T.C. Memo. 1998-184

UNITED STATES TAX COURT

GOLDEN GATE LITHO, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6569-95. Filed May 18, 1998.

Jon R. Vaught, for petitioner.

Elaine L. Sierra, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WRIGHT, Judge: Respondent determined a deficiency of 

$133,906 in petitioner's Federal income tax and an accuracyrelated penalty under section 6662(a) of $26,781 for the taxable

year ending May 31, 1991.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and
- 2 -

1 Respondent concedes that petitioner is entitled to deduct

commission expenses in the amount of $21,888. Petitioner

concedes that it is not entitled to deduct a loss of $6,215 on

the sale of an automobile.

all Rule references are to the Tax Court Rules of Practice and

Procedure. After concessions1 by the parties, the issues to be

decided are: 

(1) Whether petitioner is required to change from the cash

method of accounting to the accrual method of accounting;

(2) if petitioner is required to change to the accrual

method of accounting, to what extent, if any, adjustments were

properly made under section 481; and 

(3) whether petitioner is liable for the accuracy-related

penalty under section 6662(a).

FINDINGS OF FACT

Petitioner is a California corporation organized in 1980.

At the time of filing the petition in this case, petitioner's

principal place of business was in Oakland, California. 

Petitioner is owned 76 percent by its president, Clifford Asher

(Mr. Asher), and 24 percent by Mr. Asher's son, Donald Asher.

Petitioner is in the lithography or commercial printing

business. The business was established by a prior owner in 1937. 

In 1973, Mr. Asher purchased the business from the prior owner. 

In 1980, Mr. Asher incorporated the business and changed its name

to Golden Gate Litho. 
- 3 -

2 Petitioner usually donates the scraps to a school or

makes scratch pads out of the them.

Petitioner prints calendars, napkins, greeting cards, and

forms according to the specifications of its customers. 

Petitioner orders the types of paper and supplies needed for

print jobs after receiving job orders. Petitioner does not

maintain a stock of paper or other materials because each job

requires paper of a different weight and finish. Usually when a

job is completed, any materials left over are scraps and are not

used for other jobs.2 

On average, it takes 2 to 3 weeks from the time an order is

placed to complete the job and ship the order to the customer.

Petitioner holds title to (and bears the risk of loss of) the

supplies and printed goods until the final goods are shipped to

its customers. After the goods are shipped, the client is billed

for the order. Petitioner usually receives payment for an order

within 45 days of shipment.

A large portion of petitioner's work is done for one

customer, Suzy's Zoo Greeting Cards. For the taxable year ending

May 31, 1991, Suzy's Zoo Greeting Cards accounted for

approximately 70 percent of petitioner's accounts receivable at

the start of the taxable year and approximately 80 percent of the

accounts receivable at the end of the taxable year. 
- 4 -

Petitioner has used the cash receipts and disbursements

method of accounting (cash method) for tax purposes since its

incorporation. Petitioner reports sales at the time it receives

payment. Petitioner deducts the cost of materials and supplies

for each printing job in the year of purchase and deducts all

expenses in the year paid. Petitioner did not report any

beginning or ending inventory on its tax returns and did not use

inventory accounting for either tax or financial accounting

purposes for the year at issue or the immediately preceding tax

year. Since its incorporation, petitioner has reported no

opening or closing inventories on its tax returns. 

Petitioner reported its income under the cash method for the

taxable years ending May 31, 1989 through 1995, as follows:

 Taxable Year Ending 

5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95

Gross receipts $1,450,643 $1,462,904 $1,678,433 $1,499,946 $1,399,727 $1,357,166 $1,135,232

Cost of goods

 sold 939,217 890,986 1,026,832 900,459 834,879 94,623 759,113

Gross profit 511,426 571,918 651,601 599,487 564,848 462,543 376,119

Total deductions 468,360 585,688 615,220 562,412 541,842 531,526 480,820

Net income1 43,066 (13,770) 36,381 37,075 23,006 (68,983) (104,701)

Other income2 8,821 18,238 16,683 17,147 21,083 15,346 12,797

Special deductions -0- 670 3,064 4,222 6,293 6,007 6,117

Taxable income 51,887 3,798 50,000 50,000 37,796 (59,644) (98,021)

Schedule A (cost of 

goods sold):

 Inventory 

 beginning year -0- -0- -0- -0- -0- -0- -0- 

 Purchases 546,827 483,172 577,861 449,492 380,327 420,730 282,490 

Labor 335,783 375,021 395,210 377,987 382,311 396,928 324,124

 Union benefits 30,004 25,460 28,153 32,383 37,010 35,969 29,624

 Misc. O/S 

 services -0- -0- 18,468 30,995 29,594 33,595 116,410

 Sales Tax 20,543 -0- -0- -0- -0- -0- -0-

 Freight 6,060 7,333 7,140 9,602 5,637 7,401 6,465 

Inventory 

 end year -0- -0- -0- -0- -0- -0- -0-

 Total 939,217 890,986 1,026,832 900,459 834,879 894,623 759,113

Schedule E 

(compensation of 

officers):
- 5 -

3 Amounts are rounded to the nearest dollar.

 C. F. Asher 156,250 205,000 228,000 182,500 165,000 165,000 135,000

 D. Asher wage 

 in C.O.G.S. -0- 106,545 138,978 134,620 132,295 143,741 101,015

1 Taxable income excluding other income and before NOL and special deductions.

2 Dividends, interest, gross rents and royalties, capital gain, and other income.

Mr. Asher and petitioner's bookkeeper used a commercial

bookkeeping program to prepare balance sheets that included

estimates of petitioner's end-of-year accounts receivable,

accounts payable, salaries and wages payable, and work in

process. The bookkeeper determined the amount of accounts

payable by totaling bills that were due. The bookkeeper also

determined the amount of accounts receivable by compiling

amounts reflected on customer account cards. Mr. Asher

estimated the amount reflected on the balance sheet as work in

process. Mr. Asher's estimates of work in process were based on

the market value that included the expected profit from the

work. The balance sheets for the fiscal years ending May 31,

1989 through 1995, reflect the following amounts:3

 Taxable Year Ending 

 Item 5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95

Accounts 

 receivable $176,580 $250,378 $196,378 $142,673 $221,248 $210,471 $212,379

Accounts payable 35,999 86,334 23,711 44,198 64,206 42,278 45,087

Salaries and 

 wages payable 16,250 12,250 13,250 13,250 14,250 15,250 16,250

Pension plan

 accrual -0- 52,260 56,000 -0- -0- 20,000 73,597

Work in process 120,000 150,000 161,000 120,000 145,000 80,000 139,000

No later than July 1993, an agent of the Internal Revenue

Service (IRS) began an audit of petitioner's returns for the
- 6 -

taxable years ending May 31, 1991 and 1992. The agent has a

bachelor of science and a master's in business administration in

accounting. The audit was extensive and lasted longer than 12

months. Petitioner provided the agent with all its books and

records. Although petitioner had previously been audited and

had not been required to change from the cash method of

accounting, the agent determined that petitioner was required to

account for inventories and use the accrual method of

accounting.

During the examination of petitioner's returns, petitioner

provided the following breakdown of the work in process as of

June 1, 1991:

Paper $55,000

W.I.P. camera 5,000

W.I.P. press 30,000

W.I.P. bindery 16,000

Jobs completed and shipped 38,000

Jobs ready to bill 13,500

Jobs at outside service 3,500

 Total 161,000 

Adjustments to Taxable Year Ending May 31, 1991

In the notice of deficiency, respondent determined that

petitioner was required to maintain inventories and use the

accrual method of accounting with respect to purchases and sales

of inventory items. Respondent increased petitioner's income

for the taxable year ending May 31, 1991, by $36,002 ($11,000 +
- 7 -

4 The notice of deficiency identifies the $11,000 increase

as an adjustment to "work in process".

$78,464 - $53,462) to account for the change to the accrual

method as follows: 

(1) Respondent reduced petitioner's gross receipts or sales

by $53,462 computed as follows:

Accounts receivable at close of year, less 1$196,916

Accounts receivable at beginning of year (250,378)

Adjustment to gross receipts or sales (53,462)

1Respondent used the amount of accounts receivable provided

during the examination of petitioner's return rather than the

amount reflected on petitioner's balance sheet for the fiscal

year ending May 31, 1990.

(2) Respondent increased petitioner's income by $11,000 to

reflect an $11,000 reduction of petitioner's cost of goods sold4

to account for inventories as follows:

Work in process at beginning of year, less $150,000

Work in process at end of year (161,000)

Reduction in cost of goods sold (11,000)

(3) Respondent increased petitioner's income by $78,464 to

reflect a $78,464 reduction of petitioner's cost of goods sold

to account for purchases on the accrual method as follows:

Accounts payable at close of year, less 1$20,120

Accounts payable at beginning of year 2(98,584)

Reduction in cost of goods sold (78,464)

1 This amount is the portion of the accounts payable at the

close of the taxable year that is related to cost of goods sold. 

It does not include $5,111 in accounts payable related to

operating expenses and $11,250 in salaries and wages payable to

Mr. Asher.

2 This amount includes all accounts payable ($86,334), plus

all salaries and wages payable ($12,250) at the beginning of the
- 8 -

taxable year. It includes payables related to operating

expenses as well as those related to cost of goods sold.

Respondent determined that adjustments were required by

section 481(a) and adjusted petitioner's taxable year ending May

31, 1991, as follows:

(1) Respondent increased petitioner's income by $250,378

for the amount of accounts receivable reflected on its balance

sheet for fiscal year ending May 31, 1990;

(2) respondent increased petitioner's income by $150,000

for the value of work in process reflected on its balance sheet

for fiscal year ending May 31, 1990; and

(3) respondent decreased petitioner's income by $98,584 for

the amount of accounts payable and wages and salaries payable

reflected on its balance sheet for fiscal year ending May 31,

1990. 

Respondent made the entire section 481 adjustment to the

year of the change (taxable year ending May 31, 1991) and did

not consider the application of section 481(b). Respondent also

disallowed $21,888 in commission expenses and $6,215 that

petitioner claimed as the loss on the sale of an automobile. 

As a result of the adjustments, respondent determined that

petitioner's taxable income for the taxable year ending May 31,

1991, was $415,899 rather than $50,000 as reported on the

return. 
- 9 -

Adjustments to Taxable Year Ending May 31, 1992

In the notice of deficiency, respondent also adjusted

petitioner's taxable income for the taxable year ending May 31,

1992. Respondent reduced petitioner's income by $113,875

because of the change in accounting method. Specifically,

respondent decreased petitioner's income by $54,243 to reflect a

reduction in gross receipts, decreased petitioner's income by

$41,000 to reflect the reduction in the amount of petitioner's

work in process, and decreased petitioner's income to reflect an

$18,632 increase in the cost of goods sold. Respondent also

disallowed a repair expense of $23,624 and reduced petitioner's

depreciation deduction by $2,411. As a result of the

adjustments, respondent determined that petitioner had a $37,636

net operating loss for the taxable year ending May 31, 1992,

rather than $50,000 of taxable income as reported on the return.

OPINION

I

Whether Petitioner Is Required To Change From The Cash Method of

Accounting to The Accrual Method of Accounting

Section 446(a) requires a taxpayer to compute his taxable

income under the same method of accounting by which he regularly

computes his income in keeping his books. Section 446(b),

however, provides that "if the method used [by the taxpayer]

does not clearly reflect income, the computation of taxable
- 10 -

income shall be made under such method as, in the opinion of the

Secretary, does clearly reflect income."

In general, a method of accounting clearly reflects income

when it accurately reports taxable income under a recognized

method of accounting. Wilkinson-Beane, Inc. v. Commissioner,

420 F.2d 352, 354 (1st Cir. 1970), affg. T.C. Memo. 1969-70; RLC

Indus. Co. v. Commissioner, 98 T.C. 457, 490 (1992), affd. 58

F.3d 413 (9th Cir. 1995); Rotolo v. Commissioner, 88 T.C. 1500,

1513 (1987). Both the cash method and the accrual method are

permissible methods of accounting. Sec. 446(c)(1) and (2). 

Additionally, section 471(a) provides:

SEC. 471(a). General Rule.-- 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.

By regulation, the Secretary has determined that

inventories are necessary if the production, purchase, or sale

of merchandise is an income-producing factor. Sec. 1.471-1,

Income Tax Regs. The regulations provide that, unless otherwise

authorized by the Commissioner, a taxpayer who is required to

account for inventories must use the accrual method of

accounting with regard to purchases and sales. Sec. 1.446-

1(c)(2)(i), Income Tax Regs. 
- 11 -

A. Whether Petitioner Is Required To Maintain Inventories

Petitioner prints calendars, napkins, greeting cards, and

forms according to the specifications of its customers.

Petitioner does not maintain a stock of paper or other materials

because each job requires paper of a different weight and

finish. Petitioner orders the types of paper and supplies

needed for a job after the customer's order is placed. Usually

when a job is completed, any materials left over are scraps and

are not used for other jobs.

Respondent asserts that petitioner's production, purchase,

and sale of merchandise is an income-producing factor, and

therefore petitioner must account for inventories. Petitioner

argues that it provides a service, and the printed items it

sells to its customers and the materials it uses are not

merchandise. Petitioner argues, therefore, it is not required

to maintain inventories. 

Although not specifically defined in the Internal Revenue

Code or regulations, courts have found that the term

"merchandise", as used in section 1.471-1, Income Tax Regs., is

defined as an item held for sale. Wilkinson-Beane, Inc. v.

Commissioner, supra at 354-355; Tebarco Mechanical Corp. v.

Commissioner, T.C. Memo. 1997-311; Galedrige Constr., Inc. v.

Commissioner, T.C. Memo. 1997-240; Honeywell Inc. & Subs. v.
- 12 -

Commissioner, T.C. Memo. 1992-453, affd. without published

opinion 27 F.3d 571 (8th Cir. 1994).

Petitioner sells items that it prints according to the

specifications of its customers. The printed items are items

held for sale and, thus, are merchandise. All of petitioner's

gross receipts are generated by the sale of the items petitioner

produces for its customers. Therefore, the production and sale

of merchandise is an income-producing factor. 

Furthermore, even if we agreed that petitioner performs a

service, courts have held that, if the cost of materials a

taxpayer uses to provide a service is substantial compared to

its receipts, the material is a substantial income-producing

factor. Wilkinson-Beane, Inc. v. Commissioner, supra at 355. 

Petitioner reported the following gross receipts and purchases

for the taxable years ending May 31, 1989 through 1995:

 Taxable Year Ending 

 5/31/89 5/31/90 5/31/91 5/31/92 5/31/93 5/31/94 5/31/95

Gross receipts $1,450,643 $1,462,904 $1,678,433 $1,499,946 $1,399,727 $1,357,166 $1,135,232

Purchases $546,827 $483,172 $577,861 $449,492 $380,327 $420,730 $282,490 

Percentage 38% 33% 34% 30% 27% 31% 25%

The cost of materials petitioner uses to provide its

service is substantial compared to its receipts. Therefore,

the material petitioner uses is a substantial income-producing

factor. Petitioner's arguments have previously been considered

and rejected by this Court. See Thompson Elec., Inc. v.

Commissioner, T.C. Memo. 1995-292; J.P. Sheahan Associates,
- 13 -

Inc. v. Commissioner, T.C. Memo. 1992-239; Akers v.

Commissioner, T.C. Memo. 1984-208, affd. on this issue sub nom.

Asphalt Prods. Co. v. Commissioner, 796 F.2d 843 (6th Cir.

1986), revd. on another issue 482 U.S. 117 (1987). We find

that petitioner's sale of merchandise is an income-producing

factor and, therefore, petitioner is required to maintain

inventories.

B. Whether It Was an Abuse of Respondent's Discretion To

Change Petitioner From the Cash Method to Respondent's

Method of Accounting

The regulations provide that, unless otherwise authorized

by the Commissioner, a taxpayer who is required to account for

inventories must use the accrual method of accounting with

regard to purchases and sales. Sec. 1.446-1(c)(2)(i), Income

Tax Regs. Respondent argues that petitioner must account for

inventories and must use the accrual method of accounting. In

this case, however, the facts show that respondent completely

disregarded the applicable provisions of the Internal Revenue

Code and regulations and made no attempt to properly value

petitioner's inventory or compute petitioner's income using a

proper accrual method of accounting. 

1. Respondent's Method of Valuing Petitioner's Inventory

Was Improper

Rules governing the valuation of inventories are set forth

in regulations promulgated under section 471 and the uniform
- 14 -

capitalization rules of section 263A. See secs. 1.471-1,

1.471-2, 1.471-3, 1.471-5, Income Tax Regs.; sec. 1.263A-1T,

Temporary Income Tax Regs., 52 Fed. Reg. 10060 (Mar. 30, 1987). 

Respondent failed to comply with the rules for identifying

items properly included in inventory and for properly valuing

inventory items. 

a. Items Included in Inventory

Respondent increased petitioner's income for the taxable

year ending May 31, 1991, by $11,000 to reflect a reduction of

petitioner's cost of goods sold to account for inventories

based on the increase in the value of work in process at the

end of the year ($161,000) over the value at the beginning of

the year ($150,000). In making the computation respondent used

the value of the work in process as reflected on petitioner's

balance sheets. During the examination of petitioner's return

for the taxable year at issue, petitioner provided the

following breakdown of the work in process as of June 1, 1991:

Paper $55,000

W.I.P. camera 5,000

W.I.P. press 30,000

W.I.P. bindery 16,000

Jobs completed and shipped 38,000

Jobs ready to bill 13,500

Jobs at outside service 3,500

 Total 161,000 

Section 1.471-1, Income Tax Regs., provides in part:
- 15 -

Merchandise should be included in the inventory only

if title thereto is vested in the taxpayer. 

Accordingly, the seller should include in his

inventory goods under contract for sale but not yet

segregated and applied to the contract * * *, but

should exclude from inventory goods sold * * * title

to which has passed to the purchaser. A purchaser

should include in inventory merchandise purchased

(including containers), title to which has passed to

him, although such merchandise is in transit or for

other reasons has not been reduced to physical

possession, but should not include goods ordered for

future delivery, transfer of title to which has not

yet been effected. * * *

 

Petitioner holds title to goods until they are shipped to

the purchaser and bills the customer after the order is

shipped. Therefore, petitioner does not hold title to work in

process for jobs completed and shipped and work in process for

jobs ready to bill. Under the regulations, such goods are not

properly included in valuing petitioner's inventory, and it was

improper for respondent to do so. 

b. Respondent's Use of Estimated Market Value

"The bases of valuation most commonly used by business

concerns and which meet the requirements of section 471 are (1)

cost and (2) cost or market, whichever is lower." Sec. 1.471-

2(c), Income Tax Regs. Section 1.471-4(c), Income Tax Regs.,

provides:

Where the inventory is valued upon the basis of cost

or market, whichever is lower, the market value of

each article on hand at the inventory date shall be

compared with the cost of the article, and the lower
- 16 -

5 Sec. 263A also applies to real or personal property

described in sec. 1221(1) which is acquired by the taxpayer for

resale except for taxpayers who have annual gross receipts of $10

million or less. Sec. 263A(b)(2). There is no exception

provided for producers who have annual gross receipts of $10

million or less. 

of such values shall be taken as the inventory value

of the article. 

Section 1.471-3, Income Tax Regs., defines "cost" as

follows:

(a) In the case of merchandise on hand at the

beginning of the taxable year, the inventory price of

such goods.

* * * * * * *

(c) In the case of merchandise produced by the

taxpayer since the beginning of the taxable year, (1)

the cost of raw materials and supplies entering into

or consumed in connection with the product, (2)

expenditures for direct labor, and (3) indirect

production costs incident to and necessary for the

production of the particular article, including in

such indirect production costs an appropriate portion

of management expenses, but not including any cost of

selling or return on capital, whether by way of

interest or profit. See section 1.263A-1T for more

specific rules regarding the treatment of production

costs. * * *

The uniform capitalization rules of section 263A apply to 

real or tangible property produced by the taxpayer.5 Sec.

263A(b)(1). Section 263A(a) provides that inventory costs

include the direct costs of such property and such property's

proper share of those indirect costs part or all of which are

allocable to such property. Section 1.263A-1T, Temporary
- 17 -

Income Tax Regs., supra, provides complex rules for allocating

indirect costs to inventory.

In valuing petitioner's inventory, respondent used the

value of petitioner's work in process as reflected on

petitioner's balance sheets. The value reflected on the

balance sheets was based on Mr. Asher's estimate of the market

value of work in process and included the expected profit from

the work.

The regulations permit the use of market value only when

that value is less than cost. Therefore, respondent's use of

the value of work in process as reflected on petitioner's

balance sheets is improper. Additionally, the regulations

require a comparison of the market value of each article on

hand at the inventory date with the cost of the article. 

Respondent made no attempt to properly identify inventory items

or the direct costs of such items or to properly allocate

indirect costs associated with such items under the uniform

capitalization rules of section 263A. 

We find that respondent's method of valuing petitioner's

work in process was arbitrary and without sound basis in fact

or law.

2. Respondent's Method Is Not a Proper Accrual Method

a. Accounts Receivable

Respondent reduced petitioner's gross receipts by $53,462

to account for accounts receivable. Respondent excluded from
- 18 -

gross receipts $250,378 attributable to accounts receivable at

the beginning of the year and included $196,916 attributable to

accounts receivable at the close of the year. The amount of

receivables, however, was determined by compiling amounts

reflected on customer account cards.

Accrual method taxpayers recognize income when "all the

events have occurred which fix the right to receive such income

and the amount thereof can be determined with reasonable

accuracy." Sec. 1.446-1(c)(1)(ii), Income Tax Regs. 

Generally, under the "all events" test, accrual method

taxpayers recognize income when it is paid, due, or earned,

whichever occurs first. See, e.g., Schlude v. Commissioner,

372 U.S. 128, 133 n.6 (1963).

As discussed above, the breakdown of the work in process

at the end of the year included amounts that had been earned,

even though not billed to the client. Those amounts were

accounts receivable at the close of the taxable year. 

Consequently, gross receipts should have been increased by

those amounts. Similarly, any portion of the work in process

at the beginning of the year representing completed work that

had been shipped by the close of the previous tax year properly

was a receivable attributable to the prior taxable year. 

Consequently, gross receipts should have been reduced by that

amount. 
- 19 -

b. Adjustment for Accounts Payable

Under an accrual method of accounting, a liability is

incurred and taken into account in the taxable year in which

all the events have occurred which determine the fact of the

liability and the amount thereof can be determined with

reasonable accuracy. Sec. 1.461-1(a)(2), Income Tax Regs. 

Thus, for purposes of accrual method accounting and

ascertaining true income for a given accounting period, an

expense must be deducted in the taxable year in which all the

events have occurred which determine the fact of the liability

and fix the amount of the liability, even though the liability

is not due and payable until a later year. Aluminum Castings

Co. v. Routzahn, 282 U.S. 92 (1930); United States v. Anderson,

269 U.S. 422 (1926). 

Respondent increased petitioner's income by $78,464 to

reflect a reduction of petitioner's cost of goods sold to

account for purchases on the accrual method as follows:

Accounts payable at close of year, less $20,120

Accounts payable at beginning of year (98,584)

Reduction in cost of goods sold (78,464)

The adjustment for accounts payable was based on the

accounts payable reflected on petitioner's balance sheets for

the close of the taxable years ending May 31, 1990 and 1991. 

Although respondent's counsel would not stipulate the accuracy

of the amounts reflected on the balance sheets, it is those
- 20 -

amounts upon which respondent's adjustments are based. 

Further, petitioner's bookkeeper computed the payables by

totaling bills that were due. The payables did not include

expenses that may have properly accrued under the regulations

but for which petitioner had not yet been billed. 

Additionally, "No method of accounting will be regarded as

clearly reflecting income unless all items of gross profit and

deductions are treated with consistency from year to year."

Sec. 1.446-1(c)(2)(ii), Income Tax Regs. In this case,

respondent did not treat petitioner's accounts payable with

consistency. The accounts payable of $98,584 at the beginning

of the taxable year included all accounts payable ($86,334)

plus all salaries and wages payable ($12,500) reflected on the

balance sheet for the taxable year ending May 31, 1990. The

accounts payable of $20,120 for the close of the taxable year

included only those payables identified as payables related to

the cost of goods sold and did not include $5,111 in accounts

payable not related to the cost of goods sold or $11,250 in

salaries and wages payable to Mr. Asher. Respondent made no

adjustments to account for accounts payable at the end of the

taxable year related to the $5,111 of operating expenses or

related to the $11,250 of salaries and wages payable. 

Respondent's adjustment of these items was improper. In order

to clearly reflect petitioner's income, accounts payable at the
- 21 -

beginning and the end of the year should have been treated in a

consistent manner. 

If the accounts payable were to be allocated between those

related to the cost of goods sold and those related to

operating costs, an allocation should also have been made for

accounts payable at the beginning of the taxable year. Then

proper adjustments could be made to the cost of goods sold and

to the deduction for operating expenses.

Additionally, since respondent treated all accounts

payable at the beginning of the year as related to the cost of

goods sold, there would have been no accounts payable at the

beginning of the year related to operating expenses. 

Therefore, respondent should have increased petitioner's

deduction for operating expenses (reducing petitioner's income)

by $16,361 to reflect the increase in payables related to

operating expenses at the close of the year. 

We find respondent's determinations with respect to

petitioner's accounts receivable and payable to be

unreasonable, arbitrary, and without basis in law. 

3. It Was an Abuse of Respondent's Discretion To Change

Petitioner From the Cash Method to Respondent's

Improper Method of Accounting

During the 12-month examination of petitioner's records,

the agent made no attempt to properly value petitioner's

inventories or value payables and receivables under the accrual
- 22 -

method. Furthermore, although respondent's adjustments were

based on the amounts reflected on petitioner's balance sheets,

respondent's counsel would not stipulate the accuracy of those

amounts. 

In Keneipp v. United States, 184 F.2d 263, 268 (D.C. Cir. 

1950), the court addressed the Commissioner's power to allocate

items of income and stated:

We perceive no basis upon which the allocation

made by the Commissioner of the condemnation award

among the several pieces of property can be

sustained. * * * The Government's allocation is thus

completely erroneous on its face. The District Court

held that since there was a lump-sum award the

Commissioner of Internal Revenue had power to make

whatever allocation he pleased. The Commissioner has

no such arbitrary power. He has wide latitude in the

ascertainment of the fact as to what were the amounts

awarded on account of the several tracts and several

pieces of property. But his ascertainment must be

within the realm of the ascertainment of a fact. He

has no unilateral power to allocate as he pleases,

and thus to create income as he pleases, where no

income, or a different amount of income, exists. His

own published rule is that such an apportionment must

be upon the comparative values as of the date of the

sale. 

We think that the reasoning of the U.S. Court of Appeals

for the D.C. Circuit in the Keneipp case is equally applicable

in the case at hand. We do not think there is any legitimate

basis for the method imposed upon petitioner. In this case,

the facts clearly show that the method of accounting employed

by respondent was not authorized or warranted by any provision

of the Internal Revenue Code or the regulations. Merely
- 23 -

invoking the accrual method without a serious attempt to comply

with the rules and regulations governing that method is simply

not sufficient. Respondent has no unilateral power to value

inventory and allocate amounts to accounts receivable and

payable as he pleases in complete disregard of the Internal

Revenue Code and the regulations. To do so is an abuse of

respondent's discretion. 

 Respondent contends that petitioner must show a

substantial identity of results between the cash method and the

method of accounting respondent imposed in order to show an

abuse of discretion. We disagree. 

The substantial identity of results test is applicable

when the taxpayer is required to maintain inventories and the

Commissioner has required the taxpayer to compute its income on

a proper accrual method of accounting as provided in the

regulations. We think it would be an abuse of the Court's

discretion to require petitioner to show that the cash method

it has consistently used produces substantially the same

results as the arbitrary and erroneous method respondent

imposed. 

Respondent's adjustments based on the improper method

increased petitioner's income by $36,002 for the taxable year

ending May 31, 1991, but decreased petitioner's income by

$113,875 for the taxable year ending May 31, 1992, and created
- 24 -

a net operating loss of $37,636 for the taxable year ending May

31, 1992. Under the circumstances of this case, and given the

inadequacies of respondent's method, we think petitioner's use

of the cash method produces substantially the same results. 

Furthermore, respondent's method not only distorts

petitioner's income but will subject petitioner to further

adjustments, including adjustments under section 481, in

subsequent taxable years if petitioner attempts to properly

comply with regulations for accrual method accounting. If, in

respondent's opinion, petitioner's accounting method did not

clearly reflect its income, the remedy was to require a

computation on a basis that would correctly reflect income by

proper application of the accrual method of accounting. 

The fact that the Commissioner possesses broad authority

under section 446(b) does not mean that the Commissioner can

change a taxpayer's method of accounting with impunity. See

Prabel v. Commissioner, 91 T.C. 1101, 1112-1113 (1988), affd.

882 F.2d 820 (3d Cir. 1989); Wal-Mart Stores, Inc. v.

Commissioner, T.C. Memo. 1997-1. The Commissioner cannot

require a taxpayer to change his accounting method to one which

is unacceptable or wrong. Harden v. Commissioner, 223 F.2d

418, 421 (10th Cir. 1955), revg. and remanding 21 T.C. 781

(1954); Rotolo v. Commissioner, 88 T.C. at 1514. Courts will

not approve the Commissioner's change of a taxpayer's
- 25 -

accounting method from an incorrect method to another incorrect

method. Harden v. Commissioner, supra; Prabel v. Commissioner,

supra at 1112; see also Dayton Hudson Corp. & Subs. v.

Commissioner, T.C. Memo. 1997-260. The Commissioner's

authority is limited to substituting a method that will clearly

reflect the taxpayer's income. Harden v. Commissioner, supra

at 421. The Commissioner is required to use reasonable

accounting methods. Helvering v. Taylor, 293 U.S. 507 (1935);

Rubin v. Commissioner, T.C. Memo. 1954-213. The taxpayer has

the burden of showing that the method selected by the

Commissioner is incorrect, and that burden is extremely

difficult to carry. Hamilton Indus., Inc. v. Commissioner, 

97 T.C. 120 (1991); Photo-Sonics, Inc. v. Commissioner, 42 T.C.

926, 933 (1964), affd. 357 F.2d 656 (9th Cir. 1966). In this

case, petitioner has carried its burden because the facts

clearly show that the method selected by the Commissioner is

arbitrary, capricious, and without sound basis in fact or law. 

In Loftin & Woodard, Inc. v. United States, 577 F.2d 1206,

1229 (5th Cir. 1978), the court stated:

While abuse of this discretion by the

Commissioner must be proven by a clear showing, Wood

v. Commissioner of Internal Revenue, 245 F.2d 888

(5th Cir. 1957), it would seem that such a showing

could be predicated upon a decision to use an

accounting method that is inaccurate under the

circumstances. * * *
- 26 -

We hold it was an abuse of respondent's discretion to

require petitioner to change from the cash method to

respondent's improper and inaccurate method.

C. For the Taxable Year at Issue, Petitioner Is Not Required

To Change From the Cash Method of Accounting

Courts have recognized that the regulations do not impose

an absolute prohibition of the use of the cash method upon a

taxpayer who is required to maintain inventories. Cf. Asphalt

Prods. Co. v. Commissioner, 796 F.2d at 849 (an insignificant

increase in inventories may be grounds for finding an abuse of

discretion by the Commissioner); Estate of Sperling v.

Commissioner, 341 F.2d 201, 204 (2d Cir. 1965), affg. T.C.

Memo. 1963-260 (courts will not require the Commissioner to

place a taxpayer on the accrual method); Drazen v.

Commissioner, 34 T.C. 1070, 1079 (1960) (where inventories are

so small as to be of no consequence or consist primarily of

labor, the presence of inventories is not necessarily

sufficient to require a change in the taxpayer's method of

accounting). 

In Estate of Sperling v. Commissioner, supra, the taxpayer

argued that it was required to account for inventories and,

therefore, the Commissioner should have used the accrual method

in determining the tax deficiency. The court stated:

It is difficult to find any basis in reason for

thus placing the burden on the Commissioner to place

the taxpayer's tax returns on a different accounting
- 27 -

basis. As this case comes to us, * * * [the

taxpayer's] 1953 and 1954 tax returns show two

defects. The first is that certain alleged credits

for the purchase of metals are not adequately

documented. The second is the use of an improper

accounting method. What the Commissioner has done is

to determine deficiencies attributable to the first

defect but to leave the second alone. We may guess

that this decision was made because it was believed

that the game was not worth the candle: the

additional deficiencies, if any, which use of the

accrual method might reveal would not warrant the

considerable effort which a redetermination would

require. Whatever the reason, however, we cannot see

why the decision should be held improper.

* * * * * * *

Of course, it is possible that the taxpayer's

accounting system may be so inadequate that the

Commissioner has no choice but to redetermine the

liability on the basis of his own system; * * * But

where the taxpayer does have a rational, though

improper, system, we think that the Commissioner may

choose to let it stand and to pursue only specific

deficiencies within it. And so long as the

deficiencies which he determines are not themselves

infected by the system's shortcomings, the taxpayer

may not avoid the deficiencies simply by pointing to

the inadequacy of his own accounting system. [Id. at

204-205; citation omitted.] 

In Keneipp v. United States, 184 F.2d at 268, the court

reversed and remanded for further proceedings. In that case,

the court stated:

such proceedings need not be elaborate or extensive. 

The Bureau of Internal Revenue has many auditors who

can quickly compute the gain properly taxable to

these appellants upon the facts of this case and the

principles we have referred to.
- 28 -

By contrast, in this case proper application of the

accrual method and inventory valuation would require a full

audit of petitioner's books and records. The record does 

not provide any basis upon which the Court can properly value

petitioner's inventory or accounts receivable and payable or

otherwise discern petitioner's taxable income under a proper

accrual method. In this case, the erroneous items cannot be

discerned with relative clarity and, therefore, cannot be

corrected in a computation under Rule 155. Cf. All-Steel

Equip. Inc. v. Commissioner, 54 T.C. 1749 (1970), affd. in

part, revd. in part and remanded 467 F.2d 1184 (7th Cir. 1972). 

The Internal Revenue Code contemplates action by the

Commissioner, not the courts. Harden v. Commissioner, supra at

421. 

Since petitioner's cash method is a rational system, we

think that the Court may choose to let it stand. We see no

basis for placing a greater burden on the Court than we place

on the Commissioner. See Estate of Sperling v. Commissioner,

supra at 203. We hold that petitioner is not required to

change from the cash method of accounting for the taxable year

at issue.

II

Whether Respondent's Adjustments Under Section 481 Were Proper

Section 481(a)(1) provides that where in computing a

taxpayer's taxable income the computation is under a method of
- 29 -

accounting different from the method under which the taxpayer's

income for the preceding taxable year was computed, there shall

be taken into account those adjustments which are determined to

be necessary solely by reason of the change in order to prevent

an amount from being duplicated or omitted. Since we have held

that petitioner is not required to change from the cash method

for the taxable year at issue, petitioner's taxable income is

computed under the same method of accounting as in the previous

taxable year. Therefore, petitioner is not subject to any

adjustments under section 481.

III

Whether Petitioner Is Liable for the Accuracy-Related Penalty

Under Section 6662(a)

In its brief, petitioner addressed the accuracy-related

penalty only with respect to the change in accounting method. 

Petitioner concedes that it is not entitled to deduct the loss

on the sale of an automobile. The deficiency to be computed

under Rule 155 is attributable solely to the disallowance of

that loss. Therefore, we hold petitioner is liable for the

accuracy-related penalty under section 6662(a).

To reflect the foregoing and because of the concessions by

the parties,

Decision will be entered

under Rule 155.