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Tax Court introduces financial statement materiality into the tax law.

Three recent Tax Court decisions addressed whether a retailer could employ an estimate of inventory shrinkage in determining its ending inventory for tax purposes. Two of these cases, Wal-Mart Stores, TC Memo 1997-1, and The Kroger Co., TC Memo 1997-2, were decided in favor of the taxpayer; the third case, Dayton-Hudson Corp., TC Memo 1997-260, was decided in favor of the IRS. Estimated inventory shrinkage has been a controversial area for a number of years and these Tax Court decisions reinforce the notion that very specific fact patterns often drive the outcome.

If upheld on appeal, the Wal-Mart decision will introduce financial statement materiality into the tax law. The reasoning in Wal-Mart that involved generally accepted accounting principles (GAAP) was premised on an incorrect interpretation of the meaning of an independent auditor's unqualified audit opinion. This item focuses on that reasoning, discusses the meaning of an unqualified audit opinion and summarizes the implication of Wal-Mart for the accounting profession.

The Wal-Mart Case

Wal-Mart accrued an estimate of inventory shrinkage for both financial reporting ("book") and tax purposes. For book purposes, the accrual of estimated shrinkage is a common, if not mandatory, practice. In contrast, the Service has routinely disallowed accruals of estimated shrinkage for tax purposes. The IRS position has been that Regs. Sec. 1.471-2(d) does not permit an accrual of shrinkage until confirmed by a physical inventory. (With new Sec. 471(b) in the Taxpayer Relief Act of 1997, the Service's position is moot for tax years ending after Aug. 5, 1997.)

More specifically, the issue in Wal-Mart was whether a taxpayer that cycle counted its inventories (i.e., took physical inventories not at year-end) could accrue an estimate of inventory shrinkage for the periods between its most recent physical inventories and year-end ("stub periods"). In disallowing Wal-Mart's accrual for estimated shrinkage, Tax Court Judge Laro held that the Service had abused its Sec. 446(b) discretion because Wal-Mart's inventory accounting practice was "sound," the standard for taxpayers with perpetual inventories under Regs. Sec. 1.471-2(d). Judge Laro found that, following Sec. 471(a) and Regs. Sec. 1.471-2(a), (1) Wal-Mart's accounting for inventories conformed as nearly as may be to the best accounting practice in its trade or business; and (2) clearly reflected its income. It is important to note that GAAP is usually the standard employed to determine whether the "best accounting practice" has been employed and whether a particular accounting method produces a "clear reflection" of income (Regs. Sec. 1.446-1(a)(2) and -1(c)(1)(ii)(C)).

Judge Laro ruled that Wal-Mart's accounting for estimated shrinkage met the first standard of a "sound" inventory accounting system (i.e., it reflected the "best accounting practice") because it conformed with GAAP. Significantly, Judge Laro held that Wal-Mart's methodology conformed with GAAP because Wal-Mart received an unqualified audit opinion from its independent auditors, Ernst & Young (E&Y).

...[Wal-Mart's] financial statements were certified by E&Y as conforming to GAAP without qualification.

[The IRS] challenges the accuracy of the [taxpayers'] financial statements and contends that E&Y's certification does not pertain to the estimates of shrinkage. We disagree. Each of the [financial] 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 [taxpayers] in conformance with GAAP. [The IRS] 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 [the taxpayers'] estimates of inventory shrinkage were improper. We will not do so. We do not find that [the taxpayers'] inventory accounting method was out of compliance with GAAP.

Having detailed his notion of the significance of an unqualified audit opinion in analyzing whether Wal-Mart had employed the "best accounting practice" in estimating shrinkage, Judge Laro then held that Wal-Mart met the second standard of a "sound" inventory system (i.e., its method of estimating shrinkage produced a "clear reflection" of income), because Wal-Mart "consistently calculated their shrinkage estimates under a methodology that comported with GAAP."

Literally interpreted, Judge Laro's statements involving GAAP mean that an unqualified audit opinion is a guarantee or warranty (a "certification") that all of the accounting methods used to prepare the financial statements on which the audit opinion was rendered were in conformity with GAAP. Such an interpretation involves a serious mistake of fact, and the Tax Court's reference to E&Y's unqualified audit opinion as a"certification" reflects a common (and very serious) misunderstanding. In fact, an auditee can depart from GAAP in preparing its financial statements and, if such departure is not "material," receive an unqualified opinion from its independent auditors.

Note that the adequacy or professional caliber of the Wal-Mart audits performed by E&Y is not at issue. Based on the facts presented, E&Y's unqualified audit opinions on Wal-Mart's financial statements seem appropriate. However, Judge Laro's interpretation of the tax implications of an unqualified audit opinion must be questioned.

What Is GAAP?

Judge Laro apparently did not recognize that a professional auditing standard is devoted to the question of the meaning of "present fairly in conformity with generally accepted accounting principles in the independent; auditor's report." Statement on Auditing Standards (SAS) No. 69 defines GAAP as:

a technical accounting term that encompasses the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. It includes not only broad guidelines of general application, but also detailed practices and procedures.... Those conventions, rules, and procedures provide a standard by which to measure financial presentation.

SAS No. 69 established a five-tier hierarchy of GAAP. The five tiers, arranged from the highest to lowest level, are as follows:

* Statements and Interpretations of the Financial Accounting Standards Board (FASB), Opinions of the Accounting Principles Board (APB) and Accounting Research Bulletins of the American Institute of Certified Public Accountants (AICPA).

* FASB Technical Bulletins, AICPA Industry Audit and Accounting Guides and AICPA Statements of Position.

* Consensus Positions of the FASB Emerging Issues Task Force (EITF) and AICPA Practice Bulletins.

* AICPA Accounting Interpretations, Q&As published by the FASB staff, and industry practices widely recognized and prevalent.

* Other accounting literature (e.g., FASB Concept Statements and APB Statements).

Rule 203 of the AICPA's Code of Professional Conduct stipulates that an auditor cannot express an unqualified opinion on financial statements if those statements contain a material departure from GAAP. As established in SAS No. 69, Rule 203 refers to only the four highest levels of GAAP.

Most importantly, the definition of GAAP in SAS No. 69 does not depend on the concept of materiality. SAS No. 69 does indicate that an independent auditor's judgment concerning the "fairness" of the overall presentation of the financial statements should be based on his judgments as to whether those financial statements are within "the framework of GAAP," and it recognizes that materiality considerations are inherent in these judgments. Thus, the definition of accounting practices that constitute GAAP is not affected by materiality considerations; however, the auditor's judgment of what constitutes "fair" presentation in the financial statements is affected by materiality, as well as by GAAP.

To illustrate this somewhat subtle difference, consider the following example. A new firm elects to use a tax-basis depreciation method for its financial statements. Tax-basis depreciation methods are not considered to be GAAP, because they are not included in any of the five levels of the GAAP hierarchy. However, an auditor could justifiably issue an unqualified opinion on the firm's financial statements, if the resulting presentation of depreciation and related items within those statements was materially the same as they would have been based on an acceptable GAAP method (such as an accelerated method). Thus, while the method used is not considered to be GAAP, it is acceptable for financial statement purposes, if not materially different from a GAAP method.

In contrast, Judge Laro's Wal-Mart decision equates the unqualified audit opinions rendered on Wal-Mart's financial statements as a"certification" that all of the accounting methods used in those statements were in conformity with GAAP. Thus, the Wal-Mart decision essentially allows the financial accounting concept of "materiality" to be a determining factor in ascertaining whether a tax accounting method is a "best accounting practice" or "clearly reflects" income for tax purposes. If allowed to stand,Judge Laro's approach introduces a new, more liberal (and unwarranted) standard into the tax law.

Tax Accrual Standards and Thor Power Tool

With few exceptions, the tax law is adverse to estimates. The basic accrual standards for a deduction, cost or expense--Regs. Sec. 1.446-1(c)(1)(ii)--indicate that the "liability" needed to support the deduction, cost or expense for tax purposes is present when (1) all events that establish the fact of liability have occurred; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability. These are not absolutes; reasonable persons can (and do) differ as to what constitutes "reasonable accuracy."

While Judge Laro correctly cites Thor Power Tool Co., 439 US 522 (1979), for the proposition that the "`best accounting practice in the trade or business' is synonymous with GAAP," he failed to consider what Thor Power had to say about estimates. The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public fisc. Consistently with its goals and responsibilities, financial accounting has as its foundation the principle of conservatism, with its corollary that "possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets." In view of the Treasury's markedly different goals and responsibilities, understatement of income is not destined to be its guiding light.

... Financial accounting, in short, is hospitable to estimates, probabilities, and reasonable certainties; the tax law, with its mandate to preserve the revenue, can give no quarter to uncertainty. This is as it should be. [Footnotes omitted.]

The Service's disapproval of estimated inventory shrinkage is certainly consistent with the reluctance that Thor Power expressed about allowing estimated tax deductions.

Implications for the Accounting Profession

While Judge Laro dealt specifically with the acceptability of Wal-Mart's estimated inventory shrinkage, the logic underlying this decision has substantial and far-reaching implications. This decision obscures the traditional definition of what constitutes GAAP and, in addition, introduces financial statement materiality into the tax law. It expands what is allowable for tax purposes in that the treatment of specific items of revenue and expense is of no consequence, as long as the financial statements in which those items appear "present fairly," and are, in all "material respects," in "conformity with GAAP." The implication of Wal-Mart is that if an accounting practice is acceptable for financial statements that have received an unqualified audit opinion, that practice would meet the "best accounting practice" and"clear reflection of income" standards for tax purposes. If this interpretation is allowed to stand, it will represent a dramatic expansion of the concept of permissible tax practices and could apply to a wide variety of issues.

From Dennis J. Gaffney, PH.D., CPA, Professor of Accounting, and Diana R. Franz, PH.D., CPA, Assistant Professor of Accounting, University of Toledo, Toledi, Ohio, and Maureen H. Smith, PH.D., Consultant, Okemos, Mich. (not affiliated with AFAI)
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Author:Smith, Maureen H.
Publication:The Tax Adviser
Date:Dec 1, 1997
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