1

These cases were consolidated for purposes of trial,

briefing, and opinion, and will hereinafter be referred to as the

instant case.

T.C. Memo. 1996-105

UNITED STATES TAX COURT

HOSPITAL CORPORATION OF AMERICA AND SUBSIDIARIES,1 Petitioners v.

 COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 10663-91, 13074-91, Filed March 7, 1996

 28588-91, 6351-92.

N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

and John W. Bonds, Jr., for petitioners in docket No. 10663-91.

N. Jerold Cohen, Randolph W. Thrower, J.D. Fleming, Jr.,

Walter H. Wingfield, Stephen F. Gertzman, Reginald J. Clark,
- 2 -

Amanda B. Scott, Walter T. Henderson, Jr., William H. Bradley,

John W. Bonds, Jr., and Daniel R. McKeithen, for petitioners in

docket No. 13074-91.

N. Jerold Cohen, Walter H. Wingfield, Stephen F. Gertzman,

Amanda B. Scott, Reginald J. Clark, Randolph W. Thrower, Walter

T. Henderson, Jr., and John W. Bonds, Jr., for petitioners in

docket No. 28588-91.

N. Jerold Cohen, Reginald J. Clark, Randolph W. Thrower,

Walter T. Henderson, and John W. Bonds, Jr., for petitioners in

docket No. 6351-92.

Robert J. Shilliday, Vallie C. Brooks, and William B.

McCarthy, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined deficiencies in

petitioners' consolidated corporate Federal income taxes as

follows:

Year Deficiency

1978 $2,187,079.00

1980 388,006.58

1981 94,605,958.92

1982 29,691,505.11

1983 43,738,703.50

1984 53,831,713.90

1985 85,613,533.00

1986 69,331,412.00

1987 294,571,908.00

1988 25,317,840.00
- 3 -

2

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

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

Procedure. 

3

The instant case involves several issues, some of which have

been settled. The issues remaining for decision involve matters

falling into four reasonably distinct categories, which the

parties have denominated as the tax accounting issues, the MACRS

depreciation issue, the HealthTrust issue, and the captive

insurance or Parthenon Insurance Co. issues. Issues involved in

the first three categories were presented at a special trial

session, and the captive insurance issues were severed for trial

purposes and were presented at a subsequent special trial

session. Separate briefs of the parties were filed for each of

the distinct categories of issues. The instant opinion involves

one of the tax accounting issues. The other issues remaining for

decision will be addressed in one or more separate opinions

subsequently to be released.

Respondent also determined that petitioners are liable for

increased interest under section 6621(c)2 for each year in issue. 

The issue we decide in the instant opinion3 is whether

respondent's determination changing certain petitioners from a

hybrid method of accounting to an overall accrual method of

accounting for the taxable years ended 1981 through 1986 was an

abuse of respondent's discretion.

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91. The stipulated facts are incorporated herein by

reference and are found accordingly.

During the years in issue, petitioners were members of an

affiliated group of corporations whose common parent was Hospital
- 4 -

4

During 1989, HCA became a privately held corporation and

remained so until 1992, when it again went public and changed its

name to HCA-Hospital Corp. of America. On Feb. 10, 1994, the

corporation was merged with and into Galen Healthcare, Inc., a

subsidiary of Columbia Healthcare Corp. of Louisville, Kentucky,

and such subsidiary changed its name to HCA-Hospital Corp. of

America. On that same date, the parent changed its name to

Columbia/HCA Healthcare Corporation. 

Corporation of America (HCA). HCA maintained its principal

offices in Nashville, Tennessee, on the date the petitions were

filed. For each of the years involved in the instant case, HCA

and its domestic subsidiaries filed a consolidated U.S.

Corporation Income Tax Return on Form 1120 with the Director of

the Internal Revenue Service Center at Memphis, Tennessee. 

General Background

In 1960, Park View Hospital, Inc., was incorporated under

the laws of the State of Tennessee. During 1968, Park View

Hospital, Inc., joined with 11 other hospitals to form HCA, and

thereafter until 1989, HCA stock was publicly held and traded on

the New York Stock Exchange.4 

Petitioners' primary business is the ownership, operation,

and management of hospitals. As of January 1, 1981, petitioners

owned and operated 101 hospitals. By the end of 1986,

petitioners owned and operated 243 hospitals through 134

corporations. 

HCA and its subsidiaries were formed as for-profit

corporations, based on the theory that operating health care
- 5 -

5

Hereinafter, we sometimes will use the term “medical supply”

to refer to a medical supply or pharmaceutical.

6

 The parties have stipulated that our holding relating to the

change in method of accounting adjustments for petitioners'

hospitals shall also apply to the change in method of accounting

adjustments proposed for petitioners' medically related nonhospital businesses. 

facilities as a group promotes greater efficiency and provides

economies of scale and thereby generates a profit. HCA was one

of the first public corporations to operate hospitals as a forprofit business. 

Most of petitioners' hospitals are acute care hospitals

providing a facility, personnel, equipment, and medical supplies

and pharmaceuticals5 needed to perform medical and surgical

procedures to treat injured or sick persons with various physical

disorders. Some of petitioners' facilities are psychiatric

hospitals providing medical treatment to persons with mental or

emotional disorders and drug and alcohol dependency problems. 

Certain petitioners operate a variety of medically related

businesses ancillary to the hospitals, including laundries,

office buildings, home health care facilities, ambulance

companies, and laboratories.6

Description of Petitioners' Hospitals

All of petitioners' hospitals maintain and operate patient

floors on which patient rooms are situated. They also maintain

and operate kitchens which are used to prepare food for patients

and for the hospital cafeterias. 
- 6 -

Acute Care Hospitals

Petitioners' acute care hospitals provide to the physicians

on their staff and their patients the facilities, equipment,

medical supplies, and nursing and other personnel necessary for

the diagnosis and treatment of physical conditions that cannot be

performed at the physicians’ own offices. The physicians on the

medical staff of petitioners' hospitals generally are not

employees of the hospital and usually operate medical practices

independent of the hospitals. They join the staff of the

hospital in order to gain access to the hospitals’ facilities for

use by them and their patients. 

A wide range of medical procedures is performed in

petitioners' hospitals, such as diagnostic and surgical

procedures (inpatient and outpatient), emergency treatment, child

delivery, neonatal care, and intensive care treatment. Most of

those procedures require the use of medical supplies. 

Petitioners' hospitals employ administrative personnel,

nurses, patient attendants, laboratory technicians, physical

therapists, and other medical personnel to provide medical

treatment to patients under the direction and supervision of the

patient's attending physician. All registered nursing positions

and many other positions require special professional or

technical training and/or certification.

When admitted to one of petitioners' hospitals, a patient is

required to sign various releases, insurance assignments, and
- 7 -

7 

During the years involved, petitioners received

reimbursements from Medicare equal to 35 percent to 43 percent of

the total operating revenues reported on the Forms 10-K filed

with the Securities and Exchange Commission (SEC). 

8

When Medicare is the third-party payer, hospitals can

collect only the "Medicare co-payments" from patients. Should

the total payments from Medicare and the patient not equal the

total amount billed to the patient, the hospital is not allowed

to collect the difference from the patient. 

patient agreements. The hospital generally requires each patient

to agree to pay for all charges incurred while in the hospital

upon demand by the hospital. Medicare,7 Blue Cross, health

maintenance organization (HMO), and some other insurance plan

patients, however, are responsible only for a copayment.8 

For acute care hospital patients, the nurses and patient

attendants perform a wide variety of services, including, but not

limited to, assisting physicians during patient examinations and

medical procedures and treatments, administering medications,

preparing and operating specialized equipment used in treating

patients, monitoring patients' conditions, serving meals to

patients and regulating and monitoring their food intake,

assisting in bathing patients, and helping them into and out of

bed. Nurses and other hospital personnel also are involved in

surgical procedures performed at a hospital. If an acute care

hospital maintains a delivery room and obstetric care and newborn

care units, delivery room nurses and other staff employees assist

the physician in the delivery of newborn infants, provide daily
- 8 -

nursing care for newborn infants, and instruct mothers in

postnatal self-care and newborn care. 

For patients in intensive care units, the nurses and patient

attendants provide care of a more sustained and specialized

nature than that provided to the usual medical and surgical

patients. Nurses and attendants also staff the emergency room. 

Acute care hospitals generally provide numerous ancillary

services in support of basic hospital and nursing care provided

to patients. Ancillary units include laboratories for performing

diagnostic and routine laboratory tests of all kinds, a blood

bank for procuring, receiving, and storing a supply of blood and

blood derivatives to be used in surgery and patient treatment, an

electrocardiology department for performing a variety of

diagnostic testing of patients with heart disease, a radiology

department for taking radiographs and fluorographs (often

including a separate cardiac catheterization laboratory,

ultrasound laboratory, nuclear medicine facility, angiocardiology

center, and other units performing various radiological

functions), and an anesthesiology department for assisting in

surgery and other in-hospital procedures by administering gases

and other anesthetics. The various ancillary departments employ

many specially trained personnel who perform specific technical

service functions necessary for patient treatment. 

As of December 31, 1986, acute care hospitals owned by

petitioners were located in 26 States and four foreign countries.
- 9 -

Psychiatric Hospitals

As of January 1, 1981, petitioners did not own any

psychiatric hospitals although a number of petitioners' hospitals

operated psychiatric wards within them. During 1981, petitioners

acquired and operated 22 psychiatric hospitals. At the end of

1986, petitioners operated 39 psychiatric hospitals, which were

located in 14 States and one foreign country.

Petitioners' psychiatric hospitals provide for the mid- and

long-term treatment of persons suffering from mental and

emotional diseases and disorders. Typically, these facilities do

not provide the broad range of medical treatment provided by

petitioners' acute care hospitals. 

Petitioners' psychiatric hospitals employ administrative

personnel, nurses, patient attendants, counselors, therapists,

pharmacists, and other medical personnel to care for patients

with mental and emotional diseases and disorders. The

professional personnel working at psychiatric facilities are

trained in procedures such as crisis intervention and special

therapies for treating mental problems associated with aging,

substance abuse, sexual abuse, depression, grief and loss, stress

management, and the emotional problems of adolescence, as well as

psychotic or chronic disorders. The treatment programs at the

psychiatric hospitals emphasize not only therapy and counseling,

but also education and the development of communication skills. 
- 10 -

Psychiatric treatment is conducted under the direction of and

pursuant to a program prescribed by an attending physician.

Services Performed by Certain Hospital Departments

The Central Supply Services Department

The central supply services department (central supply), and

sometimes a separate materials management department, purchase

and stock the medical and surgical supplies and equipment which

are used in the treatment of patients. When supplies purchased

through central supply or materials management are physically

stored in other areas of the hospital, such as the operating room

or the emergency room, employees of central supply regularly

replenish such stock. Central supply, or a separate autoclave

department, also cleans, assembles, maintains, and issues

portable apparatus required for patient care, and it collects,

assembles, sterilizes, and redistributes reusable items. All

purchasing decisions at petitioners' hospitals are made at the

individual hospital level by employees in central supply or the

materials management department, although the corporate office

does negotiate and provide national purchasing contracts that the

local hospitals may use at their option. 

The Pharmaceutical Department

Personnel in the pharmaceutical department (often called the

pharmacy) procure, store, control, and dispense medications that

are used in the treatment of inpatients or outpatients and, when

necessary, compound or mix prescribed medications unavailable in
- 11 -

prepackaged unit doses. Pharmacy items are dispensed only on the

order of a physician. 

When the pharmacy receives an order from the nursing unit,

pharmacy personnel examine the order by (1) reviewing any

medications that the patient is already taking and any condition

of the patient that may affect what medications the patient

should be taking and (2) checking in each case for drug

interactions and allergies. The pharmacy then fills the order,

and the medication is dispensed to the nursing unit. The

medication is administered to the patient by a nurse, who records

the procedure on a medication administration record (MAR). At

the end of each day, the pharmacy pulls a copy of the original

dispensing order and compares it to the MAR to verify that all

medications have been administered according to the direction of

the physician. All pharmacy items are prepared and dispensed

under the direction of a licensed pharmacist. The pharmacy

department typically employs several pharmacists as well as a

number of specially trained technicians. 

The pharmacy department also adds medications to intravenous

(IV) solutions. Such medications are referred to as

"admixtures." Admixtures for IV solutions are prepared by

pharmacy department personnel under a special hood that filters

air to ensure the sterility of the admixture. These activities

require great care and precision and are usually performed by
- 12 -

technicians with special training in the preparation of

admixtures. 

Although the policy of petitioners' hospitals is not to fill

prescriptions for patients after they are discharged from the

hospital, on occasion a hospital will do so in a situation of

extreme hardship, as, for example, when the medication is not

readily available at a commercial pharmacy. The price charged to

a patient for filling a discharge prescription is not the same as

the charge posted on a patient bill when administered at the

hospital, and the charge is not included on the patient's

hospital bill. The pharmacy also occasionally sells

pharmaceutical products to employees and staff physicians at

acquisition cost plus an administration fee. The hospital

generally records cash sales of drugs and medicines to employees

in an account entitled "retail pharmacy". The pharmacy

department does not sell or otherwise provide pharmacy items to

the general public. 

Purchasing decisions regarding pharmaceuticals are made at

the individual hospital level by employees of the hospital, based

on formularies established by a hospital committee composed

primarily of staff physicians. 

Medical Records Department

Each hospital maintains a medical records department that

stores and retrieves each patient's medical record. Such record

reflects, through contemporaneous recordations by the attending
- 13 -

physician or nurse, a complete summary of all treatment

administered to a patient while in the hospital and chronicles

the actions taken by the patient's medical doctor and hospital

personnel at the direction of the attending physician. The

patient's medical record also records the patient's progress

while in the hospital and the patient's reaction to drugs and

various medical procedures. 

Other Hospital Personnel

Each hospital also employs a staff of engineering and

maintenance personnel to repair and to service its nonmedical

equipment and a staff of housekeeping and janitorial personnel to

maintain required standards of cleanliness. 

Petitioners' Use of Supplies

Petitioners' hospitals frequently use various medical

supplies in providing medical care to patients. Each hospital

maintains thousands of different types of medical supplies for

use in treating a wide variety of medical conditions. 

The hospital staff or the attending physician, sometimes

after consultation with the patient, decides which medical

supplies will be used during the patient's stay. Patients cannot

order a particular medical supply. Numerous medical supplies are

used in performing diagnostic, surgical, and other procedures on

patients, including, for example, scalpels and other surgical

instruments, sponges, surgical drapes, surgical gowns, towels,

syringes, alcohol preparations, drainage and irrigating tubes,
- 14 -

tourniquets, suction tubing and canisters, and various IV tubes,

needle hubs, and catheters. 

The medical supplies used in the treatment of patients are

either reusable or disposable. Reusable medical supplies, such

as stainless steel instruments, are sterilized and repackaged

after each use. Disposable single-use medical supplies are

increasingly used and include IV solution bags, tubing and

catheters, syringes, bedpans, diapers, egg crate mattresses,

moisture-barrier pads, pillows, surgical drapes, table covers,

sterile gloves, towels and linens, kits for surgical shave prep

and scrub prior to incision, scalpels with plastic handles, and

kits for inserting and removing sutures. The hospital is

responsible for discarding disposable medical supplies. 

Certain other medical supplies are applied to, implanted in,

otherwise administered to, furnished to, or used in connection

with the treatment of, patients. Examples include casts,

crutches, canes, walkers, bandages, sutures, splints, skin

staples, joint replacements, pacemakers, heart valves, orthopedic

devices, and physical and occupational therapy items. Such items

often leave the acute care hospital with the patient, although

medical supplies such as sutures, splints, skin staples, and

implants can be removed from the patient only by a physician or

other trained medical personnel. 

Petitioners' psychiatric hospitals use medical supplies less

frequently in the course of treating their patients than
- 15 -

petitioners' acute care hospitals. The principal medical

supplies used in psychiatric facilities are prescription drugs

and medicines. In some instances, medical supplies and equipment

might be used in certain treatments, such as insulin therapy,

electroshock therapy, and hydrotherapy. 

Intravenous Solutions

During a hospital stay, a patient may receive an IV

solution. The administration of an IV solution involves the

injection of a prescribed solution directly into the patient's

vein, frequently together with prescribed amounts of admixtures. 

The administration of an IV involves a number of steps,

including preparing the IV solution, mixing in any required

admixtures in the appropriate quantities, distributing the

solution to the patient floor, assembling the IV apparatus (which

may consist of a reusable pump and disposable tubing, connectors,

needle hubs, and catheters), setting the rate of flow, monitoring

the rate of flow, and monitoring the patient's response to the

medication. Monitoring the rate of flow and the patient's

reaction are critical aspects of the administration of an IV

because the infusion of the IV fluid at too rapid a rate could

harm the patient and the patient could have an adverse reaction

to medication administered through the IV. Once the

administration of the IV is complete, the IV apparatus and any

unused IV fluid are disposed of in a biohazardous disposal

receptacle to be discarded by the hospital. Typically, the
- 16 -

solution used to administer an IV costs about $1. The patient

charge for the administration of an IV solution is typically

about $20. 

Blood Transfusions

Patients undergoing surgery or other health care treatments

may receive transfusions of blood and blood derivatives. 

Petitioners' hospitals acquire most of their blood and blood

components from the American Red Cross under agreements providing

that all blood remains under the jurisdiction of the Red Cross

until transfused to the patient. These agreements prohibit the

sale of blood by the hospital. They also prohibit the hospital

from making any charge to the patient other than the processing

fee that the hospital pays to the Red Cross plus any charge for

the services the hospital renders in administering the blood. 

Blood transfusions require typing of the patient's blood,

procuring a supply of blood of the proper type, delivering it for

administration to the patient, assembling the transfusion

apparatus and injecting it into the patient, monitoring the

transfusion carefully, detaching the apparatus when the

transfusion is completed, and disposing of the apparatus and any

remaining blood in accordance with appropriate hospital

procedures. 

Other Medical Supplies

Many ancillary hospital departments utilize supplies in

performing their particular specialties. For example, x-ray
- 17 -

film, chemicals, dyes, and nuclear materials are used in

radiological diagnostic procedures. Anesthetic gases are

administered to patients during surgery. Oxygen is administered

to patients by the respiratory therapy department. Dyes are

injected in patients with possible coronary artery disease during

the diagnostic procedure known as cardiac catheterization. 

Petitioners' Purchases of Supplies

Petitioners' hospitals purchase medical supplies and medical

equipment for use in the treatment of patients. They purchase

some of those items from their suppliers (usually the

manufacturer of the items) at discounts not available to

wholesalers, retailers, or resellers of such items. Most of the

pharmaceutical supply contracts entered into by petitioners'

hospitals prohibit the resale of pharmaceuticals by the hospitals

and limit the hospitals’ purchases to items for their own use. 

The majority of the medical supplies are physically located

in four departments: The operating room, materials management

and central supply, the pharmacy, and the laboratory. Each

hospital takes physical inventories of its medical supplies at

yearend. 

For tax years ended 1982 through 1988, petitioners'

hospitals claimed the following supplies expenses and total

deductions on their consolidated Federal income tax returns:
- 18 -

Year Supplies Expenses Total Deductions

1982 $460,994,278 $2,806,887,860

1983 495,309,714 3,003,382,379

1984 511,832,402 3,112,503,386

1985 573,913,170 3,942,358,533

1986 674,200,054 4,650,746,958

1987 648,445,800 4,501,953,880

1988 561,721,210 3,655,162,924

Petitioners reported the following supplies expenses and total

expenses on their books for the years ended 1981 through 1986:

Year Supplies Expenses Total Expenses

1981 $282,265,685 $1,481,029,776

1982 405,666,204 2,229,237,905

1983 435,068,134 2,316,952,040

1984 453,784,846 2,454,214,828

1985 511,141,278 2,968,564,755

1986 583,139,057 3,364,050,625

For taxable years ended 1981 through 1986, the cost of

medical supplies compared to total hospital expenses, including

amortization and depreciation, and compared to total revenue is

as follows:

 Percent of Supplies Percent of Supplies

 Year to Total Expenses to Total Revenue

 1981 15.76% 15.19%

 1982 15.28 14.08

 1983 15.47 13.80

 1984 15.02 13.36

 1985 13.56 12.73

 1986 13.17 12.29

Hospital Billing Practices

The format for hospital bills used by petitioners' hospitals

follows the outline of a uniform bill developed by the health

insurance industry in conjunction with the Health Care Financing
- 19 -

Administration and private insurance companies. The patient is

furnished a summary bill that shows separate charge categories

such as patient room charges, pharmacy, medical/surgical

supplies, and laboratory. Upon request, the patient can receive

a more detailed bill that itemizes each separate charge within

the broad categories. 

The particular type of medical care provided to the patient

determines how items are listed on a summary bill. For example,

the bill often identifies charges by location, such as patient

room, operating room, recovery room, delivery room, nursery,

emergency room, or intensive care unit. The bill may also

identify charges by procedures, such as radiology, anesthesia,

nuclear medicine, various laboratory procedures (including

endoscopy, electrocardiology, echogram, electromyogram, cardiac

function, cardiac catheterization, electroencephalography,

computerized axial tomography, ultrasound, and angiocardiology),

inhalation therapy, pulmonary function, physical therapy,

hemodialysis, and occupation therapy. The detailed bill may

identify charges by the name and/or code of a particular medical

supply used in diagnosing or treating the patient. 

Central supply breaks down certain medical supplies that are

received in bulk into separate "issue units". On each issue unit

it places a sticker which includes a procedure code number and a

short description of the item. When a medical supply with a

sticker is used in treating the patient, the nurse peels off the
- 20 -

sticker and puts it on the patient's daily charge card. The

patient's daily charge cards for all departments, except the

operating room and pharmacy, are sent back to central supply

where each item's procedure code is keyed into a hospital

computer terminal which is connected directly with the main data

center at HCA's corporate office in Nashville, Tennessee. The

appropriate charge to the patient's account is made automatically 

for a later billing to the patient. 

When a medical supply is used during a surgical procedure in

the operating room, the nurse checks the item off on a "charge

sheet" maintained in the name of each patient undergoing a

surgical procedure. After the conclusion of the surgical

procedure, the charge sheet is used by operating room personnel

to key the appropriate item procedure codes into the computer for

posting to the patient's account. 

All orders for medications for a patient are listed on a MAR

prepared for that patient and delivered by the pharmacy

department to the attending nurse station. The nurse checks off

each item of medication on the MAR as it is administered to the

patient. A copy of the MAR is returned to the pharmacy

department, which then inputs the appropriate patient charge into

the hospital computer terminal.

Each hospital's computer procedure file contains all of the

hospital's procedure codes for various patient procedure charges,

including those in which medical supplies are used. When
- 21 -

hospital personnel input a patient number and a procedure code

for a charge, the procedure file automatically posts the charge

amount to "Accounts Receivable--Patient", to a general ledger

revenue account, and to the patient's account. The patient

charge amount for many individual procedures involving a medical

supply is determined by the hospital based on a schedule of

algorithms input into the computer. The schedule of algorithms

typically determines the charge for a procedure involving a

medical supply as a multiple of the cost of the item used or as a

multiple of the average wholesale price of the pharmaceutical

used. The amount of that multiple varies from item to item and

ranges from 150 percent of cost to well over 4,000 percent of

cost. 

Each hospital's computer room master file contains all

hospital room numbers and their respective rates. The room

master file automatically posts room charges daily, not only to

"Accounts Receivable--Patient" and to a general ledger revenue

account, but also to the patient's account and to the billing or

receivable system. 

A charge for nursing care is not separately listed on either

the summary or the detailed bills provided to the hospitals'

patients. The charge for nursing is included in the charge for

the room, in the charge identified by location, and in the other

charge categories, including the cost of certain medical supplies

used for patients. 
- 22 -

Petitioners' system of billing, typical of most hospitals,

has evolved over time in conformity with the reimbursement

practices and procedures of private insurance companies as well

as Medicare and Medicaid, and in conformity with State laws and

regulations. During the beginning of the 20th century, hospitals

typically charged for their services on a per-case or per diem

basis. Subsequently, with the advent of the private health

insurance industry, particularly Blue Cross/Blue Shield

organizations, pressure was placed on hospitals to develop a

charging structure which would enable the insurer to measure the

degree of service furnished to each patient so that the insurer

company could assure itself that it was not subsidizing the cost

of care furnished to other patients. Consequently, insurance

companies required hospitals to detail charges and to bill for

services on a departmental basis. 

Until 1983, Medicare and Medicaid paid hospitals based on

the cost of services as computed under a formula using the

detailed charges listed by the hospitals. Effective with

Medicare cost reporting periods beginning on and after October 1,

1983, however, Medicare began to phase in, over a 3-year

transition period, its system of paying hospitals for inpatient

services on the basis of diagnostic related groups (DRG’s). 

Under that system, hospitals are paid a flat amount for a

particular procedure, such as a gall bladder operation,

regardless of the precise course of treatment administered to the
- 23 -

patient, the length of the hospital stay, or the number and type

of medical supplies used. Additional payments, however, may be

made to hospitals for discharges involving an extremely long stay

or unusually high costs when compared to most discharges

classified in the same DRG. Managed care networks, HMO's, and

some insurance companies also employ similar reimbursement

practices. 

Between 70 and 80 percent of hospital bills are paid on the

basis of DRG’s or some other negotiated per case or per diem

basis. In most cases, the itemized bill does not bear any

particular relationship to the amount that actually will be due

the hospital for the services provided. Hospitals, however,

continue to detail charges in their bills because Medicare and

insurance companies continue to require such itemization. 

Insurers pay some types of hospital stays based on detailed

itemized charges, such as outpatient hospital stays and

psychiatric stays. Uninsured patients with the ability to pay

are presented with a complete bill and may be held liable for

payment of the full amount. 

For most of their income, hospitals contemplate receiving

two or more payments on behalf of the patient, consisting of one

or more payments from third-party payers and one or more payments

of a deductible or copayment amount by the patient. 

Petitioners' Accounting System
- 24 -

9

For example, the central supply center would be credited or

charged with all direct revenues and expenses incurred in

preparing and issuing medical and surgical supplies and other

equipment to patients. Appropriate subaccounts would be

established to accumulate the expenses of the center under

classifications such as salaries and wages, professional fees,

supplies, etc. 

10

A chart of accounts is a listing of account titles, with

numerical symbols, employed in the compilation of accounting data

concerning the assets, liabilities, capital, revenue, and

expenses of an enterprise. American Hospital Association, Chart

of Accounts for Hospitals 25 (1966 ed.).

Petitioners maintain the hospitals' books and records on a

functional accounting system which separates the various

functions of operating a hospital into general ledger cost

centers whether or not those functions represent separate

responsibility cost centers. Accordingly, revenues and expenses

for the same function are recorded in the related revenue and

expense centers9 shown in petitioners' chart of accounts.10 The

hospitals' revenue centers generally are classified into routine

services and ancillary services. Examples of routine service

revenue centers are Medical & Surgical Acute Care, Intensive

Care--Medical, and New Born Care. Examples of routine ancillary

revenue centers are Central Supply, Laboratory, and Blood Bank. 

Additional details indicated in the accounting system are the

classification of the particular revenue within the revenue

center, such as inpatient or outpatient revenue, the type of

payment expected with respect to the patient, and the
- 25 -

identification of specific medical supplies used while performing

a particular hospital procedure. Costs classified as Payroll,

Fees, and Cost of Sales--Supplies, Repairs, Leases and Rental,

must be recorded in the cost centers responsible for incurring

and controlling such costs. Supplies are charged to operations

during the period in which they are consumed or expended. 

Petitioners use a specific identification requisition system to

identify and allocate appropriate supply costs to the consuming

cost center and to identify the period in which the supplies were

consumed. Fixed costs (such as depreciation, interest, rent,

taxes, and insurance), employee benefits, and certain overhead

costs (such as maintenance and repairs) are not departmentalized

under petitioners' accounting system but are recorded in

specified cost centers.

Thus, under petitioners' accounting system, petitioners

track patient revenue, operating expenses, and gross margins for

each hospital. They also track financial operating indicators on

such items as revenue, labor costs, and supply costs, among

others. The hospitals also maintain separate accounts for such

categories as Operating Room, Central Supply, Laboratory,

Pharmacy, Dietary, Plant Operations & Maintenance, Linen, and

Housekeeping. 

Petitioners' Chart of Accounts

Petitioners' hospitals record their revenue and expenses

pursuant to a uniform chart of accounts promulgated by HCA's
- 26 -

corporate offices in Nashville. Petitioners' hospitals are

required to follow HCA's chart of accounts in recording all

revenue and expense items. The revenue and expense center

section of the chart of accounts lists the functions that

normally are performed in a hospital. Each hospital is expected

to establish a functional cost center for each material function

that it performs. The HCA chart of accounts gives individual

hospitals a certain degree of flexibility in selecting which

accounts to use to track costs and revenue. Hospitals are

permitted to establish separate, more detailed, accounts within

ranges prescribed by the chart of accounts. For example,

hospitals might establish separate accounts, within the

prescribed range, to record revenue and expenses related to the

use of medical supplies in the operating room, the emergency

room, and other areas of the hospital. 

The HCA chart of accounts is based upon the Chart of

Accounts for Hospitals published by the American Hospital

Association (AHA). The AHA strongly recommends to its member

hospitals the use of an accrual method of accounting for

financial accounting purposes to insure completeness, accuracy,

and meaningfulness of accounting data. 

Accounting Methods Used by Petitioners and in the Hospital

Industry

Before 1987, for financial reporting purposes, many nonprofit and for-profit hospitals used an accrual method of
- 27 -

11

Sec. 448, which was added to the Code by sec. 801 of the Tax

Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2345, wherein

Congress required certain corporations, including hospitals, to

change prospectively beginning in 1987 to an overall accrual

method, does not apply to the accounting issue under discussion

in the instant opinion. 

accounting. During that time for tax purposes, however, many

nonprofit hospitals used an accrual method of accounting while

many for-profit hospitals used the cash method or a hybrid method

of accounting.11 Petitioners use an accrual method of accounting

for financial reporting purposes and for reporting to the

Securities and Exchange Commission (SEC). 

Tax Returns and History of Use of Method of Tax Accounting

HCA adopted and used an accrual method of accounting for

Federal income tax purposes on its initial Federal income tax

return and continues to use such method. Before the taxable year

ended 1979, most of HCA's hospitals and other subsidiaries used

the cash method of accounting in reporting taxable income for

Federal income tax purposes on the returns as originally filed. 

For each taxable year ended before 1987, HCA's Tax

Department prepared records to reconcile income determined on the

accrual method used for financial reporting purposes and income

computed on the cash method used for tax reporting purposes. 

HCA's Tax Department retained the results of the computations

made in arriving at cash method taxable income as shown on

petitioners' Federal income tax returns and made those results
- 28 -

available to respondent's agents examining petitioners' books and

returns. 

1972-73 Audit

At the end of 1973, petitioners owned and operated 45

hospitals. During an examination of petitioners' corporate

income tax returns for the taxable years ended 1972 and 1973, the

Internal Revenue Service (IRS) District Director, Nashville,

Tennessee, proposed a number of adjustments, including a proposal

to change the method of accounting of HCA's hospitals using the

cash method to an accrual method. 

As grounds for the proposal to place those hospitals on an

accrual method of accounting, the revenue agent's report (RAR)

asserted, inter alia, that, because inventories were material and

had a direct effect on taxable income, the cash method did not

properly reflect income. The RAR also asserted that the cash

method did not properly reflect petitioners' income, regardless

of inventories, because the cash method did not match revenue

with expenditures. Furthermore, the RAR indicated that

petitioners had not obtained the approval of the Commissioner of

Internal Revenue (Commissioner) to change the method of

accounting from the accrual basis used to maintain their books

and records to the cash method used for tax purposes. 

Additionally, the RAR stated that, because the purchase or sale

of merchandise was an income-producing factor for petitioners'

hospitals, they were required to use inventories pursuant to
- 29 -

12

Respondent objects to the admission of evidence relating to

consideration of the proposed adjustments for the years ended

1972 and 1973 by the Nashville Appeals Office on the ground that

the discussions with the Appeals officers were settlement

negotiations and, thus, evidence relating to such matters is

inadmissible pursuant to Fed. R. Evid. 408, which generally

renders inadmissible evidence of compromises and offers to

compromise. We have held in a prior opinion in the instant case

that evidence relating to the resolution of such matters is not

excludable under Fed. R. Evid. 408 because the evidence was not

presented to show the validity or invalidity of petitioners'

claim that the hybrid method clearly reflects income. Hospital

Corp. of America v. Commissioner, T.C. Memo. 1994-100; see also

Wentz v. Commissioner, 105 T.C. 1, 5-7 (1995).

section 1.446-1(a)(4)(i), Income Tax Regs. The RAR further

asserted that the existence of merchandise inventories required

the hospitals to use an overall accrual method. 

In disagreeing with the proposed adjustments, petitioners

contended that they were entitled to use the cash method in

reporting their income because the hospitals merely used or

consumed various medical supplies in the course of providing

typical hospital services. Subsequently, the Commissioner issued

a notice of deficiency for the years ended 1972 and 1973. 

Petitioners timely filed a petition in the U.S. Tax Court

challenging the proposed change in accounting method as well as

certain other determinations of the Commissioner. The issues

raised in the petition, including the accounting method

adjustment, were then referred for consideration to the IRS

Appeals Office in Nashville (Nashville Appeals Office). The

Nashville Appeals Office considered the case in early 1980.12
- 30 -

13 

HCA's Chart of Accounts defines bad debts as "accounts which

are deemed uncollectible from the patient or any third party due

(continued...)

Two Appeals officers were assigned to the case, Hubert

Johnson (Appeals Officer Johnson) and Robert Sinclair (Appeals

Officer Sinclair). Appeals Officer Johnson was responsible for

the method of accounting issue, but both Appeals officers

attended the conferences relating to the accounting method issue. 

Petitioners' tax director, Terry Deaton (Mr. Deaton), and

petitioners' in-house counsel, Charles L. Kown (Mr. Kown), among

others, represented petitioners during the negotiations with the

Nashville Appeals Office regarding the accounting method issue. 

In an effort to resolve the case, Appeals Officer Johnson

proposed that the hospitals report a portion of their income and

related expenses on an accrual method and the balance of income

and related expenses on the cash method (hereinafter sometimes

referred to as the hybrid method). Petitioners agreed to the 

proposal. Under the hybrid method, the amount included in income

on an accrual basis was computed by multiplying each hospital's

year-end patient receivables by the ratio of total revenue in the

Central Supply and Pharmacy accounts to total revenue in all

patient revenue accounts. 

Appeals Officer Johnson and petitioners' representatives

agreed to petitioners' use of a reserve method of accounting for

bad debts,13 calculated by applying the "Black Motor" formula, in
- 31 -

13(...continued)

to the patient's unwillingness or inability to pay." 

conjunction with the hybrid method. See Black Motor Co. v.

Commissioner, 41 B.T.A. 300 (1940), affd. 125 F.2d 977 (6th Cir.

1942). Additionally, they agreed that the cost of medical

supplies was to be capitalized in a supply inventory and deducted

only when such supplies were consumed in the course of treating

the patient, rather than when the supplies were purchased. 

During their negotiations with Appeals Officer Johnson, one

of petitioners' representatives requested a closing agreement

relating to the use of the hybrid method, but Appeals Officer

Johnson refused because he knew that petitioners' returns for

subsequent taxable years were already under examination and he

did not want to preclude resolution of such years on a different

basis. Appeals Officer Johnson and Appeals Officer Sinclair

viewed the resolution of the 1972 and 1973 years as "merely a

settlement on the basis of the hazards of litigation." They did

not intend for their actions to effectuate a change in method of

accounting for the hospitals. Neither Appeals Officer Johnson

nor Appeals Officer Sinclair believed that, as a result of their

actions, the IRS was bound to permit the use of the hybrid method

by the hospitals for subsequent years. 

 Mr. Deaton and Mr. Kown, however, believed that

petitioners' method of accounting for the hospitals had been

changed to the hybrid method by the IRS as a result of the
- 32 -

agreement they reached with Appeals Officers Johnson and

Sinclair. During the negotiations, Mr. Deaton informed Appeals

Officer Sinclair that petitioners would file their consolidated

1979 return using the hybrid method even though such return had

initially been prepared on the cash method and the time for

filing was near. Mr. Kown would not have agreed to adopt the

hybrid method for the 1972 and 1973 years had he known that the

IRS would object to its use for petitioners' returns filed for

subsequent taxable years. 

In an attempt to memorialize his understanding of the

agreement with Appeals Officers Johnson and Sinclair, Mr. Kown

wrote them a letter on June 13, 1980, in which he outlined his

understanding of the proposed resolution of the accounting method

issue. Mr. Kown further stated that it was petitioners'

understanding that their agreement with respect to such issue

would be binding until Congress expressly prohibited the hybrid

method of accounting by hospitals. Mr. Kown sent the letter

prior to the time the stipulations regarding such issues were

prepared and filed with the U.S. Tax Court. He did not receive a

written response to his letter but he subsequently discussed it

in a telephone conversation with Appeals Officer Sinclair. At

such time, Appeals Officer Sinclair, while "making no promises",

indicated that he thought that the hybrid method would continue

to be followed unless a statutory change or a final controlling

court decision required a different result. 
- 33 -

14

 See Hospital Corp. of America v. Commissioner, 81 T.C. 520

(1983).

The adjustments calculated for 1972 pursuant to the hybrid

method included adjustments resulting from the changes in

accounts receivable, accounts payable, and supplies for 1972, and

also the cumulative balances in such accounts. No adjustment was

made to subtract the corresponding portion of 1971 year-end

accounts receivable (i.e., the beginning of the year balance for

1972). The adjustment for taxable year ended 1973 was computed

in the same manner, except that the amount that was included in

income for 1972 was subtracted from the 1973 year-end cumulative

balance to determine the amount to be included for 1973. The

resolution of the accounting adjustment and certain other

adjustments raised in the notice of deficiency issued for taxable

years ended 1972 and 1973 were reflected in a stipulation filed

with the U.S. Tax Court. Petitioners litigated another issue for

taxable years ended 1972 and 1973 in the U.S. Tax Court.14 

1974-75 Audit

While the Nashville Appeals Office was considering the

resolution of petitioners' taxable years ended 1972 and 1973, a

team of revenue agents concluded their audit of petitioners'

returns for taxable years ended 1974 and 1975. The RAR for those

years raised numerous issues, including a challenge to the use of

the cash method of accounting by some of HCA's subsidiaries. The
- 34 -

examination for the taxable years ended 1974 and 1975 was

suspended, however, when petitioners filed their petition with

the Tax Court relating to the same accounting issue for the

taxable years ended 1972 and 1973. 

After the accounting method issue for the taxable years

ended 1972 and 1973 was resolved, the examination of petitioners'

returns for the taxable years ended 1974 and 1975 resumed. 

Following consultation with the Nashville Appeals Office, the

revenue agents revised the RAR to compute petitioners' taxable

income for taxable years ended 1974 and 1975 using the hybrid

method, but modified to include in patient receivables the net

debit balances shown as due from Medicare and Medicaid

(hereinafter sometimes referred to as the hybrid method as

modified). Petitioners agreed to those adjustments and paid the

resulting deficiencies for the taxable years ended 1974 and 1975.

 1976-78 Audit

In March 1980, a team of revenue agents commenced an

examination of petitioners' returns for the taxable years ended

1976 through 1978. The cash method of accounting had been used

by most of HCA's subsidiaries for such years. The revenue agents

did not propose to change the hospitals to an overall accrual

method of accounting, but rather, after discussions with the

Nashville Appeals Office and pursuant to instructions from their

case manager, they used the hybrid method as modified to compute

income for the hospitals for the years ended 1976 through 1978. 
- 35 -

15 

The number of hospitals owned by petitioners reporting for

Federal income tax purposes on an accrual method and the hybrid

method for each of the years ended 1979 through 1986 were: 

 1979 1980 1981 1982 1983 1984 1985 1986

Accrual 13 14 16 17 15 15 16 15

Hybrid 76 87 155 170 174 183 218 228

Petitioners accepted the proposed adjustments and paid the

resulting deficiencies. 

Returns Filed Under the Hybrid Method

For the taxable year ended 1979, most of HCA's hospitals

used the hybrid method for reporting income for Federal tax

purposes.15 To reconcile each hospital's income recorded on the

accrual method used for financial reporting purposes to the

hybrid method used for Federal income tax purposes, HCA's Tax

Department prepared records (referred to as cash conversions)

reflecting the appropriate adjustments. When filing the return

for taxable year ended 1979, petitioners did not increase yearend patient accounts receivable to which the hybrid method

percentage was applied to include the net debit balance of

Medicare and Medicaid receivables as proposed and agreed to on

audit of the returns filed for the years ended 1974 and 1975,

because petitioners had filed the return for taxable year ended

1979 before the conclusion of the examination of the returns

filed for taxable years ended 1974 and 1975. For taxable year

ended 1980 the hospitals included the net debit balance of
- 36 -

Medicare and Medicaid receivables in patient receivables for

purposes of calculating the revenue to be reported on the accrual

method. 

1979-80 Audit

A team of revenue agents examined petitioners' returns for

the taxable years ended 1979 and 1980 and proposed in their RAR

to change, inter alia, the hospitals' method of accounting from

the hybrid method, or the hybrid method as modified, to an

overall accrual method. The reasons cited in the RAR were

essentially identical to the reasons cited in the RAR's for the

1972-73, 1974-75, and 1976-78 audits. In addition, the RAR

contended that the returns filed using the hybrid method, or the

hybrid method as modified, were difficult to audit. 

At petitioners' request, the accounting issue was referred

for consideration to the Atlanta, Georgia, Appeals Office. The

Appeals Officer reviewing the returns for taxable years ended

1979 and 1980, Appeals Officer Griffin, concluded that the

accounting method issue adjustment for the years ended 1972 and

1973 appeared to have been computed as a change in method of

accounting, rather than as an adjustment relating to those years

alone and that use of the hybrid method as modified clearly

reflected income of the hospitals. Accordingly, in November 1986

Appeals Officer Griffin resolved the proposed accounting method

adjustment for the years ended 1979 and 1980 by permitting
- 37 -

petitioners to use the hybrid method as modified, but adjusting

for the years under consideration the fraction used to determine

the portion of patient receivables to be reported on an accrual

method by including in the numerator of that fraction the revenue

included in certain additional accounts which were similar in

nature to the Central Supply and Pharmacy accounts so as to

correct for perceived deviations from the hybrid method agreed to

for the earlier years (hereinafter referred to as the hybrid

method as further modified). The inclusion of the revenue from

such additional accounts raised the percentage of year-end

patient receivables being reported on an accrual method by

approximately one and one-half percentage points. 

Returns for the Years in Issue

The accounting method adjustment for petitioners' taxable

years ended 1979 and 1980 was resolved in December 1986, at which

time petitioners' returns for the taxable years ended 1981

through 1985 already had been filed. For such years the

hospitals used the hybrid method as modified for reporting

taxable income. 

Petitioners also used the hybrid formula as modified, rather

than the hybrid formula as further modified, for the return they

filed for taxable year ended 1986 because they were informed that

respondent's revenue agents auditing the returns for taxable

years ended 1981 and 1982 intended to challenge petitioners' use

of the hybrid method for those years. The teams of agents
- 38 -

assigned to audit petitioners' returns for taxable years ended

1983 and 1984 and taxable years ended 1985 and 1986 likewise

challenged petitioners' use of the hybrid method as modified for

reporting taxable income of the hospitals.

 Without considering the effect of other adjustments, the use

of an overall accrual method of accounting would increase

petitioners' income for the taxable years ended 1981 through 1986

as set forth in the following table: 

 Year Amount

 1981 $197,470,976

 1982 41,916,668

 1983 68,510,810

 1984 95,125,139

 1985 122,573,714

 1986 62,405,334

For taxable years ended 1981 through 1986, the percentages

of revenue derived from operations of petitioners' U.S.-owned

hospitals from room and board (including nursing services) and

ancillary services, as reported on Forms 10-K that petitioners

filed with the SEC, were as follows:

 1981 1982 1983 1984 1985 1986

Room and board 34% 34% 33% 32% 30% 27%

Ancillary 

 services 66 66 67 68 70 73

Ancillary services include, among other things, outpatient

treatments; physiotherapy; the use of the operating room, the

recovery room, the delivery room, or special facilities;

examinations; laboratory tests; x-rays; EKG’s; as well as the

administration or use of medical supplies. For psychiatric
- 39 -

16

Sec. 446 provides in pertinent part as follows:

SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.

(a) General Rule.--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.

(b) Exceptions.--If no method of accounting has been

regularly used by the taxpayer, or if the method used does

not clearly reflect income, the computation of taxable

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

the Secretary, does clearly reflect income.

(c) Permissible Methods.--Subject to the provisions of

subsections (a) and (b), a taxpayer may compute taxable

income under any of the following methods of accounting--

(1) the cash receipts and disbursements method;

(2) an accrual method;

(3) any other method permitted by this chapter; 

or

(4) any combination of the foregoing methods 

permitted under regulations prescribed by the 

Secretary.

(d) Taxpayer Engaged in More Than One Business.--A

taxpayer engaged in more than one trade or business may, in

computing taxable income, use a different method of

accounting for each trade or business. 

(e) Requirement Respecting Change of Accounting

Method.--Except as otherwise expressly provided in this

chapter, a taxpayer who changes the method of accounting on

the basis of which he regularly computes his income in

keeping his books shall, before computing his taxable income

under the new method, secure the consent of the Secretary. 

hospitals, ancillary services include group and individual

therapy.

OPINION

Section 446(a)16 requires a taxpayer to compute taxable

income under the method of accounting it regularly uses in
- 40 -

keeping its books. Section 446(b), however, provides that if the

method of accounting regularly utilized by the taxpayer does not

clearly reflect taxable income, the computation of taxable income

shall be made under such method as, in the Commissioner's

opinion, does clearly reflect income. The Commissioner's

authority under section 446(b) reaches not only overall methods

of accounting but also a taxpayer's method of accounting for

specific items of income and expense. Ford Motor Co. v.

Commissioner, 102 T.C. 87, 100 (1994), affd. 71 F.3d 209 (6th

Cir. 1995); Prabel v. Commissioner, 91 T.C. 1101, 1112 (1988),

affd. 882 F.2d 820 (3d Cir. 1989); sec. 1.446-1(a), Income Tax

Regs. 

It is well recognized that section 446 grants the

Commissioner broad discretion in matters of accounting and gives

the Commissioner wide latitude to adjust a taxpayer's method of

accounting so as to reflect income clearly. E.g., Thor Power

Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979);

Commissioner v. Joseph E. Seagram & Sons, Inc., 394 F.2d 738, 743

(2d Cir. 1968), revg. 46 T.C. 698 (1966); Thomas v. Commissioner,

92 T.C. 206, 220 (1989). Section 446 imposes a heavy burden of

proof on a taxpayer disputing the Commissioner's determination on

accounting matters. Thor Power Tool Co. v. Commissioner, supra

at 532-533. To prevail, a taxpayer must establish that

respondent's determination is "clearly unlawful" or "plainly

arbitrary". Id. 
- 41 -

17

To determine whether an accounting method clearly reflects

income, the Court of Appeals for the Sixth Circuit, to which an

(continued...)

Nonetheless, where a taxpayer's method of accounting does

clearly reflect income, respondent cannot require the taxpayer to

change to a different method even if the Commissioner's method

more clearly reflects income. Ford Motor Co. v. Commissioner, 71

F.3d at 213; Ansley-Sheppard-Burgess Co. v. Commissioner, 104

T.C. 367, 371 (1995); Molsen v. Commissioner, 85 T.C. 485, 498

(1985). Additionally, the Commissioner may not require a

taxpayer to adopt a method of accounting which does not clearly

reflect income. Rotolo v. Commissioner, 88 T.C. 1500, 1514

(1987). Our inquiry is limited to the question of whether the

accounting method in issue clearly reflects income, and we do not

decide whether a method is superior to other possible methods. 

RLC Indus. Co. v. Commissioner, 98 T.C. 457, 492 (1992), affd. 58

F.3d 413 (9th Cir. 1995); see also Brown v. Helvering, 291 U.S.

193, 204-205 (1934).

Generally, a taxpayer's accounting method clearly reflects

income if it results in accurately reported 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.

1969-79; RLC Indus. Co. v. Commissioner, supra at 490; see also

Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453, affd.

without published opinion 27 F.3d 571 (8th Cir. 1994).17 Whether
- 42 -

17(...continued)

appeal in the instant case would lie absent stipulation to the

contrary, follows the standard enunciated in Caldwell v.

Commissioner, 202 F.2d 112, 115 (2d Cir. 1953), that "income

should be reflected with as much accuracy as standard methods of

accounting practice permit." Asphalt Prods. Co. v. Commissioner,

796 F.2d 843, 849 (6th Cir. 1986), affg. in part and revg. in

part Akers v. Commissioner, T.C. Memo. 1984-208, revd. per curiam

on another issue 482 U.S. 117 (1987).

a particular method of accounting clearly reflects income is a

question of fact which must be decided on a case-by-case basis. 

Ansley-Sheppard-Burgess Co. v. Commissioner, supra; Peninsula

Steel Prods. & Equip. Co. v. Commissioner, 78 T.C. 1029, 1045

(1982). The Court's task is not to determine whether, in its own

opinion, the taxpayer's method of accounting clearly reflects

income but to determine whether there is an adequate basis in law

for the Commissioner's conclusion that it does not. American

Fletcher Corp. v. United States, 832 F.2d 436, 438 (7th Cir.

1987); RCA Corp. v. United States, 664 F.2d 881, 886 (2d Cir.

1981); Ansley-Sheppard-Burgess Co. v. Commissioner, supra.

Financial and tax accounting treatment may often diverge. 

Thor Power Tool Co. v. Commissioner, supra at 542-544; Challenge

Publications, Inc. v. Commissioner, 845 F.2d 1541, 1546 (9th Cir.

1988), affg. T.C. Memo. 1986-36. Consequently, even if a method

of accounting comports with Generally Accepted Accounting

Principles (GAAP), the method will not control for tax purposes

if it does not clearly reflect income. Thor Power Tool Co. v.

Commissioner, supra at 538-544; see also Hamilton Indus., Inc. v.
- 43 -

18

For years after 1984, sec. 461(h) also requires the

occurrence of economic performance with respect to a liability.

Commissioner, 97 T.C. 120, 128 (1991); UFE, Inc. v. Commissioner,

92 T.C. 1314, 1321 (1989); Sandor v. Commissioner, 62 T.C. 469,

477 (1974), affd. 536 F.2d 874 (9th Cir. 1976). Moreover, an

accounting method that conforms to GAAP, but does not comply with

the Commissioner's regulations, may not clearly reflect income. 

Peninsula Steel Prods. & Equip. Co. v. Commissioner, supra. 

Section 446(c) specifically recognizes as permissible

methods of accounting, the cash receipts and disbursements method

(cash method), an accrual method, any other method permitted by

chapter 1 of the Internal Revenue Code, or any combination of the

foregoing methods permitted under regulations prescribed by the

Secretary of the Treasury (a hybrid method). Generally, under

the cash method of accounting, an item of income or expense is

reported when received or paid, without regard to the economic

events giving rise to the item. Under an accrual method of

accounting, on the other hand, an item of income or expense

generally is reported for the accounting period during which all

the events have occurred which fix the taxpayer's right to

receive the item of income or which establish the fact of

liability giving rise to the deduction, and the amount thereof

can be determined with reasonable accuracy.18 Hallmark Cards,
- 44 -

Inc. v. Commissioner, 90 T.C. 26, 32 (1988); secs. 1.446-

1(c)(1)(ii), 1.451-1(a), Income Tax Regs. 

Petitioners contend that respondent's determination

requiring the hospitals to change from the hybrid method to an

overall accrual method was an abuse of respondent's discretion

because, during earlier audits, respondent had changed those

hospitals from the cash method to the hybrid method and, in

subsequent audits, had reviewed and approved the use of the

hybrid method. Petitioners assert that, in changing the

hospitals to the hybrid method, respondent necessarily determined

that the hybrid method clearly reflected the hospitals' income

and that during the years in issue there were no changes in the

law or the facts which would cause the hybrid method to fail in

continuing to reflect income clearly. Accordingly, petitioners

contend, respondent cannot now change the hospitals to an overall

accrual method for the years in issue. 

On the other hand, respondent contends that no change in

petitioners' method of accounting was approved by respondent as

clearly reflecting income when respondent's agents resolved the

examinations of petitioners' returns for taxable years ended 1972

through 1980. Accordingly, respondent contends, the resolution

of those years by the agreement to use the hybrid method was

merely for "settlement" purposes. Respondent also contends that

the hospitals purchased and sold inventory, and, consequently,

they must use an accrual method for the taxable years ended 1981
- 45 -

19 

Sec. 1.446-1(c)(2), Income Tax Regs., provides as follows:

(2) Special rules. (i) In any case in which it is

necessary to use an inventory the accrual method of

accounting must be used with regard to purchases and sales

unless otherwise authorized under subdivision (ii) of this

subparagraph.

(ii) 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. The Commissioner may authorize a taxpayer to adopt or

change to a method of accounting permitted by this chapter

although the method is not specifically described in the

regulations in this part if, in the opinion of the

Commissioner, income is clearly reflected by the use of such

method. Further, the Commissioner may authorize a taxpayer

to continue the use of a method of accounting consistently

used by the taxpayer, even though not specifically

authorized by the regulations in this part, if, in the

opinion of the Commissioner, income is clearly reflected by

the use of such method. See section 446(a) and paragraph

(a) of this section, which require that 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, and section 446(e) and paragraph (e) of this

section, which require the prior approval of the

Commissioner in the case of changes in accounting method.

through 1986, as mandated by section 1.446-1(c)(2), Income Tax

Regs.,19 regardless of any determination respondent may have made

for taxable years ended 1972 through 1980. Additionally,

respondent contends that petitioners' hybrid method does not

clearly reflect income. 

The parties devoted a considerable portion of their briefs

to advocating their respective positions that respondent did or

did not change the hospitals to the hybrid method of accounting

as part of the resolution of the audit of petitioners' returns
- 46 -

20

As noted supra note 11, beginning in 1987, petitioners are

required by sec. 448 to use an overall accrual method.

21

Although petitioners contend in their briefs that the cash

method is an appropriate method of accounting for the hospitals,

they do not assert a claim that tax for each of the years ended

1981 through 1986 should be recomputed under the cash method, and

they concede that the hybrid method of accounting clearly

reflects their income for those years. Accordingly, we deem

petitioners' failure to assert a claim for recomputation of tax

under the cash method of accounting as a concession that income

should be reported on the hybrid method of accounting for the

years ended 1981 through 1986.

22

Respondent argues that the change of accounting method issue

is in reality a change from the cash method to the accrual

method. Respondent, however, does not seek to hold petitioners

to the cash method of accounting. Rather, respondent seeks to

impose a different method. Under such circumstances, the consent

of the Commissioner under sec. 446(e), which requires the

Commissioner's prior consent to a change of method of accounting

for computing income, generally is not required. See Convergent

Technologies, Inc. v. Commissioner, T.C. Memo. 1995-320 (“When 

* * * [the Commissioner] does not seek to hold a taxpayer to a

previously adopted method of accounting but rather seeks to

impose another method in place of the one utilized by the

taxpayer, the consent of * * * [the Commissioner] under section

(continued...)

for taxable years ended 1972 and 1973. As will be discussed more

fully below, we conclude that the hybrid method of accounting

clearly reflects petitioners' income for the years in issue20

and, consequently, it was an abuse of discretion for respondent

to change petitioners to an overall accrual method of accounting

for the years ending 1981 through 1986.21 Accordingly, we need

not, nor do we, address herein the issue of whether respondent

changed the hospitals' method of accounting during an earlier

audit.22
- 47 -

22(...continued)

446(e) is generally not required” (citing Silver Queen Motel v.

Commissioner, 55 T.C. 1101 (1971) and Foley v. Commissioner, 56

T.C. 765 (1971))).

The parties’ briefs also extensively debated the question of

whether petitioners’ sales of medical supplies are sales of

merchandise which would require the maintenance of inventories

and an overall accrual method of accounting. Specifically,

petitioners contend that the large inventories of medical

supplies maintained by the hospitals are not merchandise sold to

patients. They argue that their hospitals are engaged in service

businesses and that such supplies do not fit the definition of

merchandise, i.e., goods acquired or produced for sale to

customers in the ordinary course of business at a profit, but are

merely items used in the course of providing medical services. 

Accordingly, petitioners maintain that the hospitals are not

required to use an accrual method of accounting for their medical

supplies. Alternatively, petitioners contend that, even if the

medical supplies are merchandise, the hybrid method as further

modified specifically is permitted under respondent's regulations

and clearly reflects the income of the hospitals. 

Respondent contends, on the other hand, that section 471

does not require that merchandise be sold, only that it be

purchased and then used in some way to produce income. 

Accordingly, respondent contends that section 1.471-1, Income Tax
- 48 -

23

Sec. 1.471-1, Income Tax Regs., provides in part as follows:

§ 1.471-1 Need for inventories.

In order to reflect taxable income correctly,

inventories at the beginning and end of each taxable year

are necessary in every case in which the production,

purchase, or sale of merchandise is an income-producing

factor. The inventory should include all finished or partly

finished goods and, in the case of raw materials and

supplies, only those which have been acquired for sale or

which will physically become a part of merchandise intended

for sale, in which class fall containers, such as kegs,

bottles, and cases, whether returnable or not, if title

thereto will pass to the purchaser of the product to be sold

therein. 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 and goods out upon consignment, but

should exclude from inventory goods sold (including

containers), 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. 

Regs.,23 is not limited to goods held for sale to retail

customers, or even just to sale transactions, but is broad enough

to capture every transaction in which petitioners' hospitals use

a medical supply in treating a patient. Respondent maintains

that medical supplies are considered to be merchandise in the

business of the respective manufacturers, wholesalers, and

retailers which manufacture, distribute, and sell the medical

supplies; that the medical supplies continue to be merchandise
- 49 -

when purchased by petitioners' hospitals; and that the medical

supplies therefore are merchandise which must be inventoried and

are subject to section 471. Respondent posits that the test for

distinguishing merchandise inventory from supplies inventory is

whether the applicable item has been separately charged to a

patient. 

Petitioners disagree with respondent's definition of

merchandise. They assert that the hospitals do not acquire

medical supplies for sale to patients, the transactions between

hospitals and patients are not intended as sales, the

transactions are not viewed as sales, and sales do not occur. 

Petitioners contend that the hospitals' patients obtain no right

to select, control, transfer to others, dispose of, or otherwise

exercise normal ownership rights over the supplies used in

providing services to them. Petitioners argue that even such

items as crutches or admission kits are provided by a hospital

because of the particular treatment needs of the patient while in

the hospital, and not as a means of selling those items to the

patient. 

In support of their respective positions, the parties

presented the opinions of various experts. 

Because we conclude below that petitioners’ use of the

hybrid method clearly reflects the income of the hospitals, we do

not decide the question of whether the furnishing of medical

supplies by petitioners’ hospitals as a part of the rendering of
- 50 -

24

Sec. 1.446-1(c)(1)(iv), Income Tax Regs., provides in

pertinent part as follows:

Permissible methods.--(1) In general. Subject to the

provisions of paragraphs (a) and (b) of this section, a

taxpayer may compute his taxable income under any of the

following methods of accounting:

* * * * * * *

(iv) Combinations of the foregoing methods. (a) In

accordance with the following rules, any combination of the

foregoing methods of accounting will be permitted in

connection with a trade or business if such combination

clearly reflects income and is consistently used. Where a

combination of methods of accounting includes any special

methods, such as those referred to in subdivision (iii) of

this subparagraph, the taxpayer must comply with the

requirements relating to such special methods. A taxpayer

using an accrual method of accounting with respect to

purchases and sales may use the cash method in computing all

other items of income and expense. However, a taxpayer who

uses the cash method of accounting in computing gross income

from his trade or business shall use the cash method in

computing expenses of such trade or business. Similarly, a

taxpayer who uses an accrual method of accounting in

computing business expenses shall use an accrual method in

computing items affecting gross income from his trade or

business.

(continued...)

services to their patients could be considered to be a sale of

merchandise which must be inventoried pursuant to section 1.471-

1, Income Tax Regs.

Petitioners contend that even if its hospitals are required

to use inventories under section 471, the use of an overall

accrual method is not necessary to reflect income clearly. They

maintain that under section 1.446-1(c)(1)(iv), Income Tax

Regs.,24 an accrual method is required only with regard to
- 51 -

24(...continued)

(b) A taxpayer using one method of accounting in

computing items of income and deductions of his trade or

business may compute other items of income and deductions

not connected with his trade or business under a different

method of accounting. [Emphasis supplied.]

purchases and sales and that the cash method is permitted for

computing all other items of income and expense. They contend

further that the hybrid method is expressly recognized and

approved by respondent’s regulations. Petitioners additionally

contend that if the applicable hospitals were actually engaged in

the sale of supplies, they would be entitled to use the

installment method of reporting income, which would result in

approximately the same or somewhat less income being reported

than what was reported under the hybrid method as further

modified.

Respondent contends, on the other hand, that petitioners may

not use the hybrid method as further modified because only a

unitary business is involved in the instant case. Petitioners

counter that the hybrid method is an appropriate method even when

a taxpayer’s business is a single business rather than multiple

businesses. We agree with petitioners’ conclusion that the

regulations do not restrict the use of a hybrid method to

taxpayers engaged in more than one business. Cf. sec. 1.446-

1(c)(1)(iv) through (d), Income Tax Regs.

Section 1.446-1(c)(1)(iv), Income Tax Regs., authorizes the

use of a hybrid method such as the one used by petitioners in the
- 52 -

instant case. The regulation provides: “A taxpayer using an

accrual method of accounting with respect to purchases and sales

may use the cash method in computing all other items of income

and expense.” Consequently, taxpayers are specifically allowed

to use the accrual method for purchases and sales of inventory

items and the cash method for the remaining items of income and

expense. The hybrid method formulated during the audit of

petitioners’ 1972-73 returns was designed to capture for accrual

purposes income and expenses relating to the purchases and sales

of inventory while permitting income and related expenses from

all other sources to be computed on the cash method. In three

succeeding audits, respondent’s agents used the hybrid method as

modified or as further modified to incorporate additional income.

Respondent does not argue, nor do we find, that petitioners’

hospitals impermissibly mixed the cash and accrual methods by,

for example, reporting income on the cash method and related

expenses on an accrual method, in contravention of section 1.446-

1(c)(1)(iv), Income Tax Regs. See supra note 25. Petitioners’

hospitals, moreover, utilize a sophisticated cost center

accounting system under which it is quite feasible to accurately

segregate accounts containing merchandise for which an accrual

method is required from accounts which do not contain merchandise

for which the cash method is appropriate. Under such

circumstances, we are persuaded that petitioners’ hospitals

utilized a hybrid method permitted under the regulations. 
- 53 -

Respondent’s acquiescence in petitioners’ use of the hybrid

method and the hybrid method as modified or as further modified

over four consecutive audit cycles to compute taxable income of

the applicable hospitals, while not binding on respondent, under

the circumstances of the instant case is a factor in petitioners’

favor. See Klein Chocolate Co. v. Commissioner, 36 T.C. 142

(1961); Geometric Stamping Co. v. Commissioner, 26 T.C. 301

(1956); see also Public Service Co. v. Commissioner, 78 T.C. 445,

456 (1982). Another favorable factor is the overwhelming

acceptance of the cash method of accounting in the health care

industry. See Public Service Co. v. Commissioner, supra; Madison

Gas & Electric Co. v. Commissioner, 72 T.C. 521, 556 (1979),

affd. 633 F.2d 512 (7th Cir. 1980). Additionally, petitioners’

hospitals are in the health care industry, which is primarily a

service industry. See St. Luke’s Hospital, Inc. v. Commissioner,

35 T.C. 236, 238 (1960); see also “Audits of Providers of Health

Care Services”, AICPA Audit and Accounting Guide (1992); Office

of Management and Budget, Standard Industrial Classification

Manual, 387-388 (1987). Such industries historically have been

permitted to use the cash method.

Respondent objects to petitioners' use of the hybrid method

of accounting for the hospitals because of the disparity between

the income reported under that method and the income that would

have been reported had the hospitals employed an overall accrual
- 54 -

method of accounting. That disparity results because a portion

of income is reported on the cash basis. 

We have noted on other occasions that some distortion of

income is inherent in the cash method of accounting. For

example, in Van Raden v. Commissioner, 71 T.C. 1083, 1104 (1979),

affd. 650 F.2d 1046 (9th Cir. 1981), we stated:

The cash method of accounting will usually result

in some distortion of income because the benefits

derived from payments for expenses or materials extend

to varying degrees into more than one annual accounting

period. If the cash method is consistently utilized

and no attempt is made to unreasonably prepay expenses

or purchase supplies in advance, the distortion is not

material and over a period of years the distortions

will tend to cancel out each other. * * * 

We are satisfied from the record in the instant case that

the hospitals made no attempt to unreasonably prepay expenses or

purchase supplies in advance or to intentionally delay the

billing of receivables to defer collections to the next taxable

year. There is no evidence that the hospitals' books are kept

inaccurately, unfairly, or dishonestly. 

Section 1.446-1(a)(2), Income Tax Regs., expressly

recognizes that a uniform accounting method cannot be prescribed

for all taxpayers and that the appropriateness of any given

method will depend upon the taxpayer's needs. RECO Indus. v.

Commissioner, 83 T.C. 912, 928 (1984). The method of accounting

and the nature of a taxpayer's trade or business are

inextricable. Accordingly, industry practice and trade custom,

although not dispositive, are factors to be considered in
- 55 -

determining whether a method of accounting clearly reflects

income. Public Service Co. v. Commissioner, supra at 455-457;

Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 728 (1981);

Magnon v. Commissioner, 73 T.C. 980, 1004-1006 (1980); Epic

Metals Corp. & Subs. v. Commissioner, T.C. Memo. 1984-322, affd.

without published opinion 770 F.2d 1069 (3d Cir. 1985). 

Consequently, any distortion of income must be examined in light

of the business practice or business activities that give rise to

the transaction which the Commissioner has determined must be

accorded a different accounting treatment. Van Raden v.

Commissioner, supra.

In the instant case, the use of a hybrid method of

accounting was specifically designed for petitioners’ hospitals

during the audit of petitioners' returns for the taxable years

ended 1972 and 1973 to capture, for accrual purposes, income and

expenses relating to the purchases and sales of many medical

supplies while permitting income and related expenses from all

other sources to be computed on the cash method. As stated

above, section 1.446-1(c)(iv)(a), Income Tax Regs., permits a

taxpayer using the accrual method with respect to purchases and

sales to use the cash method in computing all other items of

income and expense, provided that the taxpayer's income is

clearly reflected by the use of such method. Accordingly, the
- 56 -

25

In Sullivan v. Commissioner, T.C. Memo. 1963-264, the

taxpayer, a subcontractor to general contractors on building

construction jobs who also did some manufacturing of component

parts, changed his method of accounting from the cash method to a

modified accrual method whereby he accounted for purchases and

sales on the accrual method and all other items of income and

expense on the cash method. We noted that the Commissioner's

regulations explicitly sanction such a hybrid method. Under such

circumstances, we held that the taxpayer could not accrue as a

legal and auditing expense an auditing fee incurred during the

tax year for reconstructing his accounting records and paid

during a later tax year, but that the taxpayer would have to

account for and deduct such auditing expense on the cash method;

i.e., the method he used for all his expenses other than

purchases.

regulations under section 446 specifically authorize the use of

the hybrid method.25 See also sec. 446(c)(4).

In RLC Indus. Co. v. Commissioner, 98 T.C. at 502-503, the

taxpayer, a large timber user, combined timber in Oregon and

California into a single block for purposes of computing its

depletion under sections 611 and 631. Even though the taxpayer's

method was specifically authorized under the regulations, the

Commissioner argued that the taxpayer's approach did not clearly

reflect income. We observed:

In this case, petitioner complied with the

regulations and was in conformity with accounting

principles, industry practice, and other standards

considered in this area. Respondent argues that the

method that she determined would more clearly reflect

income. Respondent's focus is upon the disparity

between the method she determined and the one used by

petitioner. That focus, in the setting of this case,

is an insufficient reason for the imposition of a

differing method determined by respondent. The best

method is not necessarily the one which produces the

most tax in a particular year. If, as here, a

taxpayer's method is consistently applied and clearly
- 57 -

reflects income, we will not sustain respondent's

determination merely because it produces more income

tax for the taxable year under consideration. * * * 

Disparity in amount is not, per se, necessarily

indicative of a failure to clearly reflect income. 

* * * [Id.; fn. ref. omitted.] 

In the instant case, the record as a whole suggests that a

substantial portion of the disparity between income reported on

the accrual method and income reported on the hybrid method

results from respondent's proposed accrual of revenue related to

room charges and ancillary services. Such ancillary services

would include the use of special facilities such as the operating

room, the recovery room, and the delivery room, as well as

laboratory tests, x-rays, physical therapy, and group and

individual therapy for psychiatric patients. Because such income

results from the provision of services, it historically has been

reported on the cash method. 

We also are persuaded by the statement of Mr. Duis, one of

petitioners’ experts, that the increase in accounts receivable

reflected on petitioners' returns for the years in issue

primarily resulted from the rapid increase in the number of

hospitals that formed HCA over those years and not from a change

in business practice. Consequently, we do not find that the

disparity in income reported under the hybrid method from that

which would have been reported under an accrual method sufficient

reason in the instant case for requiring the hospitals to adopt

an overall accrual method of accounting.
- 58 -

 We are persuaded that petitioners' use of the hybrid method

was particularly appropriate in view of the hospitals'

operations. 

Respondent contends, however, that the hospitals' hybrid

method as modified and as further modified does not clearly

reflect income because it does not result in income substantially

identical to the income which would be reported under an overall

accrual method. Respondent contends that the substantialidentity-of-results test focuses on whether there are substantial

accounts receivable. According to respondent, petitioners do not

pass the substantial-identity-of-results test because the

hospitals have title to a substantial amount of inventory and

have a substantial amount of accounts receivable. 

The courts have applied a substantial-identity-of-results

test for determining whether there was an abuse of respondent's

discretion in not permitting a taxpayer with inventories to

continue to use the cash method of accounting under section

1.446-1(c)(2)(ii), Income Tax Regs. See Ansley-Sheppard-Burgess

Co. v. Commissioner, 104 T.C. at 377; see also Ralston Dev. Corp.

v. United States, 937 F.2d 510, 514 (10th Cir. 1991); American

Fletcher Corp. v. United States, 832 F.2d at 440; Asphalt Prods.

Co. v. Commissioner, 796 F.2d 843 (6th Cir. 1986), affg. in part

and revg. in part Akers v. Commissioner, T.C. Memo. 1984-208,

revd. per curiam on another issue 482 U.S. 117 (1987); WilkinsonBeane, Inc. v. Commissioner, 420 F.2d at 356; J.P. Sheahan
- 59 -

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

v. Commissioner, T.C. Memo. 1985-277. 

The substantial-identity-of-results test was first

articulated in Wilkinson-Beane, Inc. v. Commissioner, supra. The

taxpayer had argued that the disparity in gross income under the

cash method and an accrual method was inconsequential. The Court

of Appeals disagreed, stating:

The standard we apply is whether the taxpayer's method

of accounting reflects his income with as much accuracy

as standard methods of accounting permit. In our view,

this means that the taxpayer must demonstrate

substantial identity of results between his method and

the method selected by the Commissioner. * * * [Id.

at 356; fn. ref. omitted.]

We recently had occasion to address the substantialidentity-of-results test in Ansley-Sheppard-Burgess Co. v.

Commissioner, supra. In that case, the Commissioner argued,

inter alia, that in order to show an abuse of discretion by the

Commissioner a taxpayer using the cash method to report income

must, in all instances, be able to show a substantial identity of

results between the cash method and the method of accounting

which the Commissioner determines clearly reflects the taxpayer's

income. We disagreed, stating:

Respondent's contention that we must apply the

substantial-identity-of-results test in cases where the

taxpayer is not required to maintain an inventory is

without support in the case law. * * * [Id. at 377.]

The Court of Appeals for the Sixth Circuit, to which the

instant case would be appealable absent stipulation to the
- 60 -

contrary, applied the substantial-identity-of-results test in

Asphalt Prods. Co. v. Commissioner, supra. The taxpayer, which

produced and sold emulsified asphalt, had employed the cash

method of accounting from its inception. Through 1973, the

taxpayer had only nominal inventories on hand at yearend because

it normally closed down its operations for several weeks before

the end of the year. The taxpayer's principal customers were

county governments in Tennessee that used emulsified asphalt for

road construction and maintenance. The county governments

received revenues required for that purpose from their share of

State gasoline taxes. As an effect of the Arab oil embargo of

1973, the price of emulsified asphalt rose rapidly while the

consumption of gasoline dropped sharply. Consequently, the

taxpayer's accounts receivable increased substantially between

January 1, 1974, and January 1, 1975. Additionally, because

suppliers of the petroleum residue that was the principal

ingredient of emulsified asphalt required their customers to

accept their allocations of the petroleum residue on a monthly

basis, the taxpayer had inventories on hand at the end of 1974

and 1975. On audit, the Commissioner determined that the

taxpayer had to use the accrual method of accounting because the

use of inventories was necessary to clearly reflect income due to

the fact that the production and sale of merchandise was an

income-producing factor. The Commissioner determined

additionally that the fluctuations in accounts receivable
- 61 -

resulted in a mismatching of receipts from sales and cost of

sales and therefore the cash method was not appropriate. The

Court of Appeals for the Sixth Circuit agreed that the change of

accounting method by the Commissioner was not an abuse of

discretion under the circumstances in that "Though the temporary

increase in inventory in the present case was not significant,

the large increase in accounts receivable created a situation

where only use of the accrual method of accounting would avoid a

serious distortion." Asphalt Prods. Co. v. Commissioner, supra

at 848-849.

Relying on Wilkinson-Beane, Inc. v. Commissioner, supra, the

Court of Appeals for the Sixth Circuit concluded that "Where the

Commissioner has determined that the accounting method used by a

taxpayer does not clearly reflect income, in order to prevail,

'the taxpayer must demonstrate substantial identity of results

between his method and the method selected by the Commissioner.'" 

Id. at 849. In that case, the taxpayer reported income from the

sale of merchandise on the cash method of accounting. In the

instant case, the hospitals used a hybrid method, not a cash

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

T.C. Memo. 1969-79, we specifically cautioned that "It must be

remembered that our analysis of the above regulations and cases

is in the context of the cash or accrual bases of accounting. We

are not faced with a hybrid method." 
- 62 -

The substantial-identity-of-results test is not applicable

under the circumstances present in the instant case. As we read

Asphalt Products, it is clear that the focus of the Court of

Appeals for the Sixth Circuit was on the mismatching of the

taxpayer's receipts from the sale of products with its cost of

goods sold. See, e.g., 796 F.2d at 847. Indeed, that court

stated:

If the temporary and rather insignificant increase in

inventories of raw materials had been the only basis

for the Commissioner's determination, we would have

been inclined to find an abuse of discretion. We do

not construe the Code provisions and regulations

relating to inventories in the absolute terms adopted

by the Commissioner and the Tax Court. However, the

taxpayer's method of accounting did not produce an

accurate picture of its 1974 income. The income tax is

structured on an annual basis. Using the cash method,

the cost of materials sold in 1974 was deducted on the

1974 return, yet the proceeds from that portion of the

same sales represented by the accounts receivable were

not included in the taxpayer's gross receipts as

reported on its return. Unlike the inventory item, the

accounts receivable were not negligible before 1974 and

did not shrink even to their former size at the end of

the oil emergency. The taxpayer had accounts

receivable of $238,000 at the end of 1976. These facts

supported the Commissioner's determination that the

cash receipts and disbursements method did not clearly

reflect the taxpayer's income. [Id. at 849.]

In the instant case, petitioners report patient receivables

and related expenses attributable to the Pharmacy and Central

Supply accounts on the accrual method. Consequently, the

presence of the substantial accounts receivable at yearend does

not mean "that the cost of goods sold had been deducted while the
- 63 -

proceeds from the sales of these goods had not been included in

income." Id. at 848. 

In light of all the facts and circumstances, we conclude

that application of the substantial-identity-of-results test is

unwarranted in the instant case. We have held above that the

hybrid method is a permissible method under the regulations and

that it clearly reflects the taxable income of the hospitals.

We have considered other arguments raised by respondent but

find them unpersuasive. In view of our holding, we do not

address petitioners' contention that the legislative history of

section 801 of the Tax Reform Act of 1986, Pub. L. 99-514, 100

Stat. 2345 (adding section 448 to the Code, which requires

certain corporations, including hospitals, to change

prospectively beginning in 1987 to an overall accrual method),

demonstrates that Congress recognized that under prior law

hospitals could use the cash method or a hybrid method of

accounting. Also, we do not address petitioners’ contention that

they would be entitled to report on the installment method if the

hybrid method were found not to clearly reflect their income. 

Additionally, we do not decide respondent’s contention that the

hospitals sold merchandise. Finally, as stated above, we do not

decide the issue of whether respondent changed the hospitals’

method of accounting during an earlier audit.

One final word. The instant case contains a voluminous

record and involves numerous factual issues to be decided by this
- 64 -

Court. The issue we have decided in this opinion is only the

first of such issues, albeit the one involving a substantial

portion of the deficiencies in controversy. As inherently

factual as these issues are, we think it is appropriate at this

juncture to remind the parties of our previous admonitions

concerning settlement of the instant case. Consequently, we

direct the parties to make another good faith effort to settle

the remaining issues.

To reflect the foregoing,

Appropriate orders

 will be issued.