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The Internal Revenue Service's increasing power with the clear reflection of income standard.

Many corporate tax professionals are discovering to their chagrin that the selection of accounting methods for reporting taxable income that meet the requirements of generally accepted accounting principles (GAAP), or that have been previously accepted by the Internal Revenue Service, may no longer be acceptable. The IRS has recently denied the taxpayer's choice of inventory valuation method in three different circumstances by claiming that the taxpayer's method did not clearly reflect income. In all instances, the inventory valuation method was acceptable under GAAP, and in some instances, the inventory valuation method had bee recognized by the Securities and Exchange Commission (SEC) or by the Treasury Regulations. This article documents that the IRS's power with the clear reflection of income standard has increased in recent years, and that the IRS has instituted policies to increase their power even more unless the judiciary or legislature takes steps to limit this authority.

The implications of these decisions for corporate tax professionals are immense. As the disparity between acceptable inventory valuation methods for financial and tax reporting grows, it will become much more costly for firms to correctly report both financial and taxable income. Additionally, as the complexity and ambiguity of meeting federal income tax requirements increases, a decline in the compliance level of firms may result. Noncompliance could flow from mistakes and errors, or from willful noncompliance because of the unreasonableness of the standards. Given the judiciary's willingness to accede to the IRS's aggressive use of the clear reflection of income standard, tax professionals may well have to appeal to legislators to reverse, or at least slow down, this proliferation of increasingly complex rules.

This article reviews the various judicial and legislative directives concerning the clear reflection of income standard. It then delineates the critical elements of the definition of this standard and analyzes the manner in which the courts have been increasing the power of the IRS concerning this standard. Finally, it describes the implications of these decisions for corporate tax professionals.

I. The Clear Reflection of Income Standard

Section 446(a) of the Internal Revenue Code addresses the choice of accounting methods for reporting taxable income, as follows:

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.

Consequently, it appears that corporations should be able to use GAAP for reporting taxable income since GAAP is the standard most corporations adhere to in keeping their books. Nonetheless, section 446(b) provides an exception to this rule if the method used by the taxpayer does not clearly reflect income. In such a case, the IRS has the power to require the taxpayer to use a method which does clearly reflect income.

The phrase "clearly reflect income" means that income should be determined with as much accuracy as the standard methods of accounting permit.(1) Treas. Reg. [section] 1.446-1 elaborates that a method will ordinarily be regarded as clearly reflecting income if two conditions are met: first, the method must reflect the consistent application of GAAP in a particular trade or business in accordance with accepted conditions or practices in that trade or business; and second, all items of income and expense must be treated consistently from year to year.

If the taxpayer's accounting method does not clearly reflect income, the IRS has broad power to reconstruct the income by whatever method seems appropriate, and the taxpayer has the burden of proving that its method does clearly reflect income if it does not wish to accept the IRS's reconstruction.(2) The regulations do not state that accounting methods meeting the requirements of GAAP will always meet the clear reflection of income standard; rather, the regulations aver only that consistently applied GAAP-approved methods will ordinarily" meet the statutory standard.

The specific tax accounting rules for inventories are

provided in section 471(a) of the Code:

Whenever in the opinion of the Secretary 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 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. Treas. Reg. [section] 1.471-2 elaborates that trade customs within an industry should be considered when identifying best accounting practices, and that consistency of application should be given greater weight than any particular method of valuing inventory as long as the method is consistent with the regulations.

Therefore, the method by which inventories are to be valued for determining taxable income must withstand scrutiny at two levels. First, the method must conform to the best accounting practice in the trade or business. Although the phrase "best accounting practice in the trade or business" has not been defined by Congress, the Supreme Court in Thor Power Tool suggested it is a surrogate or proxy for GAAP.(3) Second, the method must clearly reflect income. Most accountants are likely to view these two requirements as one and the same, because the purpose of GAAP is to clearly reflect income. Nevertheless, the IRS has claimed in many circumstances that GAAP does not clearly reflect income, and the courts seem willing to support the IRS in these positions. The result of these decisions has been to increase substantially the power that the IRS wields under section 446(b).

Il. Tog Shop and Thor Power Tool

A. The Tog Shop, Inc.

In 1989, a U.S. District Court in The Tog Shop, Inc. v. United States(4) determined that the inventory accounting method used by Tog to value excess discontinued goods did not clearly reflect income even though the method met the requirements of GAAP. This decision was recently upheld by the U.S. Court of Appeals for the Eleventh Circuit. Tog was a mail-order company that sells ladies fashions. After each selling season, Tog had excess merchandise on hand that was not suitable for inclusion in next year's catalogue. To dispose of this merchandise, Tog opened retail outlet stores. On average, the company sent about 100,000 items a year to these stores. Because of shop wear and changes in style, the merchandise could not be sold at normal selling prices.

For its 1980 and 1981 tax years, Tog elected to use the "lower of cost or market method" and valued the excess inventory at net realizable value, which is the replacement cost of inventory less the direct cost of disposing of it. Tog did not compare cost and market for each individual item in its inventory. Instead, Tog applied a percentage formula to the total inventory, which was classified by age, to determine the value of the merchandise.

Although this inventory valuation method met the provisions of GAAP and was consistently applied as required by Treas. Reg. [section] 1.471-2, the IRS argued that the method did not clearly reflect income. Even though GAAP would allow the valuation of classes of items, the court agreed with the IRS. The only case cited as precedent in Tog was the Thor Power Tool case. To understand the reasons for and implications of the court's decision in Tog, therefore, it is necessary to review and analyze Thor.

B. The Thor Power Tool Co. Decision

Thor was a tool manufacturing company that wrote down what it considered to be excess inventory to its estimate of the inventory's net realizable value in accordance with GAAP; it did this even though the inventory continued to be held for sale at regular retail prices. The excess inventory consisted of spare parts for machines that were no longer being manufactured, but that customers continued to use. All the spare parts that Thor estimated it would need for the life of a particular machine were manufactured at the time of original production because it was very expensive to retool the plant to produce these parts. As a result, large lots of spare parts were made at one time.

Usually when a company has excess inventory, it will reduce the prices of the goods in an attempt to sell them more quickly. In Thor's situation, however, the inventory consisted of spare parts whose demand was solely determined by whether the original parts became defective. Consequently, demand was very price insensitive, and Thor decided to keep the selling prices at regular retail levels since lowering the prices would not have increased demand for these products. The Commissioner disallowed the writedown, stating that it did not clearly reflect income, and the Supreme Court agreed. One of the key factors cited by the Court was that, even though Thor claimed that the inventory level for the spare parts was excessive, it continued to hold the inventory for sale at regular retail prices.

The decision in Thor, which related to a manufacturing company, has now been expanded to restrict the inventory methods of a retail firm in Tog. Thus, the precedent set in Thor has the potential to restrict the alternative methods of determining inventory values for many different industries.

C. Analysis of Decisions

In Tog and Thor, the courts focused on the differing objectives of financial and tax reporting to justify the decisions that, although the inventory methods used were acceptable under GAAP, they did not clearly reflect income. The opinion of the Supreme Court on the importance of these differing objectives is clear:

There is no presumption that an inventory practice

conformable to "generally accepted accounting principles"

is valid for tax purposes. Such a presumption

is unsupportable in light of the statute, this

Court's past decisions, and the differing objectives

of tax and financial accounting.(5) Even in light of the differing objectives of tax and financial reporting, however, the decisions in Thor and Tog may not be warranted. There are at least two problems with the courts' reasoning in these decisions. These problems will be illustrated in the context of the Thor decision since that case was used to rubber stamp the Commissioner's position in Tog. First, the arguments of the Supreme Court are contradictory. Second, the Court ignores the economic realities faced by Thor.

1. Contradictory Arguments of the Court. The Supreme Court rationalized its decision that the GAAP-approved method did not clearly reflect income by focusing on the differing objectives of tax and financial reporting. The primary goal of financial reporting is to provide information to third parties,(6) whereas the primary goal of the income tax system is to collect the correct amount of tax due from each taxpayer.(7) Because of the inherent liability that accountants are exposed to when reporting financial information to third parties, the accounting profession has adopted the principle of conservatism as one of its axioms. Because of the conservatism principle, GAAP rules tend toward underreporting income. On the other hand, tax reporting is not based on the conservatism principle, but rather on a set of rules developed by Congress, Treasury, IRS, and the judiciary.

Thus, the objectives of financial reporting and tax reporting are clearly different. It does not follow, however, that the methods used in tax and financial reporting differ in all circumstances; even given the differing objectives, some GAAP methods may clearly reflect taxable income and some GAAP methods may not. Thus, to claim a method does not clearly reflect income because of these differing objectives is not sufficient.

Example 1: For depreciation, the Internal Revenue Code generally allows a faster write-off of the cost of assets than does GAAP. The time periods over which assets are depreciated are affected by the conservatism principle for financial reporting and by various congressional objectives, such as stimulating the economy, for tax reporting. Nonetheless, both GAAP and tax rules generally recognize the intrinsic nature of these depreciable assets - that a specific item meets the definition of an asset whose value is expected to decline over time, and that this decline should be recognized in the computation of income. The two reporting regimes differ only in the time period over which the asset should be depreciated. That is, the difference between tax and financial reporting is not in the definition of the asset, but in the treatment of the asset.

Example 1 illustrates the reasons that some differences in tax and financial reporting, such as differences in depreciation write-offs, exist. In the Tog and Thor cases, the issue centered around excess inventory. Although the Supreme Court used the terminology of the "inherent differences between the objectives of tax and financial reporting," a closer analysis reveals that the decision was not based on these inherent differences. If the ruling had been based on these inherent differences, the Supreme Court would have defined the inventory in the same manner for tax and financial reporting, but nevertheless ruled that excess inventory may be written down for financial reporting but not for tax reporting. In Thor, however, the Court concluded that the inventory items actually had different definitions for tax and financial reporting.

To illustrate, the Supreme Court acknowledged that Thor's inventory method met the requirements of GAAP and, consequently, that if the excess inventory had not been written down, the auditors would not have been able to render a clean opinion. In other words, the write-down was necessary to clearly reflect income." On the other hand, the Court also concluded:

Thor's "excess inventory" was normal and unexceptional,

and was indistinguishable from and intermingled

with the inventory that was not written

down.(9)

On this basis, the Court ruled that even though the inventory in question was normal, unexceptional, and indistinguishable from its other inventory, the auditors would not have been able to give a clean opinion in the absence of a writedown. Financial reporting rules, however, would never allow the writing down of inventory that was normal, unexceptional, and indistinguishable from the other inventory. Hence, the Court must have believed that for financial reporting purposes the inventory was "excess" inventory, but that for tax reporting the exact same inventory was "indistinguishable" from the other inventory. Under this analysis, the Court applied two separate definitions to the identical asset depending upon whether the asset was being reported for financial or tax purposes. This cannot be defended based on the "differing objectives of tax and financial reporting."

The Court's purported rationale is specious because the determination whether the inventory was excess inventory should have been predicated on the specific characteristics of the inventory, and these characteristics remain the same regardless of the objectives of tax and financial reporting. Stated differently, the characteristics of the inventory are exogenous to, and independent of, the reporting regime being used.

2. Economic Realities Ignored. Another issue highlighted in these cases is the manner in which income should be clearly reflected. Income cannot clearly be reflected without considering the interaction of economic principles with reporting requirements. The Supreme Court in Thor, however, ignored some basic economic principles in rendering its decision.

For example, Thor had decided that much of its spare parts inventory would never be sold, but these items were very price inelastic; demand was primarily a function of whether the original part needed to be replaced. If Thor had reduced the prices of the parts it expected to sell, demand for the parts would have increased very little, if at all. The Supreme Court found it significant that Thor did not reduce the selling prices of its excess inventory. In a legal context, not reducing the prices did not make sense, because one usually assumes that the demand for goods is related to the price for those goods. From an economic viewpoint, however, it is not rational to reduce the price of goods that are very price inelastic. It was not only beneficial for Thor not to reduce the prices, but also for the Treasury, because the higher prices maximized income and, thereby, tax revenues. The Supreme Court ignored this point and attributed the lack of a price reduction to the nature of the inventory; it baldly assumed that non-discounted inventory could not be excess inventory.

D. Summary

In Thor, the Supreme Court determined that an item of inventory was excess inventory for financial reporting purposes, but that the identical unit was not excess inventory for tax reporting, thus concluding that the writing down of this asset for tax purposes would not clearly reflect income. The nature of the asset, however, does not change depending upon the type of income that is being computed. The Supreme Court masked its decision behind the rhetoric of differing objectives of tax and financial reporting, but it ignored the economic realities faced by Thor.

The inventory method used by Thor (and also by Tog) is not specifically authorized by the regulations.(10) Although this in and of itself does not mean that the method did not clearly reflect income, it does mean that the taxpayer had a higher burden of proof than would be necessary if the inventory method were expressly authorized by the regulations. The next section describes a recent case in which the inventory method used was not inconsistent with the regulations, and yet the IRS and courts still ruled that the method did not clearly reflect income.

III. Hamilton Industries

The clear reflection of income standard is also at the core of Hamilton Industries, Inc. v. Commission Hamilton, the Tax Court held that inventory purchased at a bargain price should be separated from other identical units of inventory when using the dollar-value LIFO method. This separation has the effect of removing the bargain element from the LIFO layer in the year of acquisition.

A. Background

Mayline and Hamilton (a wholly owned subsidiary of Mayline) were incorporated in 1975 and 1982, respectively, to purchase the assets of two manufacturing companies, including finished goods, work-in-progress, and raw materials (hereinafter referred to as "the bargain purchase inventory").(12) After the acquisition, the acquiring company continued the manufacturing operations of the acquired company and produced units identical to those manufactured before the acquisitions. The bargain purchase inventory in the two acquisitions was allocated values of $79,028 and $6,550,262, while the FIFO values of the inventory, which the IRS used as a surrogate of fair market value, were $2,034,680 and $16,566,320, respectively.

The acquiring companies elected to use the dollar-value LIFO method for valuing the inventory, using one natural business unit pool, the double-extension method, and the earliest cost method of pricing increments. Using this method, the difference in the bargain purchase inventory's fair market value and allocated value would not be recognized until the base-year levels of each company's inventory were liquidated.

The IRS claimed that the company's inventory valuation method did not clearly reflect income. Arguing that the only method clearly reflecting income was basically a specific identification method, the IRS wanted the bargain elements of the inventory to be recognized when the bargain purchase inventory was actually sold. To achieve this result, the IRS argued that the bargain purchase inventory should be treated as a separate item from other identical units of inventory.
Example 2
 In 1992 Company P was incoporated to purchase the assets
of Company A. As part of the acquisition, 100 units of
inventory item B were purchased at a bargain price of $20
each. During 1992 P manufactures 100 units of item B at a
cost of $25 each and also sells 100 units of item B. Assume
that P elected the dollar-value LIFO method, using the double
extension and earliest acquisition costs methods.
TAXPAYER'S METHOD: Ending inventory is computed,
as follows:
 Base Year Cost Earliest Cost
 LIFO
 Unit Total Unit Total Index
Year Item Units Cost (X) Cost (Y) (Y/X)
1992 B 100 $20 $2,000 $20 $2,000 100%
 1992
 Base
 Year LIFO
 Cost Index Value
Beginning Inventory $ 0 N/A $ 0
Layer 1 2,000 100% 2,000
Ending Inventory $2,000 $2,000
LIFO Value ($25 X 100) = $2,500
LIFO Value 2,000
LIFO Reserve $ 500
IRS METHOD: Units manufactured after the purchase
(C) would be treated as separate from the bargain purchase
units (B). Ending inventory would be computed
for 1992, as follows:
 Base Year Cost Earliest Cost
 LIFO
 Unit (X) Unit (Y) Index
Item Units Cost Total Cost Total (Y/X)
B 0 $20 $ 0 $20 $ 0
C 100 $25 $2,500 $25 $2,500 100%
 1992
 Base
 Year LIFO
 Cost Index Value
Beginning Inventory $ 0 N/A $ 0
Layer 1 2,500 100% 2,500
Ending Inventory $2,500 $2,500
FIFO Value ($25 x 100) = $2,500
LIFO Value 2,500
LIFO Reserve $ 0


The effect of the taxpayer's method and the IRS's method of inventory valuation on taxable income in the year of acquisition is illustrated in Example 2. Under the IRS method, there are no bargain purchase items in ending inventory and the LIFO reserve is not preserved. In contrast, under the taxpayer's method the bargain element is preserved in the LIFO reserve.

The Tax Court agreed with the IRS's argument that the bargain purchase inventory should be treated separately from the other inventory, reasoning that to do otherwise would not clearly reflect income if the amount of the bargain element is large.

B. Analysis of the Decision

As in Thor, there are some fundamental problems with the decision in Hamilton. Specifically, the decision suffers from contradictory reasoning and from a mischaracterization of the role that GAAP should play in the inventory valuation process.

1. Contradictory Reasoning. The Tax Court ruled that separate item treatment was necessary for the bargain purchase inventory because income would not otherwise be clearly reflected. The IRS had also argued that, based on Treas. Reg. [section] 1.472-8, which requires manufacturers who also purchase goods from others for resale to use separate pools for its manufacturing and selling operations, separate pools were required for the bargain purchase inventory and the regular inventory. The court rejected this argument, stating it would distort income. The separate item treatment that was approved by the court, however, produces the same increase in income as the proposed separate pooling method. How can the same amount of income distort income under the pooling method, but clearly reflect income under the separate item method? In truth, the amount of the distortion of income, if any, must be measured by comparing reported income to an estimate of what actual income should be for the particular facts and circumstances. The court did not do this and, as a result, its application of the clear reflection of income standard is contradictory and very confusing.

2. Requirements of GAAP and the Regulations. The regulations state that an inventory method that meets the requirements of GAAP and that is consistently applied will ordinarily be assumed to clearly reflect income. Testimony was introduced at the trial demonstrating that the taxpayer's method was in conformity with GAAP, whereas the IRS's method was not. Thus, this case is similar to Thor in that the court determined that the GAAP method did not clearly reflect income. In fact, the court cited Thor as justification for its ruling that one should not assume that GAAP necessarily clearly reflects income.

The Hamilton case, however, is distinguishable from Thor. In Thor, the inventory valuation method used was not expressly authorized under the regulations. In Hamilton, the method both met the requirements of GAAP and was consistently applied. In addition, the method was consistent with the regulations. Hence, all the conditions of section 471 were satisfied, even though the court upheld the IRS's argument that income was not clearly reflected.

C. Summary

The Hamilton case has substantially increased the IRS's power concerning the clear reflection of income standard. The implications go beyond the specific facts and circumstances of a bargain purchase of inventory. The disallowance of inventory methods that meet the requirements of GAAP and are consistently applied are now subject to adjustment even if they are consistent with the regulations.

Example 2

In 1992 Company P was incorporated to purchase the assets of Company A. As part of the acquisition, 100 units of inventory item B were purchased at a bargain price of $20 each. During 1992 P manufactures 100 units of item B at a cost of $25 each and also sells 100 units of item B. Assume that P elected the dollar-value LIFO method, using the double extension and earliest acquisition costs methods.

TAXPAYER'S METHOD: Ending inventory is computed, as follows: [TABULAR DATA OMITTED]

IRS METHOD: Units manufactured after the purchase (C) would be treated as separate from the bargain purchase units (B). Ending inventory would be computed for 1992, as follows: [TABULAR DATA OMITTED]

IV. The Components-of-Cost Method

A. Background

The IRS has also denied the use of GAAP inventory methods related to the components-of-cost method for computing LIFO price indices.(13) The components-of-cost method of computing a LIFO price index was developed to enable companies that manufacture many different or rapidly changing items to procure the benefits of using the LIFO method. As a practical matter, a firm with many different product types cannot compute separate unit costs for each item in its inventory, computations that are required in order to use LIFO. The components-of-cost method solves this valuation problem by treating the inventory as consisting of basic elements of cost, such as materials, labor, and overhead, instead of thousands of different product units that vary in style, size, etc. Basically, this method permits a valuation of inputs to the manufacturing process rather than the outputs.

The component-of-cost method may actually better achieve the purpose of LIFO than a product-cost approach because overhead costs have a fixed component that does not increase proportionately with production costs. Thus, the product approach may reflect a price increase when production levels decrease and more overhead has to be absorbed by each individual unit, whereas the components-of-cost method would not suffer from this type of measurement error. The IRS has long recognized the components-of-cost method as an acceptable inventory valuation method. In fact, the IRS's LIFO training manual recognizes the components-of-cost method as a permissible valuation method for manufacturing companies.(14) Furthermore, Treas. Reg. [sub-section] 1.472-1(c) and 1.472-8(b)(3)(ii) recognize the use of the components-of-cost method for raw materials.

Nevertheless, the IRS has recently questioned the use of the components-of-cost method. In Letter Ruling No. 7920008 (February 12, 1979), the IRS held that the components-of-cost method would not automatically be accepted as a valid inventory method in all cases. Instead, the IRS stated that to use the method the taxpayer must prove that the method clearly reflects income.(15) Thus, the clear reflection standard has raised its onerous head once again.

B. Advantages of the Components-of-Cost Method

As with the issues in Thor and Hamilton, the components-of-cost method facially meets the requirements of GAAP. In fact, in November 1984 the AICPA's Accounting Standards Executive Committee provided a report to the FASB that explains why the components-of-cost method may be preferable to the unit-cost method. Among the reasons cited are the following:

1. The components-of-cost method may be the only

method to develop a LIFO cost index if the unit cost

of the finished product is not developed by the cost

accounting system.

2. If product types are constantly changing, or if the

product line continually evolves, it is impossible to

develop comparable base-year costs. The base year

cost of the underlying material, labor, and overhead

components, however, should be available.

3. Manufacturers that have significant changes in the

purchased, as opposed to produced, material ingredients

of their finished products can experience

large fluctuations in unit costs that are not related

to inflation. Use of the product-cost method in such

cases would result in meaningless index fluctuations.

4. The degree of utilization of manufacturing capacity

can have a significant effect on the unit cost of

finished products from period to period because of

the allocation of manufacturing overhead.

5. In many cases, the most appropriate manner of

factoring the inflationary effect out of inventories is

to factor it out of the underlying cost components.

The Securities and Exchange Commission endorsed this issues paper in Staff Accounting Bulletin No. 58. This signifies a very strong vote of support for the validity of this method of computing LIFO price indexes.

C. Summary

The components-of-cost method has previously been approved by the regulations, currently meets the standards of GAAP, and has previously been approved by the IRS. Nevertheless, the IRS has adopted the position that the components-of-cost method may not be acceptable in all circumstances, and that the burden is on the taxpayer to justify that the method clearly reflects income. Thus, it appears that the IRS is attempting to continue to expand the scope of the clear reflection of income standard.

V. Implications and Conclusion

The IRS has begun to use the clear reflection of income standard of section 446(b) aggressively to disallow the use of several different types of inventory methods. Taxpayers have challenged the IRS on at least two occasions; surprisingly, the courts have held for the IRS in both cases. Both of these decisions, however, are devoid of internal consistency. In Thor, the Supreme Court defined the same item of inventory in two contradictory ways, depending upon whether taxable income or financial income was being computed. In Hamilton, the Tax Court ruled that, even though the amount of inventory would be the same under two different treatments, one treatment clearly reflected income whereas the other did not. These cases have tremendously increased the IRS's power to monitor and change accounting methods.

The implications of the IRS's increased power under section 446(b) are immense. The progression of the IRS's power is marked. In Thor, the IRS was allowed to disallow a GAAP-approved method that was consistently applied, but that was not authorized by the regulations. In Hamilton, the IRS's power was extended even further, as it disallowed a method that not only met the requirements of GAAP and was consistently applied, but that was also consistent with the regulations. In the most recent chapter in this sap, the clear reflection of income standard is being used to restrict the components-of-cost method, a method that meets the requirements of GAAP, has been approved by the SEC, is authorized by the regulations, and is taught to be acceptable in IRS training manuals.

These judicial and administrative decisions have substantially increased the ambiguity and complexity of corporate tax planning. As a result, the perceived fairness of the tax law has likely decreased. The IRS has seized upon what is tantamount to an iron hand -- the clear reflection of income standard -- to disallow any accounting method that does not produce its desired result.

Additionally, the compliance burden placed on corporate tax professionals has increased tremendously as a result of these decisions. As the tax rules deviate more and more from GAAP, companies are forced to implement two separate cost systems, or to use the mandated tax system for financial reporting purposes. If this latter situation occurs, however, tax policy will be dictating the accounting method used for financial reporting purposes, a practice that accounting policymakers generally do not view as healthy. Perhaps more important, the IRS-imposed method may not meet the requirements of GAAP -- something to which an expert witness testified in Hamilton.

These decisions might also undermine the reporting standards of the accounting profession. The Supreme Court in Thor implied that, although the excess inventory was normal and indistinguishable from the regular inventory, GAAP would require that the inventory be written down. If this conclusion were true, the reliability of the standards that the accounting profession has set for financial reporting would be highly suspect. But, in point of fact, the Court's conclusion that GAAP would require such inventory to be written down is incorrect. Nonetheless, that the Supreme Court has the perception that GAAP would allow such a write-down of inventory is troubling. It is also disturbing that the courts have ruled that several different types of GAAP accounting methods do not clearly reflect income, given that the purpose of GAAP is to clearly reflect income.

This article has questioned the reasoning of the courts in both Thor and Hamilton. Given these recent judicial decisions, the only check on the substantial increase in the IRS's ability to use the clear reflection of income standard may be legislative action. As the topic of simplification is often heard resounding from Capitol Hill these days, a prime target for simplification could be the acceptability of GAAP accounting methods for reporting taxable income. Much of the ambiguity and complexity in this area could be removed if Congress provided that any method that meets the requirements of GAAP and is consistently applied will be deemed to be acceptable for tax purposes. In the interim, corporate tax executives must carefully evaluate the accounting methods they are using for computing taxable income and determine whether the methods are likely to withstand the IRS's power under the clear reflection of income standard. (1) Boynton v. Pedrick, 136 F. Supp. 888 (S.D.N.Y 1954). (2) Rotolo v. Commissioner, 88 T.C. 1500, 1513-14 (1987). (3) Thor Power Tool Co. v. Commissioner, 439 U.S. 532 (1979). (4) 721 F. Supp 300 (D. Ga. 1989), aff'd, 916 F.2d 720 (11th Cir. 1990). (5) Thor, 439 U.S. at 523. (6) Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 1, at viii (November 1978). (7) Thor, 439 U.S. at 542. (8) Thor, 439 U.S. at 530-31, 533. (9) Thor, 439 U.S. at 536. (10) Treas. Reg. [sub-section] 1.471-1 through 1.471-4 cover the inventory method used by both Tog and Thor. Although both taxpayers argued that their method was consistent with the regulations, the courts determined otherwise. The taxpayers valued classes of items, whereas the IRS requested values on each separate item in inventory. Some tax professionals, however, argue that the inventory methods used by Tog and Thor were not inconsistent with the regulations. The issue is not clear from doubt. (11) 97 T.C. No. 9 (1991). (12) For a detailed discussion of this case see M.D. Levy, C.E. MacNeil, and H.J. Guarascio, Hamilton Industries: Abusing the Clear Reflection Standard, Tax Notes (February 10, 1992). (13) On April 13, 1992, the Tax Division of the American Institute of Certified Public Accountants sent a position paper on this subject to the Internal Revenue Service. See "Service Urged Not to Prohibit Components-of-Costs Method under LIFO," BNA Daily Tax Report, No. 75, at G-3 to G-4 (April 17, 1992). (14) Internal Revenue Manual, LIFO Method of Inventory Valuation. Training 3127-01, at 64 (June 1976). (15) The IRS position is also stated in a July 31, 1992, letter it sent to the American Institute of Certified Public Accountants in response to the AICPA's April 13 letter. BNA Daily Tax Report, No. 152, at L-24 (August 6, 1992); see note 13 supra (citation to AICPA letter).

GREGORY A. CARNES is an assistant professor of accounting at Louisiana State University. He is a certified public accountant, and his articles on tax planning subjects have appeared in Taxation for Accountants, Taxation for Lawyers, The CPA Journal, and The Tax Adviser.

TED D. ENGLEBRECHT is the KPMG Peat Marwick Professor of Accounting at Georgia State University. He has nearly a dozen books on tax subjects, and his articles have appeared in many tax and accounting publications.
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Author:Englebrecht, Ted D.
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Date:Nov 1, 1992
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