Rev. Rul. 71-234

Rev. Rul. 71-234 ¹

The purpose of this Revenue Ruling is to update and restate, under the current statute and regulations, the position set forth in T.B.R. 48, C.B. 1, 47 (1919).

The question presented is whether the average cost method of taking inventories (sometimes also referred to as "the rolling average method") may be used by the taxpayer under the circumstances described below.

The taxpayer, a domestic corporation, produces a product that requires aging from one to three years. The materials purchased are not currently consumed in manufacture, but are held for aging purposes. Furthermore, prices are subject to substantial fluctuation. In computing its inventories, materials purchased during a month are added, both as to quantity and cost, to the quantity and cost balance brought forward from the previous month and an average cost to the close of the month is computed by dividing the total quantity into the total money figure. This average is then applied to the quantity of materials used for manufacture during the month and the amount so computed is credited to the material account.

The specific question in the instant case is whether inventories computed under this method form a proper factor for the computation of income for Federal income tax purposes.

Section 471 of the Internal Revenue Code of 1954 provides as follows:

Whenever in the opinion of the Secretary or his delegate the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary or his delegate 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.

Section 1.471-1 of the Income Tax Regulations provides that, 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.

Section 1.471-2(a) of the regulations provides as follows:

(a) Section 471 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.

Section 1.471-2(c) of the regulations provides, in part, as follows:

(c) The bases of valuation most commonly used by business concerns and which meet the requirements of section 471 are (1) cost and (2) cost or market, whichever is lower.

In a business requiring goods to be carried for lengthy periods and where an average cost method of inventory valuation is used an overstatement of profit will occur whenever the current market is declining, while on an advancing market the profits on the actual sales of the year will be understated. When the market is stable the average method will reflect with approximate accuracy the true profit. The computation of taxable income upon such a basis results in an assignment of income to a year, not upon the basis of the transactions of the year, but upon the basis of transactions parts of which spread over more than a year. An annual accounting period is a fundamental requirement of the Federal income tax law, and every computation of taxable income must be made in conformity therewith. This the average cost inventory method in the instant case failed to do.

Accordingly, the taxpayer in the instant case may not use the average cost inventory method or rolling average method since this method does not conform to the requirements of section 471 of the Code and the applicable regulations thereunder.

T.B.R. 48 is hereby superseded, since the position stated therein is restated under the current law in this Revenue Ruling.

¹ Prepared pursuant to Rev. Proc. 67-6, C.B. 1967-1, 576.