The Sixth Circuit Court of Appeals recently upheld a Tax Court finding that the consistent omission of a step when computing inventory cost under the dollar-value LIFO method was a change in accounting method rather than a mathematical error. Thus a $1,754,293 cumulative difference between the correct valuation of inventory and the taxpayer’s computed amount at the beginning of the first year under examination was included in that year’s income under IRC § 481.
Taxpayers have some latitude when choosing an accounting method as long as the method clearly reflects income. An accounting method includes the treatment of a specific item as well as an overall method. According to Treasury Regulations, a change in accounting method includes a change in the treatment of an item that affects its proper timing as a deduction or inclusion in income but excludes a mathematical error, posting error or an error in the computation of tax. In the year a taxpayer’s accounting method is changed, IRC § 481 requires an adjustment to that year’s taxable income to prevent the duplication or omission of income or deductions due to the change.
The Huffman Group is composed of four S corporations, each of which is an automobile dealership in the Louisville, Ky., area. Two of the car dealerships began using the dollar-value link-chain method for valuing their inventory in 1979, while the other two started using it in 1989. Whenever an inventory increment was added in a year, Huffman’s accountant valued the newly added layer at the base year prices, failing to multiply the layer by the current year’s price index. Thus, the accountant understated ending inventory, overstated cost of goods sold and understated taxable income. Upon examination, the IRS increased taxable income for each open tax year for all four dealerships by $924,479, which the taxpayer agreed with. The IRS also applied section 481 and increased the first open tax year’s taxable income by $1,754,293—the difference between the inventory amount as adjusted by the IRS and the dealerships’ reported inventory amount at the beginning of the first open tax year. The taxpayers disagreed with this adjustment and asked the Tax Court for relief, arguing that they had not changed accounting methods but instead had made a mathematical error. The Tax Court held in favor of the IRS, stating that mathematical errors are errors in addition, subtraction, multiplication and division, not the omission of a critical step. The Huffman Group members appealed the decision to the Sixth Circuit.
The Sixth Circuit agreed with the Tax Court but chose not to opine about its definition of mathematical errors. Instead, the court held the change met the regulations’ requirements as a change in method because the continued use of the taxpayer’s method would only have deferred, not permanently excluded, income. The lower inventory valuation would result in higher future income when the inventory was liquidated. It also noted that Huffman’s situation was similar to an example in the regulations illustrating a corrective change in method. In Treas. Reg. § 1.446-1(e)(2)(iii), Example 6, properly including overhead costs in inventory valuation after those costs had consistently been omitted is given as an illustration of a change in accounting method.
This case illustrates that a change in accounting method for tax purposes is a broader concept than for financial accounting purposes. Under FASB Statement no. 154, Accounting Changes and Error Corrections , the Huffman Group’s change would be a mistake in the application of GAAP and thus an accounting error, not a change in accounting principle.
Huffman v. Comm., 101 AFTR2d 2008-1078
Prepared by Charles J. Reichert , CPA, professor of accounting, University of Wisconsin–Superior.