. in part Akers v. Commissioner, T.C. Memo.

1984-208, revd. per curiam on another issue 482 U.S. 117 (1987).

The Court of Appeals for the Sixth Circuit has stated:
                                - 23 -

     § 446 gives the Commissioner discretion with respect to
     two determinations. The Commissioner first determines
     whether the accounting method chosen by a taxpayer
     clearly reflects income. If the Commissioner concludes
     that the taxpayer's chosen method does not meet this
     standard, he has the further discretion to require that
     computations be made under the method which, in his
     opinion, does clearly reflect income. It would be
     difficult to describe administrative discretion in
     broader terms.

Id. at 847.

     Notwithstanding the authority conferred under section

446(b), the Commissioner cannot require a taxpayer to change to

another method where the taxpayer's method of accounting does

clearly reflect income, even if the method proposed by the

Commissioner more clearly reflects income.     Ford Motor Co. v.

Commissioner, 71 F.3d 209, 213 (6th Cir. 1995), affg. 102 T.C. 87

(1994); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.

367, 371 (1995); Hospital Corp. of Am. v. Commissioner, T.C.

Memo. 1996-105.     Nor will the courts approve the Commissioner's

change of a taxpayer's accounting method from an incorrect method

to another incorrect method.     Harden v. Commissioner, 223 F.2d

418, 421 (10th Cir. 1955), revg. 21 T.C. 781 (1954); Prabel v.

Commissioner, 91 T.C. 1101, 1112 (1988), affd. 882 F.2d 820 (3d

Cir. 1989); see also Southern Cal. Sav. & Loan v. Commissioner,

95 T.C. 35, 44 (1990) (Wells, J., concurring) (“Section 446(b)

authorizes respondent to require accounting changes that produce

clearer reflections of income, not greater distortions of

income”).     Therefore, in order to prevail in a case where the
                              - 24 -

Commissioner determines that a taxpayer's method of accounting

does not clearly reflect income, the taxpayer must demonstrate

either that his method of accounting clearly reflects income or

that the Commissioner's method does not clearly reflect income.

See Asphalt Prods. Co. v. Commissioner, supra at 847; Kroger Co.

& Subs. v. Commissioner, T.C. Memo. 1997-2.

     C.   The Divisions' Shrinkage Methods

     The Divisions maintained book inventory records from which

yearend inventories could be determined.     Losses for the taxable

year occasioned by shrinkage factors (taxable year shrinkage)

were reflected in the Divisions' book inventory records under

methods (individually, Target's shrinkage method and Dayton's

shrinkage method; together, when no distinction is intended, the

Divisions' shrinkage methods) that essentially involved three

variables:   (1) an estimate of losses from shrinkage factors for

the portion of the taxable year preceding the date of the

physical inventory (preinventory accrual), (2) the accrual error

(a measure of error in both the prior year's shrinkage accrual

and the preinventory accrual), and (3) the shrinkage accrual for

the taxable year.

     Target accounted for shrinkage as a percentage of sales

using rates (accrual rates) that were set for each department in

each store for each taxable year.   Those rates were derived from

a companywide accrual rate that was based on a combination of

factors including historical shrinkage experience, demographics,
                              - 25 -

crime levels, management problems, measures to improve shrinkage,

industry trends, performance of warehouses, and store

acquisitions.   Except for stores opened during the year, Target

generally conducted a complete physical inventory of an entire

store on a particular day once each year.

     Dayton's accounted for shrinkage as a percentage of sales

using rates (accrual rates) that were set for each department for

each taxable year.   Companywide, department accrual rates were

based on a combination of factors including the most recent

shrinkage history and shrinkage trends of the particular

department, the employment of new marketing strategies, changes

in demographics, trends that were developing in related

departments, changes in security procedures, and particular theft

problems.   Dayton's conducted its physical inventories of its

departments by counting inventory on the same day at every store

that maintained a particular department.    The physical

inventories of the departments were performed at various times

throughout the year, and, during the year in issue, they were

performed as early as February 1983 and as late as January 1984.

     In sum, both Target and Dayton's estimated losses from

shrinkage factors as a percentage of sales, using methods that

essentially reflected (1) verified shrinkage for the preinventory

period, (2) an estimate of yearend shrinkage (shrinkage

accruals), and (3) accrual error attributable to the shrinkage

accrual for the prior taxable year.
                                - 26 -

     D.   Respondent's Method

     Respondent would permit the Divisions to account for losses

from shrinkage factors only when such losses are verified by

physical inventories (respondent's method).   Respondent claims

that that “method is nothing more than application of the

principle that taxpayers may not reduce income by unverified

losses or expenditures, or unreliable estimates”.   Upon closer

analysis, we conclude that respondent's method essentially

estimates yearend shrinkage for the taxable year based on yearend

shrinkage for the prior taxable year.

     Respondent's method would adjust the Divisions' book

inventories by disallowing any shrinkage accrual.   The Divisions'

cost of goods sold, as determined by book inventories, would

essentially include shrinkage for inventory cycles beginning in

the prior taxable year and ending in the taxable year and not any

portion of the shrinkage determined for inventory cycles

beginning within the taxable year and ending in the next taxable

year (i.e., yearend shrinkage).    In sum, the Divisions’ cost of

goods sold for a taxable year that included cross-year inventory

cycles would include shrinkage accurately measured (i.e.,

verifiable) for some period other than that taxable year (i.e.,

an inventory year).

     If it is assumed that there is yearend shrinkage, then,

unless the amount of yearend shrinkage for the taxable year is

identical to the amount of yearend shrinkage for the previous
                                                     - 27 -

year, respondent’s method would produce only an estimate of the

loss from shrinkage factors for the taxable year.                                            The facts

underlying that conclusion can be illustrated by the following

diagram, in which it is assumed that a physical inventory is

taken semiannually, on March 31 and September 30, and that the

taxpayer is a calendar year taxpayer.


                  1995 Taxable Year             1996 Taxable Year               1997 Taxable Year

                                      Dec. 31                       Dec. 31                         Dec. 31



          1995 Inventory Year          1996 Inventory Year            1997 Inventory Year

Sept.30      Mar. 31       Sept. 30        Mar. 31       Sept. 30             Mar. 31     Sept. 30




Under respondent’s method, the taxpayer’s cost of goods sold for

a taxable year would be computed by including shrinkage for the

taxpayer’s inventory year ending September 30.                                          Shrinkage for the

inventory year might equal taxable year shrinkage, but the

occurrence of that remote possibility is impossible to verify.

What is likely (almost a certainty) is that the taxpayer,

computing his cost of goods sold under respondent's method, would

be making that computation using some figure for taxable year

shrinkage that was not the actual taxable year shrinkage.                                                     In

other words, the taxpayer would be forced to use what is almost

certainly no more than an estimate of taxable year shrinkage in

computing cost of goods sold.
                              - 28 -

     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 Divisions 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 Divisions’

shrinkage methods and respondent’s method is that respondent,

without admitting it, accepts an estimate of yearend shrinkage

while the Divisions, by making shrinkage accruals, consciously

attempt to estimate that shrinkage.3

3
     Petitioner attempts to distort our understanding of
respondent's method by stating that, for Target, “[r]espondent
allows shrinkage at retail of $6,152,381 or 0.202 percent of
sales.” Petitioner also states that “[r]espondent has not even
allowed the shrinkage verified by physical inventories during the
year of $51,323,565.” That characterization of respondent's
method is misleading because it fails to recognize that
respondent's adjustments for the year in issue are not isolated
determinations, but, rather, reflect a method change. Indeed, in
the petition, petitioner alleges, alternatively, that a sec. 481
adjustment would be required in the event that respondent's
adjustments are sustained. At trial, however, petitioner's
counsel acknowledged that no evidence was submitted on that issue
and that petitioner intended to rely on defeating respondent's
determination of deficiency. On brief, petitioner's counsel
cites respondent's failure to make an adjustment to opening
inventory as evidence of the arbitrariness of respondent's
method. Adjustments to opening inventory are the province of
sec. 481; petitioner having abandoned its sec. 481 argument, we
                                                   (continued...)
                                 - 29 -

     E.     Petitioner's Expert Testimony

             1.   Introduction

     Petitioner relies on expert testimony to demonstrate that

(1) the Divisions' shrinkage methods clearly reflect income,

(2) respondent's method does not clearly reflect income, or

(3) the Divisions' shrinkage methods more clearly reflect income

when compared to respondent's method.       In particular, petitioner

relies on such testimony to demonstrate a strong correlation

between sales and shrinkage, which correlation underlies the

Divisions' shrinkage accruals and petitioner's contention that

respondent's method does not clearly reflect income.        Petitioner

presents principally the expert testimony of W. Eugene Seago,

Ph.D.     Dr. Seago is a certified public accountant and a professor

of accounting at Virginia Polytechnic Institute and State

University.

             2.   Correlation Between Sales and Shrinkage

     Statistical correlation (R) is a measure of the degree to

which two variable quantities tend to change with respect to each

other.     R is expressed in a range between positive one and

negative one.     A correlation of positive one indicates that the

two quantities change in exact proportion and in the same



3
 (...continued)
believe that it cannot show arbitrariness based on respondent's
failure to make an adjustment to opening inventory, and we reject
petitioner's attempt to distort respondent's method.
                                - 30 -

direction, whether up or down.     A correlation of zero indicates

that the two quantities change without reference to each other.

A correlation of negative one indicates that the two quantities

change in exact proportion, but in opposite directions:    When one

goes up, the other goes down.    In addition, the square of the

correlation coefficient is termed the coefficient of

determination (R2).   Generally, R2 measures the predictive power

of one variable with respect to another variable.    The principal

experts in this case do not limit their use of the term

“correlation” to represent R in the technical sense, but rather,

use that term to signify R2 at times and also to signify the

general relationship between two variables.    We shall conform,

for purposes of this report, to the experts’ broad usage of the

term “correlation”.

     Dr. Seago states in his rebuttal report that “[t]he purpose

of ascertaining whether shrinkage correlates to sales is to test

whether Target's use of sales to estimate shrinkage is

appropriate.”   Dr. Seago acknowledges that testing the

correlation of sales and shrinkage at the LIFO pool level for

Target would be highly relevant because tax effects occur at that

level, but, since data to test that correlation does not exist,

he concludes that the “next best thing” is to examine correlation

at the aggregate division level.    Dr. Seago is of the opinion
                               - 31 -

that the correlation between sales and shrinkage at the aggregate

Target-wide level is strong.

     Dr. Seago conducted a regression analysis of the

relationship between sales and shrinkage at the aggregate Target-

wide level during the years 1979 through 1988 (the 10-year

correlation analysis).   For each Target store, he paired actual

sales figures between inventory dates with verified shrinkage

figures for the same period.   Dr. Seago then aggregated the data

according to the taxable year in which the closing inventory was

taken.   He is of the opinion that, for the years examined, “[t]he

change in sales each year explained over 97% of the change in

shrinkage.”   Dr. Seago concludes that, “according to the

statistical evidence, sales is a nearly perfect predictor of the

loss from shrinkage.”    He did not conduct a similar analysis with

respect to Dayton's.

      To compensate for the absence of data to test correlation

at the LIFO pool level, Dr. Seago randomly placed individual

Target stores into 21 “surrogate pools” and examined the

correlation between sales and shrinkage for the fiscal years 1979

through 1988.   Dr. Seago concludes that the correlation between

sales and shrinkage at the surrogate pool level is strong and

that “comparable results would be achieved if sales and shrinkage

for the actual LIFO pools were available.”
                              - 32 -

          3.   Shrinkage Accrual Accuracy Analysis

     Dr. Seago believes that the 10-year correlation analysis

demonstrating a correlation between sales and shrinkage with

respect to Target leads to the conclusion that the Divisions'

shrinkage methods4 are theoretically correct methods.   Dr. Seago

acknowledges, however, that the next step is to determine whether

those methods were properly applied.   He recognizes that a

comparison of the shrinkage verified by physical count with the

shrinkage claimed by petitioner for the taxable year is of

limited significance because the comparison would be of figures

for two different periods.   In an attempt to analyze the accuracy

of the Divisions' shrinkage methods and to compare those methods

with respondent's method, Dr. Seago developed a model to

determine taxable year shrinkage.   He applied that model to data

for Target during the taxable years that ended in 1983 through

1986.

     Dr. Seago believes that, when a physical inventory is taken

at the close of a period that includes portions of 2 taxable



4
     It should be noted that Dr. Seago refers to both Target's
shrinkage method and Dayton's shrinkage method as Dayton Hudson's
method, without distinction. Although there are many significant
similarities between the two methods, this Court will evaluate
the two methods independently and refer to the two methods as the
Divisions' shrinkage methods only for convenience and when there
are no relevant distinctions.
                              - 33 -

years, and an accrual error is detected, some portion of that

error is attributable to each of the taxable years.   With support

from the results of the 10-year correlation analysis, Dr. Seago

assumed that sales and shrinkage were perfectly correlated

throughout the year and, thus, determined that any accrual error

should be allocated according to the relative sales between the

two relevant taxable years to arrive at a figure for taxable year

shrinkage.   Dr. Seago examined Target's sales figures for the

taxable years ending in 1984, 1985, and 1986, and determined that

approximately 75 percent of sales between physical inventory

dates are allocable to the taxable year prior to the taxable year

in which the physical inventory is taken.   As a result, Dr. Seago

allocated 75 percent of the applicable accrual error to the

taxable year prior to the taxable year in which the physical

inventory was taken and 25 percent to the taxable year in which

the physical inventory was taken.   Dr. Seago compared his

resulting figures for taxable year shrinkage (sales-allocated

taxable year shrinkage) with the shrinkage claimed by Target for

tax purposes and the shrinkage that would be allowed under

respondent's method.   Dr. Seago's analysis produced the following

results:5



5
     These tables contain a few minor computational errors, and
we have taken the liberty of calculating the aggregate percentage
difference using Dr. Seago's numbers.
                                   - 34 -
                           TARGET'S SHRINKAGE METHOD

                                            Target Book
 Taxable                    Sales-          Shrinkage Minus   Difference as
 Year        Target         Allocated       Sales-Allocated   Percent of
 Ending      Book           Taxable Year    Taxable Year      Sales-Allocated
 In          Shrinkage      Shrinkage       Shrinkage         Shrinkage

  1983       $54,175,800    $48,257,951       $5,917,849          12.26%
  1984        63,773,400     63,217,484          555,916           0.88%
  1985        66,205,504     73,483,645       -7,278,141          -9.90%
  1986        82,227,200     81,441,206          785,994           0.97%

  1983-      266,381,904    266,400,286          -18,382          -0.01%
  1986

                     RESPONDENT'S METHOD - TARGET DIVISION

                                            Verified
 Taxable     Loss           Sales-          Loss Minus        Difference as
 Year        Verified by    Allocated       Sales-Allocated   Percent of
 Ending      Physical       Taxable Year    Taxable Year      Sales-Allocated
 In          Inventory      Shrinkage       Shrinkage         Shrinkage

  1983       $41,733,212    $48,257,951      -$6,524,739         -13.52%
  1984        51,323,565     63,217,484      -11,893,929         -18.81%
  1985        65,194,206     73,483,645       -8,289,439         -11.28%
  1986        80,248,800     81,441,206       -1,192,406          -1.46%

  1983-      238,499,783    266,400,286      -27,630,152         -10.37%
  1986

     Dr. Seago determined that Target's estimates of taxable year

shrinkage produced, in the aggregate, a net underestimate in the

amount of $18,382 for the taxable years ending in 1983 through

1986 when compared to sales-allocated taxable year shrinkage.              He

also determined that the maximum error under Target's shrinkage

method was 12.26 percent of sales-allocated taxable year

shrinkage.    From that analysis, Dr. Seago concludes that the

Divisions' shrinkage methods produced “a reasonably accurate

measure of the loss” occasioned by shrinkage factors.            Dr. Seago

notes that, in contrast, respondent's method yields a cumulative

overstatement of income in the amount of $27,630,152.            Dr. Seago
                                - 35 -

concludes that respondent's method “contains a systematic bias

towards the understatement of losses during periods when sales

are increasing.”

          4.     Sales Percentage Shrinkage Analyses

     To further examine the accuracy of Target's shrinkage

method, Dr. Seago computed for each Target store during the

taxable years ending in 1980 through 1989 (1) the verified

shrinkage between physical inventory dates as a percentage of

sales for that period (actual shrinkage), (2) the shrinkage

estimates accrued in book inventory as a percentage of sales for

the same period (estimated shrinkage), and (3) the difference

between (1) and (2).     Dr. Seago hypothesized that, if Target

could accurately predict shrinkage between physical inventory

dates, i.e., the difference between actual and estimated

shrinkage is small, Target should likewise accurately predict

shrinkage for the taxable year.

     Dr. Seago's calculations revealed that, over the period

examined, the simple average difference between actual and

estimated shrinkage was 0.12 percent of sales and the weighted

average (weighted by sales) difference was 0.16 percent of sales.

That difference represents approximately 7 percent of actual

shrinkage.     In addition, Dr. Seago performed a regression

analysis comparing sales and shrinkage for each Target store
                              - 36 -

during the taxable years ending in 1980 through 1989.6    He

determined an R2 of 0.367.   Dr. Seago explains that finding by

stating, “while an accrual based solely on the historical

relationship between sales and shrinkage would result in

substantial errors in predictions * * *, Target personnel are

able to significantly reduce the error by adjusting the accrual

factor to take into account factors known to contribute to

shrinkage in the particular store.”    Dr. Seago asserts that the

demonstrated success of Target in predicting store shrinkage

suggests that Target likewise accurately predicts shrinkage at

the department level.

     Dr. Seago also presents a sales percentage shrinkage

analysis for Target at the aggregate division level.     He states

that, from 1979 through 1988, verified shrinkage has averaged

2.102 percent of sales, with a range of 1.90 percent to 2.30

percent.   Dr. Seago states that Target's estimates of shrinkage

as a percentage of sales, when compared to the verified

percentage, showed that the estimates deviated from the actual

figures by no more than 25 percent.



6
     That analysis of the relationship between sales and
shrinkage at the individual store level appears in Dr. Seago's
rebuttal report and is distinct from the 10-year correlation
analysis.
                                - 37 -

            5.   Dr. Seago's Criticism of Respondent's Method

     Dr. Seago states that the shortcomings of respondent's

method are that (1) the loss for the taxable year is dependent on

the date of the physical inventories and (2) losses actually

attributable to a prior taxable year are included in the loss for

the current year and losses attributable to the current taxable

year are deducted in the following taxable year.     Dr. Seago

asserts that respondent's method contains a systematic bias

towards understating losses when sales are increasing.

     F.   Respondent's Expert Testimony

            1.   Introduction

     Respondent presents the testimony of two experts, Dennis J.

Gaffney, Ph.D., a professor of accounting at the University of

Toledo, and David W. LaRue, Ph.D., an associate professor of

commerce at the University of Virginia.

            2.   Dr. Gaffney

     Dr. Gaffney was requested to render an opinion as to whether

the Divisions' shrinkage methods were appropriate for financial

accounting and reporting purposes and, if so, the degree of error

in estimating shrinkage that could be tolerated for those

purposes.    Although Dr. Gaffney's opinions on those issues are

not relevant with respect to the issue of clear reflection of

income for tax purposes, we believe that Dr. Gaffney's comparison

of Target's verified and accrued shrinkage in retail sales
                                         - 38 -

figures for inventory periods that ended in taxable years ending

in 1980 through 1993, nevertheless, provides an important

perspective on sales and shrinkage data for Target.                    That

comparison produced the following results:
     TARGET - COMPARISON OF VERIFIED AND ACCRUED SHRINKAGE FOR INVENTORY PERIODS7



           Verified Shrinkage    Accrued Shrinkage       Accrued Minus Verified

TYE in       $000    %Sales       $000     %Sales     $000    %Sales     %Difference



    1980    17,513    1.94       20,689     2.29      3,175    0.35           18.04

    1981    25,608    2.25       25,763     2.27        156    0.02           0.89

    1982    37,186    2.21       36,605     2.18       -580   -0.03           -1.36

    1983    41,733    2.15       43,983     2.26      2,250    0.11           5.12

    1984    51,324    2.02       61,464     2.42     10,141    0.40           19.80

    1985    65,194    2.00       76,076     2.33     10,882    0.33           16.50

    1986    80,249    2.20       81,370     2.23      1,121    0.03           1.36

    1987    91,512    2.30       85,749     2.15     -5,763   -0.15           -6.52

    1988    87,816    2.05       91,068     2.12      3,252    0.07           3.41

    1989   115,560    1.90      145,048     2.38     29,488    0.48           25.26

    1990    97,610    1.57      147,806     2.37     50,196    0.80           50.96

    1991   148,717    1.92      169,731     2.19     21,014    0.27           14.06

    1992   130,260    1.59      163,944     2.00     33,683    0.41           25.79



7
     Dr. Gaffney notes that the columns “may not foot and
crossfoot due to rounding.” In addition, he notes that the data
for 1981, which was provided by petitioner, do not appear
mathematically correct, and the 1993 data include warehouse
shrinkage that was computed separately in that year. Lastly, we
have taken the liberty of deleting Dr. Gaffney's aggregate
calculations because those calculations did not take into account
the adjustment to book inventories following physical
inventories.
                                     - 39 -
1993     162,692    1.70       188,526   1.98   25,834   0.28       16.47



Dr. Gaffney observed that out of the 14 years considered by him,

an overaccrual of shrinkage was made in 12 of those years.

            3.     Dr. LaRue

       Dr. LaRue testified to, among other things, the “tax

effects” resulting from the accrual of erroneous estimates of

unverified shrinkage (shrinkage estimation errors).             He designed

simulation models to analyze shrinkage estimation errors that

result from the use of cycle counting in conjunction with the

LIFO Retail Method.        Dr. LaRue believes that the LIFO Retail

Method imposes certain additional demands on any method of

shrinkage estimation.        To better appreciate Dr. LaRue's

assertion, we must acquire a basic understanding of the LIFO

Retail Method.      See secs. 1.471-8, 1.472-1(k), 1.472-8(c), Income

Tax Regs.

       The LIFO Retail Method is a method of inventory valuation

designed to meet the special needs of high volume retailers

dealing in a wide variety of merchandise.         In general terms, the

sales at retail for an accounting period are subtracted from the

retail value of goods available for sale during that period to

produce a figure for the retail value of ending inventory.             That

figure for the retail value of ending inventory must be converted

into a figure for cost of ending inventory, which can be
                              - 40 -

subtracted from cost of goods available for sale during that

period to produce a figure for cost of goods sold.

     In simplified terms, the process of converting the current

year retail value of ending inventory to cost of ending inventory

involves dividing the current year retail value of ending

inventory by the current retail price index (which, for retailers

using U.S. Bureau of Labor Statistics (BLS) indexes, is the

current BLS price index for the particular inventory pool divided

by the BLS price index for the year in which that pool was

adopted (base year)) to yield a figure for current year retail

value of ending inventory expressed in base year dollars.

Comparing that result to a similar figure computed as of the end

of the immediately preceding accounting period reveals whether an

increment or decrement in the quantity of goods has occurred as

of the end of the period, as opposed to mere changes in retail

price levels.   If there has been no decrement in the quantity of

goods as of the end of the period, cost of ending inventory is

the sum of the prior year's cost of ending inventory plus the

cost of the quantity of inventory in the current increment (if

any).   The retail value of the increment expressed in base year

dollars is multiplied by the current year's retail price index

and then multiplied by the cost complement8 to arrive at the cost


8
     Generally, the cost complement is the weighted average
relationship between the cost of current year purchases and the
                                                   (continued...)
                                - 41 -

of the increment in the quantity of goods.    In the event of a

decrement, the decrease is subtracted from the annual layers of

the period's beginning inventory in reverse chronological order.

Those procedures are applied to each LIFO pool, which generally

maintains its own set of BLS indexes, cost complement, layer

structure, and other pool attributes.

     Having acquired a basic understanding of the LIFO Retail

Method, we can better analyze Dr. LaRue's criticism of the

Divisions' shrinkage methods.    Dr. LaRue believes that the

process of making corrections to shrinkage estimates in the

subsequent year is inadequate because changes in LIFO pool

attributes, such as BLS indexes and cost complements, prevent

corrections from accurately offsetting previous shrinkage

estimation errors in the earlier year.    In addition, Dr. LaRue

asserts that the varying tax effects of shrinkage estimation

errors among LIFO pools, which is a product of differing pool

attributes, even undermines the validity of a methodology that,

in the aggregate, produces an accurate estimate of taxable year

shrinkage.   In sum, Dr. LaRue believes that cycle counting and

the LIFO Retail Method impose “significant additional demands on

the design and implementation of a methodology that might be




8
 (...continued)
retail value assigned to those purchases.
                             - 42 -

considered capable of producing sound accruals of shrinkage

losses.”

     In addition, Dr. LaRue considered Target's shrinkage method

and concluded as follows:

     In my opinion, the “methodology” employed by Target to
     forecast its shrinkage experience and to then allocate
     that forecast to each of the departments in each of its
     stores for the purpose of accruing these losses in its
     books and records fails to evidence the objectivity and
     verifiability required to establish the overall process
     as a sound method that can be expected to clearly
     reflect its income.

That opinion, according to Dr. LaRue, is based on Target's

failure to “directly” consider a department's actual shrinkage

experience in setting that particular department's shrinkage rate

coupled with the inability of “a disinterested party with full

knowledge of all relevant data * * * to independently reconstruct

the forecasted shrinkage derived” by Target's shrinkage method.

     Dr. LaRue disagrees with Dr. Seago's conclusion that the

Divisions' shrinkage methods produce reasonably accurate

estimates of losses from shrinkage factors.   Dr. LaRue believes

that the tax effects of shrinkage estimation errors are not the

result of errors at the aggregate level because shrinkage is

accrued at the store and department levels, and, therefore,

minimal errors at the aggregate level are misleading.   Dr. LaRue

states:

     I think he [Dr. Seago] is looking at the wrong
     phenomena. I think it doesn't matter a whole lot. It
     matters, but it doesn't matter a whole lot whether our
                               - 43 -

     shrinkage estimation methodology produces very small or
     very large errors at the aggregate level. Shrinkage is
     not accrued at the aggregate level.

Dr. LaRue believes that, notwithstanding a net figure of zero at

the aggregate level, the fact that retail dollars of shrinkage

have to be converted into cost dollars among the various LIFO

pools, which pools utilize diverse conversion processes (i.e.,

differing BLS indexes and cost complements), undermines the

significance of Dr. Seago's shrinkage accrual accuracy analysis.

Dr. LaRue acknowledges, however, that a finding of low shrinkage

estimation error at the aggregate level is not irrelevant.

Indeed, he believes that such a finding creates a presumption of

a “pretty good model”.

     In addition, Dr. LaRue, although in agreement with

Dr. Seago's mathematics, questioned the significance of the high

correlation between sales and shrinkage derived from the 10-year

correlation analysis.    Dr. LaRue conducted his own analysis of

Target data and concludes that the correlation between sales and

shrinkage disintegrates as the level of analysis moves from the

Target-wide level to the department and store levels.

     G.   Evaluation of Expert Testimony

           1.   Origin of Shrinkage Estimation Errors

     An inquiry into the origin of shrinkage estimation errors

provides the proper perspective to evaluate Dr. LaRue's criticism

that the Divisions' shrinkage methods are inherently flawed
                               - 44 -

because the additional demands of the LIFO Retail Method prevent

accurate, subsequent year corrections of shrinkage estimation

errors.    If physical inventories were required to be taken at

yearend, taxable year shrinkage would be known with certainty,

and no estimate of yearend shrinkage would be necessary.

Physical inventories, however, are not required to be taken at

yearend.    Sec. 1.471-2(d), Income Tax Regs.   Once the Secretary

decided not to require physical inventories at yearend, see

Dayton Hudson Corp. & Subs. v. Commissioner, 101 T.C. at 467;

sec. 1.471-2(d), Income Tax Regs., and taxpayers began to

exercise the privilege of computing yearend inventories from book

inventory records, estimations of yearend shrinkage became

inescapable, whether the method of estimating yearend shrinkage

involves calculation (the Divisions' shrinkage methods) or

substitution (respondent's method).

     The realization that estimates of yearend shrinkage are an

inescapable byproduct of cycle counting reveals that Dr. LaRue's

criticisms are, in fact, a condemnation of cycle counting by

means of highlighting the additional demands of the LIFO Retail

Method, which are just as applicable to respondent's method.      In

other words, errors resulting from respondent's method of

substituting yearend shrinkage for the taxable year with yearend

shrinkage for the prior taxable year are subject to the same

problems of varying tax effects arising from changing LIFO pool
                                  - 45 -

attributes and dissimilar pool attributes among pools.

Respondent’s proposed adjustments will not eliminate the flaws

perceived by Dr. LaRue.       It appears that only the practice of

yearend physical inventories at all stores or departments could

eliminate such errors.       That, however, would not be practical,

nor is it required by the regulations.       See sec. 1.471-2(d),

Income Tax Regs.    In sum, we consider Dr. LaRue's objection as an

inherent component of all estimates of yearend shrinkage.

            2.   Dr. Seago

     As a preliminary matter, Dr. Seago, in his report and in his

testimony at trial, made clear that his opinions regarding clear

reflection of income were made in the context of financial

accounting principles and not tax accounting principles.       In

addition, Dr. Seago, at trial, acknowledged that he had not

reviewed directly any taxpayer's method of accounting for

inventory shrinkage other than the Divisions' shrinkage methods.

Although we consider Dr. Seago's concessions in evaluating the

weight of his testimony, this Court will focus on the substance

of his analyses.

     We first consider Dr. Seago's shrinkage accrual accuracy

analysis.    Under the cycle method of counting used by the

Divisions, yearend inventories are not ordinarily taken, and,

thus, whether the Divisions’ shrinkage methods clearly reflect

income is not a fact that petitioner can prove simply by
                              - 46 -

comparing the shrinkage claimed by Target and by Dayton's for the

taxable year to actual taxable year shrinkage figures.

Petitioner must rely on an indirect method of proof.   That is why

petitioner relies on the expert testimony of Dr. Seago.

Dr. Seago developed a model for determining taxable year

shrinkage.   First, Dr. Seago assumed that sales and shrinkage are

“perfectly correlated”, based on his findings in the 10-year

correlation analysis, supra section VI.E.2.   As we have stated,

Dr. Seago allocated 75 percent of any accrual error to the

taxable year prior to the taxable year in which the physical

inventory was taken and 25 percent to the taxable year in which

the physical inventory was taken.   That allocation of the accrual

error in conjunction with the aggregate of monthly accruals for

shrinkage for the relevant taxable years yielded, in Dr. Seago's

opinion, the best estimate of taxable year shrinkage (i.e.,

sales-allocated taxable year shrinkage).

     Dr. LaRue criticizes Dr. Seago for aggregating sales and

shrinkage figures at the Target-wide level.   Dr. LaRue believes

that variances in LIFO pool attributes and discontinuities in the

timing of the physical inventories throughout the taxable year

render the aggregate data virtually meaningless.   Although we

appreciate Dr. LaRue's criticism, we believe that an analysis of

divisionwide or companywide data is not necessarily without

merit, especially when an analysis of such data exposes relative
                               - 47 -

differences between methods at the aggregate level.   See Kroger

Co. & Subs. v. Commissioner, T.C. Memo. 1997-2 (accepting the

taxpayer's presentation of an aggregate analysis, which compared

the taxpayer's method with the Commissioner's method based on an

allocation of cross-year inventory shrinkage as a function of

time; this Court found the aggregate analysis dispositive of

whether there was an abuse of discretion by the Commissioner).

Taxable year shrinkage estimates derived by a taxpayer's

shrinkage method and by the Commissioner's method must be

subjected to the same indexes and cost complements when

converting from retail to cost, and, thus, relative differences

between two methods at the aggregate level may be significant.

     This Court, however, agrees with Dr. LaRue when aggregate

data is used for other purposes.   In particular, we have

difficulty accepting the significance of Dr. Seago's 10-year

correlation analysis, which found a strong correlation between

sales and shrinkage for Target during the years 1979 through

1988, and which underlies Dr. Seago's shrinkage accrual accuracy

analysis.   At the most basic level, it appears that changes in

the Divisions’ LIFO pool attributes from year to year,

differences in attributes among pools, and discontinuities in the

timing of physical inventories from year to year combine to

produce sales and shrinkage figures that represent different

variables from year to year.   We understand correlation, for
                              - 48 -

present purposes, as a measure of the degree to which two

variable, but consistently constituted, quantities tend to change

with respect to each other and not as a measure of the degree to

which two inconsistently constituted quantities change with

respect to each other.   Essentially, Dr. Seago has not persuaded

this Court that the strong correlation between sales and

shrinkage derived from the 10-year correlation analysis is the

product of the true relationship between sales and shrinkage and

not the product of the confluence of varying LIFO pool

attributes.   Dr. Seago has failed to explain that apparently

fundamental flaw in the 10-year correlation analysis.    That is

not to say that we would never accept statistical analyses

demonstrating a correlation between sales and shrinkage; that is

only to say that Dr. Seago, in this case, has simply failed to

prove the significance of the correlation derived from the

10-year correlation analysis.9   Dr. Seago recognizes that an


9
     It should be noted that, in Kroger Co. & Subs. v.
Commissioner, T.C. Memo. 1997-2, we stated:

     Although we accept Dr. Bates' opinion as to the
     correlation between sales and shrinkage at the business
     level, and we are impressed by Dr. Bates' sales-based
     accuracy analysis, we are hesitant to rest our
     conclusion as to the accuracy of the retailers'
     shrinkage method on a correlation whose significance we
     may not fully appreciate. * * *

Similarly, in this case, although we accept Dr. Seago's opinion
that the data he examined in the 10-year correlation analysis
revealed a strong correlation, Dr. Seago has not demonstrated the
                                                   (continued...)
                              - 49 -

analysis of the correlation between sales and shrinkage at the

LIFO pool level would produce a more meaningful correlation and

attempts to examine that correlation by the creation of surrogate

pools in the absence of such data.     We are not convinced by

Dr. Seago's analysis of hypothetical pools of data derived from

randomly placing individual Target stores into 21 pools because

that approach divorces particular sales and shrinkage figures for

each actual pool from the corresponding pool attributes; the

preservation of that relationship is precisely the purpose of

analyzing sales and shrinkage data at the LIFO pool level.

     Because we are reluctant to accept Dr. Seago's 10-year

correlation analysis, his shrinkage accrual accuracy analysis

does not persuade us that Target's shrinkage method clearly

reflects income, that respondent's method does not clearly

reflect income, or that Target's shrinkage method more clearly

reflects income when compared to respondent's method.     Dr. Seago

allocated accrual errors under the assumption, which was derived

from the 10-year correlation analysis, that sales and shrinkage

are perfectly correlated.   In addition, Target's monthly accruals

for shrinkage were made as a percentage of sales.     Therefore,

Dr. Seago's estimate of the actual taxable year shrinkage--sales-

allocated taxable year shrinkage--relies entirely on the critical


9
 (...continued)
significance of that finding to the issue of clear reflection of
income.
                             - 50 -

assumption that sales and shrinkage are sufficiently correlated

so that the sum of aggregate monthly shrinkage accrued as a

percentage of sales for the taxable year, adjusted for an

allocation of any accrual error based on a ratio of relative

sales between the relevant taxable years, yields a figure for

taxable year shrinkage that would clearly reflect income.10

Although we believe that sales have some value as a predictor of

shrinkage at the Target-wide level, we simply cannot accept the

critical assumption that underlies Dr. Seago's shrinkage accrual

accuracy analysis.

     Dr. Seago did not conduct an analysis of the correlation

between sales and shrinkage or a shrinkage accrual accuracy

analysis for data derived from the operations of Dayton’s.    We

assume that petitioner wishes that we infer both a strong

correlation between sales and shrinkage and a favorable shrinkage



10
     In addition, this Court has difficulty with Dr. Seago's
shrinkage accrual accuracy analysis for other reasons. Target's
shrinkage method results in the accrual of shrinkage based on a
rate set at the beginning of the taxable year for each department
within each store. Thus, conceivably, a department within a
store could accrue shrinkage at two different rates during the
cross-year inventory period, e.g., 2 percent of sales during the
taxable year's physical-to-yearend period and 2.5 percent of
sales during the period prior to the physical inventory in the
next taxable year. An allocation of any accrual error only, as
opposed to an allocation of total verified shrinkage, is
inconsistent with the underlying assumption that sales and
shrinkage are perfectly correlated. In the same vein, Dr. Seago
allocates accrual error based on a 75/25 ratio that is an
approximation of the relative sales between the relevant taxable
years and not the actual cross-year sales percentages.
                                - 51 -

accrual accuracy analysis for Dayton's based on the analyses of

Target data.   Even if this Court were to engage in that type of

speculation, our rejection of the analyses with respect to Target

renders that method of proof ineffectual.    In addition,

petitioner presents evidence demonstrating that the aggregate

estimated shrinkage rates of Dayton’s for inventory periods

spanning the taxable year in issue are less than the verified

rates of shrinkage for the same periods.    That evidence, without

more, does not provide a basis to evaluate clear reflection of

income for the taxable year in issue for the reasons set forth in

our discussion that follows of Dr. Seago's sales percentage

shrinkage analyses based on Target data.

     Dr. Seago presents analyses that compare actual and

estimated shrinkage rates as a percentage of sales for physical

inventory periods (sales percentage shrinkage analyses).    See

supra sec. VI.E.4.   Those analyses were conducted at both the

store and Target-wide levels.    Not only are we unimpressed by

Dr. Seago's results, we have reservations about his assumptions.

Dr. Seago's analyses compare results for inventory periods and

not the taxable year or any other taxable year.    An identity of

results between actual and estimated shrinkage rates as a

percentage of sales for inventory periods does not tell us

anything about the relative distribution of losses from shrinkage

factors within those inventory periods.    Thus, unless sales and
                              - 52 -

shrinkage are correlated, evidence of an identity between actual

and estimated shrinkage rates for an inventory period is no

evidence that the shrinkage estimation rate for the inventory

period is accurate for that portion of a taxable year that falls

within (but is not identical to) the inventory period.11    We

rejected above a general correlation between sales and shrinkage

based on the 10-year correlation analysis.   In addition,

Dr. Seago derived only an R2 of 0.367 from his disaggregated

analysis of Target stores during the taxable years ending in 1980

through 1989.   In sum, we cannot accept Dr. Seago's assumption of

a strong correlation between sales and shrinkage, and, therefore,

Dr. Seago's sales percentage shrinkage analyses do not persuade

us that the Divisions' shrinkage methods clearly reflect income.




11
     The requirement of the assumption that sales and shrinkage
are correlated is illustrated by the following example. Assume
that X Co. (1) is a calendar year taxpayer; (2) has an inventory
period from Apr. 1 to Mar. 31; (3) has no sales from Jan. 1,
1990, to Mar. 31, 1990, and $1 of shrinkage for that period;
(4) has $100 of sales from Apr. 1, 1990, to Dec. 31, 1990, and no
shrinkage for that period; (5) has no sales from Jan. 1, 1991, to
Mar. 31, 1991, and $2 of shrinkage for that period; and
(6) accrued shrinkage at a rate of 2 percent of sales for all
relevant periods. Upon the physical inventory on Mar. 31, 1991,
X Co.'s records would indicate $100 of sales and $2 of shrinkage
during the inventory period. Thus, verified shrinkage of
2 percent of sales would correspond to accrued shrinkage of
2 percent of sales. The identity of results for the inventory
period does not correspond to an identity of results for the
taxable year because actual shrinkage for the taxable year was
1 percent of sales. That discrepancy exists because the example
did not assume that sales and shrinkage are correlated.
                              - 53 -

     Lastly, Dr. Seago criticizes respondent's method as

containing a systematic bias towards understating losses when

sales are increasing.   The validity of that assertion also relies

on a strong correlation between sales and shrinkage.   Although

respondent's method is merely another method of estimating losses

from shrinkage factors for the taxable year, see supra section

VI.D., Dr. Seago's unproven assertion, however, does not convince

us that respondent's method does not clearly reflect income.

     H.   Is Respondent's Determination That the Divisions'
          Shrinkage Methods Do Not Clearly Reflect Income and That
          Respondent's Method Does Clearly Reflect Income an Abuse
          of Discretion?

     Petitioner has a heavy burden to prove that respondent's

determination that Target's shrinkage method and Dayton's

shrinkage method do not clearly reflect income and that

respondent's method does clearly reflect income is an abuse of

discretion.   See supra sec. VI.B.   We find no such abuse of

discretion here.   But cf. Kroger Co. & Subs. v. Commissioner,

T.C. Memo. 1997-2 (finding an abuse of discretion); Wal-Mart

Stores, Inc. v. Commissioner, T.C. Memo. 1997-1 (same).

     Petitioner relies on the testimony of Dr. Seago who asserts

that both Target's shrinkage method and Dayton's shrinkage method

produce reasonably accurate shrinkage accruals and that those

methods clearly reflect income.   Dr. Seago also asserts that

respondent's method does not clearly reflect income.   The

critical assumption upon which all of Dr. Seago's conclusions
                               - 54 -

rely is the existence of a strong correlation between sales and

shrinkage derived from the 10-year correlation analysis.      We

cannot take the inferential leap that is required to accept that

assumption.    In light of respondent's broad discretion to

determine clear reflection of income, this Court cannot accept

the significance of Dr. Seago's 10-year correlation analysis

because we cannot overlook the fact that aggregate sales and

shrinkage data at the Target-wide level consist of sales and

shrinkage figures from numerous LIFO pools, which each have

different pool attributes that vary from year to year.    In

addition, we are not persuaded by any of the other evidence

presented by petitioner in this case.    Therefore, respondent's

determination that the Divisions' shrinkage methods do not

clearly reflect income and that respondent's method does clearly

reflect income is not an abuse of discretion.

VII.   Conclusion

       The Divisions' systems of maintaining book inventories do

not clearly reflect income.    They are, thus, not sound within the

meaning of section 1.471-2(d), Income Tax Regs.    To reflect the

foregoing,


                                          Decision will be entered

                                     for respondent.
