*3224 Action of the petitioner held to have been sufficient to effect substantial compliance with the statute with respect to charging off certain worthless accounts.
*557 The Commissioner determined a deficiency in income and profits taxes for the fiscal year ended September 30, 1920, in the amount of $7,683.60. The original petition assigned the following errors: (1) That the Commissioner erred in disallowing as deductions worthless notes and accounts charged off; (2) reductions in inventories; (3) freight on merchandise deducted to bring inventory to a basis of cost or market, whichever is lower. The latter two assignments *558 of error were withdrawn and the petition amended to assign as an additional error the failure to include in purchases for the year certain goods, the invoices of which were dated prior to the close of the fiscal year, and the petitioner further claimed that the inventories of September 30, 1919, and September 30, 1920, were improperly priced because of the failure to take into consideration*3225 the 5 per cent trade discount allowed the petitioner on purchases of merchandise during the fiscal years 1919 and 1920.
At the hearing the respondent amended his answer so as to allege that the amount theretofore allowed as a deduction on account of bad debts was erroneous, for the reason that the debts were not ascertained to be worthless during the year and charged off the books.
During the hearing, the respondent conceded that open accounts totaling $7,904.90, which is $2,260.78 in excess of the debts previously allowed by the respondent as worthless and charged off, were ascertained to be worthless by the petitioner during the taxable year, but does not concede that the said accounts were properly charged off the books as being worthless.
It was stipulated that the petitioner's income should be reduced to the extent of $7,770.29 by reason of the erroneous inclusion of trade discounts in the opening and closing inventories.
FINDINGS OF FACT.
Petitioner is an Arizona corporation having its principal office in the City of Mesa. It was engaged in the sale of general hardware and farm implements at wholesale and retail with a main store at Mesa and branch stores at Glendale, *3226 Phoenix, and Chandler, Ariz.
At the close of the year ended September 30, 1920, there was charged to profit and loss on the books of the petitioner, through the medium of "Trading Account," the sum of $15,871.02, which was composed of the following items: open accounts, $7,904.90, trade acceptances, $4,314.50; and notes receivable, $3,651.62. The journal entry with respect to the open accounts was as follows:
| Trading Account | $7,904.90 | |
| To Bad and Doubtful Accounts - | ||
| Mesa | $5,937.30 | |
| Phoenix | 1,032.42 | |
| Glendale | 773.56 | |
| Chandler | 161.62 |
Similar entries were made with respect to the notes and trade acceptances. The assets on account of which the foregoing charges were made to profit and loss were not diminished at this time by any amount claimed as bad debts.
*559 The petitioner maintained a loose-leaf accounts-receivable ledger in which the individual accounts were kept. Each month a transcript was made showing the debit balances of the accounts in this ledger and on these transcripts an officer of the corporation noted what accounts should be charged off as bad. When this was done, the loose-leaf ledger sheets bearing the accounts determined*3227 bad were taken out of the accounts-receivable ledger and placed in a bad-debt ledger.
In preparing the balance sheet which accompanied the return, the accounts receivable were taken from the accounts-receivable control account and listed as assets and in constructing the liability side of the balance sheet these credit balances in the accounts-receivable control account were set up as a reserve for bad debts. Whatever collections were made in the subsequent year upon the accounts here claimed as bad, were included in income for such subsequent year.
The open accounts in the amount of $7,904.90 were ascertained to be worthless during the taxable year. Upon an audit of petitioner's return, in connection with a revenue agent's report, respondent allowed $5,642.12 of this amount.
The trade acceptances in the amount of $4,314.50 had been discounted at a bank and had been charged back to the petitioner. These trade acceptances were renewals of original trade acceptances, the originals running for periods ranging from 3 months to 6 months.
The petitioner in making its inventories did not include therein certain goods which had been ordered. These goods were entered in the*3228 purchase book after the close of 1920. The invoices, however, were dated prior to the close of the fiscal year. These invoices were not included in purchases for the fiscal year 1920 in determining the cost of goods sold.
The particular goods in the inventory which were in the gross sales for the fiscal year 1920 could not be identified.
OPINION.
LITTLETON: With respect to the debts represented by open accounts in the amount of $7,904.90, it was stipulated at the hearing that these accounts were ascertained to be worthless during the taxable year. This leaves for consideration with respect to this item only the question as to whether they were charged off within the meaning of the statute so as to entitle the petitioner to the deduction on account thereof. While we have held that the statute is clear and unambiguous as requiring that the accounts must be charged off, we have not required, nor do we think the statute contemplates, any particular method of accomplishing this purpose. In other words, we have recognized that accounting and bookkeeping systems are far *560 from being standardized and that the "charge-off" may be effected in a variety of ways and yet*3229 be sufficient for substantial compliance with the statute which is all we consider necessary. As we said in , "It is not the physical act done within the year to which Congress has referred, but to the setting up of evidence of the ascertainment of worthlessness substantially as of the date of such ascertainment and in confirmation thereof."
When viewed in the foregoing manner, we find that the petitioner substantially complied with the statute in writing off these accounts. After it had been ascertained that certain accounts were worthless, an entry was made charging "Trading Account" (Profit and Loss) and crediting an account denominated "Bad and Doubtful Accounts." This latter account was segregated for each of the stores operated by the petitioner on the basis of the worthless accounts applicable to each store. In explanation of why the credit was made in this way rather than to the accounts themselves, which would have eliminated them from its books, petitioner's secretary-treasurer testified as follows:
Q. Mr. Stapley, the stipulation just read into the record shows that no entry was made on the individual accounts*3230 receivable at the time these bad debts were charged off. What happened to the individual accounts?
A. They were placed in the bad debt ledger; taken from the record ledger and placed in a bad debt ledger.
Q. Were they kept in that bad debt ledger indefinitely?A. No, not indefinitely; we kept them there until such itme as they are absolutely determined hopeless, and then we filed them away.
Q. And they are thereupon no longer a part of the records? A. No, sir.Q. What was your reason for not doing this with the individual accounts receivable and for not actually charging these bad debts off on the accounts receivable control account, why did you charge them to a bad debt ledger and keep them before you?
A. We always kept them before us in the hope of collection; just because we charge them off, we do not entirely give up the idea of trying to enforce collection.
The same witness further stated that:
My intention was and what I thought was being done was that they were being charged off; not a reserve, but charged off.
Whatever amounts were collected on these accounts in subsequent years were reported as income.
When we consider the above facts, *3231 together with the frank and unequivocal character of the witness's testimony, we can not escape the conclusion that what the petitioner sought to accomplish was a "charging off" of these accounts. The first objection raised by the respondent to such a conclusion is the fact that in preparing the *561 balance sheet which was submitted with its return, the accounts were shown as assets with an item on the liability side in the same amount denominated "Reserve for Bad Debts." That is, what the respondent says is that the effect of the "charge-off" was to charge "Profit and Loss" and credit "Reserve for Bad Debts" and thus not only have the assets on the balance sheet, but also leave the surplus unimpaired. But we do not understand this to be the effect of the entries. We find no evidence, either in the testimony or in the books which were submitted in evidence showing the existence of a reserve account on the petitioner's books. While the record shows that the accounts as such remained on the books after the making of the "charge-off" entry, it appears that they were so kept merely for the purpose of maintaining a follow-up memorandum of each account. The accounts which both*3232 parties to this proceeding have stipulated were worthless, were so designated by individual accounts placed in a bad debt ledger, and segregated for the four stores where the accounts were incurred. In this manner, accounts which were worthless and which are here shown to have been charged to profit and loss were eliminated from among the good accounts. In this sense, accounts which were worthless within the meaning of the statute could be followed up, and only for this purpose does it appear that they remained on the petitioner's books. Apparently, then, when petitioner came to prepare a balance sheet as at September 30, 1920, to accompany its income-tax return, it reflected the existence of these accounts on its books by showing the accounts in total on the asset side and a reserve in the amount of the worthless debts on the liability side. From all the facts in the record, we do not interpret this as meaning that the reserve shown on this balance sheet was considered as a part of surplus, but rather that it was in the nature of a valuation reserve which had the effect of offsetting the worthless accounts shown on the asset side.
In consideration of the foregoing, the Board*3233 is of the opinion that the acts done by the petitioner constituted a substantial compliance with the statute with respect to charging off the open accounts in the amount of $7,904.90, and, accordingly, a deduction of this amount (which is $2,262.78 in excess of that previously allowed) should be allowed as a deduction from gross income.
With respect to the trade acceptances, the evidence introduced is insufficient to show that they were ascertained to be worthless during the taxable year. The evidence consisted merely of a statement showing that the trade acceptances had been charged back to the petitioner by the bank. This does not prove worthlessness.
The claim of the petitioner for a deduction on account of notes receivable in the amount of $3,641.62, included in the total amount of $15,871.72 representing so-called bad debts, was withdrawn by the *562 petitioner and no evidence was introduced in respect thereto. The action of the respondent in disallowing the deduction is, therefore, sustained.
This leaves for consideration the question as to whether the petitioner is entitled to have its purchases increased over that allowed by the respondent for goods not entered*3234 in the purchases account until after the close of the taxable year, but invoices of which were dated prior to the close of the year.
The items included in these invoices could not be identified. It could not be determined definitely whether they were included in sales made during the year or whether they were included in inventories. The witness for the petitioner testified as to the general custom of the petitioner and that if that custom had been followed with respect to these particular goods, the goods would undoubtedly have been received before the close of the fiscal year 1920 and would have either been included in the sales or inventories at the close of the year. The testimony at most gives rise only to a presumption and in our opinion is not sufficient to establish the claim made. There is no preponderance of evidence to show that the action of the respondent in this regard was incorrect.
Reviewed by the Board.
Judgment will be entered under Rule 50.