All-Steel Equip. Inc. v. Comm'r of Internal Revenue

• Decision Date: 30 September 1970
• Docket Number: Docket No. 2805-66.
• Citation: 54 T.C. 1749
• Parties: ALL-STEEL EQUIPMENT INC., PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

54 T.C. 1749

ALL-STEEL EQUIPMENT INC., PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 2805-66.

United States Tax Court

Filed September 30, 1970.

Arthur E. Bryan, Jr., Don S. Harnack, and James M. Roche, for the petitioner.

Nelson E. Shafer, for the respondent.

The petitioner consistently valued its inventory by use of the prime cost method including in inventory only the cost of direct labor and materials. The respondent determined that such method did not clearly reflect the petitioner's income and that its inventory should be valued by use of the full absorption method. Held (1) the petitioner's method of accounting did not clearly reflect its income; and (2) the respondent did not abuse his discretion in requiring the petitioner to value its inventory by use of the full absorption method.

SIMPSON, Judge:

The respondent determined deficiencies in the petitioner's income taxes of $212,842.90 for the taxable year 1962 and $36,547.03 for the taxable year 1963. Some of the issues have been settled, and the only question remaining for decision is whether the respondent erred in revaluing the petitioner's opening and closing inventories to include therein an allocable portion of indirect manufacturing expenses.

FINDINGS OF FACT

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

The petitioner is an Illinois corporation which had its principal office in Montgomery, Ill., at the time its petition was filed in this case. The general method of accounting employed by the petitioner in keeping its books and records and preparing its Federal income tax returns is and has been the accrual method. It timely filed its 1962 and 1963 Federal income tax returns with the district director of internal revenue, Chicago, Ill.

The petitioner is engaged in the metal fabricating business. It was incorporated and commenced business in 1912. Initially, its product lines consisted of electrical cutout boxes and shop tote boxes. Over the years, the petitioner's business has expanded both as to volume and product lines. In 1962 and 1963, the petitioner's business consisted generally of the manufacture and sale of metal office furniture. The office furniture lines included office desks, credenzas, bookcases, chairs, storage cabinets, filing cabinets, and lockers.

In computing its income for financial reporting and Federal income tax purposes, the petitioner has used inventories at least since 1928. Its inventories have consistently been valued by use of a ‘prime cost’ method and reflect only direct labor and materials, but no manufacturing overhead. It had been audited by the respondent for all years since 1916, except for the years 1928 and 1951, and its use of the prime cost method for valuing its inventories was not challenged until the issuance of the notice of deficiency with respect to 1962 and 1963.

The petitioner's books have been audited by reputable independent accounting firms since 1933. None of the reports issued as a result of such audits concluded that the use of prime costing prevented the petitioner's financial statements from fairly presenting its financial condition and the results of its operations. The reports for the years 1959 through 1965 indicate that the accounting firm then conducting the audits, Peat, Marwick, Mitchell & Co., felt that the use of the prime costing method of valuing inventories was not in accordance with generally accepted accounting principles, but that its application by the petitioner did not result in any significant accounting error. Each of the reports before us disclose that the petitioner included no overhead items in its inventory valuation.

For the year 1962, the books and records and the tax return of the petitioner showed an opening inventory of $3,734,480.16 and a closing inventory of $3,631,037.08. For the year 1963, its opening inventory was $3,631,038.08, and its closing inventory was $4,491,806.26. The respondent in his notice of deficiency determined that the use of the prime cost method for valuing such inventories did not clearly reflect the petitioner's income for such years. He determined that the costs of such inventories should include an allocable portion of all manufacturing expenses. To compute the portion of such expenses allocable to closing inventories, he first ascertained the amount of direct labor included in the cost of goods produced during the year. He then computed the amount of indirect manufacturing expense that should be allocated to the production of goods. The amount of such indirect expense was divided by the amount of such direct labor to determine the ‘Overhead Ratio.’ Such ratio was then applied to the amount of direct labor cost included in the inventory on hand at the end of the year, and such result was added to the costs of such inventory. As a result of these computations, he increased the costs of the closing inventory for 1962 by $494,637.99 and the closing inventory for 1963 by $604,450.78.

In his determination, the respondent included in the manufacturing expenses to be allocated to the costs of inventory some items which he now concedes should have been totally or partially excluded. These items appeared in the petitioner's manufacturing ledger, but the respondent now concedes that they are properly allocable to general overhead, selling, warehousing, or other nonmanufacturing activities.

OPINION

Gross income, in a merchandising or manufacturing business, means total sales less cost of goods sold. Sec. 1.61-3(a), Income Tax Regs. The cost of goods sold during a year is determined by subtracting the cost of inventory on hand at the end of the year from the total of the cost of inventory on hand at the beginning of the year and the cost incurred during the year in acquiring new inventory.¹ Schedule A, Form 1120. The cost of inventory on hand at the end of a year becomes the cost of opening inventory for the next succeeding year. Thus, if an expense is properly allocable to the costs of acquiring the inventory on hand at the end of the year, it is not deductible in the year it is incurred; in effect, the expense is deferred until the year in which such inventory is sold. On the other hand, if the expense is not considered part of inventory cost, it ordinarily is currently deductible in accordance with the general method of accounting of the taxpayer. In this case, we have an interesting question of whether certain overhead expenses are currently deductible or whether such expenses should be allocated to inventories and deferred until a later year.

The initial question to be decided is whether any change should be made in the petitioner's method of valuing its inventory. The respondent contends that, since the petitioner's method of valuing inventory, which included only the cost of direct labor and materials, was not in accordance with either generally accepted accounting principles or applicable Income Tax Regulations, the use of such method did not clearly reflect income, and therefore, he is authorized to require the use of a different method. On the other hand, the petitioner's position is that, irrespective of whether its method of valuing inventory conforms, in the abstract, to the general principles of accounting and to the Income Tax Regulations, such method has been consistently used, has not resulted in any material errors, and therefore clearly reflected income for the year 1962 and 1963. Accordingly, the petitioner contends that under section 446 of the Internal Revenue Code of 1954,² the respondent was not authorized to change its method of accounting. See Glenn v. Kentucky Color & Chemical Co., 186 F.2d 975 (C.A. 6, 1951); Fort Howard Paper Co., 49 T.C. 275(1967); Sam W. Emerson Co., 37 T.C. 1063(1962).

Section 446(a) and (b) provides:

(a) GENERAL RULE.— 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.

(b) EXCEPTIONS.— If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary or his delegate, does clearly reflect income.

Section 471 provides:

Whenever in the opinion of the Secretary of his delegate 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 or his delegate 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.

First, it is quite clear that the petitioner's method of valuing its inventory, the prime cost method, does not, in the abstract, clearly reflect income.

Prime costing is not considered a generally accepted accounting principle for purposes of commercial accounting. Although we heard some testimony that prime costing was an acceptable method of accounting for the cost of inventory at the time the petitioner commenced to use such method, the first official pronouncement on the question by the American Institute of Certified Public Accountants was published in 1947 and is not contained in Accounting Research Bull. No. 43(1961). In part, it provides: ‘It should * * * be recognized that the exclusion of all overheads from inventory costs does not constitute an accepted accounting procedure.’ A.R.B. No. 43, p. 29. This provision of A.R.B. No. 43 was reexamined by the AICPA in 1964 and 1965 and was not modified in any way. AICPA, Opinions of the Accounting Principles Board 6 (1965). A principal purpose of the A.R.B.‘s was to encourage some degree of uniformity in accounting practices, and they constitute the most authoritative statement of generally accepted accounting principles. A.R.B. No. 43, p. 8. Additionally, other accounting authorities appear to agree that prime costing is not...