Accounting method change for inventory shrinkage may benefit retailers experiencing thefts

November 2023

In brief

Retailers may be able to use inventory shrinkage reserves determined under US generally accepted accounting principles (GAAP) to account for damage and theft for tax purposes. In light of the recent spike in thefts, a retailer that currently uses the retail safe harbor method to account for inventory shrinkage may benefit from a change in accounting method.

Observation: In the current environment, retailers may benefit from using the GAAP inventory shrinkage method as their tax method to increase the estimated amount of inventory shrinkage included in cost of goods sold and reduce taxable income. As part of this analysis, retailers should examine their other methods of accounting for inventory to identify additional potential opportunities to reduce taxable income.

In detail

Inventory shrinkage is a discrepancy between the inventory in a taxpayer’s records and actual physical inventory on hand, often arising from theft, damage, or bookkeeping errors. A taxpayer determines actual shrinkage by taking a periodic physical count of goods on hand, which typically is done several months before the end of the year. Under GAAP, a taxpayer may maintain a reserve that estimates the inventory shrinkage that occurs between the date of the last physical count and the end of the year – i.e., the “stub period.” Section 472(b) permits a taxpayer to estimate inventory shrinkage if the taxpayer normally takes a physical count of inventories at each location on a regular and consistent basis and makes proper adjustments to account for the difference between estimated shrinkage and actual shrinkage.

Retailers typically compute an inventory shrinkage reserve under GAAP that is based on actual inventory shrinkage for the current year. For tax purposes, many retailers use the retail safe harbor method authorized in Rev. Proc. 98-29 to estimate inventory shrinkage for the stub period. The retail safe harbor method is based on average actual inventory shrinkage for the current tax year and the two preceding tax years. Rev. Proc. 98-29 provides that retailers generally may use any other method of accounting to estimate inventory shrinkage if the method is reasonable and clearly reflects income.

Because of a recent spike in thefts experienced by many retailers, the inventory shrinkage reserve used under GAAP may exceed the estimated inventory shrinkage computed under the retail safe harbor method. Therefore, retailers may have an opportunity to increase cost of goods sold and reduce taxable income by changing from the retail safe harbor method to the GAAP method of estimating inventory shrinkage.

Observation:  In our experience, the IRS generally has accepted a taxpayer’s GAAP inventory shrinkage method as a reasonable tax method that clearly reflects income.

For retailers using the retail safe harbor method, changing to the GAAP method for estimating inventory shrinkage is a nonautomatic method change that would have to be filed by the end of the taxpayer’s tax year, which, for many retailers, is January 31, 2024. However, a retailer that does not claim estimated inventory shrinkage for tax purposes generally would qualify to change its tax method of accounting to the GAAP inventory shrinkage method under the automatic method change procedures.

Observation:  Inventory shrinkage may be taken into account under either a first-in, first-out (FIFO) or last-in, first-out (LIFO) method because estimated shrinkage measures a loss of quantity, not a loss in value -- which would be impermissible under LIFO.

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Ed Geils

Ed Geils

Global and US Tax Knowledge Management Leader, PwC US

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