                   T.C. Memo. 1997-1



                UNITED STATES TAX COURT



WAL-MART STORES, INC. AND SUBSIDIARIES, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 27022-93.                   Filed January 2, 1997.



     Ps operate retail department stores and clubs.
Ps' accounting records set forth each store/club's
inventory, and Ps count each store/club's inventory
during the year to verify the records' accuracy. In
order to reflect the "shrinkage" of inventory at
yearend caused by theft, breakage, and clerical errors
occurring after a count, Ps estimate this shrinkage
based on gross sales. Ps' inclusion of the estimates
in costs of goods sold reduces their gross income.
     Held: Ps' method of estimating inventory
shrinkage at yearend is permissible because the method:
(1) Conforms as nearly as may be to the best accounting
practice in the trade or business and (2) clearly
reflects income.
                                      - 2 -

     Alexander Zakupowsky, Jr., Frederick Brook Voght, Jean Ann

Pawlow, and Carol Ann Johnson, for petitioners.

     Albert L. Sandlin, Jr., Thomas R. Ascher, James P. Dawson,

and Martin L. Osborne, for respondent.


                  MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:        Wal-Mart Stores, Inc., & Subsidiaries,

petitioned the Court to redetermine respondent's determination of

deficiencies in their Federal income tax.            Respondent determined

the following deficiencies:

                   Taxable Year Ended                  Deficiency

     Jan.   31,   1984   (1983   taxable   year)       $9,937,545
     Jan.   31,   1985   (1984   taxable   year)        4,084,255
     Jan.   31,   1986   (1985   taxable   year)        9,381,626
     Jan.   31,   1987   (1986   taxable   year)        8,206,962

     Following concessions by the parties, we must decide whether

petitioners' estimates of inventory shrinkage at yearend are

permissible.      We hold they are.        Section references are to the

Internal Revenue Code in effect for the subject years.              Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar.            The term

"shrinkage" refers to the excess value of book inventory over

actual inventory.        The term "overage" refers to the excess value

of actual inventory over book inventory.            The term "physical

inventory" refers to the counting of the goods that are actually

in inventory.
                                - 3 -

                          FINDINGS OF FACT

I.   Background

     A.   General Information

     Some of the facts have been stipulated and are so found.

The stipulated facts and exhibits submitted therewith are

incorporated herein by this reference.   Petitioners comprise an

affiliated group of corporations that use an accrual method of

accounting for financial accounting and tax purposes.    They filed

Federal consolidated income tax returns and amended Federal

consolidated income tax returns for the subject years.    Their

common parent is Wal-Mart Stores, Inc. (Parent).   Parent's

principal place of business was in Bentonville, Arkansas, when it

petitioned the Court.

     At all relevant times, Kuhn's-Big K Stores Corp. (Kuhn's)

and Big K Edwards, Inc. (Edwards), were two of Parent's

subsidiaries, and Sam's Wholesale Clubs (Sam's) was one of

Parent's divisions.   (We hereinafter use the name "Wal-Mart" to

refer collectively to Parent (without regard to Sam's), Kuhn's,

and Edwards.   We hereinafter use the term "petitioners" to refer

collectively to Wal-Mart and Sam's.)

     Sam's operated its stores (clubs) on a discount warehouse

basis.    Wal-Mart operated its stores as mass discount retailers.

Each Wal-Mart store contained up to 37 departments, and, in the

aggregate, these departments carried a wide range of merchandise,

including home furnishings, electrical appliances, automotive and
                               - 4 -

hardware items, electronics, toys, candy, and pet supplies, as

well as apparel for men, women, boys, and girls.

     Inventory is petitioners' most essential and valuable asset,

and it is critical to their success.   Petitioners strive to

maintain enough inventory to satisfy their customers' needs,

while at the same time minimizing the dollar amount of their

inventories.   One measure of the effectiveness of Wal-Mart's

inventory management is its impressive rate of inventory turnover

(sales/inventory).   Wal-Mart's inventory turned over 4.5 times in

its 1983 taxable year, while the average turnover for Wal-Mart's

competitors was approximately 2.8 times.   Another indication of

the effectiveness of Wal-Mart's inventory management was that

many other companies (both domestic and foreign) sought advice

from Wal-Mart on inventory management.

     B.   Respondent's Adjustments

     Respondent issued petitioners two notices of deficiency, one

for their 1983 and 1984 taxable years and the other for their

1985 and 1986 taxable years.   Both notices reflected an increase

to petitioners' ending inventories on account of respondent's

disallowance of their estimated inventory shrinkage.1   Respondent




     1
       The notice for 1983 and 1984 disallowed shrinkage
estimates for Wal-Mart only. The notice for 1985 and 1986
disallowed shrinkage estimates for Wal-Mart and Sam's.
                               - 5 -

determined that petitioners' ending inventories as reported

understated their taxable income by the following amounts:2

           Taxable Year                Understatement

                1983                     $24,276,994
                1984                       7,837,122
                1985                      20,394,840
                1986                       1,196,045

     The shrinkage disallowed by respondent relates to the period

of time referred to by the parties as the "stub period".     In

general, the stub period is the time between the date of the last

physical inventory prior to the taxable yearend and the taxable

yearend.   In some cases, Wal-Mart took a physical inventory in

January and booked the inventory in February of the next year.

In those cases, the stub period is the time between the date of

the physical inventory immediately prior to the January physical

inventory and the taxable yearend.     In other cases, Wal-Mart

booked two consecutive January inventories in February.     In those

cases, the stub period is the time between the first January

inventory and the taxable yearend following the second January

inventory.   In the case of a new store for which a physical

inventory was not taken before the taxable yearend, the stub

period is the period beginning with the date of the store opening

and ending with the taxable yearend.


     2
       Respondent also determined that part of these
understatements stemmed from petitioners' miscalculation of a
cost complement. The parties have settled their disagreements
with respect to this calculation, and it is not at issue herein.
                                  - 6 -

     C.   Scope of Petitioners' Operations

     Wal-Mart is one of the largest operators of mass merchandise

retail stores in the United States.        During the subject years,

the numbers of Wal-Mart's stores and Sam's clubs were as follows:

        Taxable Year            Wal-Mart               Sam's

            1983                     642                   3
            1984                     745                  11
            1985                     859                  23
            1986                     980                  49

Many of these stores were open to the public 24 hours a day.

        During the subject years, Wal-Mart purchased and sold

products labeled with the manufacturer's name (name brands), as

well as products with its own name brand.        The dollar amounts of

petitioners' purchases and the retail values of its net sales

were as follows:

                      Purchases                       Sales
 Year     Wal-Mart           Sam's         Wal-Mart            Sam's

 1983 $3,543,245,308  $41,192,081 $4,566,514,170            $37,364,011
 1984 4,808,957,832   232,156,657 6,068,673,313             221,585,916
 1985 5,855,108,264   749,927,690 7,501,658,005             776,483,444
 1986 8,037,262,151 1,608,040,382 9,933,879,035           1,670,806,324

        A typical Wal-Mart store averaged 53,000, 55,000, 57,000,

and 59,000 square feet in the respective taxable years, and

petitioners' total square footage of retail space increased from

27.7 million in the 1983 taxable year to 63 million in the 1986

taxable year.      Wal-Mart's stores carried between 60,000 and
                                   - 7 -

90,000 specific types of merchandise (stock keeping units or

SKU's).3       Sam's clubs carried between 3,500 and 5,000 SKU's.

          Wal-Mart received approximately 80 percent of its

merchandise through petitioners' distribution system.       Wal-Mart's

distribution centers increased from 6 in 1984 to 10 in 1987.

In the later year, petitioners' total distribution center space

was over 7 million square feet, and each distribution center

received and shipped in excess of 30 million cases of merchandise

a year, the equivalent of 96 trailer loads per working day.

II.   Petitioners' Inventory Practice

          A.   Inventory Systems in General

          Inventory accounting requires allocating each period's

cost of goods available for sale between:       (1) Cost of goods sold

and (2) the value of ending inventory.        Taxpayers may use either

the perpetual or periodic inventory system for this allocation.

Under both systems, the cost of each purchase is recorded

contemporaneously with the purchase, and the revenue from each

sale is recorded contemporaneously with each sale.       But for these

similarities, recording differs depending on whether the taxpayer

uses a periodic or a perpetual system.

          Under the periodic system, an entry is not made to record

the quantity or cost of an item of merchandise when it is sold.

A physical count is generally performed at yearend to ascertain

      3
       In general, identical units are one SKU's, and each
different size and brand is a different SKU.
                                 - 8 -

the items in and value of the ending inventory.       The cost of

goods sold is the residual amount.       No distinction is made

between the cost of the goods that were actually sold during the

period and the expense of shrinkage.

         Under the perpetual system, the cost and/or quantity of

goods sold are contemporaneously recorded at or about the time of

sale.    Thus, the perpetual system continuously reveals the cost

and/or quantity of goods sold since the beginning of the current

period and the cost and/or quantity of goods that are (or should

be) on hand at any given time.     Physical inventory counts are

performed periodically to confirm the accuracy of the inventory

as stated in the taxpayer's books, and adjustments are made to

the books to reconcile the inventory stated therein with the

actual inventory.

         B.   Petitioners' Inventory Accounting Method

         Petitioners maintained a perpetual inventory system.

Wal-Mart used the Last In, First Out (LIFO) method of identifying

items in ending inventory, see sec. 1.472-1, Income Tax Regs.,

and the retail method of pricing inventories, see sec. 1.471-8,

Income Tax Regs.4     Wal-Mart determined the cost of the LIFO

inventories using the dollar value LIFO method, see sec. 1.472-8,

Income Tax Regs., and it valued any increase in inventory

quantities based on the cost of the earliest acquisitions during

     4
       Many of Wal-Mart's competitors also used the retail
inventory method to account for their inventories.
                               - 9 -

the year, see sec. 1.472-2, Income Tax Regs. At the end of each

month, Wal-Mart applied a cost complement to convert its

inventory balances from retail to deemed cost.    Wal-Mart's

internal monthly financial statements reported inventory

shrinkage (both estimated and verified) as an increase to cost of

goods sold.

      Sam's did not use the retail method.     Sam's used the First

In, First Out method of identifying items in ending inventory.

      C.   Cycle Counting

      Petitioners did not count the actual yearend inventory at

each of their stores.   They counted each store's inventory at

various times during the year (referred to as cycle counting).

The use of cycle counting, and the absence of a physical count at

yearend, is common in petitioners' industry.    Petitioners used

this technique during the subject years because they were unable

to physically count the inventories at all of their stores/clubs

on the last day of the taxable year.    Cycle counting was also

advantageous to them because it was less disruptive to business

operations, and it allowed management to receive information

throughout the year on the effectiveness of internal operations

and changes in external behavior.    The continuous flow of

information facilitated management's response to shrinkage trends

on a timely basis.

      During the subject years, petitioners' independent

auditors were Ernst & Young (E&Y).     E&Y advised Wal-Mart that it
                               - 10 -

could use cycle counting because:    (1) Wal-Mart had accurate

retail accounting records, (2) Wal-Mart had retained independent

counting services to work with Wal-Mart's internal audit

department, and (3) Wal-Mart's previous physical inventories had

not required significant changes to the retail records.    E&Y

certified that petitioners' financial statements for the subject

years (which included the shrinkage estimates) conformed with

Generally Accepted Accounting Principles (GAAP), issuing

unqualified opinions to that effect for each of the years.    E&Y

had been periodically reviewing petitioners' methodology for

accounting for shrinkage, including the accrual of the shrinkage

estimate during the stub period, and E&Y had never recommended

that petitioners change their method of accounting for shrinkage.

      D.     Physical Counts

      The amount of shrinkage or overage was verified by

petitioners when the inventory on hand was counted.    In general,

Wal-Mart counted each store's inventory approximately every 11 to

13 months.    In the case of new stores, petitioners did not count

the inventory until the store had been open for at least

6 months.    Petitioners also did not count inventory in the months

of November, December, and the first week in January.    During

November and December, Wal-Mart was focusing on the Christmas

season, which is one of the busiest times of the year, and its

inventory was at a maximum.    During the first week of January,

Wal-Mart's employees were recuperating from the Christmas season,
                               - 11 -

and they were responding to the return of merchandise from

customers.   Wal-Mart's inventory was generally at its lowest

during the month of January.

      Wal-Mart counted the inventory at some of its stores

during the last 3 weeks in January.     The results of some of these

inventories were posted in January of the same taxable year,

while the results of most of these inventories were posted in

February of the subsequent taxable year.     The ending inventory

for the year of the counts was not corrected for verified

shrinkage for those stores inventoried in January and posted in

February.    The following chart shows the number of inventories

taken in January, the number of January inventories posted in

January, and the number of January inventories posted in

February for the taxable years at issue:

                        Number of
                         January        Posted in     Posted in
             Year      Inventories       January       February

             1983             39             39           - 0 -
             1984             73              9              64
             1985             73              1              72
             1986       93 or 95           - 0 -       93 or 95

During the subject years, the highest percentages of physical

inventories took place from March through September.

      In general, it takes 4 to 6 weeks to prepare a store for

inventory.    Forty-five days prior to a scheduled count,

Wal-Mart's internal audit department would send a preparation

package to the store for completion before the inventory was
                                - 12 -

taken.    Completion of the package by the store was designed to

ensure accuracy and consistency in the count and reconciliation

with book inventory.    The package included detailed instructions

for store preparation to ensure an efficient count.    The package

included 13 schedules that were reviewed or completed prior to

the day of the count.

         Persons involved in a count included a team of independent

counters (18 to 40 individuals) and representatives from

Wal-Mart's loss prevention department (one to two individuals),

internal audit department (one to three individuals), and

operations division (one to two individuals).    E&Y was also

present at the inventories of randomly selected stores to test

the count's accuracy by recounting results.    All salable

merchandise in a store was counted by the independent counters on

the day of the physical inventory, and they based the count on

the inventory's retail value.

         Wal-Mart took inventory while the stores were open to

customers.    Each store count took a full day, commencing at

approximately 8 a.m. and concluding at approximately 6 p.m.

Thereafter, while still at the store, the physical count team

reconciled the physical count to the book inventory.    These

reconciliations were reviewed by petitioners' internal audit

department on a future date.    Due to the time necessary to review

the reconciliations, petitioners did not book the results of a

physical inventory until the next month.
                               - 13 -

       Sam's physical inventory procedure was essentially the

same as Wal-Mart's procedure, except that Sam's conducted its

inventories before business hours and the physical count was

completed within 4 to 5 hours.     In addition, two inventories were

usually taken during the taxable year at each of Sam's clubs, and

the items, rather than retail values, were counted.    Physical

counts were sometimes taken at Sam's in January, and the results

of physical inventories at Sam's were booked the day after the

physical inventory.   Unlike the records of Wal-Mart, petitioners

kept records for Sam's that listed the quantity and cost of items

in inventory on any given date.

       In addition to the physical inventories performed at each

club, Sam's personnel routinely performed item audits on specific

products held in inventory.   In an item audit, Sam's personnel

counted the goods on hand for a particular SKU's, and they

reconciled the count with the club's stock status report.    Any

discrepancy was immediately booked.     Item audits were performed

daily or weekly at the club manager's discretion.

III.   Accounting for Shrinkage

       A.   Shrinkage in General

       Inventory shrinkage occurs daily and is an inherent cost

of the retail business.   Causes of shrinkage include theft,

damage, breakage, spoilage, and bookkeeping errors.    Although

shrinkage cannot be eliminated entirely, it can be minimized

through methods that include the use of loss prevention
                                 - 14 -

equipment, employee involvement and screening, prosecutions for

theft, security devices, training of security personnel, and

effective control systems for paperwork, bookkeeping, and

accounting.     Shrinkage is particularly high around the holiday

seasons such as Christmas and Easter.

         B.   Wal-Mart's Response to Shrinkage

         In the early 1980's, prior to the subject years, Wal-Mart

modified its computer system to improve the accuracy of its

inventory accounting.     Wal-Mart employed various other techniques

to reduce shrinkage and overage during the subject years, such as

closed-circuit camera systems, burglar alarms, and close scrutiny

over the hiring and performance of employees.5     In the latter

regard, Wal-Mart tried not to hire applicants who might be

inclined to commit theft, and Wal-Mart focused on employee

training to reduce bookkeeping errors.      Each store manager was

also evaluated in part on his or her ability to reduce shrinkage,

and employees at stores that reported excessive shrinkage or

overages were not eligible for a bonus.      Store managers with

higher than expected shrinkage were required to attend internal

seminars on shrinkage, and they were subject to demotion or

termination if the high shrinkage continued.

         Shrinkage reduces profits and was viewed by petitioners

during the subject years as reflecting poor management and


     5
         Sam's employed similar measures.
                               - 15 -

adversely affecting employee morale.    Petitioners aimed to reduce

shrinkage, and they devoted extensive resources to the mitigation

and monitoring of it.    Petitioners' management discussed

shrinkage weekly among themselves, and they regularly discussed

the subject with the audit committee of the board of directors,

as well as the regional managers, district managers, and store

managers.

      C.    Petitioners' Monthly Shrinkage Estimates

      Wal-Mart estimated shrinkage for each store for the period

between the physical inventory and the end of the taxable year by

multiplying a retail shrinkage rate (stated as a percentage of

sales) by the store's sales for the period between the physical

inventory and the end of the taxable year.    For new stores,

Wal-Mart estimated shrinkage based on a fixed rate established by

its senior management.    In the 1983 and 1984 taxable years, the

retail shrinkage rate for new stores was 3 percent of sales.    In

the 1985 and 1986 taxable years, the rate was 2 percent of sales.

Wal-Mart used the fixed rate from the date the store opened until

the date that the first inventory was taken at the store.

      After Wal-Mart took the first inventory at a store, it

computed a shrinkage rate for that store by dividing the store's

shrinkage at retail, as verified by the first inventory, by the

store's sales for the period starting with the date the store

opened and ending on the inventory date.    The shrinkage rate, as

computed, was subjected to the imposition and application of
                               - 16 -

certain floor and ceiling percentage limitations that were

established by Wal-Mart's senior management, and that are

discussed further below.    After Wal-Mart took a second inventory

at the store, it computed the shrinkage rate for that store

similarly to the method described above, except that it used the

shrinkage as verified by both the first and second inventories,

and it used the sales for the period starting with the date the

store opened and ending on the date of the second inventory.    The

floor and ceiling limitations described below were also applied

to this rate.   After Wal-Mart took a third inventory at the

store, it computed a shrinkage rate for that store in a fashion

similar to that of the first 2 years, except that it used the

shrinkage as verified by the first, second, and third

inventories, and it used the sales for the period commencing with

the date the store opened and ending on the date of the third

inventory.   This shrinkage rate, as computed, was subjected to

the floor and ceiling limitations described below.

      After Wal-Mart took the fourth and each subsequent

inventory, the retail shrinkage rate was based on a rolling

average of the historical shrinkage over the last three

inventories of the store.   The rate was computed by dividing the

amount of shrinkage at retail, as verified by the current

inventory and the preceding two inventories, by the sales for the

period commencing with the date of the third preceding inventory

and ending on the current inventory date.   This shrinkage rate,
                                - 17 -

as computed, was subjected to the floor and ceiling limitations

described below.

         The floor and ceiling percentage limitations mentioned

above were internal guidelines set forth in memoranda prepared by

Wal-Mart's senior management.    These guidelines were followed by

all of Wal-Mart's stores.    Wal-Mart's internal audit department

recommended the amount of a ceiling and floor limitation to the

controllers and vice presidents of the respective operating

divisions based on a weighted 5-year average, and they, in turn,

recommended the guidelines for these limitations to Wal-Mart's

president.    Wal-Mart's president was the ultimate setter of these

guidelines, and, once set and implemented, these guidelines were

effective until revised through the procedure used to establish

them.    The floor and ceiling percentage limitations were applied

as follows:    (1) If the computed shrinkage rate was below the

floor, the rate was adjusted upward to equal the floor; (2) if

the computed shrinkage rate exceeded the ceiling, it was adjusted

downward to equal the ceiling; (3) if the computed shrinkage rate

was an overage, the rate was replaced by the floor.    In practice,

the ceiling was seldom applied, and the floor was applied more

often.    As one example of the application of the floor and

ceiling percentage limitations, the following table contains

information from the 1986 taxable year that illustrates how a

computed average shrinkage rate was adjusted:
                                   - 18 -


              Store    Computed %           Applied %     % Applied

               201    -1.08   shrinkage      -1.08        Computed
               397    -3.90   shrinkage      -3.85        Ceiling
               531    -0.27   shrinkage      -1.00        Floor
               782    +0.32   overage        -1.40        Floor

         Sam's consistently determined shrinkage projections for

its clubs by multiplying a fixed rate of .2 percent by monthly

sales.    None of the clubs, including new clubs, applied a floor

or ceiling percentage limitation to the .2-percent rate.        The

.2-percent rate was determined by petitioner's senior management

on the basis of their analysis of historical results from

warehouse operations.     Sam's shrinkage estimates are a smaller

part of overall annual shrinkage because Sam's warehouse format

allows it to continuously take item physical inventories in

addition to taking complete physical inventories twice a year.

         Sam's underestimated shrinkage.      Sales during the physical

inventory cycle for Sam's, expressed in thousands of dollars,

were $597,954 for 1985 and $1,314,344 for 1986.         Shrinkage during

the physical inventory cycle for Sam's, expressed in thousands of

dollars, was $567 for 1985 and $4,669 for 1986.         Sam's shrinkage

as a percentage of sales for the physical inventories taken

during 1985 and 1986 was .27% (($567 + $4,669)/($597,954 +

$1,314,344)).

         D.   Adjustment of Monthly Estimates

         Petitioners adjusted their inventory accounts to reflect

the results of each physical count of a store or club.        Each time
                                 - 19 -

petitioners took a physical count, they adjusted any over- or

under-estimate of shrinkage, so that their books and records

reflected inventories on hand as verified by the physical count.

This was a continuous process throughout the year, as stores and

clubs were physically counted in the cycle procedure.

         E.   Yearend Allocations and LIFO Effects

         Wal-Mart estimated shrinkage for each store, not for each

department within each store.     At the end of each subject year,

Wal-Mart aggregated the estimate for shrinkage for the stub

period as reported in its records for all of its stores.

Wal-Mart then allocated this aggregate estimated shrinkage to

each department on the basis of the relative amount of all

shrinkage verified during the year for each department as

reported in the December purchase recap report.6     At the end of

each taxable year, Wal-Mart allocated the consolidated ending

inventory (net of shrinkage), as reported in the general journal,

among each of its departments.7     For the 1984, 1985, and 1986


     6
       Purchase recap reports were prepared monthly, and they
listed beginning inventory at retail, purchases at cost and
retail, sales at retail, markdowns at retail, and ending
inventory at retail. The inventory amounts shown in the monthly
purchase recap reports were stated net of shrinkage (overage) as
determined from physical inventories taken from the beginning of
the year to date. The shrinkage (overage) determined from the
physical inventory was included in the purchase recap report when
the inventory was completed, including verification and recording
in the books. The shrinkage (overage) reported in the purchase
recap report was reported on a departmental basis from the
physical counts of the departments.
     7
         Wal-Mart recorded purchases, sales, and related
                                                     (continued...)
                                - 20 -

taxable years, the allocation was made on the basis of the

relative value of ending inventory in each department (net of

shrinkage as allocated) as reported in the yearend purchase recap

report.    In petitioners' 1983 taxable year, the allocation was

made on the basis of the results of physical inventories taken

during the month of January 1984.    A separate allocation in the

same manner was made for the stores of Parent, Kuhn's, and

Edwards.

         Parent, Kuhn's, and Edwards each had its own LIFO pools.

Petitioners made separate LIFO computations for each of these

entities.    Petitioners separately recorded shrinkage as verified

by physical counts by department for Parent, Kuhn's, and Edwards.

Petitioners also allocated aggregate estimated stub period

shrinkage separately to each of the entity's departments.

Petitioners did not allocate an estimate of shrinkage to pools at

the individual store level.    Petitioners did not make yearend

allocations and reconciliations or LIFO computations for

individual stores.    Yearend allocations and LIFO computations

were performed on a division-wide basis.

         Petitioners reported the same shrinkage for both financial

and tax purposes.    For purposes of preparing financial statements



     7
      (...continued)
information in the general journal. The general journal
contained information on a store basis and contained basically
the same accounts for each store. The general journal contained
the records of the total shrinkage as verified by physical count
and estimated shrinkage by store, but not by department.
                                 - 21 -

and the Federal income tax return, petitioners reported shrinkage

on an aggregate basis.    Other large retail businesses, in

addition to Wal-Mart, estimate shrinkage for the stub period.

The practice of estimating shrinkage as a percentage of sales is

prevalent in the retail industry.

                                 OPINION

I.   Overview

         We must decide whether petitioners' estimates of inventory

shrinkage at yearend are permissible.      In Dayton Hudson Corp. &

Subs. v. Commissioner, 101 T.C. 462 (1993), we held that a

taxpayer was entitled to use an estimate of yearend shrinkage if

the taxpayer's method of accounting for its inventory was

"sound".    In the instant case, respondent asks us to reconsider

our holding in Dayton Hudson.      We will not do so.   We adhere to

our opinion in Dayton Hudson Corp. & Subs. v. Commissioner,

supra, for the reasons stated therein.     We will not disturb

petitioners' method of accounting for their inventories,

including their estimates of shrinkage at yearend, if the method

is "sound".     Stated differently, petitioners will prevail if they

prove that their inventory method meets the following two-prong

test:    (1) It conforms as nearly as may be to the best accounting

practice in the trade or business and (2) it clearly reflects

income.    Sec. 471(a);8 see also Thor Power Tool Co. v.


     8
         Sec. 471(a) provides:

                                                        (continued...)
                                - 22 -

Commissioner, 439 U.S. 522, 531-532 (1979); Dayton Hudson Corp. &

Subs. v. Commissioner, supra; sec. 1.471-2(a)(1) and (2), Income

Tax Regs.    We analyze these prongs seriatim, and we set forth our

analysis below.    Before doing so, however, we pause to summarize

the qualifications of the experts.

         During the cases in chief, petitioners called two

witnesses whom the Court recognized as experts, and respondent

called three.    We are given broad discretion to evaluate the

cogency of each expert's analysis and to weigh it accordingly.

See Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 301

(1996).    We must evaluate and weigh each expert's opinion in


     8
      (...continued)
     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.

The Commissioner has prescribed rules under sec. 471(a) for
taxpayers like petitioners that employ a perpetual inventory
system. In pertinent part, sec. 1.471-2(d), Income Tax Regs.,
provides:

     Where the taxpayer maintains book inventories in
     accordance with a sound accounting system in which the
     respective inventory accounts are charged with the
     actual cost of the goods purchased or produced and
     credited with the value of goods used, transferred, or
     sold, calculated upon the basis of the actual cost of
     the goods acquired during the taxable year (including
     the inventory at the beginning of the year), the net
     value as shown by such inventory accounts will be
     deemed to be the cost of the goods on hand. The
     balances shown by such book inventories should be
     verified by physical inventories at reasonable
     intervals and adjusted to conform therewith.
                              - 23 -

light of his or her qualifications and with regard to all other

evidence in the record.   Id.; IT&S of Iowa, Inc. v. Commissioner,

97 T.C. 496, 508 (1991); Parker v. Commissioner, 86 T.C. 547, 561

(1986).   We are not bound by an expert’s opinion, especially when

it is contrary to our own judgment.     Trans City Life Ins. Co. v.

Commissioner, supra at 302.   If we believe it is appropriate to

do so, we may adopt an expert’s opinion in its entirety, or we

may reject it in its entirety.   Helvering v. National Grocery

Co., 304 U.S. 282, 294-295 (1938); see Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980).

We may also choose to adopt only parts of an expert’s opinion.

Parker v. Commissioner, supra at 562.

      The Court recognized Robert M. Zimmerman, petitioners'

first expert, as an expert on shrinkage in the retail industry,

as well as on matters of GAAP.   Mr. Zimmerman has been a

certified public accountant (C.P.A.) since 1959, and he has

worked for a national accounting firm for 15 years as a partner

and/or director, specializing in the retail industry and

directing the firm's operations therein.    Mr. Zimmerman consults

currently in the retail industry, and he has written repeatedly

on the subject of retail accounting and financial control.

Mr. Zimmerman holds an undergraduate degree in accounting and a

master's degree in taxation, both from New York University.

      The Court recognized petitioners' second expert,

Thomas E. Doerfler, as an expert on statistics.    Dr. Doerfler has
                               - 24 -

consulted on the subject of statistics for over 25 years, and he

is currently employed as a senior consultant in that area at a

diversified international management and technology consulting

firm.   Dr. Doerfler holds an undergraduate degree in mathematics

from the University of Dayton and two graduate degrees (M.S. and

Ph.D) in statistics from Iowa State University.    He has

previously appeared before this and other Courts as an expert on

statistical issues involving sampling and estimation.

        Respondent's first expert, Steven Elliott Fienberg, was

recognized by the Court as an expert on statistics.    Dr. Fienberg

is a professor at Carnegie-Mellon University, where he teaches

statistical science at both the undergraduate and graduate level.

Dr. Fienberg holds a Ph.D in statistics from Harvard University,

and he has previously testified as an expert in Federal, State,

and local courts.   Dr. Fienberg is currently the president of the

international society for Bayesian analysis, and he chairs the

committee of presidents of statistical sciences.

        The Court recognized respondent's second expert,

David W. LaRue, as an expert in financial, tax, and inventory

accounting.   Dr. LaRue, an associate professor at the University

of Virginia, holds a Ph.D in taxation and accounting from the

University of Houston.   He specializes in the fields of Federal

taxation and accounting, and he has written repeatedly on those

subjects.
                                - 25 -

       Respondent's third expert, James Earnest Wheeler, was

recognized by the Court as an expert in financial and tax

accounting.    Dr. Wheeler is a professor of accounting at the

University of Michigan, and he holds a Ph.D. in accounting from

the University of Illinois.     Dr. Wheeler specializes and teaches

in the fields of Federal taxation and accounting, and he has

written frequently on those subjects.

       The Court also recognized as experts two other witnesses

called by petitioner during rebuttal; namely, Charles Bates and

James Bradow.    Both of these witnesses were qualified as experts

for the sole purpose of rebuttal.     Dr. Bates was recognized as an

expert on tax accounting for purposes of rebutting Dr. Fienberg.

He is a principal with KPMG Peat Marwick, heading its economic

analysis group with a particular focus on statistical application

to the field of economics (econometrics).     He has a master's and

a Ph.D in economics from the University of Rochester.     Mr. Bradow

was recognized as an expert in econometrics for purposes of

rebutting Dr. Wheeler.    Mr. Bradow is a C.P.A. and a partner of

E&Y.

 II.   Best Accounting Practice

       Petitioners contend that their method of estimating

shrinkage conforms to the best accounting practice in the

industry.     Respondent alleges to the contrary.   Respondent argues

that the retail industry does not have "one per se industry

standard for estimating shrinkage" because other retailers use
                               - 26 -

variations of petitioners' method, rather than strictly following

it.   According to respondent, Wal-Mart's competitors in the

retail industry use different historic periods to ascertain their

shrinkage rates, and they adjust these rates differently than the

ceiling and floor levels used by Wal-Mart.    Respondent also

argues that petitioners' shrinkage estimates do not conform to

GAAP for the reasons stated by Dr. Wheeler.    Respondent adds that

petitioners' financial statements as a whole may have satisfied

GAAP, but that their estimates of shrinkage do not.    Respondent

contends that E&Y was able to certify the subject statements

without qualification because petitioners' shrinkage estimates

were immaterial from a financial point of view.    Respondent

alleges that materiality is a financial accounting concept that

does not apply to tax accounting.

        The Supreme Court has indicated that the phrase "best

accounting practice in the trade or business" is synonymous with

GAAP.   Thor Power Tool Co. v. Commissioner, 439 U.S. at 531; see

also Hachette USA, Inc. v. Commissioner, 105 T.C. 234, 247

(1995), affd. 87 F.3d 43 (2d Cir. 1996).   Thus, petitioners'

method of accounting for their inventories will satisfy the first

prong of our two-prong test if it conforms to GAAP.    We believe

it does.   Petitioners' estimate of stub period shrinkage as a

percentage of sales is a widely accepted industry practice.

Petitioners consistently followed this practice, and they

utilized the estimates resulting therefrom in their financial
                               - 27 -

statements.   Petitioners' financial statements were certified by

E&Y as conforming to GAAP without qualification.

        Respondent challenges the accuracy of petitioners'

financial statements and contends that E&Y's certification does

not pertain to the estimates of shrinkage.      We disagree.   Each of

the statements is accompanied by E&Y's unqualified certification

that E&Y has examined the financial statements in accordance with

generally accepted auditing principles, and that the statements

present the financial position of petitioners in conformance with

GAAP.   Respondent invites the Court to focus on the accounting

concept of materiality and conclude that E&Y was able to render

an unqualified opinion even though petitioners' estimates of

inventory shrinkage were improper.      We will not do so.   We do not

find that petitioners' inventory accounting method was out of

compliance with GAAP.   Petitioners' witness James A. Walker, Jr.,

a C.P.A. and Wal-Mart's current senior vice

president/comptroller, testified that Wal-Mart's method of

accounting for shrinkage conformed with GAAP.      Respondent did not

persuasively challenge Mr. Walker's testimony, and we find that

his testimony was consistent with the testimony of

Robert Lundgren.   Mr. Lundgren is also a C.P.A, and he is the

partner of E&Y who directed the audit of Wal-.Mart for the

relevant years and gave the approval for the firm's opinion on

the financial statements.   To the extent that Dr. Wheeler
                                  - 28 -

testified that petitioners' inventory method did not comply with

GAAP, we are unpersuaded by that testimony.

      Petitioners' shrinkage methodology is supported by FASB

Statement of Concepts No. 6 (Statement No. 6).    In relevant part,

Statement No. 6 states:

      26. An asset has three essential characteristics:
      (a) it embodies a probable future benefit that
      involves a capacity * * * to contribute directly or
      indirectly to future net cash inflows, (b) a
      particular entity can obtain the benefit and control
      others' access to it, and (c) the transaction or
      other event giving rise to the entity's right to or
      control of the benefit has already occurred.

      *         *      *      *         *     *        *

      33. Once acquired, an asset continues as an asset
      of the entity until the entity collects it,
      transfers it to another entity, or uses it up, or
      some other event or circumstance destroys the future
      benefit or removes the entity's ability to obtain
      it.

Petitioners' method of accounting for shrinkage comports with

Statement No. 6 because petitioners adjusted their inventories,

which were their largest asset, to reflect the value of the

merchandise that was on hand at yearend.    If petitioners had not

made these adjustments, the value of their ending inventories

would have been overstated by the value lost through shrinkage.

Merchandise that is not available for sale to customers does not

"contribute * * * to future net cash inflows" or provide a

"benefit".

      We also are guided by the retail industry's accounting

practice.    In the absence of specific guidance, the generally
                               - 29 -

accepted standard for a trade or industry may be established by

reference to a common practice followed by members of that trade

or industry.   See sec. 1.471-2(a)(1), Income Tax Regs.

(inventories must conform to the best accounting practice in the

trade or business).    Petitioners' methodology for estimating stub

period shrinkage is consistent with and comparable to the best

practice used in the retail industry.      Like most major retailers,

petitioners use cycle counting, which is widely accepted in the

retail industry.    Petitioners' physical inventory process is

strictly and carefully conducted and reviewed by independent

counting services, petitioners' internal auditors and loss

prevention department, and independent auditors.      Petitioners'

competitors also estimate shrinkage as a percentage of sales.

Estimating shrinkage for the stub period as a percentage of sales

is the best practice available in the industry.      It is also

relevant that petitioners used the same shrinkage estimates for

reports issued to the Securities Exchange Commission.

       We conclude that petitioners' method of accounting for

their inventories, including their estimates of shrinkage at

yearend, conforms as nearly as may be to the best accounting

practice in the trade or business.      We so hold, and we turn to

the second prong.

III.   Clear Reflection of Income

       Inventory accounting is governed by sections 446 and 471.

Section 471 prescribes the general rule for inventories.      The
                              - 30 -

regulations thereunder follow the statutory text in stating that

a method of accounting for inventory "must conform as nearly as

may be to the best accounting practice in the trade or business,"

and "must clearly reflect the income."   Sec. 1.471-2(a)(1) and

(2), Income Tax Regs.

      Section 446(a) contains the general rule for tax

accounting.   Section 446(a) states that the accounting method

used to compute taxable income generally must be based on the

method of accounting used to compute book income.   When the

accounting method used to compute taxable income does not clearly

reflect income, section 446(b) gives the Commissioner broad

authority to prescribe a method that does clearly reflect income.

Thor Power Tool Co. v. Commissioner, supra at 532; Commissioner

v. Hansen, 360 U.S. 446, 467 (1959); Ford Motor Co. v.

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

(1994); see also sec. 1.446-1(a)(2), Income Tax Regs. ("no method

of accounting is acceptable unless, in the opinion of the

Commissioner, it clearly reflects income").   The Commissioner's

exercise of authority under section 446(b) is given "much

latitude" and cannot be disturbed unless "clearly unlawful".

Thor Power Tool Co. v. Commissioner, 439 U.S. at 532-533; Lucas

v. American Code Co., 280 U.S. 445, 449 (1930); see also United

States v. Catto, 384 U.S. 102 (1966); Schlude v. Commissioner,

372 U.S. 128, 133-134 (1963); American Auto. Association v.

United States, 367 U.S. 687, 697-698 (1961); Automobile Club of
                               - 31 -

Mich. v. Commissioner, 353 U.S. 180, 189-190 (1957); Brown v.

Helvering, 291 U.S. 193, 203 (1934).    Taxpayers challenging the

Commissioner's authority must prove that the Commissioner's

determination is "clearly unlawful" or "plainly arbitrary".

Thor Power Tool Co. v. Commissioner, supra at 532-533.    The

Commissioner's authority under section 446(b) encompasses overall

methods of accounting, as well as specific methods utilized to

report any item of income or expense.    Id. at 531; Ford Motor Co.

v. Commissioner, 102 T.C. at 100; Prabel v. Commissioner, 91 T.C.

1101, 1112-1113 (1988), affd. 882 F.2d 820 (3d Cir. 1989); sec.

1.446-1(a), Income Tax Regs.

      The fact that the Commissioner possesses broad authority

under section 446(b) does not mean that the Commissioner can

change a taxpayer's method of accounting with impunity.    See,

e.g., Prabel v. Commissioner, supra at 1112-1113.    Thus, for

example, if a taxpayer uses a method of accounting that clearly

reflects income, the Commissioner may not require a change to

another method merely because the Commissioner believes that the

latter method will reflect income more clearly.     Ansley-Sheppard-

Burgess Co. v. Commissioner, 104 T.C. 367 (1995); Auburn Packing

Co. v. Commissioner, 60 T.C. 794 (1973); Garth v. Commissioner,

56 T.C. 610 (1971); see also St. James Sugar Co-op, Inc. v.

United States, 643 F.2d 1219 (5th Cir. 1981); Photo-Sonics, Inc.

v. Commissioner, 357 F.2d 656, 658 (9th Cir. 1966), affg. 42 T.C.

926 (1964); Bay State Gas Co. v. Commissioner, 75 T.C. 410, 417
                               - 32 -

(1980), affd. 689 F.2d 1 (1st Cir. 1982).   Likewise, we have

allowed the use of an accounting method that was challenged by

the Commissioner, when the taxpayer's method clearly reflected

income and the Commissioner's method did not.   See Rotolo v.

Commissioner, 88 T.C. 1500, 1514 (1987).    We also have allowed

the consistent application of accounting methods that were

authorized by the Code or the underlying regulations.   See RLC

Indus. Co. & Subs. v. Commissioner, 98 T.C. 457, 491-492 (1992),

affd. 58 F.3d 413 (9th Cir. 1995).

        When a taxpayer challenges the Commissioner's authority

under section 446(b), we inquire whether the accounting method in

issue clearly reflects income.    The answer to this question does

not hinge on whether the taxpayer's method is superior to the

Commissioner's method, or vice versa.    Id. at 492; see also Brown

v. Helvering, supra at 204-205.    Instead, the answer must be

found by analyzing the unique facts and circumstances of the

case.   Ansley-Sheppard-Burgess Co. v. Commissioner, supra;

Peninsula Steel Prods. & Equip. Co. v. Commissioner, 78 T.C.

1029, 1045 (1982).

        Although it is not dispositive of our analysis, we believe

that a critical fact to consider is whether the taxpayer is

consistently utilizing a recognized method of accounting that

comports with GAAP, and that is prevalent in the industry.

See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354

(1st Cir. 1970), affg. T.C. Memo. 1969-79; RLC Indus. Co. & Subs.
                                - 33 -

v. Commissioner, supra at 490.    We recognize that the treatment

of an item for financial accounting and Federal income tax

purposes does not always mesh, and that an accounting method that

is acceptable under GAAP may be unacceptable for Federal income

tax purposes because it does not clearly reflect income.       Thor

Power Tool Co. v. Commissioner, supra at 538-544; see also

Hamilton Indus., Inc. v. Commissioner, 97 T.C. 120, 128 (1991);

UFE, Inc. v. Commissioner, 92 T.C. 1314, 1321 (1989); Sandor v.

Commissioner, 62 T.C. 469, 477 (1974), affd. 536 F.2d 874 (9th

Cir. 1976); Peninsula Steel Prods. & Equip. Co. v. Commissioner,

supra.    All the same, the regulations under section 446(b)

contemplate that a method of accounting "ordinarily" will clearly

reflect income when it "reflects the consistent application of

generally accepted accounting principles in a particular trade or

business in accordance with accepted conditions or practices in

that trade or business".    Sec. 1.446-1(a)(2), Income Tax Regs.

         In this regard, we believe that the instant case falls

within the contemplation of section 1.446-1(a)(2), Income Tax

Regs.    Petitioners consistently calculated their shrinkage

estimates under a methodology that comported with GAAP.    Under

this methodology, they generally estimated shrinkage every month

based on a 3-year rolling average, which was revised after every

actual count.    They adjusted any prior under- or over-estimate of

shrinkage each time they counted their inventory so that their
                                - 34 -

books and records reflected the amount of inventory on hand as

verified by the count.

      A comparison of the total annual shrinkage recorded in

petitioners' books (booked shrinkage) to the total shrinkage

verified by actual count (verified shrinkage) during each of the

years demonstrates that petitioners' method of estimation was

reasonable.   The following table compares booked shrinkage as a

percentage of sales for the annual accounting period to verified

shrinkage as a percentage of sales for the period between the

physical inventory and the immediately preceding physical

inventory.

                 Shrinkage as a Percentage of Sales

      Year            Booked               Verified

      1983               1.47                1.48
      1984               1.11                1.06
      1985               1.36                1.37
      1986               1.00                1.00

Although this comparison matches shrinkage for the physical

inventory cycle to shrinkage for the taxable year, which is a

different period, we believe that this comparison is appropriate

under the facts herein.    Both periods cover the period from the

beginning of the taxable year to the physical inventory dates,

and both amounts of shrinkage relate to sales for the period over

which the shrinkage is measured.    Moreover, the combination of

the monthly estimates for the period from the beginning of the

taxable year to the physical inventory date, taking into account

the adjustments made at the time of the physical counts, reflects
                               - 35 -

the actual shrinkage for the year through the physical inventory

date.   For the period from the beginning of the year to the date

of the physical inventory, the estimated shrinkage combined with

the part of the physical inventory adjustment attributable to the

current year was the amount of actual shrinkage for that period

as verified by the physical count.      This was so without regard to

any difference between the shrinkage estimate and the actual

shrinkage for the period.

        We recognize that the period over which petitioners'

shrinkage can be known with a higher degree of certainty is the

period from physical inventory to physical inventory; i.e., this

is the period over which the amount of shrinkage can be verified

by physical count.   Any analysis of this period alone, however,

is inappropriate because it ignores an important part of

petitioners' method of accounting; namely, the adjustment that is

made on the last day of that cycle when the book inventory is

adjusted to the physical count.   Yet, if this adjustment is made,

the analysis is unhelpful to us in determining the reasonableness

of the stub period shrinkage estimate because, at the time of the

physical count, petitioners' method of accounting is as precise

as the physical count.   Accordingly, any analysis of the physical

inventory cycle alone either ignores a fundamental part of

petitioners' method of annual accounting (i.e., the reconciling

adjustment booked at the time of the physical count) or shows

that the method is accurate at the time of the physical count.
                              - 36 -

Neither of these analyses properly evaluates the stub period

estimate.

      By comparing the unadjusted results from physical

inventories to the adjusted book amounts, the verification

provided by the physical counts helps test the overall accuracy

of petitioners' entire method of accounting for shrinkage, as it

affects petitioners' inventory balances and annual determination

of income.   As shown in the above table, petitioners' shrinkage

adjustment to inventories for each taxable year reasonably

represents the amount of shrinkage verified by physical counts

taken in the same year.   In the 1986 taxable year, the numbers

are the same.   In the 1983 and 1985 taxable years, the numbers

are within .0001 percent.   In both 1983 and 1985, the amounts

booked were less than the amount verified by the physical counts.

Only in the 1984 taxable year did the amount booked exceed the

amount verified by physical count, and that overstatement was

only .0005 percent.   These modest differences indicate that

petitioners' method of accounting for shrinkage produced

reasonable results.   Respondent's determination, by contrast,

would have petitioners omit shrinkage estimates for the subject

years in the respective amounts of $33.6 million, $40.2 million,

$62.1 million, and $67.9 million.

      The second way in which the reasonableness of petitioners'

shrinkage estimates can be seen is by understanding the

relationship between shrinkage and sales.   Respondent relies on
                                - 37 -

Dr. Fienberg's testimony to argue that such a relationship does

not exist.    We do not find this testimony to be persuasive.       We

read the record to support a finding of a relationship between

shrinkage and sales under which a store's shrinkage will increase

or decrease in accordance with its sales.      An increase in sales,

for example, results in an increase in purchases, and, as

purchases rise, so do the goods lost in shipment or through

paperwork errors.    An increase in sales results in more inventory

being placed on the shelves for sale, and, as the shelf inventory

increases, so do the goods lost through breakage, theft, and

erroneous price changes.    An increase in sales results in greater

customer traffic in the store, and, as more customers enter the

store, the ratio of sales personnel to customers declines, making

it more difficult to detect theft.       An increase in sales results

in the employment of additional sales personnel, and, as sales

personnel increase, so does employee theft.

         With this relationship in mind, we find that the

reasonableness of petitioners' shrinkage estimates is seen

further by comparing:    (1) The retail value of shrinkage

estimates for the stub period to the verified shrinkage for the

same period and (2) the individual stub period estimates to the

shrinkage that was attributable to the stub period and that was

verified by a physical count in the next year.9      The verified


     9
       We compare the following year's physical inventory because
stub period shrinkage is verified through physical inventories
                                                   (continued...)
                                         - 38 -

shrinkage in the stub period can be fairly approximated by

multiplying the verified shrinkage by the ratio of (i) stub

period sales to (ii) sales for the entire physical inventory

cycle.      The following table shows this analysis:

               Verified Shrinkage Allocable to Stub Period
                           (in thousands of dollars)
Stub period sales
                    1983       1984           1985         1986         Total

  Parent      $2,394,894   $3,207,316   $4,147,484 $5,457,379        $15,207,073
  Kuhn's         230,542      299,992      353,714     424,967         1,309,215
  Edwards        112,265      150,491     157,650      182,945           603,351
    Total      2,737,701    3,657,799   4,658,848    6,065,291        17,119,639
Sales between physical inventories that include stub period

                    1983       1984           1985         1986         Total

  Parent       $4,084,989   $5,063,087     $6,951,462   $8,908,722   $25,008,260
  Kuhn's          389,005      465,129        551,540      656,671     2,062,345
  Edwards         190,890      244,489        266,793      296,036       998,208
    Total       4,664,884    5,772,705      7,769,795    9,861,429    28,068,813


Stub period sales as percent of sales between physical inventories

               1983         1984           1985         1986         Total

  Parent       58.6         63.3           60.0         61.3         60.8
  Kuhn's       59.3         64.5           64.1         64.7         63.5
  Edwards      58.8         61.6           59.1         61.8         60.4
  Overall      58.7         63.4           60.0         61.5         61.0


Total verified shrinkage

                 1983         1984           1985          1986        Total

  Parent       $40,663      $67,543        $68,542      $ 99,253     $276,001
  Kuhn's         5,532        8,159          6,100         7,302       27,093
  Edwards        3,298        3,558          3,353         4,312       14,521
    Total       49,493       79,260         77,995       110,867      317,615




      9
      (...continued)
taken in the following period. For example, the physical
inventory results for the stub period that ended Jan. 31, 1984,
were reflected in the physical inventories taken in the 1984
taxable year.
                                      - 39 -
Verified shrinkage allocated to stub period on basis of percent of sales in stub
period

                1983        1984          1985       1986         Total

  Parent      $23,829     $42,755       $41,125    $60,842      $168,551
  Kuhn's        3,280       5,263         3,910      4,724        17,177
  Edwards       1,939       2,191         1,982      2,665         8,777
    Total      29,048      50,209        47,017     68,231       194,505

We now compare the stub period estimates for each year to the

verified shrinkage allocable to the stub period as it was

reflected in the previous table.

      Comparison of Verified Shrinkage to Shrinkage Estimates
                      (in thousands of dollars)
Verified shrinkage allocated to stub period on basis of percent of sales in stub
period

                1983        1984          1985       1986         Total

  Parent      $23,829     $42,755       $41,125    $60,842      $168,551
  Kuhn's        3,280       5,263         3,910      4,724        17,177
  Edwards       1,939       2,191         1,982      2,665         8,777
    Total      29,048      50,209        47,017     68,231       194,505

Stub period shrinkage estimated

                1983        1984          1985       1986         Total

  Parent      $27,983     $33,996       $54,178    $60,197      $176,354
  Kuhn's        4,059       4,056         5,777      5,339        19,231
  Edwards       1,556       2,151         2,185      2,364         8,256
    Total      33,598      40,203        62,140     67,900       203,841

Over (Under) Estimated

                1983        1984          1985       1986         Total

  Parent      $4,154       $(8,759)     $13,053    $(5,707)      $2,741
  Kuhn's         779        (1,107)       1,867        615        2,154
  Edwards       (383)          (40)         203       (301)        (521)
    Total      4,550        (9,906)      15,123     (5,393)      (4,374)

        As illustrated in the second table, our retrospective

allocation of the shrinkage verified by physical count results in

higher or lower shrinkage for each stub period than the shrinkage

estimates at issue herein.          We believe that this should be

expected, however, because Wal-Mart did not have the benefit of
                                     - 40 -

hindsight in estimating shrinkage.            It also did not have the

results of the subsequent inventories that are used in this

comparison when it made its estimates.            All the same, we believe

that our comparison of Wal-Mart's estimates with those made with

the benefit of hindsight helps demonstrate that Wal-Mart's method

is reasonable.      Wal-Mart's estimation procedure resulted in

Parent's stores underestimating shrinkage in 2 years (1984 and

1986) and overestimating shrinkage in 2 years (1983 and 1985).

Similarly, Kuhn's and Edwards underestimated shrinkage in some

years and overestimated shrinkage in other years.

           We conclude that Wal-Mart's shrinkage estimates clearly

reflect income, and that Wal-Mart has met the second prong of our

two-prong test.      We so hold.10    Because respondent has determined

to the contrary, we reverse her determination.

IV.        Sam's

           The correlation of shrinkage to sales supports Sam's use

of estimates.      The reasonableness of Sam's shrinkage estimates

for the 1985 and 1986 taxable years is evident from the data.

During those years, petitioners verified shrinkage through the

physical inventories of Sam's in the amount of $5.236 million.

Over the same period, Sam's recorded sales of $1.912 billion.

Thus, Sam's shrinkage for the 2-year period was approximately

.27 percent of sales, or slightly higher than the .2-percent rate



      10
       We note that Dr. LaRue has not persuaded us that we
should hold otherwise.
                               - 41 -

actually used.   We conclude that Sam's shrinkage estimates were

permissible, and we so hold.

      In reaching all of our holdings herein, we have considered

all arguments made by respondent for contrary holdings and, to

the extent not discussed above, find them to be irrelevant or

without merit.

      To reflect the foregoing,

                                          Decision will be entered

                                        under Rule 155.
