Document: 58 L.Ed.2d 785 99 S.Ct. 773 439 U.S. 522 THOR POWER TOOL COMPANY, Petitioner,v.COMMISSIONER OF INTERNAL REVENUE. No. 77-920. Argued Nov. 1, 1978. Decided Jan. 16, 1979. Syllabus Inventory accounting for tax purposes is governed by §§ 446 and 471 of the Internal Revenue Code 1954. Section provides that taxable income to be computed under taxpayer's normal method unless "does not clearly reflect income," in which event "under such as, opinion [Commissioner], does income." "[w]henever [Commissioner] use inventories necessary order determine any taxpayer, inventory shall taken taxpayer on basis as may prescribe conforming nearly best practice trade or business most reflecting The implementing Regulations require a value at cost "market" (defined replacement cost) lower. specify two situations valued below so defined: (1) where course has actually offered merchandise sale prices lower than cost; (2) defective. In 1964, petitioner, tool manufacturer, wrote down accord with "generally accepted principles" what it regarded "excess" its own estimate "net realizable value" (generally scrap value) goods (mostly spare parts), but continued hold their original prices. It offset write-down against 1964 sales thereby produced net operating loss year. Commissioner disallowed offset, maintaining did purposes. Deductions bad debts are covered § 166. 166(c) an accrual-basis "shall allowed (in discretion [Commissioner]) deduction reasonable addition reserve debts." 1965, petitioner added asserted sum presupposed substantially higher charge-off rate had experienced immediately preceding years. ruled was excessive, determined, pursuant "six-year moving average" formula derived from Black Motor Co. v. Commissioner, 41 B.T.A. 300, he lesser "reasonable" amount petitioner's reserve. On petition redetermination, Tax Court upheld Commissioner's exercise respect both bad-debt deduction, Appeals affirmed. Held : 1. abuse his determining failed clearly, since plainly inconsistent governing Regulations. Pp. 531-546. (a) Although conceding "an active market prevailed" date, made no effort thus ascertain general rule Petitioner, however, bring itself within either authorized exceptions valuing "market." Whereas demand concrete evidence reduced value, provided objective whatever management ascribed it. 535-538. (b) There presumption conformable valid Such insupportable light statute, this Court's past decisions, differing objectives financial accounting. 538-544. (c) While argues should forced defer benefit currently deemed unsalable until future years, when items disposed of, "dilemma" nothing more choice every paper must face. 545-546. 2. recomputing according formula. Because show why debt collections 1965 would less likely prior carry "heavy burden" showing application have been arbitrary. 546-550. 7th Cir., 563 F.2d 861, Mark H. Berens, petitioner. Stuart A. Smith, Washington, D. C., respondent. Mr. Justice BLACKMUN delivered Court. 1 This case, comes us, presents federal issues. One do other relates 2 Issue. Thor Power Tool (hereinafter sometimes referred taxpayer), principles," excess Thor's goods. Despite write-down, year; then carryback 1963 172 1954, 26 U.S.C. 172. Revenue, serve purposes, carryback. 3 Bad-debt Code, 166(c), based experience, 4 Court, unreviewed decision Judge Goffe, respects. 64 T.C. 154 (1975). As consequence, also because adjustments issue here, court redetermined, App. 264, following deficiencies tax: 5 calendar year 1963—$494,055.99 6 1965—$59,287.48 7 United States Seventh Circuit 861 (1977). We granted certiorari, 435 914, 98 1466, 55 504 (1978), consider these important recurring 8 * Issue 9 Taxpayer Delaware corporation principal place Illinois. manufactures hand-held power tools, parts accessories, rubber products. At various plants service branches, maintains raw materials, work-in-process, finished completed tools. all times relevant, used, "lower market" inventories. 23-24. See Treas.Reg. 1.471-2(c), CFR 1.471-2(c) (1978). 10 tools typically contain 50 200 parts, each stocks meet replacements. difficulty, time manufacture, predicting liberal quantities part avoid subsequent production runs. Additional runs entail costly retooling result delays filling orders. 54-55. 11 1960, instituted procedure writing accessories models longer produced. created contra-account credited account 10% part's parent model ceased. T.C., 156-157; 24. effect amortize over 10-year period. For first nine months $22,090. 157; 12 late new took control promptly concluded overvalued.1 After "a physical locations" divisions, id., 52, off approximately $2.75 million obsolete damaged defective demonstration samples, similar items. Id., 52-53. writeoff scrapped articles shortly after removal closing inventory.2 Management $245,000 stocked three unsuccessful 56. too, sold close 1964. 62. 13 left some 44,000 assorted items, status here. many articles, mostly parts,3 were inventory, is, they held reasonably foreseeable demand. decided written value," which, cases, value. 160-161; Brief Petitioner 9; Tr. Oral Arg. 11. 14 Two methods used quantity inventory. Where accurate data available, forecast item actual usage, usage parts. assumed same applied aging schedule: corresponding one year's estimated kept years' entirely; 50% 75%. 26.4 presented statistical rationalize percentages frame. president justified citing opined "somewhat between" possible alternative solutions.5 yielded total $744,030. 160. 15 inadequate permit forecasts demand, second plants, company employed flat percentage write-downs 5%, types inventory.6 support percentages. Its observed "this precise way doing it," said "felt adjustment nature order, figures represented our required reduce value." 67. $160,832. 16 once, sell them prices, done $3 permitted. Rather, retained physically 160-161. found that, owing peculiar involved,7 price reductions avail went on, gradually scrap; record unclear dispositions place.8 17 therefore was: Ten-year amortization 18 discontinued $22,090 First (aging 19 usage) 744,030 Second (flat 20 write-downs) 160,832 Total $926,952 contra-account, decreasing increasing sold, amount.9 contended carrying audit, entirety, asserting upholding determination, fact conform principles"; indeed, "thoroughly convinced . case." 165. if write basis, accountants unable give statements desired certification. 161-162. held, conformance enough; 446(b), well, 1954 446(b) 471, prescribe, independent requirement, "clearly rejected argument Treasury Regulations, 167-171, abused clearly. B 471. 446(a) states accounting: "Taxable regularly computes keeping books." provides, income, computation promulgated state "no acceptable unless, reflects Treas. Reg. 1.446-1(a)(2), 1.446-1(a)(2) (1964).10 prescribes states: "Whenever point out, obviously establishes distinct tests conform. First, "as be" "best practice," phrase synonymous principles." Second, "must 1.471-2(a)(2), 1.471-2(a)(2) (1964). obvious face, accompanying vest wide whether particular reflective income. cases confirm breadth discretion. construing predecessors, "[t]he broad powers Hansen, 360 446, 467, 79 1270, 1282, 1360 (1959). Since "[m]uch latitude discretion," interpretation statute's clear-reflection standard "should interfered unlawful." Lucas American Co., 280 445, 449, 202, 203, 74 L.Ed. 538 (1930). To Catto, 384 102, 114, 86 1311, 1317, 398 (1966); Schlude 372 128, 133-134, 83 601, 604, 633 (1963); Automobile Assn. States, 367 687, 697-698, 81 1727, 1732, 1109 (1961); Club Michigan 353 180, 189-190, 77 707, 712-713, 746 (1957); Brown Helvering, 291 193, 54 356, 360, 78 725 (1934). 203 Act 1918, 40 Stat. 1060, predecessor bears burden [proof]," disallowance set aside shown "plainly arbitrary." Structural Steel 281 271, 263, 266, 848 noted, case conformed "within term, 'best practice,' term section regulations section." 161, challenged finding, there dispute satisfied 471's two-pronged test. only question, then, satisfy test's prong unbridled arbitrary we sustain part, challenged.11 noted above pertinent rules out 1.471-4, 1.471-4 That Regulation defines mean, ordinarily, "the current bid prevailing date volume usually purchased taxpayer." 1.471-4(a). courts uniformly interpreted "bid price" mean cost, pay open purchase reproduce items.12 exists, using "such fair dates nearest specific purchasers others good faith, compensation paid cancellation contracts commitments." 1.471-4(b). permitted defined. cost. Inventories those direct disposition, "and correctness will determined reference period before inventory." Ibid. warn "which vary materially ascertained market." situation If "unsalable unusable damage, imperfections, shop wear, changes style, odd broken lots, causes," "at bona fide selling disposition." 1.471-2(c). define "bona "actual offering during ending later 30 days date." proving exceptional upon come classifications indicated," "maintain records disposition enable verification made." From language, regulatory scheme clear. "Market" defined "replacement cost," depart specified situations. When makes departure, substantiate valuation providing offerings, sales, contract cancellations. absence kind, assertions "market cognizable computing tax. clear us procedures scheme. conceded see 169, "made reproduction cost" 162. seeking exceptions. able take advantage 1.471-4(b) since, found, offer Indeed, concedes bear came classifications. 171; F.2d, 867. Actually, unexceptional, indistinguishable intermingled down. More importantly, provide hard further kept. records. 171. simply well-educated guess never sold. formulae management's collective "business experience"; contained seemingly chosen reason multiples five embodied kind anagogical symmetry. evidence. could subjective estimates goods' ultimate salability, able, observed, 170, "to how much wanted given year."13 reasons, agree acted deciding well-known potential avoidance inherent accounting,14 insist high evidentiary allowing properly it.15 C major conclusion finding points language (1964), "[a] consistent generally principles ordinarily income" (emphasis added). 1.471-2(b), 1.471-2(b) likewise stated conformity "can, rule, added).16 These provisions, contends, Once established conformity, runs, shifts affirmatively demonstrate Unless can "demonstrably distorts Chamber Commerce Amicus Curiae 3, adoption "motivated avoidance," 25, favor day. concludes, rebut embody postulates, little case. Regulations; yield face inconsistency. believe, present. existence above, establish moreover, leave doubt test paramount. requires practice, categorically Most if, "in [his] opinion," completely odds notion "presumption" favor. presumption; say merely practices pass muster And will. But discretion, determines not, different without having running Treasury. postulates finds decisions. early specifying "is expressly limited believes accounts U.S., S.Ct., 203. recently, recognize prepaid received, even though mismatch expenses revenues contravention commercial 690, 1730. "[T]o performing function Association 'is practices,' " concluded, binding Treasury." 693, "[W]e mindful characterization transaction hand, other, need necessarily same." Frank Lyon 561, 577, 1291, 1300, 550 Idaho 418 15, 94 2757, 2765, 535 (1974). divergence between especially common seeks losses. E. g., (1959) (reserve cover contingent liability nonperformance guarantee); (1934) expected unearned commissions anticipated insurance policy cancellations); supra contested lawsuit). rationale amply encompasses aim. By president's concession, company's founded belief inevitably become useless due breakage, technological change, fluctuations like.17 Thor, words, sought "deduction" loss. Under circumstanced shelter beneath accountancy presumption. Third, vastly have. primary goal useful information management, shareholders, creditors, interested; responsibility accountant protect parties being misled. system, contrast, equitable collection revenue; Service public fisc. Consistently goals responsibilities, foundation principle conservatism, corollary "possible errors measurement [should] direction understatement rather overstatement assets."18 view Treasury's markedly responsibilities destined guiding light. Given diversity, contrariety, objectives, presumptive equivalency unacceptable.19 difference mirrored numerous differences treatment. law deferred "all events" occurred make fixed certain, Anderson, 269 422, 441, 46 131, 134, 70 347 (1926), accrued soon estimated.20 Conversely, recognized "claim right," "ability pay," "control" rationales, accrual better matched.21 Financial accounting, short, hospitable estimates, probabilities, certainties; law, mandate preserve revenue, quarter uncertainty. be. Reasonable useful, essential, giving shareholders creditors picture firm's overall health; accountant's conservatism cannot bind efforts collect taxes. "Only few reserves voluntarily matter conservative accounting," Brandeis "are Acts." 201-202, 360. Finally, create insurmountable difficulties administration. Accountants long far canonical ensure identical treatment transactions.22 "Generally rather, tolerate range treatments, leaving among alternatives management. Such, precisely here.23 Variances sort tolerable reporting, questionable system designed similarly situated taxpayers election "acceptable" options dispositive firm, decide unilaterally—within limits dictated accountants—the wished pay. unilateral decisions just inequitable; unenforceable. D complains adverse poses dilemma. According virtually impossible inventory's prices; says reduced-price "pull rug out" "non-excess" trying simultaneously. "closed transaction" once. Yet immediate scrapping undesirable ultimately might prove greater anticipated. sees unattractive Hobson's choice: carried years instead overstating overvaluation scrapped, prematurely detriment manufacturer customers." 25. indeed dilemma confronts reality who realize now garner benefit, realization, hoping luck later. quite simply, suffered present deliberately manufactured judged marginal machinery surpass expectations. rational judgment and, unpredictably, sell. course, confident prediction willing now; wants keep This, judgment, subsidize hedging bets. entitled, cake eat too. II 166 166(a)(1) sets forth "any becomes worthless year." Alternatively, permits method. implemented "[i]n lieu subsection (a), A balance up level losses outstanding end pertinent, beginning $93,000. During undertook stringent review receivable. division, credit personnel studied accounts; 100% wholly uncollectible, 1% receivables. clerks analyzed 90 balances $100; collectibility ratio $100 age. 2% due, accounts. 162-163. judgments, approved levels indicated $136,150 reserve, bringing year-end figure slightly $229,000. claimed 166(c). excessive. He believed 300 (1940), aff'd grounds, 125 977 (CA6 1942). recent chargeoff history.24 1960-1965, annual chargeoffs amounted, average, 3.128% 163. Applying receivables, $154,156.80 receivable default. $61,359.20, addition. Accordingly, remaining $74,790.80 deduction. Both 174-175, Circuit, 870, ruling. discretion" Commissioner. statutory determination (and hence deductible) sustained proves discretion.25 respect.26 unreasonable arbitrary.27 received approval 1940, enjoyed branches Federal Government. consistently Commissioner,28 courts,29 collaterally Congress.30 faults retrospectivity: ascertaining additions assertedly penalizes delayed making writeoffs past, whose receivables recently begun deteriorate. Petitioner's objection altogether irrational, falls short rendering Common sense suggests experience offers index problems suffer currently. possesses inconsiderable enhancing certainty predictability area peculiarly susceptible abuse. event, near-universal acceptance, inclined disturb now. Granting valid, question invoking Of acknowledged Rev.Rul. 76-362, 1976-2 Cum.Bull. 45, 46—in generate result. unrepresentative reason, produce year.31 suffers extraordinary reversal (the bankruptcy customer, example), fail.32 conditions cause entitled to—and prepared allow—an larger call for. supra. "did years." 175. "infer[red] entire probably [previously] infused into petitioner" cited customers specifically render unreliable; second-guessed predecessor, taking "tougher" approach. Management's pessimism unreasonable, sanguine view.33 ordered. August Stewart-Warner Corp., shareholder (owning 20% shares), agreed assets. ensuing examination audit led conclude assets overstated liabilities understated. agreement rescinded agreed, instead, assistance Thor. brief, Respondent 6, 17, 30-31, oral argument, 24-25, maintained allowance off. explanation. 864 challenges factual predicate, asserts 40% remained unscrapped 1967. Reply 8. resolve dispute; accept explanation broke follows: Raw materials 4,297 Work-in-process 1,781 Finished 33,670 4,344 number 44,092 154, 158 (1955). operation well illustrated chart 159. assumes 100 units hypothetical hand varied 20-100: ANTICIPATED DEMAND Units Percent 0-12 13-18 19-24 + 24 write- Item 12-31-64 Months 60 0% 75% ------ 0 7.5 =72.5 ------- = 45.0 22.5 80 =10.0 E =0.0 "So here I fell back my manufacturing evaluating previous association. felt overly conservative, understate too optimistic overvalue [in of] factors affect changes, like, opinion, time. somewhat off, say, everything compared [off] today." 57. formulated Write-down Type Percentage Amount motor plant $26,341 work- in-process, 99,954 (3) hardware 34,537 $160,832 159-160; 209. specialized attract bargain hunters; buy regardless price, needed fix tools; work-in-process except manufacturers secondary market. T. appears 78% 1965-1971. 161; 218. concern like Gross Profit basically equals Sales minus Cost Goods Sold. Sold Opening Inventory, plus Acquired, Closing Inventory. reduction therefore, increases decreases accordingly. "method accounting" include "not over-all item. 1.446-(a)(1), 1.446-1(a)(1) 166; 17-19. Even timely challenge established, still 'must revenue statutes,' 'should overruled weighty reasons.' Bingler Johnson, 394 741, 750, 89 1439, 1445, 22 695 (1969), quoting South Texas Lumber 333 496, 501, 68 695, 698, 92 831 (1948). disallowing constituted "change method," obtain consent, 446(e), 446(e). change material item." 1.446-1(e)(2)(i), 1.446-1(e)(2)(i) reach contention. Loveman & Son Export Corp. 34 776, 796 (1960), aff'd, 296 732 1961), cert. denied 369 860, 82 950, (1962). Schnelwar Jurgensen, New Operation Other Valuation Considerations, 33 N.Y.U.Inst. Fed.Tax. 1077, 1093-1094 (1975); AICPA Accounting Principles Board, Research Bulletin 43, ch. 4, Statement (1953), reprinted APB 6016 (1973). Raum emphasized means replace inventory; "it resold resale." 796. justify Space Controls, Inc. 322 144 (CA5 1963), cases. trailers fixed-price Government; stipulated suitable military apart contract. overruns exceeded price. Appeals, divided vote, 1.471-4(b), reasoning 151. approving Fifth Circuit's dispense sale" note distinguishable one. value; all. reliance Cartridge 284 511, 52 243, 76 431 (1932), think, misplaced. ammunition Government World War I. 1918 instructed stop immediately, provision settlement claims unfinished undelivered negotiated negotiations yet begun; accordingly, "market," $232,000. 519, 246. figure, $732,000, realized Army 1920-1922. accordance principle, controlled, noting "had assurance settlements finally ever receive inventories." 520, support, conflict with, Just loss, gain. respect, least, travels two-way street. See, e. H.R.Doc.No.140, 87th Cong., 1st Sess., (1961) President's message); B. Bittker L. Stone, Income, Estate, Gift Taxation 843 (4th ed. 1972); Skinner, Problems, Taxes 748-749 (1972); Schwaigart, Increasing IRS Emphasis Stresses Need Proper Practices, J.Tax. 66, 69 (1963). contends prohibited 1.471-2(f), 1.471-2(f) "The part: "(1) Deducting depreciation thereof. "(2) Taking work process, nominal proper "(3) Omitting portions stock hand." 77-364, 1977-2 183 (percentage "slow" "doubtful" violates 1.471-2(f)(1)); 77-228, 182 (deduction 1.471-2(f)(3)). contentions. either. Until 1973, applicable "In year, weight consistency inventorying 1.471-1 1.471-9. An sheet position can, amended 1973 engaged "full absorption costing," 1.471-11. T.D. 7285, 1973-2 163, 164; 1.471-11 amendments, final sentence 1.471-2(b)—containing rule" language—was deleted; further, requirement "substantially 1.479-9 revised through 1.471-11." (1978) amendments inapplicable 167; F.2d., 866 n. agree. "I think pretty [inventory representing supply] inherently [than 1-year things happen Some lost. damaged. change. won't you changes. So confronted problem, anybody field [would be], develop relationship usage." 56-57 (testimony president). Basic Concepts Underlying Statements Business Enterprises, ¶ 171 (1970), 9089 Sterling, Conservatism: Fundamental Principle Traditional Accounting, Abacus 109-113 (1967). Accord, Raby Richter, Conformity 139 J. Accountancy 42, 44, 48 (Mar. 1975); Arnett, Taxable Income vs. Income: How Much Uniformity Can Stand?, 44 Rev. 482, 485-487, 492-493 (July 1969); Cannon, Pressures Accountants' Independence, 27 419, 419-422 (1952). McClure, Diverse Interpretations Concepts, 142 67, 68-69 (Oct. 1976); Kupfer, Disclosure Matters; Conflicts With Technical Requirements, 1121, 1122 Healy, Narrowing Gap Between Tulane Inst. 407, 417 (1973); Challenge: Profession Lead System?, 126 (Sept. 1968). 21 supra, 44; 486; Accountancy, 68. 492 (noting "many diverse 'acceptable' inventories, depreciating assets, amortizing will," like); "methods costs widely methods, applied, purposes"); Eaton, Reporting Changing Society, 104 (Aug. 1957); Cox, Conflicting Managerial Purposes, 242 (1958); 421 (suggesting prone 'generally accepted' 'somebody tried it' "). 23 experts testify practice." They testified down, this. 166, 184, 196. details calculation B.T.A., 302. CCH 1978 Stand. Fed. Rep., 1624.0992; Whitman, Gilbert, Picotte, Bad Debt Formula: Why Doesn't Work Adjust It, 35 366 (1971). 25 Malone Hyde, 568 474, 477 1978); Dev. Carolina 428 451, 453 (CA4), denied, 400 957, 91 355, 265 (1970); Haskel Engineering Supply 380 786, 789 (CA9 1967); Patterson Pizitz, Inc., 267, 270 1965), 383 910, 895, 666 Ehlen 323 535, 539, 163 Ct.Cl. 35, 42 James Messer 57 848, 864-865 (1972). Atlantic Discount 473 412, 414-415 1973) (citing cases); Consolidated-Hammer Dry Plate Film 317 829, 834 (CA7 1963). 477; Nat. Bank Chicago 546 759, 761 1976), 915, 97 2176, 53 225 28 ("[A]s debts" 166(c)). 29 413, 415; 540-541, Ct.Cl., 45; 857, 865-866. 585(b)(3) (using banks); 586(b)(1) compute small investment companies). 31 Westchester Development 63 198, 212 (1974), acq., 1975-2 (Commissioner "wholly unrepresentative" "comparatively brief operational history"). 32 Calavo, 304 650, 651-652, 654 655 1962) (extraordinary debtor became insolvent). significant portion reflected blanket Treasury, 46, courts, 787, 789; 866, mechanical overcome discretionary invocation

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