The increased importance of inventory valuations in purchase price allocations.

By providing that most acquired intangible assets are to be amortized over a 15-year period, Sec. 197 has simplified purchase price allocations and eliminated the need to estimate the fair market value (FMV) of most individual intangible assets. Enactment of Sec. 197, however, has increased the relative importance of the valuation of tangible assets, such as machinery and equipment, building components and inventory. An inventory valuation potentially can increase the amount of purchase price allocated to acquired inventory, which is a short-lived asset (generally, less than one year), and accelerate the write-off of the purchase price.

Inventory valuations typically result in inventory write-ups from book value. Inventory is a "short-lived asset"; any write-up to the inventory on acquisition typically is included in cost of goods sold and offsets income in the first year following purchase. Rev. Proc. 77-12, setting forth inventory valuation guidelines for use by taxpayers and the IRS, applies when assets of a business that has inventory items are purchased.

Comment: The basis of inventory acquired in an acquisition will offset the revenue recognized on its disposition as cost of goods sold; the higher the inventory valuation, the greater the cost of goods sold deduction available. However, taxpayers will not be able to use a LIFO inventory election to prevent the higher income recognition attributable to a bargain purchase of inventory; see Hamilton Industries, 97 TC 9 (1991).

Rev. Proc. 77-12 provides three methods to value inventory: (1) the comparable sales approach, (2) the cost of reproduction approach and (3) the income approach. Each approach uses an estimate of book value of the inventory in the calculations.

* The comparable sales approach uses the inventory's expected selling price to customers of the business as the basis for its determination of FMV. The selling price of the finished goods inventory is estimated by using the inventory's book value and the expected gross margin to be achieved when the inventory is sold in the normal course of the business's ongoing operations. Consideration is given to expenses associated with the sale of the inventory, i.e., costs of disposition (such as applicable discounts, freight and shipping charges) and sales commissions. The period of time associated with "turning" the inventory and collecting the receivables associated with the sale also must be studied. Some profit commensurate with the risk involved in holding the inventory for the period of time until cash is collected should be included.

* The cost of reproduction approach involved an analysis of the expenses incurred in getting the inventory to its present condition with regard to salability. The original purchase price of the raw materials and all expenses associated with transforming these raw materials into work-in-process and finished goods are analyzed and accumulated, to get an indication of the cost or "effort" required to perform the process again and to replace or reproduce the asset with inventory of like utility. The biggest component of the cost of reproduction typically is the costs captured by normal accounting procedures to arrive at the inventory's book value. Additional expenses, such as ordering, distribution, processing and inventory management, also are included to estimate the inventory's FMV. Holding period costs, which consider inventory turns or production time, as well as the required rate of return, are also estimated.

Note: The Service has taken the position, in an Industry Specialization Program paper, that the cost of reproduction approach, rather than comparable sales, should be used in valuing retailers' acquired inventory. However, in Nestle Holdings, TC Memo 1995-441, the Tax Court held that the taxpayer correctly valued inventory acquired in a Sec. 338(h) (10) transaction from a manufacturing company target using the comparative sales approach, rejecting the IRS's position that the cost of reproduction approach was required.

* The income approach is used for inventory items expected to generate income over a multi-year period in the future. It is used only infrequently for typical inventory valuations (since inventory generally turns in less than one year).