[939]*939OPINION.
Tbammelu:
The only question presented in this case for decision is whether the Commissioner is in error in refusing to allow the petitioner to place its inventories of factory supplies, small tools stores, and power and maintenance stores on a “ cost or market, whichever is lower,” basis which is the basis used in its valuation of its raw material, goods in process and finished goods. Broadly speaking, the question is, Are the items which have been excluded items which are subject to the usual rules of inventory valuations?
[940]*940The Commissioner denied the reduction to market on the ground that supplies and items of that character which do not form a component part of the finished product, are pr@perly prepaid expenses and, therefore, should be carried at cost.
The authority for the use of inventories is contained in section 203, Revenue Act of 1918, which follows:
That whenever in the opinion of the Commissioner the nse of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
Pursuant to the authority vested in him by statute, the Commissioner, with the approval of the Secretary, promulgated regulations governing the use of inventories. Regulations 45, article 1581, provides as follows:
* * * The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in productive processes, together with all finished or partly finished goods * * *.
Article 1581 of Regulations 62 under the Revenue Act of 1921, contains the identical language.
The quoted part of the regulations is not, in our opinion, in conflict with the statute but is a reasonable regulation for the carrying out of the statutory provisions.
The Act provides two tests to which each inventory must conform: (1) It must conform as nearly as may be to the best accounting practice in the trade or business, and (2) it must clearly reflect the income. Article 1582, Regulations 45 and 62.
An examination of accounting authorities shows that while a practical unanimity of opinion exists with respect to the proper treatment of raw materials, goods in process and finished goods, from an inventory standpoint, a wide divergence prevails not only as to the valuation of supplies, but also as to their proper grouping in the balance sheet. The following excerpts will indicate, to some extent, the differences which exist:
R. H. Montgomery, “Auditing Theory and Practice,” vol. 1, p. TT2:
Supplies, Stores, Etc. — In addition to tbe regular stock-in-trade, other supplies are usually on band and should, of course, appear in tbe inventory, unless tbe total value is very small.
These items should be separated from tbe merchandise stock. Such items as fuel, office and factory supplies, and similar materials and stores are in tbe same class of raw materials. Repair parts and construction items are not current assets. Ordinary repair parts and similar items which are to be used and charged to maintenance, say, within a year, are current assets and may be included.
[941]*941The general rules of inventory valuation apply. Care must be taken that nothing is included except usable items. The auditor should demand the original stock sheets and test their accuracy sufficiently to satisfy himself that the items are genuine ones, and that quantities are not overstated.
It is sometimes found that partly used articles are included under this caption; except under special circumstances, it is not proper to include anything except new and usable materials, which would have to be duplicated at the same or a greater cost if they were not on hand.
W. H. Bell, “Accountants’ Reports,” p. 42:
Some accountants classify supplies which are not actually ingredients of the product — fuel, repair parts, stationery, etc., as Deferred Charges, along with other prepaid expenses, but the author makes a distinction between physical or tangible items and intangible items, including the former in Inventories, under “ Current Assets.”
H. A. Finney, “Principles of Accounting,” vol. 1, ch. 3, p. 11:
Inventories of Supplies. — Should supplies be included among the inventories in the current asset section, or shown among the deferred charges? In the case of factory supplies, there is some ground for the contention that they should be shown as current assets, because they will enter into the cost of finished goods as part of the manufacturing expense, and thus, by the sale of finished goods, will be converted into cash. The same argument does not apply with equal force to salesroom and office supplies.
But even in the case of factory supplies the argument is not conclusive. The deferred charge grouping seems the more logical one, because this is a classification devoted exclusively to prepaid expenses, and hence is the more precise classification. And if factory supplies may be considered as current assets because they will ultimately be absorbed in the cost of manufacture, the same argument could be advanced in favor of including unexpired premiums on policies insuring plant assets, and all other prepaid manufacturing expenses as well.
Another argument sometimes advanced in favor of showing supplies as current assets, is that prepaid expenses at the close of one period will reduce the demands for cash during the next period, and are to that extent the equivalent of cash. But if this argument is a valid reason for including supplies inventories in the current asset group, it is an equally valid argument for including all prepaid expenses in that group, which would mean the complete abandonment of the deferred charge classification except for such items as organization expense and stock and bond discount. (Italics added.)
Walton Course, Advanced Accounting, Lecture 23, p. 6:
Supplies.' — Factory Supplies are those things, such as oil and waste, brooms, and small tools which enter into the cost of manufactured articles by being consumed in the process of manufacture, but do not enter into and become part of the product itself. New supplies are carried at cost. When issued to the factory for use, they are usually charged off as a factory expense. (Italics added.)
E. A. Saliers, “Accountants’ Handbook,” sec. 7, p. 380:
Inventories of Supplies and Repair Materials. — Value of these is cost or market, whichever is lower. If market is lower and a reserve is used, the reserve to be set up is the difference between cost and market. Reserve should or should not be used according as operations are or are not departmentized, [942]*942because in .former case it is not important that supplies be figured into cost at the reduced value, whereas in the latter case it is, since departments are run on a commercial basis.
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[939]*939OPINION.
Tbammelu:
The only question presented in this case for decision is whether the Commissioner is in error in refusing to allow the petitioner to place its inventories of factory supplies, small tools stores, and power and maintenance stores on a “ cost or market, whichever is lower,” basis which is the basis used in its valuation of its raw material, goods in process and finished goods. Broadly speaking, the question is, Are the items which have been excluded items which are subject to the usual rules of inventory valuations?
[940]*940The Commissioner denied the reduction to market on the ground that supplies and items of that character which do not form a component part of the finished product, are pr@perly prepaid expenses and, therefore, should be carried at cost.
The authority for the use of inventories is contained in section 203, Revenue Act of 1918, which follows:
That whenever in the opinion of the Commissioner the nse of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
Pursuant to the authority vested in him by statute, the Commissioner, with the approval of the Secretary, promulgated regulations governing the use of inventories. Regulations 45, article 1581, provides as follows:
* * * The inventory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in productive processes, together with all finished or partly finished goods * * *.
Article 1581 of Regulations 62 under the Revenue Act of 1921, contains the identical language.
The quoted part of the regulations is not, in our opinion, in conflict with the statute but is a reasonable regulation for the carrying out of the statutory provisions.
The Act provides two tests to which each inventory must conform: (1) It must conform as nearly as may be to the best accounting practice in the trade or business, and (2) it must clearly reflect the income. Article 1582, Regulations 45 and 62.
An examination of accounting authorities shows that while a practical unanimity of opinion exists with respect to the proper treatment of raw materials, goods in process and finished goods, from an inventory standpoint, a wide divergence prevails not only as to the valuation of supplies, but also as to their proper grouping in the balance sheet. The following excerpts will indicate, to some extent, the differences which exist:
R. H. Montgomery, “Auditing Theory and Practice,” vol. 1, p. TT2:
Supplies, Stores, Etc. — In addition to tbe regular stock-in-trade, other supplies are usually on band and should, of course, appear in tbe inventory, unless tbe total value is very small.
These items should be separated from tbe merchandise stock. Such items as fuel, office and factory supplies, and similar materials and stores are in tbe same class of raw materials. Repair parts and construction items are not current assets. Ordinary repair parts and similar items which are to be used and charged to maintenance, say, within a year, are current assets and may be included.
[941]*941The general rules of inventory valuation apply. Care must be taken that nothing is included except usable items. The auditor should demand the original stock sheets and test their accuracy sufficiently to satisfy himself that the items are genuine ones, and that quantities are not overstated.
It is sometimes found that partly used articles are included under this caption; except under special circumstances, it is not proper to include anything except new and usable materials, which would have to be duplicated at the same or a greater cost if they were not on hand.
W. H. Bell, “Accountants’ Reports,” p. 42:
Some accountants classify supplies which are not actually ingredients of the product — fuel, repair parts, stationery, etc., as Deferred Charges, along with other prepaid expenses, but the author makes a distinction between physical or tangible items and intangible items, including the former in Inventories, under “ Current Assets.”
H. A. Finney, “Principles of Accounting,” vol. 1, ch. 3, p. 11:
Inventories of Supplies. — Should supplies be included among the inventories in the current asset section, or shown among the deferred charges? In the case of factory supplies, there is some ground for the contention that they should be shown as current assets, because they will enter into the cost of finished goods as part of the manufacturing expense, and thus, by the sale of finished goods, will be converted into cash. The same argument does not apply with equal force to salesroom and office supplies.
But even in the case of factory supplies the argument is not conclusive. The deferred charge grouping seems the more logical one, because this is a classification devoted exclusively to prepaid expenses, and hence is the more precise classification. And if factory supplies may be considered as current assets because they will ultimately be absorbed in the cost of manufacture, the same argument could be advanced in favor of including unexpired premiums on policies insuring plant assets, and all other prepaid manufacturing expenses as well.
Another argument sometimes advanced in favor of showing supplies as current assets, is that prepaid expenses at the close of one period will reduce the demands for cash during the next period, and are to that extent the equivalent of cash. But if this argument is a valid reason for including supplies inventories in the current asset group, it is an equally valid argument for including all prepaid expenses in that group, which would mean the complete abandonment of the deferred charge classification except for such items as organization expense and stock and bond discount. (Italics added.)
Walton Course, Advanced Accounting, Lecture 23, p. 6:
Supplies.' — Factory Supplies are those things, such as oil and waste, brooms, and small tools which enter into the cost of manufactured articles by being consumed in the process of manufacture, but do not enter into and become part of the product itself. New supplies are carried at cost. When issued to the factory for use, they are usually charged off as a factory expense. (Italics added.)
E. A. Saliers, “Accountants’ Handbook,” sec. 7, p. 380:
Inventories of Supplies and Repair Materials. — Value of these is cost or market, whichever is lower. If market is lower and a reserve is used, the reserve to be set up is the difference between cost and market. Reserve should or should not be used according as operations are or are not departmentized, [942]*942because in .former case it is not important that supplies be figured into cost at the reduced value, whereas in the latter case it is, since departments are run on a commercial basis.
R. B. Kester, “Accounting Theory and Practice,” vol. 1, p. 12:
Deferred Charges. — Certain types of expenditure are necessary in every business to secure operating supplies. Fuel must be purchased for heating and power purposes; brooms, oil, waste, and other similar supplies are needed for cleaning and maintaining the business plant; stationery, stamps, wrapping paper, twine, cartons, packing materials, and so forth must always be on hand; insurance policies giving protection against fire are usually purchased for from one to three years and so are seldom completely used up at any given date. All items of this sort, necessary for the operation of the business but not dealt m as stools in trade, are called “ expense assets." The portions of these assets on hand at a given time, the use of which mil be deferred to a later period, are classified as “ deferred charges." (Italics added.)
A good exposition of the reasons underlying the carrying of supplies as a deferred expense is found in “Accounting Theory and Practice,” by R. B. Kester, vol. 1, p. 407, as follows:
Basic Rules for Valuation of Balance Sheet Groups. — We may now consider the principles applicable to the valuation of the various groups on the balance sheet. In the standard form of balance sheet the assets are divided into the three groups: (1) Current, (2) Deferred Charges, and (3) Fixed.
It has been seen that the assets of the current group are used for purposes of settling debts, the payment of expenses, and the purchase of merchandise. In judging the sufficiency of these assets for this purpose, it is absolutely essential to know that the values at which they are carried will be realized when they are converted into cash. From the standpoint of conservative business management an understatement of realizable value may be made, but never an overstatement. Accordingly, the fundamental principle of valuation applicable to this group is that these assets are to be valued at cost or market, whichever is the lower. When so valued, the figures at which they are carried in the balance sheet will usually represent an amount slightly less than the amount which it is expected will be realized from their conversion into cash.
The function of the deferred charges group of assets is to secure an equitable distribution of expense charges between the current and the following period. It is only because certain expenditures have been made during the current period which will benefit the succeeding period, that it is necessary to set up this group of assets. Here the problem of valuation is, therefore, simply the problem of dividing the cost of the expenditures between the current and the next period on the basis of the benefits accruing to each. In some cases the basis of division is one of time, as where an insurance policy is purchased for a definite term. The portion of the policy which has expired during the current period is the portion of its cost to be charged to the current period, the balance being deferred to succeeding periods and therefore carried as an asset. In other cases a physical inventory is necessary to determine the distribution of the cost of expenditures, as when supplies of fuel have been purchased and not entirely consumed during the current period. The basis of the value carried over to the next period is of course a fair portion of the original cost. Market or replacement cost does not have any effect on the valuation of the deferred portion.
[943]*943Apparently, a part of the confusion among accounting authorities arises on account of the purpose for which the inventory is prepared. Some confusion may also arise on account of the misuse of the word “inventory.” Generally speaking, an inventory is a list or memorandum of articles on hand. While it is entirely proper for the taxpayer to prepare and keep such lists or enumerations of articles or assets on hand, for the purpose of determining taxable income, the statute imposes restrictions. The inventory must conform as nearly as may be to the best accounting practice in the trade or business and must clearly reflect the income. Where an accountant is preparing a balance sheet to show the financial condition of a concern at a given time, certainly it would be conservative business practice to show the supplies at market when there is a wide variation between present day replacement cost or market and cost, and this could not be criticized. But it does not follow that the taxable gain should be determined by the use of such a statement. It may be and frequently is good accounting to set up reserves for future contingent liabilities, but the Revenue Acts do not recognize the same in determining gain or loss. We fail to find a clearly crystallized view as to what is good accounting with respect to supplies.
The purpose of an inventory is to enable a taxpayer to determine his income. Under most circumstances, gain or loss from the sale of articles is determined by taking the difference between cost, or March 1, 1913, value, and the sale price. In recognition of a general accounting practice with respect to a taxpayer’s stock in trade, which he has on hand for sale, taxpayers have been permitted to use the “ cost or market, whichever is lower ” basis in taking the inventory of such articles, and to use the inventories so determined in arriving at taxable income. It enables a taxpayer to deduct from realized income a reduction in value of the goods not yet sold but which are held for sale. In effect it permits the taking of what amounts to a “ paper loss.”
To permit, however, an inventory of supplies which are not bought for sale and which are not consumed or used in production processes, is going further than we feel the statute warrants. It would amount to allowing losses as reflected in the valuation of such supplies when such losses may never be realized by a sale or other disposition of the property. Such a method, in our opinion, does not clearly reflect the income nor does it conform to the best accounting practice.
To provide the full benefit of all expenses incurred in the operation of the business of a corporation, section 234 of the Revenue Act of 1918 was enacted.
The attitude of the Board on the question as to the proper method of treating, for income-tax purposes, supplies on hand to be consumed [944]*944during succeeding years, is shown in the Appeal of David Baird & Son, Inc., 2 B. T. A. 901, wherein the following statement is made:
The taxpayer kept its books of account upon an accrual basis. It kept a memorandum account of its supplies on hand, and the Commissioner, for the purpose of accurately showing the taxpayer’s net income, has allowed the deduction from gross income of supplies actually consumed during the taxable periods under review instead of the supplies purchased. It appears from the taxpayer’s books of account that for the taxable period ended November 30, 1920, it had invested $3,811.65 of its earnings for the fiscal period in supplies to be consumed during the succeeding year. We thinh that this treatment of the taxpayer's accounts more accurately reflected, its true net income than the system actually employed hy the taxpayer and that such treatment is entirely consistent with an accrual system of accounting. (Italics added.)
It is apparent from an examination of the list of inventory items on which a market value has been denied by the Commissioner, that some of them may properly fall in the class of raw material items or supplies which were used or consumed in the manufacturing or production processes and therefore might properly be inventoried at cost or market, whichever is lower. Since, however, no satisfactory segregation is furnished as between the two classes, the action of the Commissioner will not be disturbed.
Redetermination should be made in accordance with the foregoing.
Reviewed by the Board.
Judgment will be entered on 10 days' notice, under Rule 50.