*2936 Petitioner billed and was paid, twice a month, for articles manufactured upon orders from purchaser, under a cost, plus agreed profit, contract dated March 1, 1919, and expiring March 1, 1924. Materials were purchased by petitioner at prices approved by the purchaser. Upon completion of each order the purchaser examined petitioner's records and checked invoices against material orders, but made no independent detail audit. In July, 1921, the purchaser began a detailed audit of petitioner's cost records from the beginning of contract to date, and then claimed a credit for excessive billing of costs under the contract. After negotiations petitioner agreed to a compromise adjustment of the billings, based upon the audit, and credited $149,713.30 to purchaser in October, 1921. Held, the amount of the adjustment is deductible from income of the year 1921.
*16 The Commissioner has determined a deficiency of $20,557.64 in petitioner's income and profits taxes for the calendar years 1921 and 1922, and the period January*2937 1 to June 9, 1923. It is alleged that the Commissioner erred in his determination by failing to allow as a deduction from income of the year 1921 the sum of $149,713.30, representing a loss resulting from a rebate or allowance to the Fisher Body Corporation on October 11, 1921, and by applying said deduction against income of the year 1920. This proceeding is prosecuted by the Rickenbacker Motor Co., a corporation, owner of the petitioner through consolidation.
FINDINGS OF FACT.
Petitioner was a Michigan corporation with principal offices at Stanley and Twelfth Streets, Detroit, Mich. During the taxable years and prior thereto petitioner was engaged in the manufacture of wood parts for automobile bodies and automobile bodies complete.
On March 1, 1919, petitioner contracted to manufacture parts for automobile bodies and automobile bodies complete for the Fisher Body Corporation, a New York corporation, for a term of five years, expiring March 1, 1924, upon the orders and in accordance with plans and specifications to be given by the Fisher Company from time to time. Petitioner agreed to furnish all labor and materials required for the execution of the work and the Fisher*2938 Company agreed to pay, in addition to the actual cost of such work as defined in the contract, a fixed profit of $5.50 per body on one lot of bodies and a profit of 8 per cent of actual cost on all other work. Invoices were to be rendered semimonthly and payments for all work copleted and accepted were to be made twice a month and within 10 days after receiving a correct invoice for the same. Compensation for the bodies to be built at cost, plus a fixed profit of $5.50 a body, was payable at the tentative rate of $75 for each body completed and accepted, subject to an adjustment at least once every three months and at completion of all work contracted for, to actual cost plus the fixed profit. The Fisher Company had the right to inspect, at its own expense, all material and lanbor and to give such directions as from time to time it should deem necessary, and "to examine the books and records of second party (petitioner) at all times in order to determine the actual cost as defined" in the contract. It was further provided that -
5. The definition of "actual cost" as herein used is mutually understood as including the following elements of cost:
*17 (a) Material actually*2939 required and consumed.
(b) Direct labor involved in fabricating raw materials and assembling parts and bodies and such other direct labor as may be specified by party of the first part.
(c) Overhead (Indirect costs).
* * *
7. In determining the actual cost as used in this contract under the heading "(c) Overhead (indirect costs)," no compensation shall be paid on nor shall there be included therein (1) Federal tax, (2) advertising and other selling expenses, (3) donations, (4) interest on borrowed money, (5) rent, nor any other items for capital facilities. There shall, however, be included in same any new non-durable tools furnished, but any tools so furnished and paid for in the settlement by the funds of the party of the first part, (Fisher Company), shall become the property of first party. * * *.
8. "Overhead" expense shall also include depreciation to be determined from time to time and at least at the end of each year at rates to be agreed upon. * * *
The contract was made retroactive to apply to the final cost and compensation adjustment of, and settlement for certain work begun in the latter part of 1918. under this contract. As it received orders for*2940 this work petitioner under this contract. As t received orders for this work petitioner priced the required materials and submitted the quotations to the Fisher Company for approval. All purchases of materials, especially lumber, for this contract were approved by the Fisher Company before they were made by the petitioner. Billings or invoices for completed work, based upon material costs as approved by the Fisher Company, were rendered by petitioner and payments were made by the Fisher Company regularly twice a month.
Upon completion of each order the Fisher Company examined petitioner's records and checked the billings against material purchase orders previously approved by it, the first examination being made about five months after the date of the contract when the first order was completed. Representatives of the Fisher Company spent approximately ten days or two weeks in making each examination and check of petitiner's records, but, prior to July, 1921, did not make an independent detailed audit of petitioner's cost records. In these examinations the Fisher Company accepted the cost figures compiled by the firm of certified public accountants employed by petitioner to*2941 make periodical audits or checks of its costs and other records pertaining to this contract.
In 1921 the Fisher Company placed a new auditor in charge of this contract and in July, 1921, began a separate and independent audit in detail of petitioner's cost records, covering all work performed from the beginning of the contract to date. All work completed at that time had been billed and paid for, invoicing and payment having been made twice each month in accordance with the *18 contract. Upon the basis of this detailed audit, extending from July to some time in September, 1921, the Fisher Company claimed that petitioner's buildings for completed work and the payments made were excessive. It alleged that the invoices included excessive prices for lumber, and expense and overhead charges not allowable under the contract, and claimed a credit for excessive billing.
The lumber used on all work under this contract was purchased by petitioner especially for this work at the high prices which obtained at that time, the price of lumber having increased in 1918 and during the time this work was performed, and the purchases were approved by the Fisher Company at the time they*2942 were made. Petitioner had on hand a quantity of low-grade lumber purchased for other work before the advance in prices, which was not suitable for this work, and which, pursuant to instructions from the Fisher Company, was not used. The higher-priced and better-grade lumber was actually used and was billed by petitioner at actual cost. After the 1921 audit the Fisher Company contended that petitioner should have billed lumber at the average cost, using both the high and the low-priced material. Expense and overhead charges, such as freight on machinery, donations, water main, repairs to buildings, renewing lavatories, installation of air compressor, report to stockholders, revenue stamps, hauling machinery, sign company, auditor's services, profit on idle plant, and profit on outside sales, also were billed by petitioner. After the 1921 audit the Fisher Company contended that these charges were improper and not allowable under the contract.
After some discussion and negotiation petitioner agreed to an adjustment, and in October, 1921, credited to the Fisher Company $149,713.30 on account of excessive billing. This credit was a complete adjustment of all billings and payments*2943 for work completed under the contract from the beginning to date, including billings and payments made for lumber, expense and overhead in the years 1919, 1920, and 1921. At the time of this adjustment all billing of completed work had been checked and paid regularly twice a month by the Fisher Company and no claim was made at any time prior thereto for excessive or erroneous billing.
The credit of $149,713.30 was absorbed in part in 1921, by charges against the Fisher Company for additional work under the contract, the credit balance at December 31, 1921, being $89,398.05, and would have been entirely absorbed by February, 1922. The contract of March 1, 1919, was canceled by supplemental agreement dated February 13, 1922.
Petitioner kept its books upon an accrual basis of accounting.
*19 OPINION.
VAN FOSSAN: The amount of, and the right to, the deduction from gross income are not in controversy. The parties differ only as to the year in which the deduction is allowable. Petitioner contends that its liability became fixed for the first time by its acceptance of the compromise adjustment made in 1921 and that deduction may be taken in that year. The respondent*2944 contends that petitioner's liability relates to 1920, at the time of billing charges not authorized by the contract; that the adjustment in 1921 was only a bookkeeping correction and that, accordingly, the deduction must be taken in 1920.
The deduction arises from the adjustment in 1921 of billings covering work performed under the March 1, 1919, contract from the beginning to the date of the adjustment. The billings were rendered and paid semimonthly. Although the Fisher Company did not exercise its right to make an independent detailed audit of petitioner's cost records prior to July, 1921, it examined the records and checked the invoices upon the completion of each order. The billings were rendered by petitioner in accordance with its understanding of the contract and were accepted as correct by the Fisher Company until the audit was begun in July, 1921. After this audit - a complete check by its new auditor of all work completed to date - the Fisher Company for the first time questioned the invoices that had been rendered and paid. Then it claimed that the items billed by petitioner included prices for lumber, and expense and overhead charges which were not allowable under*2945 the contract, and claimed a credit for the excess payment. Petitioner and the Fisher Company after some negotiations, agreed to a compromise adjustment and petitioner credited $149,713.30 to the Fisher Company in October, 1921.
The credit is clearly the result of a compromise and settlement of conflicting interpretations of the contract, which conflict first arose in the year 1921. Prior to the July, 1921, audit there was no disagreement or controversy between the parties over the terms of the contract or the construction placed thereon. Until that time they were apparently in entire accord. No suggestion, intimation or claim of excessive billing was made at any time prior to July, 1921. Then for the first time petitioner received notice that its invoices were questioned and its charges disputed.
The amount of the adjustment was first fixed in 1921. The assertion of the claim alone did not impose or establish the liability. Not until petitioner and the Fisher Company agreed to the adjustment, with the resulting credit, did liability therefor become fixed and ascertained. Until the adjustment and credit were agreed to and made not only the amount thereof, but also the*2946 liability therefor *20 was undetermined. . Nor could petitioner have set up a reserve to meet this rebate and deducted it from 1920 income, no liability to reimburse the Fisher Company having been established or even claimed. . It is not material that the expense incurred or the liability arises from the same contract or circumstances which produces the income. . And this is true although the contract provides that an audit may be made at any time and that the compensation shall be adjusted in accordance with the audit. Such a provision does not defer or postpone the receipt or accrual of income under the contract. (), and any adjustment that is made as a result of the audit does not revert to the year in which the income was received or accrued.
As we view the record in this case, the contention of the respondent that the liability was fixed in 1920, and that the deduction is to be taken only in that year, because petitioner must have known that its billings included*2947 charges not allowable under the contract, is without merit. Petitioner rendered bills in accordance with its understanding of the contract, which apparently was acquiesced in by the Fisher Company until July, 1921. The existence of a cause of action or facts upon which a claim for compensation may be asserted is not determinative of liability.
The credit of $149,713.30 to the Fisher Company in October, 1921, is deductible in the taxable year 1921. The respondent erred in refusing to allow its deduction from income of the year 1921 and in applying the same against income of the year 1920.
Reviewed by the Board.
Judgment will be entered under Rule 50.