                      T.C. Memo. 1997-2



                UNITED STATES TAX COURT



  THE KROGER COMPANY AND SUBSIDIARIES, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 3358-94.                       Filed January 2, 1997.



     P operated supermarkets and convenience 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 year’s end. 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 year’s end and made an accrual of
the estimate. P calculated shrinkage accruals as a
percentage of gross sales.
     Held: P’s systems of maintaining book inventories
(including the making of shrinkage accruals) conform to
the best accounting practice and clearly reflect
income. They are, thus, sound within the meaning of
sec. 1.471-2(d), Income Tax Regs.
                               - 2 -

          Frederick H. Robinson, Craig D. Miller, Patricia M.

     Lacey, and Gary R. Vogel, for petitioner.

          Reid M. Huey, Nancy B. Herbert, Robert J. Kastl,

     Jennifer H. Decker, James E. Kagy, Timothy S. Sinnott, and

     Richard G. Goldman, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     HALPERN, Judge:   Respondent has determined deficiencies in

petitioner’s Federal income tax liabilities for the years 1984,

1985, and 1986 in the amounts of $7,152,527, $1,772,936, and

$1,668,392, respectively.   The parties have reached agreement on

certain issues, and the only 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 years in issue, and all

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 fact filed by the parties and the accompanying

exhibits are incorporated herein by this reference.    The parties

have made approximately 450 separate stipulations of fact,
                                 - 3 -

occupying over 100 pages, and there are 143 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.   Kroger

      The Kroger Co. (Kroger) is an Ohio corporation, with its

principal place of business in Cincinnati, Ohio.      Kroger is the

common parent corporation of an affiliated group of corporations

making a consolidated return of income.      For itself, and as sole

agent for each member of the affiliated group, Kroger filed the

petition giving rise to this case.       (In the papers filed in this

case, the convention of the parties has been to use the term

“petitioner” to refer to the affiliated group as a whole (as,

from time to time, it was constituted).      We will adopt that

convention.)

      Petitioner’s principal business activities are the operation

of supermarkets and convenience stores and the distribution and

sale of drug and general merchandise.      During the years in issue,

petitioner operated one of the nation’s largest supermarket

chains, measured by total sales, and one of the nation’s largest

drug store chains.    Kroger, itself, was in the retail food

business, operating numerous grocery product warehouses and

supermarkets.     Kroger generated over $11 billion in annual sales

from its supermarkets during each of the years in issue.      Superx,
                                  - 4 -

which operated a chain of drug and general merchandise stores

throughout the United States, was a wholly owned subsidiary

corporation of Kroger.    Superx generated over $800 million in

annual sales during each of the years in issue.     Florida Choice,

which operated a chain of supermarkets in Florida, was a division

of Superx.    Florida Choice generated over $100 million in annual

sales during each of the years in issue.     (Hereafter, for

convenience, we will refer to Kroger (but only with respect to

its retail operations), Superx, and Florida Choice, collectively,

as the retailers.)

     B.    Accounting Practices

     Petitioner’s annual accounting period and taxable year was a

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

     The retailers 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 year's end.

     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

inventory plus inventory purchased during the period minus

closing inventory.
                                - 5 -

     During the years in issue, the retailers used “cycle

counting” to conduct physical inventories of merchandise.    Cycle

counting is a method of conducting physical inventories at

individual stores, in rotation, throughout the year.    Most large

retail companies, including grocery and drug retailers, 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.   With few exceptions, the retailers

took no physical inventories at the end of any of the years in

issue.

     The retailers maintained “perpetual” or other book inventory

records (without distinction, book inventory records) from which

inventory could be determined without a physical count.

Inventory determined from book inventory records often differs

from inventory determined by physical count.   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”.
                               - 6 -

     Shrinkage and overage (hereafter, generally, shrinkage) are

attributable to a variety of factors, the total number of which

cannot be quantified, including the following:

     1.   theft of merchandise (by employees, customers, and
          vendors);

     2.   unrecorded or improperly recorded losses of merchandise
          due to spoilage, breakage, and other damage;

     3.   unit discrepancies in goods received from and/or
          returned to vendors;

     4.   failure to ring or record the proper price upon sale of
          merchandise;

     5.   errors in recording retail prices (including price
          changes) on a taxpayer’s perpetual record;

     6.   errors in marking and changing prices on merchandise;

     7.   failure to properly record returns by customers;

     8.   errors in conducting the physical inventory (including
          both unit errors and pricing errors);

     9.   errors in processing paper (including price-change
          documents, invoices, and merchandise transfers); and

     10. errors in billing and other computer systems.

     The retailers experienced some or all of the factors listed

(shrinkage factors) during the years 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)
                               - 7 -

cannot be determined for the period from the last physical count

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

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.

     For each of the years in issue, the retailers estimated and

accrued yearend shrinkage (that estimate and accrual hereafter

being referred to as shrinkage accrual).    Such shrinkage accruals

were added to the other data constituting the retailers’ book

inventory records, which were used to determine yearend

inventories.   Shrinkage accruals reduced yearend inventories,

which had the effect of increasing cost of goods sold and, as a

result, decreasing gross income.

     In determining yearend inventories, the retailers would, in

addition to taking into account shrinkage as determined by

physical count of inventory during the year (1) subtract

shrinkage accrual as of that year’s end and (2) add shrinkage

accrual as of the prior year’s end.    Errors in estimating

shrinkage accrual would be subject to correction in the

subsequent year because of the addition of the prior year’s

shrinkage accrual to the subsequent year’s ending inventory.       The

retailers calculated shrinkage accrual as a percentage of gross

sales.   In the retail industry, the practice of making shrinkage
                                - 8 -

accruals, and of calculating such accruals as a percentage of

sales, is the prevalent, if not the virtually universal,

practice; it is the best practice in that industry.

      Respondent disallowed the retailers’ shrinkage accruals.

That had the consequence of decreasing cost of goods sold and, as

a result, increasing gross income.      Respondent has proposed

deficiencies based upon that increased income.

II.   KFS Division of Kroger

      A.   General Operations

      Kroger managed its grocery products warehouses and

supermarkets on a geographic basis as Kroger Marketing Areas

(KMAs).    A KMA contained between 34 and 161 supermarkets.   The

KMAs were part of the Kroger Food Stores Division of Kroger (the

KFS division).    Altogether, the KFS division operated between

1,000 and 1,500 supermarkets between 1979 and 1992.     Each KMA had

its own management organization, which was part of the Kroger

management structure.    Management of each KMA reported to

corporate management in Kroger’s general office (the Kroger

general office).    The Kroger general office set the policies that

governed the operation of the KMAs.     After 1984, Florida Choice,

although a division of Superx, was treated as a KMA for certain

accounting purposes.

      B.   Accounting Methods and Procedures

      The accounting methods and procedures used by each KMA were

prescribed by the Kroger general office.     Pertinent aspects of
                                  - 9 -

those methods and procedures for the years in issue were as

follows.

           1.    Departments

     Store inventories were divided into departments and

subdepartments.    Shrinkage accrual was made only for the grocery,

drug/general merchandise, and cosmetics departments.

           2.    Retail Method of Inventory Valuation

     The retail method of valuing inventory was used by the KFS

division for store inventories in the grocery, drug/general

merchandise, and cosmetics departments.       Under the retail method,

the cost of goods sold is estimated by multiplying sales revenue

by the “cost complement”.      That technique translates the retail

dollar value of the goods sold into its approximate cost dollar

value.

           3.    LIFO

     Beginning with 1979, Kroger elected to use the last-in-

first-out (LIFO) method of accounting.       Kroger valued its

inventories in stores and warehouses using the dollar value, link

chain method of implementing LIFO.        The KFS division also elected

to use statistical sample techniques to determine the dollar

value indexes.    The KFS division initially used a single LIFO

pool for all items in the grocery, drug/general merchandise, and

cosmetics departments.    Beginning with 1986, the KFS division

allocated its single pool into nine pools.
                               - 10 -

           4.   Shrinkage Accruals

     The KFS division accounting policy for estimating shrinkage

accrual was as follows:

     For each store in which no physical inventory is taken
     during a period, a shrinkage and spoilage loss will be
     accrued for each department:

     a.     At the beginning of each year determine the
            KMA rate of shrinkage and spoilage, at
            retail, for the previous year for each
            department.

     b.     From this experience and evidence of trend,
            estimate the percentage (to the nearest
            hundredth of one percent) expected for the
            KMA for the current year for each department.

     c.     Use the estimated percentages for all stores
            for the current year. If a change in rate
            appears desirable within the year request
            approval of a change from the Corporate
            Accounting Policy and Methods Department. No
            approval is required to change the
            percentages at the beginning of the year.

     C.    Management of Shrinkage

     Minimization of shrinkage factors was a management goal

common to all KMAs.    Detailed records were maintained in the KMAs

on the incidence (cost) of shrinkage factors.     Records were

maintained by store and by store manager.     Control (minimization)

of shrinkage factors was an important criterion in assessing the

performance of a store manager.      A store manager could be fired

or might not be promoted for failure to minimize shrinkage

factors.    Programs were continually developed and implemented to

control shrinkage factors.
                                   - 11 -

       During the years in issue, the incidence of shrinkage

factors varied among stores, among departments within stores, and

among KMAs.     Overages were, on occasion, recorded by individual

stores and, in some years, on a net basis by entire KMAs, but

never for the KMAs together.       No accrual was made to reflect an

expectation of overage.     From 1984 through 1987, in the face of

recurring overages, the Michigan KMA did not make shrinkage

accruals.

       The management of each KMA determined shrinkage accrual

rates to be used throughout that KMA.       Judgment played a large

role in determining shrinkage accrual rates.       Factors that would

be taken into account included experience with shrinkage factors,

store sizes, merchandising techniques, regional differences, and

recent shrinkage trends.     A separate percentage rate was

determined for each department for which a shrinkage accrual was

made.

       D.   Physical Inventories

        From 1984 through 1992, the KFS division conducted an

average of 2.3 physical inventories a year in each store.

III.     Florida Choice

        Florida Choice, although a division of Superx, was operated

as if it were a part of the KFS division.       During the years in

issue, Florida Choice’s chain of supermarkets grew from 22 to

30 stores.
                                  - 12 -

      During the years in issue, Florida Choice followed the same

KFS division accounting methods and procedures utilized by the

KMAs.     Florida Choice followed the shrinkage accrual practices

and procedures applicable to the KFS division to determine its

shrinkage accrual rate as if it were a KMA.

      During 1984, Florida Choice conducted an average of three

physical inventories a store.      In 1985 and 1986, the average was

two inventories a store.

IV.   Superx

        A.   General Operations

        During the years in issue, Superx operated between 185 and

621 drug and general merchandise stores.

        Superx had its own management organization.   Superx’s

management reported to corporate management in the Kroger general

office.      The Kroger general office set the policies that governed

the general operations of Superx.

        B.   Accounting Methods and Procedures

              1.   Booking Rate Calculations

        Inventory was reflected on Superx’s inventory accounts at

cost and not at retail.

        To calculate gross income of each store (and each department

within a store) for the physical-to-yearend period, Superx

multiplied sales during that period by a percentage known as the

“booking rate”.      That process was similar to Kroger’s retail
                                - 13 -

method.   Superx determined the booking rate by calculating a

company key rate from cost price data obtained from 80 selected

stores.   The booking rate represented the percentage of each

dollar of sales that represented gross profit.       Gross income was

further reduced by shrinkage accrual.

     Cost of sales was computed by multiplying sales by the

percentage equal to (1) 100 percent less (2) the applicable

booking rate.    That amount was used to reduce inventory.

           2.    LIFO

     For its 1984 and 1985 years, Superx used the dollar value

LIFO method of calculating its inventories, using five LIFO

pools.    It excluded optical centers, deli, restaurants, liquor,

and inventories maintained by Florida Choice from its LIFO

method.    It discontinued the LIFO method for its 1986 tax year.

            3.   Shrinkage Accruals

     Superx made shrinkage accruals for all of its departments

except its optical departments.       Superx developed a single

shrinkage accrual rate, which was expressed as a percentage of

gross sales and used by all of Superx’s drug stores (and applied

uniformly, although yielding different shrinkage accruals

depending on a store’s sales).

     Superx’s shrinkage accrual rate was determined at Superx

headquarters.    Superx management primarily examined historical

shrinkage experience and recent shrinkage trends at the company
                                  - 14 -

level in determining Superx's shrinkage accrual rate.      Individual

store managers could not use a different rate.      Between 1981 and

1986, shrinkage accrual rates, as a percentage of gross sales,

varied between 2.1 percent and 2.5 percent.

     C.    Management of Shrinkage

      Controlling shrinkage factors was a significant concern of

Superx management.    Store managers could be fired, or their

compensation reduced, for failure to control shrinkage factors.

Superx maintained a risk management department, which performed

field audits to see that procedures to reduce shrinkage factors

were in place and performed analyses of shrinkage factors to aid

in control of such factors.

      D.   Physical Inventories

      During 1983 and 1984, Superx conducted an average of 1.7

physical inventories a year in each store.      In 1985, the average

was 1.6 inventories a store.



                                  OPINION

I.   Introduction

      Petitioner’s principal business activities are the operation

of supermarkets and convenience stores and the distribution and

sale of drug and general merchandise.       We are concerned here with

(1) the Kroger Food Stores Division of Kroger (the KFS division),

(2) Florida Choice, a division of Superx, which operated a chain
                              - 15 -

of supermarkets, and (3) Superx, a subsidiary corporation of

Kroger, which operated a chain of drug and general merchandise

stores (collectively, the retailers).

      During the years in issue, the retailers used cycle counting

to conduct physical inventories of merchandise.     Under the cycle

counting method, physical inventories were taken in rotation, at

the various stores, throughout the year.     Also, the retailers

maintained book inventory records from which inventories could be

determined without a physical count.     The retailers estimated

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

during the physical-to-yearend period (yearend shrinkage) and

made an accrual of that estimate (shrinkage accrual).     That

practice had the effect of increasing cost of goods sold and

decreasing gross income.

      Respondent disallowed the retailers’ shrinkage accruals, and

we must determine whether that disallowance was an abuse of

discretion.

II.   Statute and Principal Regulation

      Section 471(a) provides the following general rule:

      Whenever in the opinion of the Secretary the use of
      inventories is necessary in order clearly to determine
      the income of any taxpayer, inventories shall be taken
      by such taxpayer on such basis as the Secretary may
      prescribe as conforming as nearly as may be to the best
      accounting practice in the trade or business and as
      most clearly reflecting the income.[1]


1
      The Tax Reform Act of 1986, Pub. L. 99-514, sec. 803(b)(4),
                                                    (continued...)
                               - 16 -

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



III.    Dayton Hudson Corp. & Subs. v. Commissioner

       In Dayton Hudson Corp. & Subs. v. Commissioner, 101 T.C. 462

(1993), respondent determined a deficiency in the taxpayer’s

Federal income tax because, in computing its yearend book


(...continued)
100 Stat. 2356, designated the quoted language as sec. 471(a).
Before amendment, the quoted language was the entirety of sec.
471.
                              - 17 -

inventories, the taxpayer made a shrinkage accrual.     In the

Dayton Hudson case, which was before us on the Commissioner’s

motion for summary judgment, we held that section 1.471-2(d),

Income Tax Regs., as a matter of law, does not prohibit making a

shrinkage accrual in computing book inventories.   We

acknowledged, however, that the Commissioner might yet argue that

the taxpayer’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.

      Here, respondent acknowledges our holding in the Dayton

Hudson case, but she does not agree that it is correct.     We

adhere to that holding.

IV.   Are the Retailers’ Systems of Accounting for Inventories,
      Including the Use of Shrinkage Accruals, Sound?

      Because the retailers used cycle counting to conduct

physical inventories of merchandise, and no count was taken at

year’s end, the retailers 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.

      The question of what constitutes a “sound accounting system”

under section 1.471-2(d), Income Tax Regs., has not been answered

by the courts.   Section 1.471-2(a), Income Tax Regs., however,
                                - 18 -

provides two specific requirements with which acceptable

inventory practices must conform.    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.    Our inquiry, then, is, principally, whether the

retailers' systems of maintaining book inventories (including the

making of shrinkage accruals) conform to the best accounting

practice and clearly reflect income.     Indeed, the principal point

relied on by respondent on brief is that “Petitioner’s methods of

estimating inventory shrinkage * * * failed to clearly reflect

income.”

V.   Best Accounting Practice

      The parties have stipulated that, for financial accounting

purposes, petitioner’s financial statements for the years 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
                               - 19 -

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 retailers’ systems of 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
      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
                              - 20 -

     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.

     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,
                                - 21 -

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 her to reject a taxpayer’s method if it “does not

clearly reflect income”, and to substitute 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 that the Commissioner abused her discretion.

E.g., Asphalt Products 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).     An appeal in this case will likely

lie in the Court of Appeals for the Sixth Circuit.     That court

has said:

     § 446 gives the Commissioner discretion with respect to
     two determinations. The Commissioner first determines
     whether the accounting method chosen by a taxpayer
                               - 22 -

     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 America 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 California 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 Commissioner determines that a taxpayer's method

of accounting does not clearly reflect income, the taxpayer must
                              - 23 -

demonstrate either that his method of accounting clearly reflects

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

income.   See Asphalt Products Co. v. Commissioner, supra at 847.

     C.   Retailers' Shrinkage Method

     The retailers 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 retailers’ book inventory records under a

method (the retailers’ shrinkage method) involving three

variables:   (1) shrinkage verified by physical inventories during

the taxable year, (2) shrinkage accrual for the taxable year, and

(3) shrinkage accrual for the prior year.   The retailers

calculated shrinkage accruals as a percentage of sales.

Shrinkage accrual rates for each department within a KMA and for

Florida Choice were based on a combination of factors including

experience with shrinkage factors, store sizes, merchandising

techniques, regional differences, and recent shrinkage trends.

Rates for Superx were primarily based on historical shrinkage

experience and recent shrinkage trends at the company level.

Prior year shrinkage accrual was subtracted from the amount of

shrinkage determined by the first physical inventory of the

taxable year; that adjustment purported to calibrate shrinkage

figures so as to provide an estimate of taxable year shrinkage.
                                 - 24 -

     D.   Petitioner’s Expert Testimony

            1.    Introduction

     Petitioner relies on expert testimony to demonstrate that

the retailers' shrinkage method clearly reflects income.       In

particular, petitioner relies on such testimony to demonstrate a

strong correlation between sales and shrinkage, which correlation

underlies the retailers’ shrinkage accruals.       Petitioner presents

the expert testimony of Charles E. Bates, Ph.D.       Dr. Bates is the

director of economic litigation services for the Economic

Consulting Services Group at KPMG Peat Marwick LLP.       He is

experienced in statistics, econometric modeling, and economic

analysis.

            2.    Correlation Between Sales and Shrinkage

     Statistical correlation is a measure of the degree to which

two variable quantities tend to change with respect to each

other.    Correlations are 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 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.
                               - 25 -

     Dr. Bates is of the opinion that the correlation between

sales and shrinkage is strong.    Dr. Bates is also of the opinion

that the “business level” is the appropriate level to test the

relationship of sales to shrinkage.     Dr. Bates uses the term

“business level” to refer, individually, to the aggregate

operations of the KFS division, the aggregate operations of

Florida Choice, and the aggregate operations of Superx.     Dr.

Bates acknowledges that correlation can be tested at other

levels, e.g., the department level within a store, the store

level, or, even, at the level of the “entire Kroger corporate

entity”.    Dr. Bates believes that the business level is

appropriate because that is the level at which taxable income is

computed.

     Dr. Bates bases his opinions of strong correlation on the

application of two methods to measure the correlation between

sales and shrinkage at the business level.     The first method

derives the correlation between sales and shrinkage from

aggregate data at the business level.     The second method derives

the correlation between sales and shrinkage from individual

inventory records at the store level.     Dr. Bates is of the

opinion that, for the years he examined, the correlation between

sales and shrinkage is (1) at least 0.91 for the KFS division,

(2) at least 0.89 for Florida Choice, and (3) at least 0.94 for

Superx.
                                - 26 -

          3.     Yearend Shrinkage

     Dr. Bates is of the opinion that losses from shrinkage

factors occur during the physical-to-yearend period.    That

proposition is not as simple to demonstrate as one might think.

The problem, of course, is that, although losses on account of

shrinkage factors will be demonstrated by physical count at the

end of an accounting period, the lack of intervening physical

counts makes it impossible to demonstrate the distribution of

those losses within the period.

     Dr. Bates primarily derives his opinion by deduction from

two premises:    (1) sales occur during the physical-to-yearend

period and (2) there exists a strong correlation between sales

and shrinkage.    In other words, he concludes that, because there

are sales during the physical-to-yearend period, and there is a

statistical relationship between sales and shrinkage, it is

likely that losses from shrinkage factors occur during the

physical-to-yearend period.    He conducted two additional tests,

however, which gave him more evidence to support his conclusion.

First, he compared shrinkage among inventory cycles with

physical-to-yearend periods of differing lengths.    Second, he

applied a conventional statistical analysis to test for the

occurrence of yearend shrinkage.
                                - 27 -

          4.    Shrinkage Accrual Accuracy Analysis

     Dr. Bates is of the opinion that yearend shrinkage can

reasonably be estimated by allocating a portion of the shrinkage

revealed by the next physical count to the physical-to-yearend

period.   Dr. Bates has made such estimates in order to test the

accuracy of the retailers’ shrinkage accruals.    He concludes

that, for each of the retailers, annual losses, in the aggregate,

claimed on account of shrinkage factors are within 5 percent of

taxable year shrinkage based on an allocation of cross-year

inventory shrinkage as a function of both sales and time.

     Dr. Bates knew the amount of losses from inventory cycles

wholly within a taxable year.    To that sum he added (1) an

allocation of the shrinkage determined by the physical inventory

first taken during the taxable year and (2) an allocation of the

shrinkage determined by the physical inventory first taken during

the next taxable year.    That calculation provided his estimate of

taxable year shrinkage.    Dr. Bates calculated taxable year

shrinkage using sales to allocate shrinkage to the relevant

portions of cross-year inventory cycles (sales-based taxable year

shrinkage).    To provide an alternative estimate of actual

shrinkage, Dr. Bates calculated taxable year shrinkage using a

time-based allocation method (time-based taxable year shrinkage).

That approach allowed him to have a second way to test the

accuracy of the losses from shrinkage factors that the retailers

reported for tax purposes.
                                - 28 -

     Dr. Bates compared his estimates of taxable year shrinkage

with the losses claimed by the retailers for Federal income tax

purposes.    He performed the same calculations to determine the

accuracy of respondent's method of reflecting shrinkage factors,

which would allow no shrinkage accrual, but would take account of

shrinkage only in the year when demonstrated by physical count.

Dr. Bates made these comparisons using estimates of taxable year

shrinkage based on both sales and time.    The results of Dr.

Bates' calculations and analyses are set forth in an appendix to

this opinion.

     Dr. Bates determined that the accounting system utilized by

the KFS division for Federal income tax purposes produced, in the

aggregate, a net underestimate for the years 1984 through 1991 of

1.8 percent of sales-based taxable year shrinkage and 1.7 percent

of time-based taxable year shrinkage.    He determined that

respondent's method produced a net underestimate of 4.4 percent

of sales-based taxable year shrinkage and 4.3 percent of time-

based taxable year shrinkage.    In addition, Dr. Bates determined

that the maximum error under respondent’s method was 15.6 percent

of sales-based taxable year shrinkage and 15.7 percent of time-

based taxable year shrinkage (compared to 11.4 percent and 11.2

percent, respectively, under the system utilized by the KFS

division).    He concludes that respondent’s method is less

accurate than that used by the KFS division.
                               - 29 -

     Dr. Bates determined that the accounting system utilized by

Florida Choice produced, in the aggregate, a net underestimate

for the years 1984 through 1988 of 3.9 percent of sales-based

taxable year shrinkage and 2.9 percent of time-based taxable year

shrinkage.   He determined that respondent's method produced a net

underestimate of 6.1 percent of sales-based taxable year

shrinkage and 5.2 percent of time-based taxable year shrinkage.

Dr. Bates determined that the maximum error under respondent’s

method was 20.2 percent of sales-based taxable year shrinkage and

20.5 percent of time-based taxable year shrinkage (compared to

12.3 percent and 14.0 percent, respectively, under the system

utilized by Florida Choice).   He concludes that respondent’s

method is less accurate than that used by Florida Choice.

     Dr. Bates determined that the accounting system utilized by

Superx produced, in the aggregate, a net underestimate for the

years 1983 through 1985 of 4.7 percent of sales-based taxable

year shrinkage and 4.5 percent of time-based taxable year

shrinkage.   He determined that respondent's method produced a net

underestimate of 7.1 percent of sales-based taxable year

shrinkage and 6.8 percent of time-based taxable year shrinkage.

Dr. Bates determined that the maximum error under respondent’s

method was 9.4 percent of sales-based taxable year shrinkage and

9.8 percent of time-based taxable year shrinkage (compared to 6.1

percent and 5.4 percent, respectively, under the system utilized
                                - 30 -

by Superx).    Dr. Bates concludes that respondent’s method is less

accurate than that used by Superx.

     E.    Respondent's Expert Testimony

     Respondent offered rebuttal expert testimony of Donald M.

Roberts, Ph.D., a professor of decision and information sciences

at the University of Illinois.     Dr. Roberts had been asked to

examine the statistical basis of Dr. Bates’ conclusion that the

correlation between sales and shrinkage for the KFS division for

the period 1984 through 1992 was 0.91.     Dr. Roberts confirmed

that the correlation was 0.91.     In his rebuttal report, Dr.

Roberts does not offer any criticism of Dr. Bates’ opinion that

losses from shrinkage factors occur during the physical-to-

yearend period or undermine Dr. Bates' shrinkage accrual accuracy

analysis.     Dr. Roberts’ own opinion is that the correlation

between sales and shrinkage is generally low and that sales do

not provide a reasonable basis for estimating inventory

shrinkage.     Dr. Roberts had been asked to examine sales and

shrinkage only for the KFS division.     He examined data at the

department level within stores in the KMAs.     He computed

correlations for each department for the years 1984, 1985, and

1986.     He also computed correlations for each department within

each KMA for the period 1984 through 1992.

     Petitioner offered additional expert testimony of Dr. Bates

in rebuttal to Dr. Roberts’ opinion that the correlation between

sales and shrinkage is generally low and that sales do not
                               - 31 -

provide a reasonable basis for estimating inventory shrinkage.

Dr. Bates’ principal criticism of Dr. Roberts’ conclusion is that

Dr. Roberts’ correlations are not relevant to analyzing the

accuracy of the KFS division shrinkage accruals because Dr.

Roberts’ correlations measure the tendency of shrinkage to vary

in proportion to sales from inventory to inventory and store to

store within each department and KMA rather than the tendency of

annual shrinkage for the business to vary in proportion to annual

sales for the business.    Dr. Bates is of the opinion that it is

correlation of year-to-year changes in business level shrinkage

and sales that is relevant to determining the accuracy of

shrinkage accruals.   Dr. Bates states:   “[Dr. Roberts’] more

restricted conclusion is technically correct, but irrelevant for

assessing the propriety of accruing shrinkage as a percentage of

sales for tax purposes.”

     In his oral testimony, Dr. Roberts made clear to us the

limitations of any conclusions to be drawn from a consideration

of statistical correlation.    A strong correlation between two

variables (e.g., shrinkage and sales) does not necessarily mean

that one can predict the value of one variable (e.g., shrinkage)

based on the value of the other (e.g., sales).    To say that there

is a strong correlation between two variables means only that

there is a strong linear relationship between the two.

     Neither Dr. Bates nor Dr. Roberts finds the other's

computation of correlation inconsistent with his own.    That is
                               - 32 -

explained by the fact that they chose to correlate different

variables.    Each, however, has gone another step (beyond

correlation) and ventures an opinion as to the predictability of

shrinkage based on sales.    Not surprisingly, they have reached

different opinions.    While we cannot fully reconcile those

different opinions, Dr. Bates, principally by way of his rebuttal

report, has persuaded us that the low correlations found by Dr.

Roberts are not inconsistent with Dr. Bates’ opinion as to the

accuracy of sales as a predictor of shrinkage at the business

level.    More importantly, Dr. Roberts has not persuaded us that

the low department level correlations found by him are

determinative of the question of clear reflection of taxable

income.    Moreover, Dr. Roberts has failed to rebut Dr. Bates’

opinion that losses from shrinkage factors occur during the

physical-to-yearend period or to undermine Dr. Bates’ shrinkage

accrual accuracy analysis.

     At this point, it is sufficient to say that we attach

credence to Dr. Bates’ analysis and are convinced that, at the

business level, sales have value as a predictor of shrinkage.      We

will consider the weight to be accorded to Dr. Bates' conclusions

infra.
                               - 33 -

     F.    Shrinkage Accruals and LIFO

     The shrinkage accruals made by the retailers were only

estimates, and because they were estimates, they were subject to

error.    We have found that errors in estimating shrinkage

accruals were subject to correction in the subsequent year

because of the addition of the prior year’s shrinkage accrual to

the subsequent year’s ending inventory.    Respondent argues,

however, that the additional demands associated with the

retailers’ use of LIFO “compounds” the errors inherent in making

shrinkage accruals.

     Respondent presents the expert testimony of David W. LaRue,

Ph.D., an associate professor of commerce at the University of

Virginia, who testified to, among other things, the “tax effects”

resulting from the accrual of erroneous estimates of undetected

shrinkage for the KFS division.    Dr. LaRue examined the KFS

division’s practice of making shrinkage accruals.    He designed

simulation models to analyze shrinkage estimation errors under

the retail dollar value LIFO method used by the KFS division.      He

concluded that the process of making subsequent year corrections

was inadequate because of changes in factors such as LIFO

inflation adjustment factors and retail method cost complement

factors.    Respondent also presented the report and testimony of

William R. Sutherland, Esq., an attorney and accountant.

Mr. Sutherland came to essentially the same conclusions for

Superx that Dr. LaRue came to for the KFS division.
                               - 34 -

     Both Dr. LaRue and Mr. Sutherland concede, however, that

respondent’s adjustments--which disallow the retailers' shrinkage

accruals--would produce exactly the same types of errors if there

were undetected yearend shrinkage.      Indeed, the magnitude of such

errors under respondent’s method might well be greater because of

respondent’s failure to account for trends or other factors

applicable to the taxable year.

     In any event, respondent’s proposed adjustments will not

eliminate the flaws perceived by respondent’s experts.     It

appears that only the practice of yearend physical inventories at

all stores 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.

     G.   Retailers' Shrinkage Method Compared to Respondent's
          Method

     Respondent's method would permit the retailers to account

for losses from shrinkage factors only when such losses are

verified by physical inventories.    Respondent claims that her

"method is nothing more than the application of the principle

that taxpayers may not reduce income by unverified losses or

expenditures, or unreliable estimates."     Respondent states that

"any alternative method of estimating shrinkage imposed by

Respondent would have been wholly arbitrary since it would not

clearly reflect income."
                              - 35 -

     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 retailers' book inventories

by disallowing any shrinkage accrual.   If we were to sustain

respondent's disallowance, the retailers would compute book

inventories much as they do now, except that they would neither

add to shrinkage as determined by physical count during the year

any shrinkage accrual for the physical-to-yearend period of that

year nor subtract from such shrinkage the shrinkage accrual for

the prior year's physical-to-yearend period.   See sec. I.C.

(Findings of Fact), supra.   The retailers’ cost of goods sold, as

determined by book inventories, would, therefore, include

shrinkage for all inventory cycles beginning and ending in the

taxable year, plus shrinkage for inventory cycles beginning in

the prior taxable year and ending in the taxable year, but not

any portion of the shrinkage determined for the inventory cycle

beginning within the taxable year and ending in the next taxable

year (i.e., yearend shrinkage).   In sum, the retailers’ 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
                                                     - 36 -

identical to the amount of yearend shrinkage for the previous

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 this 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.
                               - 37 -

     Respondent does not seriously claim that losses from

shrinkage factors in a cross-year inventory cycle occur only in

the latter year.    Nor does respondent claim that losses from

shrinkage factors do not occur generally throughout an inventory

cycle.    On the record before us, we have no doubt that, on a

regular basis, the retailers experienced losses from theft,

billing errors, and other shrinkage factors.    We also have no

doubt that some of those losses were experienced during the

physical-to-yearend period and gave rise to yearend shrinkage.

Therefore, the principal difference between the retailers’

shrinkage method and respondent’s method is that respondent,

without admitting it, accepts an estimate of yearend shrinkage

while the retailers, by making a shrinkage accrual, consciously

attempt to estimate that shrinkage.

     H.    Annual Accounting

     It is well settled that the Federal income tax system is

based on annual accounting.    E.g., Heiner v. Mellon, 304 U.S.

271, 275 (1938).    "Inventories are intended to insure a clear

reflection of the year's income by matching sales during the

taxable year with the costs attributable to those sales".     Rotolo

v. Commissioner, 88 T.C. 1500, 1515 (1987).    Respondent's method,

in effect, substitutes yearend shrinkage of the prior year for

yearend shrinkage of the taxable year.    Sales during the taxable

year are matched with losses verified to be both losses for that

year and losses for the end of the prior year.    On its face,
                              - 38 -

respondent's method violates the principle of annual accounting.

Of course, under the retailers’ shrinkage method, the retailers’

estimates of shrinkage accruals are also based on information

gathered from prior years, since the retailers’ shrinkage rates

are dependent, in part, on historical data.    The distinction,

however, is that the retailers’ shrinkage method utilizes prior

year information as a factor in calculating the current year’s

shrinkage rate, whereas respondent’s method plainly substitutes

yearend shrinkage of the prior year for yearend shrinkage of the

taxable year.

     If physical inventories were required to be taken at year's

end, 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 year's end.

Sec. 1.471-2(d), Income Tax Regs.   Once the Secretary decided not

to require physical inventories at year’s end, 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

retailers' shrinkage method) or substitution (respondent's

method).   Respondent recognizes that fact.   Respondent's

position, however, is that, unless a taxpayer can demonstrate the

accuracy of his calculation of yearend shrinkage, the taxpayer
                              - 39 -

must choose between yearend physical inventories and respondent's

substitution method of accounting for yearend shrinkage.

Respondent also recognizes, however, that, under the logic of

Dayton Hudson, if petitioner demonstrates the accuracy of the

retailers' shrinkage method, that method does clearly reflect

income.   On brief, respondent states:

          The crucial issue in determining whether
     Petitioner’s methods of estimating shrinkage clearly
     reflected income is whether the methods were designed
     to produce accurate results. Clear reflection of
     income means that income should be reflected with as
     much accuracy as standard methods of accounting
     practice permit. [Citing Caldwell v. Commissioner, 202
     F.2d 112, 115 (2d Cir. 1953).]

We must determine the accuracy of the retailers' shrinkage method

to determine whether it clearly reflects income.

     I.   Accuracy

     Absolute accuracy is not required.   Indeed, respondent as

much as concedes that absolute accuracy is not required by

stating that clear reflection means reflection with as much

accuracy as standard methods of accounting practice permit.

Also, absolute accuracy is not the standard demanded of book

inventories by section 1.471-2(d), Income Tax Regs.   That section

explicitly states that balances shown by book inventories “should

be verified by physical inventories at reasonable intervals and

adjusted to conform therewith.”   (Emphasis added.)   Both

verification and adjustment would be unnecessary if only absolute

accuracy were acceptable.   Finally, section 1.446-1(c)(1)(ii)(A),
                               - 40 -

Income Tax Regs., which specifies when a liability is incurred

for purposes of the accrual method of accounting, requires only

reasonable accuracy in determining the amount of an established

liability.   As noted previously, the term “liability”

specifically includes a cost taken into account in computing cost

of goods sold.   Sec. 1.446-1(c)(1)(ii)(B), Income Tax Regs.

     The accuracy of the retailers’ shrinkage method presents a

question of fact.   Petitioner bears the burden of proving that

fact.   Rule 142(a).   Since, under the cycle method of counting

used by the retailers, yearend inventories are not ordinarily

taken, the accuracy of the retailers’ shrinkage method is not a

fact that petitioner can prove simply by comparing the retailers'

estimates (shrinkage accruals) to actual yearend shrinkage

figures.   Petitioner must rely on an indirect method of proof.

That is why petitioner relies on the expert testimony of Dr.

Bates, whose expertise is in statistics, econometric modeling,

and economic analysis.

     Dr. Bates was given the retailers' estimates of yearend

shrinkage based on sales.    He hypothesized that he could prove

the accuracy of those estimates by showing that they did not

differ, or differed by only a small percentage, from amounts

determined on the basis of a sales-based allocation of the actual

shrinkage for the relevant inventory cycles.    Dr. Bates’

conclusion is that, for each of the retailers, annual losses, in
                              - 41 -

the aggregate, claimed on account of shrinkage factors are within

5 percent of sales-based taxable year shrinkage.

     Dr. Bates performed a similar analysis to determine the

accuracy of respondent’s method of accounting for losses from

shrinkage factors.   He concluded that respondent’s method is less

accurate than the retailers’ shrinkage method and is subject to a

greater range of error.

     Dr. Bates performed a second accuracy analysis, which was

independent of the correlation between sales and shrinkage and

apportioned actual shrinkage evenly over each inventory cycle

without regard to sales or any factor other than the passage of

time (i.e., a time-based allocation).   For each of the retailers,

he found a level of accuracy similar to what he found using a

sales-based allocation.   Applying a time-based allocation to

respondent’s method, he again concluded that respondent’s method

is less accurate than the retailers’ shrinkage method and is

subject to a greater range of error.

     Dr. Bates has persuaded us that, assuming either a sales-

based or time-based allocation of losses from shrinkage factors,

the retailers’ shrinkage method is more accurate than

respondent’s method, and we so find.

     J.   Consistency of Retailers’ Inventory Practices

     As stated in section IV, supra, section 1.471-2(b), Income

Tax Regs., makes consistency of application from year to year an

important and explicit element in determining whether the
                              - 42 -

inventory practices of a taxpayer clearly reflect income.

Respondent argues that there are certain technical flaws in the

retailers' shrinkage accrual practices.    We assume that

respondent wishes us to conclude that those flaws make the

practices inconsistent and, thus, inaccurate.    Respondent cites

the failure of the Michigan KMA to accrue shrinkage for the

grocery or drug/general merchandise departments for the period

1984 through 1987 despite the general corporate policy of

shrinkage accrual.   Respondent also cites the fact that one KMA

did not follow the standard procedure that, when a store was

transferred from one KMA to another, it was to use a combination

of the two KMAs' shrinkage accrual rates during the year of

transfer.   One KMA permitted the stores transferred to its area

to continue to use the prior KMA's shrinkage rate during the year

of the transfer.   We have considered those and other incidents

cited by respondent, and we cannot conclude that the retailers’

inventory practices were applied inconsistently from year to

year.   Each of the retailers adopted accounting practices that

were to be applied uniformly and consistently.    The scope of the

retailers' operations was enormous.    The KFS division alone

operated between 1,000 and 1,500 supermarkets, with annual sales

in excess of $11 billion.   Given the scope of the retailers’

operations, and the minor flaws cited by respondent, we believe

that there was consistency of application in inventory practices

from year to year, and we so find.
                              - 43 -

     K.   Did Respondent Abuse Her Discretion in Determining That
          the Retailers’ Shrinkage Method Does Not Clearly Reflect
          Income and That Respondent’s Method Does Clearly Reflect
          Income?

     We have found that the retailers’ shrinkage method was

applied consistently from year to year.     We have also found that,

assuming either a sales-based or time-based allocation of losses

from shrinkage factors, the retailers’ shrinkage method is more

accurate than respondent’s method.

     We consider whether respondent abused her discretion in

determining that the retailers' shrinkage method does not clearly

reflect income in light of section 1.471-2(d), Income Tax Regs.,

which allows for book inventories whose balances are verified by

physical inventories conducted at reasonable intervals.

Respondent has not challenged the intervals at which the

retailers verified their book inventories by physical count.

Indeed, during each of the years in question, the KFS division

and Florida Choice conducted an average of 2 or more physical

inventories a store, and Superx conducted an average of 1.5 or

more physical inventories a store.     The retailers used cycle

counting to take physical inventories.     Throughout the year,

cycles ended and physical inventories were taken.     On average,

the physical-to-yearend period was no more than 3 months for both

the KFS division and Florida Choice.     For Superx, the average

length of the physical-to-yearend period was 4 months.     Of

course, since estimates were involved, there were bound to be
                               - 44 -

errors in the shrinkage accruals for those physical-to-yearend

periods.    Those errors, however, were subject to correction

within the next taxable year and would, on average, involve no

more than 3 or 4 months of possible overestimates.    The limited

potential for deferral is significant to us in deciding whether

income was clearly reflected.2

     Respondent abused her discretion in determining that the

retailers’ shrinkage method does not clearly reflect income and

that her method does clearly reflect income.    Taxable income must

be reflected with as much accuracy as standard methods of

accounting practice permit.    Caldwell v. Commissioner, 202 F.2d

at 115.    Because the retailers did not generally take physical

inventories at year’s end, no accounting method can state with

certainty either yearend shrinkage or the year’s taxable income.

In order to determine the accuracy of the retailers’ shrinkage


2
     Shrinkage accruals are no more than estimates, and because
there are tax incentives for maximizing shrinkage accruals, the
potential for tax avoidance exists. That is so notwithstanding
that minimization of shrinkage factors was a management goal for
each of the retailers. Essentially, the determination of
shrinkage accrual rates by the management of each KMA (the
analysis is the same for Florida Choice and Superx) is not
dependent entirely on shrinkage factors, which individual store
and department managers have an incentive to minimize. The
potential for tax avoidance is one of respondent’s objections to
shrinkage accruals. On the record before us, however, we are
unconvinced that there was a significant potential for tax
avoidance or that, indeed, there was any tax avoidance. Any
potential overestimates were subject to correction within the
following taxable year and would, on average, involve no more
than 3 or 4 months of excess shrinkage accruals. We see no
pattern of overaccruals for tax avoidance purposes.
                              - 45 -

method, we must, therefore, hypothesize the taxable income for

each of the years in question.   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.   The assumption

underlying Dr. Bates’ time-based accuracy analysis, on the other

hand, is independent of any correlation between sales and

shrinkage.   Indeed, it is independent of the correlation between

shrinkage and any particular factor.   Moreover, respondent has

not argued that shrinkage is a function of any particular factor.

Thus, the hypothesis that taxable income reflects a ratable

allocation within cross-year inventory cycles of shrinkage

determined for those cycles provides a neutral guideline to judge

not only the accuracy of the retailers’ shrinkage method but also

the relative accuracy of that method compared to respondent’s

method.   Based on Dr. Bates’ time-based comparison of the

retailers’ shrinkage method with respondent’s method, utilizing

KFS division, Florida Choice, and Superx data for various years

between 1983 and 1991, see sec. VI.D.4., supra, we are convinced

that respondent's method of estimating losses from shrinkage

factors is less accurate than the retailers' shrinkage method and

is subject to a greater range of error.
                               - 46 -

       Respondent abused her discretion because petitioner has

convinced us that the retailers’ shrinkage method was more

accurate in reflecting taxable income than was respondent’s

method.    If, indeed, shrinkage is a function of sales, our

conclusion would not change, because, on that basis also, the

retailers’ shrinkage method is more accurate than respondent’s

method.

       In sum, we conclude that respondent abused her discretion in

determining that the retailers' shrinkage method does not clearly

reflect income because the retailers' shrinkage method more

clearly reflects income when compared to respondent's method

based on an allocation of cross-year inventory shrinkage losses

as a function of time.    In addition, the frequency of the

retailers' physical inventories and the uniform and consistent

application of the retailers' shrinkage method insured correction

of overestimates on a regular basis and promoted the clear

reflection of income.




VII.    Conclusion

       The retailers’ systems of maintaining book inventories

(including the making of shrinkage accruals) conform to the best

accounting practice and clearly reflect income.    They are, thus,

sound within the meaning of section 1.471-2(d), Income Tax Regs.
                             - 47 -

     To reflect the foregoing, and to give effect to agreements

reached by the parties,


                                        Decision will be entered

                                   under Rule 155.
                                        - 48 -

                                       Appendix3

       Sales-Based Accuracy Analysis for the KFS Division
                          KFS DIVISION - RETAILERS' METHOD

                                           Sales-Allocated    Difference As
            Sales-                         Annual Shrinkage   Percent Of
            Allocated       Actual KFS     Minus Actual       Annual Sales-
            Annual          Annual Tax     KFS Annual Tax     Allocated
    Year    Shrinkage       Shrinkage      Shrinkage          Shrinkage

    1984   $16,730,176     $16,152,686         $577,491           3.5%
    1985    12,480,853      13,803,649       -1,322,796         -10.6%
    1986    18,828,725      16,674,582        2,154,143          11.4%
    1987    14,965,650      15,920,349         -954,699          -6.4%
    1988    11,573,159      10,415,192        1,157,967          10.0%
    1989    18,949,137      17,067,966        1,881,170           9.9%
    1990    23,781,623      24,735,994         -954,371          -4.0%
    1991    28,082,463      28,014,682           67,781           0.2%

    1984- 145,391,786      142,785,100        2,606,686           1.8%
    1991

                         KFS DIVISION - RESPONDENT'S METHOD

                                           Sales-Allocated    Difference As
            Sales-                         Annual Shrinkage   Percent Of
            Allocated                      Minus Shrinkage    Annual Sales-
            Annual             IRS         Based on IRS       Allocated
    Year    Shrinkage         Method       Method             Shrinkage

    1984   $16,730,176     $16,719,232          $10,944           0.1%
    1985    12,480,853      13,166,875         -686,022          -5.5%
    1986    18,828,725      16,541,601        2,287,124          12.1%
    1987    14,965,650      15,066,016         -100,366          -0.7%
    1988    11,573,159       9,763,096        1,810,063          15.6%
    1989    18,949,137      16,497,880        2,451,257          12.9%
    1990    23,781,623      24,409,148         -627,526          -2.6%
    1991    28,082,463      26,868,966        1,213,498           4.3%

    1984- 145,391,786      139,032,814        6,358,972           4.4%
    1991




3
    These tables contain a few immaterial computational errors.
                                     - 49 -

   Time-Based Accuracy Analysis for the KFS Division
                       KFS DIVISION - RETAILERS' METHOD

                                        Time-Allocated         Difference As
         Time-                          Annual Shrinkage       Percent Of
         Allocated       Actual KFS     Minus Actual           Annual Time-
         Annual          Annual Tax     KFS Annual Tax         Allocated
Year     Shrinkage       Shrinkage      Shrinkage              Shrinkage

1984    $16,804,512     $16,152,686         $651,826               3.9%
1985     12,417,480      13,803,649       -1,386,170             -11.2%
1986     18,667,248      16,674,582        1,992,666              10.7%
1987     15,153,369      15,920,349         -766,980              -5.1%
1988     11,585,858      10,415,192        1,170,666              10.1%
1989     18,930,812      17,067,966        1,862,846               9.8%
1990     23,843,933      24,735,994         -892,061              -3.7%
1991     27,847,797      28,014,682         -166,885              -0.6%

1984- 145,251,008       142,785,100        2,465,908               1.7%
1991

                      KFS DIVISION - RESPONDENT'S METHOD

                                        Time-Allocated         Difference As
         Time-                          Annual Shrinkage       Percent Of
         Allocated                      Minus Shrinkage        Annual Time-
         Annual             IRS         Based on IRS           Allocated
Year     Shrinkage         Method       Method                 Shrinkage

1984    $16,804,512     $16,719,232          $85,280               0.5%
1985     12,417,480      13,166,875         -749,396              -6.0%
1986     18,667,248      16,541,601        2,125,647              11.4%
1987     15,153,369      15,066,016           87,353               0.6%
1988     11,585,858       9,763,096        1,822,762              15.7%
1989     18,930,812      16,497,880        2,432,932              12.9%
1990     23,843,933      24,409,148         -565,215              -2.4%
1991     27,847,797      26,868,966          978,831               3.5%

1984- 145,251,008       139,032,814        6,218,194               4.3%
1991

       Sales-Based Accuracy Analysis for Florida Choice
                      FLORIDA CHOICE - RETAILERS' METHOD

                         Actual         Sales-Allocated        Difference As
         Sales-          Florida        Annual Shrinkage       Percent Of
         Allocated       Choice         Minus Actual Florida   Annual Sales-
         Annual          Annual Tax     Choice Annual          Allocated
Year     Shrinkage       Shrinkage      Shrinkage              Shrinkage

1984     $1,285,541     $1,189,507             $96,034              7.5%
1985      1,465,206      1,575,637            -110,430             -7.5%
1986      1,283,771      1,441,437            -157,666            -12.3%
1987      3,191,210      2,843,037             348,172             10.9%
1988      3,150,351      2,923,998             226,353              7.2%

1984-    10,376,079      9,973,616            402,463               3.9%
1988
                                    - 50 -

                    FLORIDA CHOICE - RESPONDENT'S METHOD

                                       Sales-Allocated        Difference As
        Sales-                         Annual Shrinkage       Percent Of
        Allocated                      Minus Shrinkage        Annual Sales-
        Annual             IRS         Based on IRS           Allocated
Year    Shrinkage        Method        Method                 Shrinkage

1984    $1,285,541     $1,025,390            $260,151            20.2%
1985     1,465,206      1,360,463             104,744             7.1%
1986     1,283,771      1,382,411             -98,640            -7.7%
1987     3,191,210      2,572,824             618,386            19.4%
1988     3,150,351      3,400,035            -249,684            -7.9%

1984-   10,376,079      9,741,123            634,956              6.1%
1988

       Time-Based Accuracy Analysis for Florida Choice
                     FLORIDA CHOICE - RETAILERS' METHOD

                        Actual         Time-Allocated         Difference As
        Time-           Florida        Annual Shrinkage       Percent Of
        Allocated       Choice         Minus Actual Florida   Annual Time-
        Annual          Annual Tax     Choice Annual          Allocated
Year    Shrinkage       Shrinkage      Shrinkage              Shrinkage

1984    $1,289,498     $1,189,507             $99,991             7.8%
1985     1,471,431      1,575,637            -104,206            -7.1%
1986     1,264,544      1,441,437            -176,893           -14.0%
1987     3,171,919      2,843,037             328,881            10.4%
1988     3,076,645      2,923,998             152,647             5.0%

1984-   10,274,037      9,973,616            300,420              2.9%
1988

                    FLORIDA CHOICE - RESPONDENT'S METHOD

                                       Time-Allocated         Difference As
        Time-                          Annual Shrinkage       Percent Of
        Allocated                      Minus Shrinkage        Annual Time-
        Annual             IRS         Based on IRS           Allocated
Year    Shrinkage        Method        Method                 Shrinkage

1984    $1,289,498     $1,025,390            $264,108            20.5%
1985     1,471,431      1,360,463             110,968             7.5%
1986     1,264,544      1,382,411            -117,867            -9.3%
1987     3,171,919      2,572,824             599,095            18.9%
1988     3,076,645      3,400,035            -323,390           -10.5%

1984-   10,274,037      9,741,123            532,914              5.2%
1988
                                   - 51 -

           Sales-Based Accuracy Analysis for Superx
                     SUPERX DIVISION - RETAILERS’ METHOD

                                      Sales-Allocated       Difference As
         Sales-         Actual        Annual Shrinkage      Percent Of
         Allocated      Superx        Minus Actual Superx   Annual Sales-
         Annual         Annual Tax    Annual Tax            Allocated
Year     Shrinkage      Shrinkage     Shrinkage             Shrinkage

1983    $15,786,221     $14,822,148         $964,073             6.1%
1984     19,940,756      19,004,471          936,285             4.7%
1985     23,163,483      22,272,344          891,139             3.8%

1983-    58,890,459      56,098,963       2,791,497              4.7%
1985

                 SUPERX DIVISION - RESPONDENT'S METHOD

                                      Sales-Allocated       Difference As
         Sales-                       Annual Shrinkage      Percent Of
         Allocated                    Minus Shrinkage       Annual Sales-
         Annual            IRS        Based on IRS          Allocated
Year     Shrinkage        Method      Method                Shrinkage

1983    $15,786,221     $14,498,732      $1,287,489              8.2%
1984     19,940,756      18,062,925       1,877,831              9.4%
1985     23,163,483      22,155,386       1,008,097              4.4%

1983-    58,890,459      54,717,043       4,173,416              7.1%
1985

            Time-Based Accuracy Analysis for Superx
                     SUPERX DIVISION - RETAILERS' METHOD

                                      Time-Allocated        Difference As
         Time-          Actual        Annual Shrinkage      Percent Of
         Allocated      Superx        Minus Actual Superx   Annual Time-
         Annual         Annual Tax    Annual Tax            Allocated
Year     Shrinkage      Shrinkage     Shrinkage             Shrinkage

1983    $15,665,951     $14,822,148        $843,803              5.4%
1984     20,020,109      19,004,471       1,015,638              5.1%
1985     23,050,060      22,272,344         777,716              3.4%

1983-    58,736,119      56,098,963       2,637,157              4.5%
1985
                                 - 52 -
                 SUPERX DIVISION - RESPONDENT'S METHOD

                                    Time-Allocated       Difference As
         Time-                      Annual Shrinkage     Percent Of
         Allocated                  Minus Shrinkage      Annual Time-
         Annual          IRS        Based on IRS         Allocated
Year     Shrinkage      Method      Method               Shrinkage

1983    $15,665,951   $14,498,732     $1,167,219              7.5%
1984     20,020,109    18,062,925      1,957,184              9.8%
1985     23,050,060    22,155,386        894,674              3.9%

1983-    58,736,119   54,717,043       4,019,076              6.8%
1985
