Rev. Rul. 77-364

Advice has been requested whether the taxpayer's method of determining market value based on percentage write downs for purposes of valuing its inventory at cost or market, whichever is lower, is an acceptable method of inventory valuation under section 471 of the Internal Revenue Code of 1954.

The taxpayer is a domestic manufacturing corporation that files its Federal income tax returns on a calendar year basis. The taxpayer uses the accrual method of accounting and maintains a perpetual inventory system. The taxpayer values its inventory at cost or market, whichever is lower.

In determining the market value of its inventory, the taxpayer classified each item according to its sales activity for the year: active, slow, or doubtful. A percentage of cost was then assigned to each classification. Active items were assigned a value equal to 50 percent of cost; slow items were valued at 35 percent of cost; and doubtful items were valued at 15 percent of cost. The taxpayer selected the percentage values to reflect what it considered to be a reasonable estimate of the market value of each class of inventory based on the taxpayer's experience. The taxpayer has used the same percentages every year but the classification of each item is reconsidered every year. The taxpayer never sells an item of inventory at a price below its cost regardless of age.

Section 471 of the Code provides that whenever in the opinion of the Secretary 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 may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income.

Section 1.471-2(f)(1) of the Income Tax Regulations states that "the following methods, among others, are sometimes used in taking or valuing inventories, but are not in accord with the regulations in this part: (1) deducting from the inventory a reserve for price changes, or an estimated depreciation in the value thereof."

Section 1.471-4(a) of the regulations provides, in part, that, under ordinary circumstances and for normal goods in an inventory, "market" means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer.

Section 1.471-4(b) of the regulations provides that when no open market exists or when quotations are nominal, due to inactive market conditions, the taxpayer must use such evidence of a fair market price at the date or dates nearest the inventory as may be available, such as specific purchases or sales by the taxpayer or others in reasonable volume and made in good faith, or compensation paid for cancellation of contracts for purchase commitments. When the taxpayer in the regular course of business has offered for sale such merchandise at prices lower than the current price as above defined, the inventory may be valued at such prices less direct cost disposition, and the correctness of such prices will be determined by reference to the actual sales of the taxpayer for a reasonable period before and after the date of the inventory. Prices that vary materially from the actual prices so ascertained will not be accepted as reflecting the market.

Section 1.471-4 of the regulations requires that the cost of each item of inventory be compared to its market value. Market value means the price at which the item would sell on the inventory date. If a market price is not available on the inventory date, the taxpayer must determine a fair market price based on all the evidence available on the inventory date.

In the present situation, the taxpayer made no attempt to establish a market price based on the sales price or on all the available evidence on the inventory date. The taxpayer wrote down its inventory based on percentages without any indication as to whether the amounts determined by use of the percentages reflected the true market value of the active, slow, or doubtful items. In addition, the use of a percentage write down is similar to reducing the value of the inventory by estimated depreciation, which is prohibited by section 1.471-2(f) of the regulations.

Accordingly, the taxpayer's method of determining market value based on percentage write downs is not an acceptable method of inventory valuation.

Any change in a taxpayer's method of valuing inventory from the percentage method used herein to the method prescribed in section 1.471-4 of the regulations is a change in method of accounting to which the provisions of section 446 and 481 of the Code apply.