*4301 1. The amount of depreciated cost of assets formerly written off as expense and properly restored to invested capital through surplus determined.
2. The amount of the fair market value on March 1, 1913, of assets subject to depreciation determined.
*1081 This proceeding involves deficiencies in income and profits taxes for 1917, 1918, and 1919 of $12,654.45, $36,747.97 and $2,977.52. The petitioner assigns as errors in determining these deficiencies the following actions of the respondent:
(1) Reduction of invested capital for all the years involved by refusing to include therein as part of surplus the cost of capital items improperly charged to expense;
(2) Increasing net income for all the years involved by refusing to allow the deduction of an amount sufficient to constitute a reasonable allowance for exhaustion, wear and tear;
(3) Reduction of invested capital for 1917 by reducing earned surplus as of the end of 1916 by the amount of Federal income taxes for*4302 1916 and prior years;
(4) Reduction of invested capital for 1918 by reducing earned surplus as of the end of 1917 by the amount of Federal income tax for 1917;
(5) Reduction of invested capital for 1917 by reducing earned surplus as of the end of 1916 by the amount of dividends declared in excess of available earnings, determined by deducting a tentative tax.
FINDINGS OF FACT.
The petitioner is a Pennsylvania corporation, incorporated on August 9, 1886. It acquired the plant and going business of Ormrod, Fisher & Co., a partnership engaged in the manufacture and sale of iron castings, principally cast iron pipe.
The authorized and issued capital stock at the date of incorporation was $100,000, of which $20,000 was issued for cash and $80,000 to the partners of Ormrod, Fisher & Co. for property.
From 1886 to 1897 the total of the plant and equipment accounts stood on the petitioner's books of account at $80,000, an amount equal to the par value of stock issued for property. From 1897 to 1901 these accounts stood on the books at $180,000, the increase representing an amount equal to the par value of a stock dividend declared in 1897. From 1901 to 1916 these accounts*4303 stood on the books at *1082 $200,000, an amount equal to the par value of the total stock outstanding.
During this entire period the petitioner's records and books of account were kept in an irregular manner. No attempt was made to classify expenditures on account of plant and equipment as capital costs or maintenance expenses. Everything was charged to the cost of making pipe. To a large extent the construction of buildings was done by the petitioner itself and the cost absorbed as part of its operating costs.
In 1915 a change in accounting policy was effected. Pursuant to this policy there was made an appraisal of the petitioner's plant and equipment as of March 24, 1916. This appraisal was based upon a personal inspection of the plant. It includes a detailed schedule or inventory of the properties of the petitioner in existence at that time. The appraisal purports to reflect a so-called current value of the petitioner's properties.
Public accountants installed an entirely new accounting system, including a cost system. All accounts on the new books, with the exception of the plant asset accounts, were taken from the previous books and records. The asset*4304 accounts were restated, with the appraisal as a basis. The petitioner desired to show upon its books the cost of its assets. It considered that the appraisal reflected some appreciation in value, and it was decided to reduce the appraisal value by 25 per cent. This was done and the resulting figure was placed on the books.
After the installation of the new accounting system, accountants instructed employees of the petitioner in the use of the system. These instructions went into detail as to the nature of those expenditures which should be capitalized and those which should be charged to the operations of the year. The new system of accounting was followed strictly from the time it was installed.
The amount set up on its books by the petitioner as a restoration of the cost of its plant and equipment was excluded by the respondent in computing the invested capital of the petitioner, and lesser amounts substituted which were secured by a revenue agent by looking at the journals of the petitioner for the period from 1886 to 1916.
In 1926 the same company which made the appraisal of the petitioner's property in 1916 made a further investigation and submitted a report purporting*4305 to reflect both the value of the petitioner's property on March 1, 1913, and the cost of each item of the property in existence on March 24, 1916.
*1083 The cost of property owned on March 24, 1916, which was acquired subsequent to the purchase of the business, was as follows:
| Buildings | $267,675.59 |
| Machinery and equipment | 255,823.59 |
| Horses, wagons, and automobiles | 2,573.15 |
| Flasks | 61,351.50 |
| Patterns | 56,299.75 |
| Office furniture and fixtures | 2,026.26 |
| Total | 645,749.84 |
The cost of property owned on March 24, 1916, which was acquired subsequent to the purchase of the business, less exhaustion, wear, tear and obsolescence, accrued to that date, was:
| Buildings | $205,141.71 |
| Machinery and equipment | 193,173.49 |
| Horses, wagons, and automobiles | 2,032.79 |
| Flasks | 44,946.26 |
| Patterns | 29,791.69 |
| Office furniture and fixtures | 1,351.56 |
| Total | 476,437.50 |
The cost of land owned on March 24, 1916, all of which was acquired subsequent to the purchase of the business was $17,098.85. This does not include a parcel of land acquired in 1906, the actual cost of which was not shown.
The net additions to and deductions from the asset accounts*4306 of the petitioner during the period from March 24 to December 31, 1916, and during 1917, 1918, and 1919, are as follows:
| 1916 (Mar. 24 to Dec. 31) | 1917 | 1918 | 1919 | |
| Buildings | $431.19 | $12.82 | ||
| Machinery and equipment | 1 $388.29 | 390.85 | 456.28 | |
| Horses, wagons, and automobiles | n1 175.00 | 7.50 | ||
| Flasks | $832.39 | 1 2,466.82 | 15.98 | 3,377.13 |
| Patterns | 1,018.76 | 1,322.61 | 2,391.17 | 784.60 |
| Office furniture and fixtures | 120.70 | 387.11 | 300.00 | |
| 1,971.85 | 1 1,320.39 | 3,536.69 | 4,630.83 |
The fair market value on March 1, 1913, of property acquired prior thereto, and owned on March 24, 1916, was as follows:
| Buildings | $281,371.54 |
| Machinery and equipment | 253,631.19 |
| Horses, wagons, and automobiles | 2,176.77 |
| Flasks | 59,169.63 |
| Patterns | 51,175.94 |
| Office furniture and fixtures | 1,935.20 |
| 649,460.27 |
*1084 The cost of property acquired subsequent to March 1, 1913, and owned on March 24, 1916, was as follows:
| Buildings | $7,408.87 |
| Machinery and equipment | 6,397.99 |
| Horses, wagons, and automobiles | 475.00 |
| Office furniture and fixtures | 304.75 |
| 14,586.61 |
It was stipulated by the parties*4307 that depreciation for 1917, 1918, and 1919 shall be computed at the following composite percentage rates:
| Per cent | |
| Buildings | 2.93 |
| Machinery and equipment | 11.22 |
| Horses, wagons, and automobiles | 16.64 |
| Flasks | 20 |
| Patterns | 17.08 |
| Office furniture and fixtures | 15 |
OPINION.
STERNHAGEN: The petitioner presented four issues in its pleading but only two of these were pressed at the hearing or supported by evidence and need therefore be considered here or decided. By the first issue raised the petitioner contends that the surplus to be included in its invested capital should include numerous capital expenditures (properly depreciated) for plant and equipment which from the time of its organization in 1886 until March 24, 1916, had been entirely written off as current expenses. The second contention is that by reason of this accounting practice the book value of its depreciable assets on March 1, 1913, was less than the fair market value and that it is entitled to a determination of such fair market value as the basis for its annual deductions within the taxable years for exhaustion, wear and tear and obsolescence. These are both questions of fact to be decided*4308 upon a preponderance of the evidence, and it should be said at the outset that all of the evidence in the record has been carefully considered. It would, however, serve no useful purpose to recount the evidence covered by a trial which consumed several days.
It is well settled as a matter of law that in ascertaining the earned surplus to be included within invested capital as provided by section 207 of the Revenue Act of 1917 and section 326 of the Revenue Act of 1918, the capital accounts shown by the books are not conclusive and that there may be restored to such surplus any amounts which truly represent capital investment at the beginning of the year but which by reason of inadvertence or irregular accounting practices were written off the accounts. ; *1085 ; ; ; . To do this, however, a taxpayer must establish by a preponderance of the evidence that such capital expenditures were in fact made and that after proper allowance*4309 for depreciation and other intervening circumstances the amount claimed to be restorable is in fact an existing asset of the cost claimed. It must also be reasonably clear that the amount claimed for restoration does not include appreciation in value since acquisition. . Simply stated, the amount to be restored is original capital cost less actual depreciation to the beginning of the taxable year.
In the present case the taxpayer charged to expense practically all of its capital expenditures for 30 years preceding 1916. It seeks to restore the depreciated cost of all its property in existence on January 1, 1917, and the beginning of each year thereafter. It has in its records the actual cost of some of these assets, but as to most of the assets the actual cost is not available. As to those which are covered by actual cost records there is substantially no dispute. In order to prove the surplus remaining in the assets not covered by its existing cost records, the taxpayer has caused a careful study to be made by an appraisal company and has proved in detail, through the testimony of all of the persons engaged*4310 in the study, the various steps used in arriving at the probable actual cost and the intervening depreciation. Every item of plant assets was examined, and by reference to existing data its probable cost fully installed upon the date of acquisition was determined. By reference to its observed condition, an estimate was made of the accrued depreciation subsequent to acquisition, and by applying this to the probable original cost the depreciated capital cost was arrived at as of March 24, 1916, when the study was completed. The probable correctness of these figures was supported by putting in the record all of the data used in the course of the study; and thus we have a complete inventory and history of the petitioner's assets, with source references for every fact or assumption used, and an oral exposition of the method by which this data was translated into an ultimate depreciated cost.
The respondent introduced no countervailing evidence either to support the figures used by him or to establish any figures other than those proposed by the taxpayer. He contented himself with testing by cross-examination the soundness of the petitioner's study.
*4311 In the main we have found the figures of the petitioner to be supported by the evidence. In so far as they included items in contravention of earlier decisions of the Board, such as so-called indirect costs like taxes, interest, and insurance during construction, we have adjusted the valuations downward. ; *1086 ; ; . We have also eliminated items acquired in 1886, presumably from the Ormrod Fisher Co., as part of the original acquisition upon organization. These, so far as the record shows, were not excluded by the respondent in the determination of invested capital and ought not therefore to be involved in any demand for restoration. Obviously to the extent that the costs of 1886 covered property which had been purchased originally by the petitioner's predecessor and turned over to the petitioner in exchange for stock, it would be included in invested capital not as surplus but as property paid in for stock or shares, and unless it can be shown that this is not*4312 the situation, such property (except where actual cost is shown) must be excluded. The exclusion must be of entire original cost undepreciated, since the evidence does not disclose the extent or amount of its depreciation. The result of these adjustments has been to find the asset costs set forth in our findings of fact, and invested capital should therefore be adjusted to include plant assets at $476,437.50 plus later additions as found and such land items the actual cost of which appears in evidence. Since the respondent's computation is not clear, we can not find specifically how this amount is allocated as between capital stock and surplus.
The second issue, although somewhat similar in its proof, is entirely different in its legal nature. The respondent, finding that the books disclosed certain asset values on March 1, 1913, applied depreciation rates thereto and limited the deduction for exhaustion, wear and tear and obsolescence of the taxable years to such book assets. The taxpayer contends that by section 234(a)(7) it is entitled in the taxable years to an allowance for the exhaustion of all its plant properties owned on March 1, 1913, upon the basis of their fair*4313 market value on March 1, 1913; and that since the books have incorrectly eliminated many capital items, it is entitled to prove their existence and value on March 1, 1913, as the basis for the exhaustion allowance. The parties have agreed, as stated in the findings, upon the rates to be applied after the March 1, 1913, values are determined. In determining such values the petitioner, in a manner similar to that already described in the ascertainment of original costs, satisfactorily proved the cost of reproduction new less depreciation to March 1, 1913, of all assets owned and in existence on that date. Confronted with the decisions of the Board in ; , and others, and guided by , the petitioner then introduced some evidence to prove fair market value. It appears, however, that the alleged fair market value on March 1, 1913, also included certain factors of so-called indirect cost which are not depreciable and are therefore not properly to be *1087 included in the valuation of the physical properties to which the*4314 depreciation rate is to be applied. See also ;;;We have therefore eliminated from the March 1, 1913, valuation claimed such amounts as the record indicates are properly attributable to these nondepreciable items, and have found the values as shown by the foregoing findings of fact. To these values it is a simple matter to apply the stipulated rates of depreciation in order to ascertain the exhaustion allowances.
In computing both the restored depreciated costs for invested capital purposes and the exhaustion allowances, it is of course necessary to make the adjustments by way of intervening additions up to the beginning of each of the taxable years involved, and also whatever intervening depreciation has occurred. These facts are clear in the record and need not be stated here in detail. What we have said is sufficient to indicate the basis for the computation of the correct deficiencies, if any.
Judgment will be entered on 15 days' notice,*4315 under Rule 50.
Considered by LANSDON, GREEN, and ARUNDELL.
Footnotes
1. Deductions. ↩