Rev. Rul. 77-134

Advice has been requested whether the Internal Revenue Service will follow the decision in Korn Industries, Inc. v. United States, 532 F. 2d 1352 (Ct. Cl. 1976), where the United States Court of Claims held that the taxpayer's change in its standard cost computation for finished goods to include 14 cost elements, where previously only 11 had been included, was not a change of accounting method but rather the correction of a mathematical or posting error.

In Korn Industries, Inc. the taxpayer, a manufacturer of furniture, computed the value of its inventories on the basis of a standard cost method. The taxpayer inventories raw materials, work-in-process, and finished goods, and at the beginning of each year developed a standard cost for each part and piece of furniture at each stage of the manufacturing process. In determining the standard cost for raw materials, work-in-process, and finished goods, the valuation required the inclusion of 14 elements of material cost.

For fiscal years ending November 30, 1965, through November 30, 1968, the taxpayer included all 14 cost elements in the standard cost of raw materials and work-in-process but included only 11 cost elements in the standard cost of finished goods. The taxpayer revised its finished goods standard cost computation for opening inventories for fiscal year ending November 30, 1969, to include all 14 cost elements. This revision resulted in the taxpayer's opening inventory as of December 1, 1968, being valued $78,378 greater than its closing inventory as of November 30, 1968. The court ruled that the finished goods standard cost revision was a correction of an error analagous to a mathematical or posting error and was not a change in method of accounting.

Section 481(a) of the Internal Revenue Code of 1954 requires that certain adjustments be made if a taxpayer changes a method of accounting used in computing taxable income.

Section 1.481-1(a)(1) of the Income Tax Regulations incorporates the standards of section 446(e) of the Code and section 1.446-1(e) of the regulations for purposes of the concept of change in method of accounting under section 481 of the Code.

Section 446(e) of the code states, in part, that a taxpayer who changes its method of accounting on the basis of which it regularly computes its income in keeping its books shall secure the consent of the Secretary of the Treasury before computing its taxable income on the new method.

Section 1.446-1(e)(2)(ii)(a) of the regulations states, in part, that a change of accounting method includes a change in the overall plan of accounting for gross income or deductions, as well as a change in any material item within the plan, and a method of accounting is not established for an item unless there is a pattern of consistent treatment. A material item is defined as any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

Section 1.446-1(e)(2)(ii)(c) of the regulations states that a change in the treatment of any material item used in an overall plan for identifying or valuing inventory is a change of accounting method.

A change of accounting method can involve a change in a taxpayer's overall method of accounting or a change in any material item within the overall method. A material item is any item that involves the proper time for including an item of income or deducting an item of expense. In addition, if a taxpayer has consistently treated an item of income or expense in a particular manner, any change from that consistent treatment is a change of accounting method regardless of whether the consistent treatment was a proper method of accounting.

By including only 11 items in its standard cost computation for finished goods, the taxpayer in Korn Industries, Inc. established a consistent pattern of treating both the 11 cost elements included as well as the three cost elements that were excluded. Furthermore, the three cost elements that were excluded are material items because they involve the proper timing of items of income or expense. Since the taxpayer in Korn Industries, Inc. established a consistent pattern of treating material items, any change from that consistent pattern is a change of accounting method.

Additionally, the three omitted items are material items used in an overall plan for valuing inventory. The taxpayer's change in their treatment is therefore also a change in method of accounting under section 1.446-1(e)(2)(ii)(c) of the regulations.

Accordingly, in Korn Industries, Inc., the taxpayer has changed its method of accounting under section 446 of the Code and such a change requires the consent of the Secretary. Furthermore, such a change is subject to the provisions of section 481 and the regulations thereunder.

The Service will not follow the decision in Korn Industries, Inc.