1989 U.S. Tax Ct. LEXIS 135">*135
P was engaged in the business of selling metal fasteners. Prior to fiscal year 1982, P determined opening and ending inventory using a perpetual book inventory record keeping system. P verified book inventory by taking a partial physical inventory. For fiscal year 1982, P determined both opening and ending inventory on the basis of a complete physical inventory that was completed several months after the close of the fiscal year. This physical inventory, after adjustments, indicated that opening inventory for fiscal year 1982 was ten times greater than ending inventory reflected in the books and as originally reported for the end of the prior fiscal year. R determined that P's opening inventory for fiscal year 1982 was $ 268,681, based on original book inventory, rather than $ 2,640,114, based on P's complete physical inventory. R did not question the accuracy of P's ending inventory for fiscal year 1982 even though ending inventory was based on the same complete physical inventory. R also argues that P's revaluation of opening and ending inventory for fiscal year 1982 is a change in accounting method.
93 T.C. 500">*501 Respondent determined a deficiency of $ 1,091,362 in petitioner's Federal income tax for the taxable year ended February 28, 1982. The issues for decision are whether petitioner correctly valued its opening inventory and, if so, whether petitioner changed its method of accounting so as to require adjustments pursuant to
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and attached exhibits are incorporated herein by this reference.
Petitioner, a Michigan corporation, 1989 U.S. Tax Ct. LEXIS 135">*137 is engaged in the business of selling metal fasteners. Petitioner's principal place of business was in Detroit, Michigan, when the petition was filed in this case.
Petitioner sells approximately 50,000 different types of bolts, nuts, and other fasteners. Petitioner sells standard fasteners, which are listed in a catalog published by the metal fastener industry and are items of general usage, and "specialty items," which are fasteners designed to fit the specific needs of a particular customer or for use in a particular product.
Petitioner files its Federal income tax returns on a fiscal year basis with its fiscal year ending February 28. Petitioner uses the accrual method of accounting and values its inventory at the "lower of cost or market."
Petitioner's main warehouse, the Wayne Division, is located in Detroit, Michigan, and its second smaller warehouse, the Warren Division, is located in Warren, Michigan. Petitioner moved into the main warehouse in 1974. The main warehouse is an old building containing approximately 70,000 square feet of floor space. The building was constructed in 1928, and an addition was made to the rear of the building in 1960. The warehouse portion1989 U.S. Tax Ct. LEXIS 135">*138 of the building is divided into eight bays, with an office across the front.
In the older portion of the main warehouse, fasteners were placed in cartons, containers, casks, and other boxes, and were stacked on wooden pallets on the floor or in large wooden and metal bins. In the other rooms, casks or boxes of fasteners were placed on pallets, and the pallets were 93 T.C. 500">*502 stacked on shelves six levels high. Petitioner's inventory was disorganized in that identical types of fasteners were stored in different areas of the main warehouse. Inventory was often lost or misplaced.
Petitioner acquired large fasteners from its Giant Bolt and Nut Division. With the exception of those products manufactured by its Giant Bolt and Nut Division, all the fasteners acquired by petitioner were purchased. Petitioner purchased fasteners directly from a manufacturer or as part of "odd lots" or surplus merchandise.
Since the date of its incorporation on April 3, 1959, petitioner has maintained a perpetual book inventory record keeping system which it utilizes to determine the amount of its inventory. An inventory card was prepared and maintained for each type of fastener petitioner purchased. 1989 U.S. Tax Ct. LEXIS 135">*139 There are approximately 70,000 inventory cards in either an active or inactive inventory file at petitioner's two warehouses. The inventory cards maintained in the inactive inventory file are for items which have been fully disposed of or items considered to be inactive. Petitioner does not destroy any of its inventory cards. The Wayne Division and the Warren Division maintain their own separate perpetual book inventory record keeping system in the same manner.
When petitioner purchased fasteners from a manufacturer, petitioner's procedure was to prepare an inventory card when it received an initial order from a manufacturer of a particular type of fastener, and to include on the inventory card a description of the fastener, the name of the supplier, the quantity received, the date it was received, its cost, and its location in the warehouse. For repetitive orders of the same type of fastener, petitioner made additional entries on the same card showing the quantity received, its cost, and the name of the supplier.
When petitioner purchased fasteners as part of "odd lots" or surplus merchandise, petitioner's procedure was to prepare "breakdown sheets" indicating the type of merchandise, 1989 U.S. Tax Ct. LEXIS 135">*140 its size, condition, finish, the quantity, the location at which the merchandise was to be stored, and the price paid per pound for the merchandise. It could take petitioner as much as 2 years to examine and break down the surplus merchandise and to prepare breakdown sheets. Once breakdown 93 T.C. 500">*503 sheets were prepared, they were then to be forwarded to the office for the preparation of inventory cards.
When petitioner shipped merchandise to a customer, petitioner's procedure called for the shipping department to prepare a shipping document containing a description of the fastener and the quantity shipped. The shipping document was to be sent to the office so that an entry could be made on the inventory card indicating the quantity shipped, the balance remaining, and the location of the unshipped items. After an order was filled in the shipping department, the box or keg from which the items were taken was not necessarily returned to the original location as noted on the inventory card.
Purchases and sales were not always recorded accurately or promptly on the inventory cards. In some instances, the inventory cards reflected quantity on hand but not cost. Inventory cards were1989 U.S. Tax Ct. LEXIS 135">*141 not prepared for all items.
Each year prior to 1982, petitioner's General Manager, Joseph Luranc, verified inventory by randomly selecting approximately 300 of its 70,000 inventory cards and comparing the quantity listed on the inventory card with the quantity found at the location specified on the inventory card. If Mr. Luranc could not find the inventory at its specified location, he made no attempt to find "missing inventory" at a location other than the location listed on the inventory card. The balance on these 300 selected inventory cards was adjusted downward or upward in accordance with the quantity actually found in stock. The downward and upward adjustments were sent to petitioner's accountant who adjusted petitioner's ending inventory accordingly.
Petitioner's perpetual book inventory record keeping system showed inventory with a value of $ 268,681 as of March 1, 1981, the beginning of the taxable year in issue. This amount was the same amount petitioner had reported as ending inventory on its original income tax return for the prior fiscal year ending February 28, 1981. 2
1989 U.S. Tax Ct. LEXIS 135">*142 93 T.C. 500">*504 Between March and October 1982, petitioner undertook its first complete physical inventory of all items located in its warehouses. Rather than physically count each item, petitioner utilized an electronic scale to determine the weight and count of a particular type of fastener in a container. Petitioner prepared an inventory tag for each item in stock. The inventory tags were then forwarded to the office for comparison with the inventory cards on file. When an inventory tag showed that the quantity of an item in stock was greater than the quantity listed on the inventory card, petitioner adjusted the quantity listed on the card upward. In numerous instances, an item was found in stock for which the inventory card showed a zero balance. When the quantity of an item in stock exceeded the quantity listed on the inventory card, and the item had been purchased over a period of more than 1 year, petitioner estimated the cost of the item when valuing the inventory.
In many instances, an item was found during the complete physical inventory for which no inventory card existed. In such a situation, petitioner established a new inventory card and entered the quantity of the1989 U.S. Tax Ct. LEXIS 135">*143 item found in the warehouse. Petitioner estimated the cost of items for which no inventory card existed based on prices listed in a 1982 catalog published by the metal fastener industry.
Petitioner completed the physical inventory in October 1982. Based on the physical inventory, petitioner prepared a schedule of inventory listing a description of each item, its quantity, its cost, and the cost of the quantity on hand. Using this schedule of inventory, petitioner calculated its ending inventory for the fiscal year ended February 28, 1982, by making adjustments for purchases and sales which occurred between the end of the fiscal year and the date of the physical inventory. In preparation for trial, petitioner rechecked the entries on the schedule with the amounts stated on the inventory cards, and made the appropriate corrections where the quantity, price, or total differed.
Based on the complete physical inventory, petitioner also determined that opening inventory for fiscal year ended 93 T.C. 500">*505 February 28, 1982, was $ 2,642,520.85. 3 Petitioner determined the quantity of items in opening inventory by taking the quantity of items found on the actual inventory date, adding to1989 U.S. Tax Ct. LEXIS 135">*144 that the quantity sold between March 1, 1981, and the actual inventory date, and subtracting from that figure the quantity purchased between March 1, 1981, and the actual inventory date. Petitioner's method of computing inventory assumes that purchases and sales between March 1, 1981, and the date of the actual physical inventory were correctly stated on the inventory cards.
The complete physical inventory finished in October 1982 and the reconstruction of opening inventory as of March 1, 1981, which was based on the complete physical inventory, indicate that the quantity of items reflected in petitioner's book inventory on March 1, 1981, was substantially understated.
Petitioner also recomputed inventory as of 1989 U.S. Tax Ct. LEXIS 135">*145 February 29, 1980, and February 28, 1979, using the same method it used to recompute inventory as of March 1, 1981, and filed amended returns for its fiscal years ending in February 1979, 1980, and 1981, using the recomputed opening and ending inventory figures. These amended returns indicate that most of the understatements of inventory discovered in 1982 had been made in years prior to taxable year ending February 28, 1979. It is petitioner's position that years prior to the one ending February 28, 1979, were closed by the statute of limitations when the amended returns were filed.
OPINION
Respondent determined that petitioner's opening inventory for fiscal year ended February 28, 1982, was $ 268,681, based on petitioner's book inventory. Petitioner reported this amount as ending inventory on its original return filed for fiscal year ended February 28, 1981. Based on information obtained from a complete physical inventory conducted 93 T.C. 500">*506 in 1982, petitioner contends that actual opening inventory on March 1, 1981, was $ 2,642,520.85.
Respondent also argues that if we find that petitioner has proven opening inventory as reported on its return,
If, as respondent argues, petitioner has changed its method of accounting for inventory, it would be inappropriate to determine ending1989 U.S. Tax Ct. LEXIS 135">*147 inventory under the new method while using the old method of accounting to determine opening inventory. It is well settled that opening and ending inventory must be computed pursuant to the same method.
If we accept respondent's position that petitioner changed its method of accounting, the proper mechanism for preventing duplications of expenses or omissions of income is embodied in
Respondent first raised the issue of whether petitioner1989 U.S. Tax Ct. LEXIS 135">*148 changed its method of accounting in his amended answer. We will preliminarily address the question of which party bears the burden of proof on this issue.
93 T.C. 500">*507 Generally, the burden of proof is on the taxpayer. Rule 142(a);
A new theory that is presented to sustain a deficiency is treated as a new matter when it either alters the original deficiency or requires the presentation of different evidence.
In his deficiency notice, respondent determined that the value of petitioner's opening inventory was $ 268,681, rather than $ 2,640,114 as reported on petitioner's return. Respondent increased petitioner's taxable income by $ 2,371,433. On February 24, 1988, respondent filed a motion for leave to file
The evidence required to establish the amount of actual opening inventory is different from the evidence required to establish that no accounting method change occurred during the year in issue. To prove opening inventory on March 1, 1981, petitioner would have to produce evidence of the quantity and cost (or market value if lower) of inventory on that date. Proof that petitioner's opening inventory figure was correct would not necessarily lead to the conclusion that there was no accounting method change. In order to establish that no accounting method change occurred, petitioner 1989 U.S. Tax Ct. LEXIS 135">*150 would have to present evidence that its method for determining inventory for March 1, 1981, and for prior years was the same. A finding that there was an accounting method change requiring a
We are convinced that petitioner's pre-1982 method of determining inventory was seriously flawed and resulted in the premature write-down of inventory. Petitioner's manager testified to the disorganized state of petitioner's warehouse. Rather than storing items of inventory in specific places by category, petitioner would allow packages of identical items to become separated and misplaced in its warehouse. Nevertheless, prior to 1982, it was petitioner's practice to check its book inventory by physically verifying about 300 items of inventory every year. Petitioner's employees would look for the items in the location shown on the inventory cards. However, if the items1989 U.S. Tax Ct. LEXIS 135">*151 could not be found in that location, petitioner's employees would look no further. Rather, petitioner would simply write off the unfound items. It is apparent that many of the items found in the complete physical inventory taken in 1982 had been written off in prior years pursuant to this practice. The result of such write-offs in prior years would have been to increase costs of goods sold and, thus, reduce reported income for those years. 5
There were obviously other systemic flaws in petitioner's method of accounting for inventory prior to 1982. Petitioner never destroyed inventory cards, even when an item became inactive. However, the complete physical inventory conducted in 1982 revealed many inventory items for which there were no inventory cards.
Petitioner purchased "odd lots" or surplus1989 U.S. Tax Ct. LEXIS 135">*152 merchandise. Under petitioner's pre-1982 system, it could take several years to record such purchases on inventory cards. It is obvious that the failure to reflect such purchases on inventory cards as part of ending inventory would result in inflating cost of goods sold and reducing income in the year of the purchase.
93 T.C. 500">*509 During the physical inventory, inventory cards were found on which no cost figures had been recorded. In these instances petitioner estimated the cost for purposes of the 1982 inventory valuation, often using current costs. This was a departure from petitioner's method of valuing inventory at the lower of cost or market.
If petitioner had continued to use its pre-1982 system, the system would have automatically self-corrected since each year's ending inventory becomes the opening inventory for the succeeding year.
Because we are here dealing with inventory, where one year's1989 U.S. Tax Ct. LEXIS 135">*153 closing inventory becomes the next year's opening inventory, we are satisfied that the present case involves only postponement of income and therefore involves a timing question.
The consistent undervaluation of ending inventory acts to defer income.
A change in accounting method occurs when there is a change in the overall method of accounting for gross income and deductions, and also when there is a change in the treatment of a "material item." See
93 T.C. 500">*510 (c) A change in an overall plan or system of identifying or valuing items in inventory is a change in method of accounting. Also a change in the treatment of any
A "material item" is "any item which involves the proper time for the inclusion of the item in income or the taking of a deduction."
1989 U.S. Tax Ct. LEXIS 135">*156 "When a taxpayer uses an accounting method which reflects an expense before it is proper to do so or which defers an item of income that should be reported currently, he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income; he has impliedly promised to report that income at a later date, when his accounting method, improper though it may be, would require it.
A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability.
Since petitioner's pre-1982 method of determining inventory involved the proper time for reporting income, it was a "material item." Petitioner's change from a seriously flawed and disorganized method of determining inventory to a method of determining both opening and ending inventory for fiscal year 1982 on the basis of a complete physical inventory is a change in the treatment of a material item and, therefore, constitutes a change in accounting method. A change in method of accounting occurs even when there is a change from an incorrect to a correct method of accounting.
Petitioner relies solely on
The instant case is distinguishable from
1989 U.S. Tax Ct. LEXIS 135">*161 Prior to 1982, petitioner consistently used a method of determining inventory which resulted in premature writedowns of ending inventory. This constituted a method of accounting.
93 T.C. 500">*513 Since we have concluded that there was a change in the method of accounting used by petitioner in the taxable year in issue,
1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect for the year in issue. All Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. As reflected on petitioner's original income tax return filed for the year in issue, the opening inventory included the value of Giant Bolt Division -- Finished Goods, in the amount of $ 5,368; Giant Bolt Division -- Work in Process, in the amount of $ 18,425; and Giant Division -- Raw Materials, Steel, in the amount of $ 35,176.69.
The closing inventory for the year in issue as reflected on the original return included the value of Giant Bolt Division -- Work in Process, in the amount of $ 24,633 and Giant Division -- Raw Materials, Steel, in the amount of $ 47,935.03. The value of Giant Bolt Division -- Finished Goods, was included in the Wayne Division inventory.↩
3. On petitioner's return for the taxable year in issue, it reported opening inventory of $ 2,640,114. Petitioner argued at trial and on brief, based on a reverification of physical inventory in preparation for trial, that the correct figure for opening inventory during the year in issue is $ 2,642,520.85.↩
4.
(1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then
(2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted * * *.↩
5. Gross income is determined by subtracting cost of goods sold from gross sales. Cost of goods sold is computed by adding purchases (additions to inventory) to opening inventory, and then subtracting closing inventory.↩
6.
7. For a discussion of
8. Since we have concluded that