*1724 1. Respondent's determination of petitioner's opening inventory for 1923 approved, for lack of evidence showing such determination to be erroneous.
2. The amount of a reasonable addition to the petitioner's reserve for bad debts determined.
*1363 This proceeding is for the redetermination of a deficiency in income tax of $388.22 for 1923. The matters in controversy are (1) whether the respondent has overstated taxable income by the amount *1364 of $103,114.87 because of an understatement of merchandise inventory on January 1, 1923, in the same amount, and (2) whether the respondent has also overstated taxable income by $40,175.68 on account of the allowance of a deduction of an insufficient amount as an addition to the petitioner's reserve for bad debts.
FINDINGS OF FACT.
The petitioner is an Indiana corporation organized in 1905 and having its principal place of business at Fort Wayne. It is a wholesale and retail dealer in milling, plumbing, electrical and automobile supplies. S. A. Lehman has been president*1725 and manager of the petitioner since its organization.
During the early years of the petitioner's existence its books were kept under the single entry system. As the volume of business increased it was found necessary to improve the bookkeeping methods and in the latter part of 1915 an accountant was employed to install a new bookkeeping system more suitable to the needs of the business. In preparation for the installation of the new system the petitioner took a physical inventory on December 31, 1915. This inventory was taken at cost, which was practically identical with the prevailing market, and amounted to $236,465.02.
It took the accountant some time to install the new double entry system of bookkeeping and to get the accounts adjusted. It was not until March 31, 1916, that the new system was started. No physical inventory was taken on March 31, 1916. However, the petitioner had kept records since December 31, 1915, of all purchases and the cost of all sales.
Lehman, the petitioner's president, instructed the accountant to open the books as of March 31, 1916, by starting with an inventory as of December 31, 1915, of $133,350.15, or $103,114.87 less than the actual*1726 physical inventory taken on that date. To this reduced inventory of December 31, 1915, was added all purchases from that date to March 31, 1916, from which was deducted the cost of all goods sold during the meantime. On this basis an amount of $150,425.06 was arrived at for an inventory on March 31, 1916. Accordingly, on March 31, 1916, the opening entry in the "Merchandise" account was a debit of $150,425.06, with detail as follows:
| Inventory, Dec. 31, 1915 | $133,350.15 |
| Purchases to March 31, 1916 | 75,096.46 |
| Freight | 1,619.54 |
| 210,066.15 | |
| Less cost of goods, Jan. 1 to March 31, 1916 | 59,641.09 |
| 150,425.06 |
*1365 The reduction of $103,114.87 from the inventory of December 31, 1915, was an arbitrary reduction made by the petitioner's president because he considered that the prices at the close of 1915 were inflated. He was of the opinion that the market would decline in a short while and he desired to put the inventory on the books at what he thought ought to be the market prices for such merchandise based on his experience in past years.
From the end of 1915 until the end of 1923 the petitioner did not take physical inventories, but employed a perpetual*1727 inventory system. Under this system a "merchandise" account was used, to which was charged all purchases at cost and to which was credited the cost of sales. Approximately 15 per cent of the petitioner's sales were made by the merchandise being shipped to the petitioner's customers directly from the factories from which it purchased the merchandise. About another 15 per cent of the petitioner's sales were of merchandise handled by the petitioner on a consignment basis. With respect to these two classes of merchandise the cost of actual sales was easily determined and the "merchandise" account was credited with the amount the petitioner actually paid for such merchandise. With respect to the remainder of the petitioner's sales the "merchandise" account was credited with the replacement cost or market value of such merchandise at the time of the sale. The petitioner turned over its inventory about every three to four months. From 1916 to 1918 there were slight increases in market prices, while in 1918 they declined. In 1919 there was again a small increase in prices. During 1920 and 1921 there was a general depression. Beginning in 1922 there began a gradual increase, which*1728 continued over into 1923.
The perpetual inventory system was carefully kept and the petitioner depended on the "merchandise" account to show what the inventory was at all times. However, in determining the actual inventory for its own purposes there was added to the amount shown on the books the amount of $103,114.87, which had been eliminated from the inventory on the books at March 31, 1916. This addition was not made in the petitioner's income-tax returns for years prior to 1923.
In the latter part of 1923 the petitioner decided to take a physical inventory of its merchandise and to have an audit made of its books as at the close of that year. In November, 1923, an entry was made charging the "merchandise" account and crediting "special surplus" with $60,000, with the explanation, "From 1915 Merchandise." This entry was made at the direction of the president of the petitioner in anticipation of the audit, since he did not wish the auditors to find such a large discrepancy between the amount of merchandise as shown by the "merchandise" account and the amount that would be shown by the physical inventory.
*1366 On December 31, 1923, a physical inventory was taken. *1729 The physical inventory on that date amounted to $329,663.79, which, together with merchandise in transit of $5,891.22, made $335,555.01. There was no merchandise on hand at the end of 1923 that was in the inventory at the end of 1915.
The petitioner's "merchandise" account at the end of 1923 showed a balance of $30,530.59 less than the physical inventory account, after giving effect to the entry of $60,000 heretofore referred to. Accordingly, in order to bring the "merchandise" account on the books into agreement with the physical inventory, another entry was made on December 31, 1923, charging the "merchandise" account with $30,530.59 and crediting "profit and loss supplemental" account with the same amount.
The following is an analysis of the "merchandise" account as shown by the petitioner's books for the year ended December 31, 1923:
| Debits: | ||
| Balance, Dec. 31, 1922 | $117,713.28 | |
| Purchases and Returned Merchandise | 1,328,866.51 | |
| Contra Item | 45,000.00 | |
| Error corrected through Profit and Loss Supplemental a/c | 20,000.00 | |
| Adjustment through Special Surplus | 60,000.00 | |
| Adjustment through Profit and Loss Supplemental a/c | 30,530.59 | |
| Total Debits | $1,602,110.38 | |
| Credits: | ||
| Cost of Sales and Returned Merchandise | 1,221,555.37 | |
| Contra Item | 45,000.00 | |
| Total Credits | 1,266,555.37 | |
| Balance, Dec. 31, 1923 | 335,555.01 |
*1730 The inventory at the close of 1923 was taken on the basis of cost or market, whichever was lower, market at that time being slightly lower than cost. During the first half of 1923 prices were advancing, while during the last half of the year they were declining. The amount of the decline was slightly in excess of the amount of the advance.
The petitioner's income-tax return for 1923 was prepared by the firm of accountants that made the audit of its books at the end of that year. In preparing the return the accountants excluded from taxable income the amount of $60,000 that had been credited to "special surplus," but included as part of the taxable income the $30,530.59 credited to the "profit and loss supplemental" account. The president of the petitioner objected to including the amount of *1367 $30,530.59 as income for 1923, on the ground that the adjustment resulted from the understatement of the inventory in 1916. The accountants, however, advised him that the item would be adjusted when the return was investigated by a field representative of the Bureau.
In determining the deficiency here involved the respondent not only did not eliminate from the petitioner's*1731 income the amount of $30,530.59, but added to its income the $60,000 which had been excluded by the accountants in preparing the return.
In determining the deficiency the respondent has used as the opening inventory for 1923 the amount of $117,713.28. This was the amount reported in the petitioner's 1923 return as the opening inventory and was also the amount shown by the "Merchandise" account on the petitioner's books as its opening inventory for 1923. It was also the amount reported by the petitioner in its 1922 return as the closing inventory for that year. The respondent used as the closing inventory for 1923 the amount of the physical inventory taken on December 31, 1923, and reported by the petitioner as its closing inventory.
The following is a statement of the petitioner's sales, gross profit and taxable income for the years 1917 through 1928. The amounts shown for the years 1917 through 1923 represent the amounts reported by petitioner in its returns for such years and adjusted by the respondent. The amounts shown for the years 1924 through 1928 are those represented by the petitioner in its returns for the respective years:
| Year | Sales | Gross profit | Taxable income |
| 1917 | $696,816.12 | $112,483.23 | $20,261.80 |
| 1918 | 827,333.12 | 101,144.90 | 14,162.07 |
| 1919 | 1,078,966.08 | 154,126.63 | 25,856.40 |
| 1920 | 1,160,540.31 | 145,846.32 | 14,216.06 |
| 1921 | 850,135.40 | 128,667.73 | 5,686.45 |
| 1922 | 1,016,608.21 | 182,077.47 | 23,575.47 |
| 1923 | $1,361,049.64 | $333,727.68 | $145,982.48 |
| 1924 | 1,231,354.60 | 204,480.59 | 17,739.23 |
| 1925 | 1,208,976.08 | 181,144.70 | 28,698.18 |
| 1926 | 1,146,487.68 | 186,878.59 | 33,340.02 |
| 1927 | 1,018,125.22 | 137,520.14 | 1 21,378.44 |
| 1928 | 1,043,077.74 | 178,234.87 | 10,582.13 |
The quantity of merchandise carried by the petitioner over the various years has never been subject to any great fluctuation.
Since 1923 the petitioner has taken physical inventory of its merchandise regularly at the close of each year. It has also continued to operate its perpetual inventory system and its experience since 1923 has been that there was very little difference between the amounts shown by the book inventory and the amounts of physical inventory.
Beginning with the year 1921, the petitioner elected to take a deduction for bad debts on the basis of a reasonable addition to a *1368 reserve for bad debts. Its deduction for bad debts for 1923 is to be computed on that basis.
In its income and profits-tax returns for 1921 and 1922, the petitioner took as deductions from income as reasonable additions to its reserve for bad debts the amounts of $1,409.74 and $6,188.80, respectively. The additions actually made to the reserve on the petitioner's books for these years were $1,409.74 and $3,000, respectively. Upon an audit of the petitioner's returns for 1921 and 1922 the respondent determined reasonable additions to the reserve to be $6,580.05*1733 and $6,373.13, respectively, and allowed as an additional deduction from income for the respective years the difference between these amounts and the amounts taken by the petitioner in its returns.
In its income-tax return for 1923 the petitioner deducted bad debts charged off within the taxable year in the amount of $31,812.56, of which $23,314.76 represented accounts receivable ascertained to be worthless and written off.
In determining the deficiency here involved the respondent determined that the petitioner's deduction for bad debts should be computed on the basis of a reasonable addition to the reserve for bad debts, based upon the experience of the petitioner with respect to bad debts for the six preceding years, 1917 through 1922. He determined a reasonable addition to the reserve for 1923 to be $8,139.08, and disallowed as a deduction the amount of $23,314.76 representing accounts receivable charged off.
The following is a statement of the petitioner's sales, bad debts charged off, recoveries on bad debts, net bad debts and the accumulative per cent of bad accounts to sales for the years 1917 through 1923 which was used by the respondent in determining the amount*1734 allowable as a reasonable addition to the petitioner's reserve for 1923. It also shows how the respondent computed the amount allowable for 1923 as well as for 1921 and 1922.
| Year | Sales | Bad debts charged off | Recovery of bad debts | Net bad debts | Accumulative per cent of bad accounts to sales |
| 1917 | $696,816.12 | $14,316.40 | $102.81 | $14,213.59 | |
| 1918 | 827,333.12 | 10,862.71 | 2,222.06 | 8,640.65 | |
| 1919 | 1,078,966.08 | 6,659.87 | 1,868.16 | 4,791.71 | |
| 1920 | 1,160,540.31 | 3,480.68 | 1,973.34 | 1,507.34 | |
| 3,763,655.63 | 35,319.66 | 6,166.37 | 29,153.29 | 0.00774 | |
| 1921 | 850,135.40 | 3,361.88 | 3,574.26 | 212.38 | (Red.) |
| 4,613,791.03 | 38,681.54 | 9,740.63 | 28,940.91 | .00627 | |
| 1922 | 1,016,608.21 | 6,188.80 | 1,456.58 | 4,732.22 | |
| 5,630,399.24 | 44,870.34 | 11,197.21 | 33,673.13 | .00598 | |
| 1923 | 1,361,049.64 | 23,314.76 | 388.27 | 22,926.49 | |
| 6,991,448.88 | 68,185.10 | 11,585.48 | 56,599.62 | .00809 |
| Additions to reserve allowed | |||
| Sales | |||
| 1921 | $850,135.40 | 0.00774 | $6,580.05 |
| 1922 | 1,016,608.21 | .00627 | 6,373.13 |
| 1923 | 1,361,049.64 | .00598 | 8,139.08 |
*1369 Prior to December 31, 1923, the petitioner carried on its books two accounts with respect to its*1735 bad debts. One was designated "reserve for bad debts" and the other "suspense account." The reserve account was built up by credits at the time provision was made on the books for bad debts, while the suspense account was built up by debits representing customers' accounts charged off as worthless. Neither the reserve account nor the suspense account was closed out prior to 1923, but both were continuing accounts, the reserve account containing an accumulation of credits on account of provision for bad debts and the suspense account containing an accumulation of debits resulting from the charging off of customers' accounts ascertained to be worthless.
On December 31, 1923, the debit balance in the suspense account was closed into the reserve for bad debts, as it was decided that there was no reason for carrying a separate suspense account and that the reserve for bad debts account should contain both the debits and credits with respect to bad debts.
The following is an analysis of the reserve for bad debts account and the suspense account for the years 1921 through 1923 as reflected by the petitioner's books:
| Reserve for bad debts | |||
| Date | Item | Debit | Credit |
| Dec. 31, 1920 | Balance | $53,927.02 | |
| 1921 | Addition | 1,409.74 | |
| Dec. 31, 1921 | Balance | 55,336.76 | |
| 1922 | Addition | 3,000.00 | |
| Dec. 31, 1922 | Balance | 58,336.76 | |
| May 31, 1923 | Suspense account of 1920 closed | $49,444.41 | |
| Dec. 31, 1923 | Suspense account closed | 4,519.84 | |
| Do | Addition to reserve | 25,000.00 | |
| Do | To balance | 29,372.51 | |
| 83,336.76 | 83,336.76 | ||
| Jan. 1, 1924 | Balance | 29,372.51 | |
| Suspense account | |||
| Date | Item | Debit | Credit |
| Dec. 31, 1920 | Balance | $49,444.41 | |
| 1921 | Bad accounts | 3,361.88 | |
| Do | Recoveries on bad debts | $3,574.26 | |
| To balance | 49,232.03 | ||
| 52,806.29 | 52,806.29 | ||
| Jan. 1, 1922 | Balance | 49,232.03 | |
| 1922 | Bad accounts | 6,188.80 | |
| Recoveries on bad accounts | 1,456.58 | ||
| To balance | 53,964.25 | ||
| 55,420.83 | 55,420.83 | ||
| Jan. 1, 1923 | 53,964.25 | ||
| May 31, 1923 | To reserve for bad debts | 49,444.41 | |
| Dec. 31, 1923 | do | 4,519.84 | |
| 53,964.25 | 53,964.25 | ||
*1370 At the end of 1923 the petitioner added to its reserve for bad debts account on its books the amount of $25,000. However, it did not deduct this amount in its income-tax return. During 1923 the petitioner charged directly to profit and loss the debts actually ascertained to be worthless in that year in the amount of $23,314.76. It included this amount in the deduction taken for bad debts in its return for 1923.
The deduction of $23,314.76 taken by the petitioner in its 1923 return for bad debts is composed of the following amounts representing sales made in the years indicated:
| 1918 | $12.35 |
| 1919 | 503.63 |
| 1920 | 2,182.72 |
| 1921 | $5,956.94 |
| 1922 | 11,642.84 |
| 1923 | 3,016.28 |
*1737 The amount of the petitioner's accounts receivable and notes receivable at the end of the years 1917 through 1923 were as follows:
| 1917 | $169,945.41 |
| 1918 | 202,454.07 |
| 1919 | 355,604.98 |
| 1920 | 333,329.48 |
| 1921 | $400,322.75 |
| 1922 | 374,040.99 |
| 1923 | 398,857.18 |
At the end of 1923 the petitioner's president, assisted by the bookkeeper, went over the accounts owing to the petitioner and made up a list of the accounts that he considered worthless or uncollectible. In determining the collectibility of the accounts he used the mercantile agencies of both Dun and Bradstreet. He also used a local credit bureau with national connections. In addition he obtained information from the banks in the different cities where the petitioner's customers were located. He also had the petitioner's own representative investigate the customer's standing or credit. Attempts at collection were made by correspondence, telegrams, local *1371 or long distance telephone calls, as the case might be, and by personal calls. In some cases suits were brought in an attempt to collect.
During 1923 the petitioner sold merchandise to manufacturers, plumbing contractors, electrical contractors, *1738 small hardware stores, small dealers in the country and to farmers in an area extending out from Fort Wayne about 150 miles. The individual sales made by the petitioner were generally small, being about $10 on an average. In order to increase its business the petitioner became more liberal with credit in 1923. As a result of this, and due to the foreclosure of farmers' mortgages by insurance companies, it developed that at the end of 1923 the petitioner had a great many accounts whose collectibility was questionable.
Based upon the then existing condition and his knowledge of the financial affairs of the petitioner's customers, and the procedure followed in 1923, the petitioner's president was of the opinion that an addition of $25,000 should be made to the petitioner's reserve for bad debts at the end of 1923. Accordingly, at December 31, 1923, appropriate entries were made on the petitioner's books in this respect, with the result that the balance in the account on that date amounted to $29,372.51.
A reasonable addition to the petitioner's reserve for bad debts for the year 1923 is $39,771.32.
OPINION.
LOVE: The petitioner alleges that the respondent erred in computing*1739 taxable income for 1923 in that he understated the merchandise inventory owned by it at the beginning of the year by the amount of $103,114.87, thereby overstating income for the year by the same amount. The respondent denies that he committed the error complained of.
In computing the petitioner's taxable income for 1923 the respondent has used as the opening inventory the amount of the perpetual or book inventory. He used the physical inventory taken on December 31, 1923, as the closing inventory. There is no controversy between the parties with respect to the closing inventory. It is only with respect to the amount of the opening inventory that they disagree. The petitioner contends that since the physical inventory taken at December 31, 1923, was used as the closing inventory for 1923, the opening inventory as shown by its books and reported in its return should be increased to an amount which would represent the actual inventory on hand at the beginning of the year. It contends that the amount necessary to be added to the book inventory at the beginning of 1923 to produce this result is $103,114.87.
In support of its contention that the book inventory at the beginning*1740 of 1923 should be increased by $103,114.87 to arrive at the *1372 amount of the actual or correct opening inventory for 1923, the petitioner submitted the testimony of its president. He testified that it was his "actual conviction" that the opening inventory as shown by the books was understated by the amount of $103,114.87. The Commissioner determined that the opening inventory for 1923, being the same as the closing inventory for 1922, as made by petitioner, and used by it in its tax return for 1922, was correct.
That determination constitutes a prima facie case. In order to overcome that prima facie case, it devolved on the petitioner to submit satisfactory evidence that it was incorrect.
The "actual conviction" of petitioner's president is not such evidence. On questions of this kind, we may not rely on guesses, surmises, or convictions. Evidence of actual facts is necessary. Were we to indulge in surmises, there might be as many or more surmises suggested against petitioner's contention as could be suggested in favor of such contention.
As said by us in the case of *1741 (affirmed by ):
We can not say upon the evidence before us that the inventory of December 31, 1918, as twice returned by the petitioner and apparently as often accepted by the respondent, is clearly incorrect. It is only by indulging, as the petitioner asks us to do, in the probabilities of the matter that there appears to be any force whatever in the petitioner's contentions. But whatever the probabilities may seem to be, they are outweighed by other considerations of greater importance. The respondent has determined that the inventory as twice returned by the petitioner was correctly valued, both as to manufactured and purchased materials, and the prima facie correctness of that determination can only be overcome by satisfactory proof of error, and not by mere indulgence in the mathematical probabilities of the situation. In , we were confronted with a somewhat similar situation, and we refused to disturb the respondent's determination as to the value of the inventory of the preceding year, holding that "Determinations of*1742 the Commissioner involving inventories which have compensating effects upon succeeding taxable years are not to be disturbed except by clear and convincing evidence of error, particularly in cases in which the taxpayer has received the benefit of alleged error in an earlier year barred at the time of appeal to this Board by the statute of limitations.
On this issue the action of the Commissioner is approved.
The remaining issue relates to the deduction to which the petitioner is entitled for bad debts. The parties have stipulated and we have found as a fact that such deduction is to be computed on the basis of a reasonable addition to a reserve for bad debts.
Until December 31, 1923, the petitioner carried on its books two accounts with respect to its bad debts. One of these was the "reserve for bad debts," and the other the "suspense account." The two accounts appear to have been only parts of a whole and when consolidated *1373 they represent a reserve for bad debts account. By consolidating them, as was actually done by the petitioner at the end of 1923, there is disclosed a net reserve for bad debts at January 1, 1923, of $4,372.51. (Credit balance in "reserve*1743 for bad debts" at January 1, 1923, of $58,336.76, less $53,964.25 representing debit balance in "suspense account" on same date.) For the years 1921 and 1922 the petitioner credited the "reserve for bad debts" account with the amounts of $1,409.74 and $3,000 respectively. For these years the respondent allowed as deductions representing reasonable additions to the reserve for bad debts the amount of $6,580.05 for 1921 and $6,373.13 for 1922. The total of the differences between the amounts allowed as deductions by the respondent and the amounts credited to the "reserve for bad debts" account by the petitioner, or $8,543.44, should be added to the amount of $4,372.51 disclosed by a consolidation of the accounts as the reserve for bad debts at January 1, 1923. By doing this the petitioner is found to have had a reserve for bad debts of $12,915.95 at January 1, 1923. Neither the respondent nor the petitioner contends that this amount did not constitute ample provision for bad debts on that date. In fact the petitioner's president was of the opinion that $4,372.51 constituted a sufficient reserve.
During 1923 the petitioner ascertained certain accounts receivable amounting to $23,314.76*1744 to be worthless and charged them off directly to profit and loss instead of to the reserve for bad debts. In its income-tax return it took a deduction of $23,314.76 for bad debts actually sustained. While at the end of 1923 the petitioner added to its reserve for bad debts account the amount of $25,000, it did not take any deduction in its return on account of this addition. The respondent in determining the deficiency disallowed the deduction of $23,314.76 taken by the petitioner for actual bad debts charged off, but did allow a deduction of $8,139.08, computed as set out in our findings of fact, as representing a reasonable addition to the petitioner's reserve for bad debts for 1923.
While the petitioner concedes in its brief that it was in error in taking a deduction in its return for actual bad debts sustained during the year, it contends that it is entitled to a deduction of such an amount as will provide a reasonable reserve at the close of 1923 against bad debts imbedded in its accounts receivable after taking into consideration charges that should properly have been made to the reserve for bad debts on account of debts ascertained to be worthless during the year. The*1745 petitioner contends that the amount necessary for this purpose is $48,314.76, or $40,175.68 more than the amount allowed by the respondent. The $48,314.76 contended for by the petitioner is composed of $23,314.76 representing the amount of bad debts charged off in 1923 and disallowed as a deduction by the respondent *1374 and $25,000 representing the amount of the addition made by the petitioner in 1923 to its reserve for bad debts, but which was not taken by it as a deduction.
While the petitioner may not deduct both bad debts charged off and an addition to a reserve for bad debts, the total of the two amounts may be allowed as a deduction provided it meets the test of reasonableness. ; . Although the petitioner does not contend that it is entitled to deduct both specific bad debts and the addition to the reserve, it contends that it is entitled to a deduction of an amount equal to the total of the two, since such an amount is a reasonable addition to the reserve in order to result in a proper balance at the end of 1923.
*1746 As pointed out above, the correct balance in the petitioner's reserve for bad debts at January 1, 1923, was $12,915.95. Debts ascertained to be worthless in 1923 and properly chargeable against the reserve amounted to $23,314.76. Accordingly, at the end of 1923 the amount of the reserve was not only wiped out, but there was a deficit of $10,398.81. The respondent allowed an addition to the reserve of $8,139.08 for 1923. His allowance plus the amount of the reserve at January 1, 1923, lacks $2,259.73 of being large enough to provide for the bad debts written off during 1923. His allowance would not only leave the reserve without a balance against which to charge doubtful accounts carried in the accounts receivable at the end of the year, but would leave the reserve with a deficit, which would be an anomaly. The amount of the reserve at January 1, 1923, having been sufficient, we think it is clear that the amount allowed by the respondent as an addition to the reserve was too small.
The petitioner's president who went over the accounts receivable at the end of 1923 and determined the amount that should be added to the reserve, testified that he was of the opinion that the*1747 deduction of $48,314.76 contended for by the petitioner was a reasonable addition to the reserve for bad debts for the year 1923. However, we are not bound in our decision by his opinion alone, but we must also consider the facts in the case as well as the basis for his opinion. ; .
The amount of bad debts charged off in 1923 was greatly in excess of the amount charged off in any of the preceding six years and was more than one-half the total for those years. The addition to the reserve for bad debts contended for was more than three times the total amount taken by the petitioner as a deduction therefor in its returns for 1921 and 1922 and almost twice as much as the total *1375 amount allowed by the respondent for those years. The petitioner, however, was operating under different conditions in 1923 from those of prior years. In that year it became more liberal with credit in order to increase its business. During the year a great many mortgages given by farmers in the area in which the petitioner sold merchandise were foreclosed. This directly affected the*1748 collectibility of accounts owing to the petitioner by certain of its farmer debtors. It also affected the financial condition of many small dealers in the country who were customers of the petitioner, as well as the condition of others who owed the petitioner. The evidence indicates that the credit standing of many of the petitioner's old and formerly reliable customers was wiped out by bankruptcy or by the foreclosure of mortgages during 1923. In view of the changed conditions in 1923 we do not think it would be proper to base a determination of the amount to be added to the reserve for bad debts in 1923 upon the amount of bad debts for prior years or upon the additions made to the reserve in prior years. In our opinion the determination is to be based upon conditions existing in 1923.
It was on the petitioner's liberality in allowing credit in 1923, together with the above mentioned conditions existing in that year and his knowledge of the financial condition of the petitioner's debtors, that the petitioner's president based his opinion as to the amount of $48,314.76 being a reasonable addition to*1749 the petitioner's reserve for bad debts. Another factor, which his testimony indicates was taken into consideration by him, was that the balance of the reserve at January 1, 1923, was $4,372.51 instead of $12,915.95, the correct amount, as heretofore indicated.
From a consideration of the evidence and giving effect to the understatement by $8,543.44 of the reserve for bad debts as carried on the petitioner's books at January 1, 1923, we think the petitioner is entitled to a deduction of $39,771.32 for 1923 as a reasonable addition to its reserve for bad debts. By adding this amount and the correct reserve at the beginning of the year and subtracting therefrom bad debts of $23,314.76 charged off during the year, the petitioner has a closing balance in the reserve at the end of 1923 of $29,372.51, which we think from the evidence is a reasonable reserve for bad debts at that time.
Since the petitioner is entitled to a deduction of $39,771.32 as a reasonable addition to its reserve for bad debts, and as the respondent allowed a deduction of $8,139.08 in determining the deficiency, a further deduction of $31,632.24 should be made from the petitioner's income in recomputing the deficiency.
*1750 Judgment will be entered under Rule 50.
Footnotes
1. Loss. ↩