Over the course of a recession, corporate inventories tend to accumulate, particularly at companies that were unsuccessful in accurately forecasting the (depressed) level of demand for their products. Accordingly, under generally accepted accounting principles (GAAP) — which normally requires the use of historical cost — a write-down of inventories may be called for to reflect their diminished utility. Further, the existing rule may require the write-down to be recorded at cost or market, whichever is lower.
In general, for financial accounting purposes, the concept of “market” means “replacement cost.” However, market should not exceed “net realizable value” (the estimated selling price minus the direct costs of disposing of the inventory), nor should it be less than the net realizable value reduced by an allowance for a “normal profit margin.”
Of course, a write-down of inventory will have the collateral effect of depressing earnings. This is so because the “cost of goods sold” figure, which appears on the income statement and is used to determine gross profit, essentially is a residual figure. It is calculated by subtracting ending inventory from the sum of the entity’s beginning inventory, plus costs incurred to acquire and manufacture inventory during the period.
That means that the lower the ending inventory balance, the greater the cost of goods sold with the result that earnings will be penalized. Indeed, this reduction in earnings is desirable for tax purposes, and the tax accounting system recognizes the validity of the lower of cost or market approach to valuing inventories. However, to sustain a write-down for tax purposes, the taxpayer must present persuasive evidence that the market value of the inventory items has diminished to a level below its cost. This burden of proof will be particularly difficult to sustain in cases in which the taxpayer retains the items in inventory and does not “scrap” them.
These lessons were learned nearly 30 years ago as a result of the decision rendered by the Supreme Court in a case entitled Thor Power Tool Co. v. Commissioner, 439 US 522 (1979). These lessons are just as relevant today as they were then.
In 1964, and under new management, Thor Power Tool Co. wrote down what it regarded as “excess inventory” to net realizable value in accordance with GAAP. The write-down produced a loss for tax purposes and the ensuing net operating loss (NOL) was carried back by Thor to secure refunds of taxes it had paid in prior years.
At all times, Thor had used the lower of cost or market method of valuing inventories. The write-down was precipitated by the new management’s belief that Thor’s inventory was “overvalued.” In fact, management wrote-off some $2.75 million of obsolete parts and similar items. The Internal Revenue Service had no quarrel with this particular writeoff because Thor promptly got rid of most of those articles.
Excess inventory, comprised primarily of spare parts, was also written down to net realizable value. However, in this case, Thor did not immediately scrap the articles or sell them at reduced prices. In fact, Thor retained the excess items in inventory and continued to sell them at their original prices. Thor charged the writeoff to an inventory contra account and this charge-off decreased closing inventory, increased cost of goods sold, and ultimately produced a loss for the year in which the write-down occurred. The IRS challenged Thor’s entitlement to the write-down and, eventually, the Supreme Court agreed with the IRS’s position.
Clear Reflection of Income
The Court noted that under Section 446(a) of the tax code, taxable income is computed under the method of accounting that the taxpayer regularly computes his income. However, Section 446(b) provides that if the method used does not clearly reflect income, the computation of taxable income is then made using a method that, in the opinion of the Commissioner, clearly reflects income.
Moreover, Regulation Section 1.446-1(a)(2) provides that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. Section 471 of the code, which deals specifically with the accounting for inventory, establishes two tests to which an inventory method must adhere. The start, the method must be acceptable and conform to GAAP. Perhaps more important, the method must clearly reflect income. (See Regulation Section 1.471-2(a).)
As a result, the Supreme Court noted that it is apparent that Section 446 and Section 471 vest the U.S. Tax Commissioner with “wide discretion” in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income. In this case, the commissioner readily conceded that Thor had satisfied the first part of the two-pronged test: Thor’s method of inventory accounting conformed with GAAP. But did its inventory accounting clearly reflect income? The answer was an unequivocal no.
Thor used, at all times, the lower of cost or market method of inventory accounting. For this purpose, the regulations — as they then existed — defined market as the “current bid price” of the item in the volume in which usually purchased by the taxpayer.1 In turn, current bid price means the “replacement” (or reproduction) cost with respect to the item — essentially the price the taxpayer would have to pay on the open market for the item.
If no such open market exists, the regulations required the taxpayer to ascertain a bid price based upon other objective evidence. Further, the regulations described two situations in which a taxpayer is permitted to value inventory below market. The first is the case in which the taxpayer has actually offered merchandise for sale at prices below replacement cost. The second is the instance in which the merchandise to be valued is “damaged.”
Here, the high court found that Thor’s procedure for writing down excess inventory was patently inconsistent with the “regulatory scheme.” In fact, Thor made no effort to determine the replacement (or reproduction) cost of the excess inventory and, therefore, failed to ascertain the “market” for such inventory.
The court concluded that in seeking to depart from replacement cost, Thor failed to bring itself within either of the authorized exceptions. Most notably, the corporation failed to sell its excess inventory, or even offer it for sale, at prices below replacement cost. Instead, it continued to sell such excess inventory at the original price.
Indeed, Thor failed to prove that its excess inventory came within the statutory conditions. As a result, the court was forced to conclude that Thor’s write-down failed — abjectly — to reflect income clearly and, therefore, the write-down was ignored for tax purposes.
GAAP is not controlling
Thor then contended that an inventory practice that conforms to GAAP (it was undisputed that Thor’s practice so conformed) is presumptively valid for tax purposes. But the Supreme Court did not agree. It concluded that no such presumption is present.
The code and the regulations, the court observed, give the Commissioner “broad discretion” to set aside a taxpayer’s method of accounting if, in his opinion, it does not clearly reflect income. This language , is “clearly at odds with the notion of a presumption in the taxpayer’s favor,” noted the court. The presumption that Thor postulated is insupportable in light of the very different objectives that financial accounting and tax accounting have.
To be sure, the high court said that financial accounting has as its “foundation” the principle of conservatism. By contrast, the goal of the income tax system is the equitable collection of revenue. Quite clearly, understatement of income, the natural outgrowth of conservatism, is not the “guiding light” of the income tax system.
In short, an accountant’s conservatism cannot bind the tax commissioner in his efforts to collect taxes. Accordingly, the fact that an inventory method may be acceptable for financial accounting purposes has absolutely no bearing on its efficacy for tax purposes. In the instant case, the method employed did not — in the commissioner’s judgment — clearly reflect the taxpayer’s income. And in virtually every case, such a determination, will be more than adequate to render the taxpayer’s accounting method unacceptable for tax purposes.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 Under current practice, the term “market’ means the aggregate of the current bid prices that is prevailing at the date of the inventory. The prices take into consideration the basic elements of cost reflected in inventories of goods purchased and on hand, goods in process of manufacture, and finished manufactured goods on hand. The basic elements of cost include direct materials, direct labor, and indirect costs required to be included in inventories under Section 263A of the tax code, and its underlying regulations. (See Regulation Section 1.471-4(a).)