                  T.C. Memo. 1997-240



                UNITED STATES TAX COURT



     GALEDRIGE CONSTRUCTION, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 21463-94.                      Filed May 22, 1997.



     P, an asphalt paving contractor, did not account for
inventories and kept its books and filed its returns on the
cash receipts and disbursements method of accounting. R
determined that the sale of merchandise was an income-
producing factor in P's business, that P must, pursuant to
sec. 1.471-1, Income Tax Regs., account for inventories, and
that P must use the accrual method of accounting to clearly
reflect income.

     Held: Emulsified asphalt, which becomes useless in less
than 5 hours, is not merchandise held for sale by P. Held,
further, P has no inventories; thus, sec. 1.471-1, Income
Tax Regs., does not apply to P for the taxable years at
issue. Held, further, P's method of accounting clearly
reflects income; R abused her discretion in requiring P to
use the accrual method of accounting.
                                 - 2 -

     John P. McDonnell, for petitioner.

     Ronald G. Dong, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:     Respondent determined deficiencies in

petitioner's Federal income tax for taxable years 1989 and 1990

of $111,613 and $775, respectively.      Respondent also determined a

section 6661 addition to petitioner's tax of $27,903 for taxable

year 1989.   All section references are to the Internal Revenue

Code in effect for the taxable years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure,

unless otherwise indicated.    All dollar amounts are rounded to

the nearest dollar.

     The issue for decision is:    Whether respondent's

determination that petitioner must account for inventories and

use the accrual method of accounting (accrual method) was an

abuse of discretion where petitioner accounted for the materials

consumed in its service business as supplies.     We hold it was.1

                           FINDINGS OF FACT

     Some of the facts have been stipulated.     The stipulated

facts and the accompanying exhibits are incorporated into our

     1
          Due to our finding that petitioner is not required to
use an inventory method of accounting, and that respondent abused
her discretion in requiring petitioner to change its method of
accounting, we need not address the issue of whether petitioner
is liable for an addition to tax or penalty for a substantial
understatement of income tax.
                                 - 3 -

findings by this reference.    At the time the petition in this

case was filed, petitioner's principal place of business was

located in Alviso, California.    Petitioner keeps its books and

records on the cash method and has always done so.    It files its

Federal income tax return using a fiscal year ending June 30.

       Petitioner is a corporation engaged in the business of

asphalt paving and related services.     Potential customers contact

petitioner, asking for an estimate to perform asphalt paving

work.    Petitioner sends an estimator to examine the area to be

paved, to measure it, and to determine the approximate amount of

asphalt needed for the job.    The estimator also considers the

equipment, number of workers, and time required to complete the

job.    Two jobs could require the same amount of asphalt but have

different costs.    For instance, it requires more time, and

possibly different equipment, to pave a parking lot with

structures on it than a wide-open parking lot.

       The estimator prepares a "proposed worksheet", which

indicates all the factors involved in estimating a bid price for

a job.    During the years in issue, the proposed worksheet had

three cost columns:    Equipment, labor, and materials.   The

equipment column had spaces to enter a description of the

equipment required, the hours required, and the hourly cost of

the equipment.    The labor column had spaces to enter the

laborers' names, the hours required, and the hourly cost of each

laborer.    Finally, the materials column had spaces for the
                                 - 4 -

quantity of asphalt required, the source of the asphalt, and the

unit rate of the asphalt charged by the supplier.    Using his or

her best judgment, the estimator filled in the equipment and

labor columns.   To fill in the materials column, the estimator

called an asphalt supplier to determine the unit rate for the

asphalt.    This rate was then entered into the materials column;

petitioner did not increase the estimated cost of the asphalt.

After each column was completed, the column totals were summed

and combined to arrive at a total direct expense.    The total

direct expense was then increased by either 20 or 25 percent to

recover overhead expenses and to make a profit on the job.

     The proposal sent to the customer contained a lump-sum bid;

it did not break out the various costs making up the bid.

Petitioner used two or three asphalt suppliers during the years

at issue and generally would not adjust its bids to compete with

an opposing paving contractor.    If accepted, the proposal formed

the basis of the contract between petitioner and the customer.2

     Once the contract was signed, petitioner obtained the

asphalt to be used in the paving job.    Petitioner never acquired

asphalt from a supplier without a signed contract with a

customer.


2
    When a job exceeded the scope of the original contract,
petitioner charged the customer on a time and materials basis.
The record is sparse with respect to the specific computation of
the time and materials charge. In any event, it appears that
this type of charge was uncommon.
                                - 5 -

     In performing its contracts, petitioner took delivery of the

materials directly from the asphalt supplier.    Petitioner's

driver picked up the asphalt and took it directly to the job

site.    The asphalt had to be laid within 2 to 5 hours from the

time it was picked up from the plant, or it would become rock

hard and have to be thrown away.    Petitioner had no way to extend

the time that asphalt is in an emulsified condition.    Once the

asphalt hardened, it could not be melted and reused; nor could it

be returned for credit to the asphalt supplier.

     Petitioner generally worked on only one job at a time,

lasting a week or less.    When the job was finished, petitioner

billed the customer and created an accounts receivable on its

books.    The asphalt company sent petitioner an invoice, usually

due within 30 days, which petitioner paid only after it received

payment from its customer.    Although petitioner, not the

customer, usually paid the supplier, there were some customers

who paid the supplier directly for the asphalt used on a job.

This was an uncommon event, however, that did not occur during

the years at issue.    Occasionally, customers issued a joint check

to petitioner and the supplier so that, in effect, the customer

paid the supplier.

     Petitioner's asphalt costs for the tax years 1989 and 1990

were $930,960 and $855,566, respectively.    Petitioner deducted

the cost of the asphalt as a supplies expense on its tax returns

for the years at issue.
                                 - 6 -

                                OPINION

     The principal issue for decision is whether it was an abuse

of respondent's discretion to require petitioner to change from

the cash method of accounting to the accrual method of

accounting.3    Subsumed in this issue is the question of whether

petitioner should be required to use inventories for tax

purposes.4

     3
             Sec. 446 provides in pertinent part:

          SEC. 446(a). General Rule.--Taxable income shall be
     computed under the method of accounting on the basis of
     which the taxpayer regularly computes his income in keeping
     his books.

          (b) Exceptions.--If no method of accounting has been
     regularly used by the taxpayer, or if the method used does
     not clearly reflect income, the computation of taxable
     income shall be made under such method as, in the opinion of
     the Secretary, does clearly reflect income.

          (c) Permissible Methods.--Subject to the provisions of
     subsections (a) and (b), a taxpayer may compute taxable
     income under any of the following methods of accounting--

             (1) the cash receipts and disbursements method;

             (2) an accrual method;

             (3) any other method permitted by this chapter; or

             (4) any combination of the foregoing methods permitted
             under regulations prescribed by the Secretary.


     4
             Sec. 471 provides in pertinent part:

          SEC. 471(a). General Rule.--Whenever in the
     opinion of the Secretary the use of inventories is
     necessary in order clearly to determine the income of
                                                   (continued...)
                               - 7 -

     A taxpayer that has inventories is required to use the

accrual method, unless it can show that use of another method

(here, the cash method) would produce a substantial identity of

results and that the Commissioner’s determination requiring a

change is an abuse of discretion.      Ansley-Sheppard-Burgess Co. v.

Commissioner, 104 T.C. 367, 377 (1995); see also Knight-Ridder

Newspapers, Inc. v. United States, 743 F.2d 781, 789, 791-793

(11th Cir. 1984); Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d

352 (1st Cir. 1970), affg. T.C. Memo. 1969-79.

A.   Merchandise

     Respondent determined that during the years in issue

petitioner's asphalt was merchandise that was an income-producing

factor, that petitioner therefore had inventories, and thus it

must use the accrual method of accounting in order to clearly

reflect taxable income.   Petitioner asserts that it is primarily

in the business of providing service; its clients purchase its

expertise in paving.   Furthermore, petitioner contends that

     4
      (...continued)
     any taxpayer, inventories shall be taken by such
     taxpayer on such basis as the Secretary may prescribe
     as conforming as nearly as may be to the best
     accounting practice in the trade or business and as
     most clearly reflecting the income.

     By regulation, the Secretary has determined that inventories
are necessary if the production, purchase, or sale of merchandise
is an income-producing factor. Sec. 1.471-1, Income Tax Regs.
Completing the statutory and regulatory scheme, sec. 1.446-
1(c)(2)(i), Income Tax Regs., provides that a taxpayer that has
inventory must also use the accrual method of accounting with
regard to purchases and sales.
                               - 8 -

respondent has no authority to require it to use an inventory

method of accounting when there is nothing on hand at the end of

the day to count.   Finally, petitioner argues that the asphalt is

neither merchandise nor an income-producing factor.

     Petitioner deducted the cost of the asphalt as a supplies

expense under section 162 and section 1.162-3, Income Tax Regs.

Section 162(a) allows a deduction for "all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business".    Section 1.162-3, Income Tax

Regs., provides in pertinent part:

     Cost of materials.--Taxpayers carrying materials and
     supplies on hand should include in expenses the charges
     for materials and supplies only in the amount that they
     are actually consumed and used in operation during the
     taxable year for which the return is made, provided
     that the costs of such materials and supplies have not
     been deducted in determining the net income or loss or
     taxable income for any previous year. * * *

     The statute and regulations do not define "merchandise" or

"inventory", nor do they clearly distinguish between "materials

and supplies" that are not actually consumed and remain on hand,

and inventory.   However, we must decide whether the emulsified

asphalt petitioner uses is a supply within the meaning of section

162 or inventory within the meaning of section 471.   We begin by

acknowledging that the authorities in this area are not easily

reconcilable.5

     5
         See Nolan, “Can the Cash Method of Accounting Clearly
Reflect Income?” Tax Notes 1063 (Feb. 24, 1997) and 1175 (March
                                                   (continued...)
                              - 9 -

     At the outset, we note that it is clear that petitioner

provides a service to its clients; if its clients wanted only to

purchase asphalt, they could have done so by dealing directly

with the asphalt supplier.

     Previously, we examined certain service transactions to

determine whether the transaction in substance involved solely

the sale of a service, or whether the transaction involved the

sale of a service and merchandise.     Wilkinson-Beane, Inc. v.

Commissioner, supra (funeral business's caskets are merchandise);

Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292

(electrical contractor's wire, conduit, and electrical panels are

merchandise); Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453

(taxpayer's "consideration" of cost of rotable parts in

determining amount of fixed fee charged customers in maintenance

service business does not establish that those parts were

acquired and held for sale; held, rotable spare parts are not

merchandise), affd. without published opinion 27 F.3d 571 (8th

Cir. 1994); J.P. Sheahan Associates, Inc. v. Commissioner, T.C.

Memo. 1992-239 (contractor's roofing materials are merchandise);

Surtronics, Inc. v. Commissioner, T.C. Memo. 1985-277

(electroplating metals are merchandise).    In this case, we must

decide whether petitioner is a seller of only a service or a

seller of a service and merchandise.

     5
      (...continued)
3, 1997), and the authorities cited therein.
                              - 10 -

     Petitioner asserts that respondent has no authority to

require it to use inventory accounting when there is nothing on

hand at the end of the day to count.   Petitioner acquired asphalt

directly from the supplier, drove to the job site, and poured it

within a few hours.   Any asphalt not laid within 2 to 5 hours of

acquisition hardened and had to be discarded.   Thus, hardened-

but-unlaid asphalt was worthless for the job for which it was

ordered and for any other job.

     Petitioner’s position has commonsense appeal and some

support in law and in industry practice.   See Ansley-Sheppard-

Burgess Co. v. Commissioner, supra (Commissioner agreed that

taxpayer/contractor did not have inventory).    Furthermore, until

the early 1990's, the Commissioner generally permitted

construction contractors to account for construction materials

and supplies as supplies, rather than as inventory.   See, e.g.,

id. at 375 ("The cash method of accounting has been widely used

throughout the contracting industry and accepted by respondent

since time immemorial."); Hunt Engg. Co. v. Commissioner, T.C.

Memo. 1956-248 (construction contractor purchasing materials for

various jobs as they were needed maintained no inventories; cash

method clearly reflected income).
                             - 11 -

     Beginning in the early 1990's, the Commissioner began to

require contractors to account for the materials used in

construction as merchandise inventory.6

     In J.P. Sheahan Associates, Inc. v. Commissioner, supra, a

roofing company argued that because it ordered materials only on

an “as needed” basis (leftover materials were either returned to

the supplier for credit or held by the taxpayer at one of its

base locations until shipped to a job site), it had no yearend

inventory and therefore did not hold merchandise for sale within

the meaning of the regulations.   The Court said:

     In so contending, petitioner ignores the fact that the
     regulations speak in terms of “every case in which the
     production, purchase, or sale of merchandise is an
     income-producing factor.” This is the foundation for
     the determination by respondent, pursuant to section
     471, that inventories should be used; the fact that
     such use may produce a zero or minimal year-end
     inventory is irrelevant. [Citations omitted.7]

     Under J.P. Sheahan Associates, Inc., it is irrelevant

whether the taxpayer has merchandise on hand at the end of the

year for the determination that it must "utilize the inventory

method in computing its taxable income."   Id.   Thus, the fact

that petitioner had no emulsified asphalt on hand at the end of




     6
          See Nolan, "Can the Cash Method of Accounting Clearly
Reflect Income?" Tax Notes 1063 (Feb. 24, 1997).
     7
         In so holding, the Court distinguished as dicta certain
language in Asphalt Prods. Co. v. Commissioner, 796 F.2d 843 (6th
Cir. 1986), affg. in part and revg. in part Akers v.
Commissioner, T.C. Memo. 1984-208.
                               - 12 -

the day is not dispositive of the issue of whether it must

maintain an inventory.

       It is equally clear from J.P. Sheahan Associates, Inc.,

that before the Commissioner may require the taxpayer to utilize

an inventory method of accounting, the taxpayer must (1) produce,

purchase, or sell merchandise (2) that is an income-producing

factor.   Thus, to find that inventories are necessary, we must

first find as fact that petitioner produces, purchases, or sells

merchandise.    Honeywell Inc. v. Commissioner, supra.    If so, then

we must find that the production, purchase, or sale of that

merchandise is an "income-producing factor".      Wilkinson-Beane,

Inc. v. Commissioner, 420 F.2d at 355; Honeywell Inc. v.

Commissioner, supra; sec. 1.471-1, Income Tax Regs.

     The fact that petitioner had no emulsified asphalt on hand

at the end of the day is not dispositive of whether it must use

an inventory method of accounting.      We think, however, that there

is a significant difference between a taxpayer who has no

material on hand at the end of the year because it was returned

to the supplier for credit, see, e.g., J.P. Sheahan Associates,

Inc. v. Commissioner, supra, and a taxpayer who has no material

on hand at the end of the day because of the ephemeral quality of

the material.   Thus, we consider the ephemeral quality of the
                              - 13 -

emulsified asphalt to be a factor that must be considered in our

analysis of whether the emulsified asphalt is "merchandise".8

     Although not specifically defined in the Internal Revenue

Code (the Code) or the regulations, courts have held that

"merchandise", as used in section 1.471-1, Income Tax Regs., is

an item acquired and held for sale.    See, e.g., Wilkinson-Beane,

Inc. v. Commissioner, supra at 354-355 (a canvassing of

authorities in the accounting field yields several definitions,

such as "goods purchased in condition for sale," "goods awaiting

sale," "articles of commerce held for sale," and "all classes of

commodities held for sale"; the common denominator seems to be

that the items in question are merchandise if held for sale);

Honeywell Inc. v. Commissioner, T.C. Memo. 1992-453 (rotable

spare parts are merchandise if they were acquired and held for

sale).   Whether an item was acquired and held for sale is

governed by the substance of the transaction and not its form.

Honeywell Inc. v. Commissioner, supra. Thus, to determine whether

an item is "merchandise", we must take into account the

particular facts and circumstances of the taxpayer in each case

and the manner and context in which the taxpayer operates the


     8
          In construing the word "merchandise" we apply the rule
that "'The natural and ordinary meaning of words will be applied
[in construing tax statutes] unless the Congress has definitely
indicated an intention that they should be otherwise construed'".
Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 354 (1st
Cir. 1970) (quoting Huntington Sec. Corp. v. Busey, 112 F.2d 368,
370 (6th Cir. 1940)), affg. T.C. Memo. 1969-79.
                              - 14 -

business at hand.   Wilkinson-Beane, Inc. v. Commissioner, supra;

Thompson Elec., Inc. v. Commissioner, T.C. Memo. 1995-292;

Honeywell Inc. v. Commissioner, supra; J.P. Sheahan Associates,

Inc. v. Commissioner, T.C. Memo. 1992-239.

     Previously, this Court has held that a manufacturer/supplier

of emulsified asphalt and asphalt products that maintained a

yearend inventory of raw materials must use the accrual method of

accounting, even though it had no finished product inventory at

the end of the year.   Akers v. Commissioner, T.C. Memo. 1984-208,

affd. on this issue and revd. in part sub nom. Asphalt Prods. Co.

v. Commissioner, 796 F.2d 843, 849 (6th Cir. 1986).   In Asphalt

Prods. Co., the taxpayer was in the business of manufacturing

emulsified asphalt from pure asphalt using a chemical treatment

and a physical process.   It maintained an inventory of raw

materials and had a fixed production plant with large tanks in

which it was able to preserve the emulsified condition of its

finished product, and therefore its marketable quality,

indefinitely.9   The facts of Asphalt Prods. Co. and the case at




     9
          Very little road contracting work was done by Asphalt
Products in the colder months of December, January, and February.
Asphalt Products generally closed its operations completely in
mid-December, and all of its employees took vacations from mid-
December until early January. Asphalt Products did not keep any
finished product in its tanks during the 2-week shutdown period.
Akers v. Commissioner, supra.
                              - 15 -

hand are clearly distinguishable.   Petitioner is in the business

of laying emulsified asphalt, not in the business of

manufacturing emulsified asphalt.   Petitioner acquires asphalt

from a producer of emulsified asphalt, has no yearend (or even

dayend) inventory of raw materials, and is unable to prevent or

even delay the asphalt from becoming rock hard and worthless

within 2 to 5 hours of its acquisition from the supplier.     Thus,

Asphalt Prods. Co. is not dispositive of the issue of whether the

asphalt is merchandise sold by petitioner.

     In Thompson Elec., Inc. v. Commissioner, supra, the taxpayer

used materials such as wiring, conduits, electrical panels, and

lighting fixtures in its electrical contracting business.     The

taxpayer maintained an inventory of unassigned materials on its

premises that it used for small contracts, in addition to

delivering materials directly from the supplier to its large-

contract customers' sites.   The taxpayer reported yearend

inventory of $68,617 and $74,876 for taxable years 1988 and 1989,

respectively.   We concluded that the material at issue was

merchandise which was an income-producing factor even though the

taxpayer did not display the material to customers or to the

public, the material was not itemized on bids or invoices nor

separately charged to the customer, the taxpayer did not sell

material separately from its services, and the taxpayer’s

customers generally did not select the materials to be used.

Thus, the fact that petitioner did not sell emulsified asphalt
                               - 16 -

separately from its services is not a fact that would preclude

asphalt from being merchandise inventory.

     The facts of Thompson Elec., Inc., however, are so different

from the facts of the instant case that it is not dispositive of

the issue of whether asphalt is merchandise.    In contrast to the

durable quality of the electrical materials that allowed Thompson

Electric, Inc., to maintain yearend inventories on its premises,

the peculiar physical properties of emulsified asphalt make it

impossible for petitioner to have any item to hold for sale at

the end of the day at either its clients' sites or its own

premises.10

     The seminal case on the issue of whether material provided

in conjunction with the sale of a service is merchandise is

Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir.

1970).    In Wilkinson-Beane, Inc., the taxpayer was an undertaking

establishment that sold caskets as part of its funeral service.

In construing the word "merchandise", the court used the ordinary

meaning of the word and found that the common denominator in all

the definitions was that the items in question are merchandise if

they are held for sale.    Id. at 354-355.   In finding caskets were


     10
          Similarly, the instant case is factually
distinguishable from J.P. Sheahan Associates, Inc. v.
Commissioner, T.C. Memo. 1992-239, on the quality of the material
used in the performance of the contracts. In J.P. Sheahan
Associates, Inc., the record showed that excess roofing materials
were either returned to the seller for credit or held for use on
another job.
                               - 17 -

merchandise, the court noted that the taxpayer normally kept an

inventory of some 35 caskets, that the caskets were not

necessarily used during the year they were purchased and

occasionally were carried for long periods of time, and that

there was a direct relationship between the magnificence of the

caskets and the cost of the service.    Id.

     The factors that led the court to conclude in Wilkinson-

Beane, Inc. that the caskets were merchandise are not present in

the instant case.    Using the ordinary meaning of the word

"merchandise", we find that the physical properties of the

emulsified asphalt prevent petitioner from holding it for sale.

Unlike the taxpayer in Wilkinson-Beane, Inc., who was able to

hold a stockpile of 35 caskets through multiple annual accounting

periods without diminished utility, the facts in this case show

that from the moment it received the emulsified asphalt from the

supplier petitioner was joined in a race that had an unalterable

predetermined outcome; within 2 to 5 hours the emulsified asphalt

would be rock hard and worthless.    Accordingly, under the facts

and circumstances of this case, we cannot find that the

emulsified asphalt is merchandise.

     It is irrelevant that the laid asphalt contained the

potential of providing many years of service to its ultimate

beneficiary, the owner of the paved surface.    The utility that

must be considered is that afforded the service provider working

with the material.    If petitioner was victorious in the race and
                              - 18 -

the asphalt was laid within the brief period that it remained in

its emulsified condition, its change of state into a rock hard

solid provided utility only to the owner of the paved surface.

If, however, petitioner managed no better than to place or show,

and all the emulsified asphalt was not laid within 2 to 5 hours

of receipt, the unlaid amount would become entirely and

irrevocably worthless to everyone.     In either event, the utility

provided by the material entirely vanished within 2 to 5 hours of

its receipt.   This peculiar physical property of the emulsified

asphalt is a material difference that distinguishes it from the

roofing materials, electrical materials, and caskets of the

aforementioned cases.

     Furthermore, unlike Wilkinson-Beane, Inc., the variable

factor in the cost of the service provided by petitioner was the

relative complexity of the client's site, and the additional

amount of labor and machinery required to lay the asphalt on a

more complex site, not the relative "magnificence" of the

material.   The facts of the instant case are thus distinguishable

from those of Wilkinson-Beane, Inc. and its progeny.

     In Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d

781, 790 (11th Cir. 1984), the Court of Appeals for the Eleventh

Circuit considered the issue of whether the taxpayer, who was in

the business of producing and selling newspapers, was required to

use an inventory method of accounting.    The taxpayer argued that

it was in a service business (the business of providing
                                - 19 -

information for its readership and running advertisements for its

clients), and that it was not the type of merchandiser envisioned

by the inventory regulations.    Id.     The court found that even

though the taxpayer sold an extremely perishable commodity (a 2-

day-old newspaper is stale), and therefore it had virtually no

inventories of finished goods, the taxpayer was required to

account for inventories because the sale of merchandise was an

income-producing factor and there was a significant fluctuation

of newsprint and ink on hand, which had a significant effect on

taxable income.   Id. at 790-791.

     The Court of Appeals also stated that in deciding whether a

taxpayer must adopt inventories, the size of the account and the

fluctuations are relevant.   Id. at 791.     After discussing the

language in section 1.471-1, Income Tax Regs., that requires

inventories in “every case in which the * * * sale of merchandise

is an income-producing factor”, the court said:

     Nevertheless, given that the ultimate goal of the
     regulation is “to reflect taxable income correctly,”
     id., we hold that purpose is not served where
     inventories and inventory fluctuations would be de
     minimis and have virtually no effect on the reflection
     of income. * * * On the other hand, if either the
     absolute level of the inventory account or its
     fluctuation during the year would be substantial, then
     the taxpayer must use inventories if it meets the other
     requirements of section 1.471-1. [Id.]

See also Ezo Products v. Commissioner, 37 T.C. 385, 393 (1961).

     Similarly, in Asphalt Prods. Co. v. Commissioner, 796 F.2d

at 849, the court said, in dicta:
                                - 20 -

        If the temporary and rather insignificant increase in
        inventories of raw materials had been the only basis
        for the Commissioner’s determination, we would have
        been inclined to find an abuse of discretion. We do
        not construe the Code provisions and regulations
        relating to inventories in the absolute terms adopted
        by the Commissioner and the Tax Court. * * *

        In contrast to the facts of Knight-Ridder Newspapers, Inc.,

petitioner has no raw materials inventory; thus, there is no

fluctuation in either the absolute value or the value relative to

taxable income.     Furthermore, we are unable to find as a fact

that the emulsified asphalt is merchandise.     Thus, we find no

factual or legal indicators in Knight-Ridder Newspapers, Inc.

that lead us to conclude that petitioner must use an inventory

method of accounting.

        Our analysis of the material at issue, and our finding that

under the facts and circumstances of this case the ephemeral

quality of the emulsified asphalt bars its inclusion in the class

of goods or commodities held for sale as "merchandise", support a

conclusion that is different from, but not contrary to, the

holdings in Wilkinson-Beane, Inc. and its progeny.

        We do not interpret section 1.471-1, Income Tax Regs., to

require that if a material is an income-producing factor it must,

per se, be "merchandise".     The section provides that "inventories

*   *    * are necessary in every case in which the production,

purchase, or sale of merchandise is an income-producing factor".

Sec. 1.471-1, Income Tax Regs. (emphasis added).     Thus, we find

that the emulsified asphalt is a supply consumed in the operation
                             - 21 -

of petitioner's service business, not merchandise.   The expense

of the asphalt is properly deducted under section 162 and the

regulations thereunder.11

     Since the emulsified asphalt is not merchandise, we do not

reach the question of whether "merchandise is an income-producing

factor" in petitioner's business.

B.   Inventory

     In construing the word "inventory" we note that the natural

and ordinary meaning of words will be applied in construing tax

statutes unless the Congress has definitely indicated an



     11
           Furthermore, treating the emulsified asphalt as a
supplies expense because it is consumed in providing service to a
client is not a treatment unique to this case. For instance, the
Commissioner has issued guidance regarding expensing material
consumed in providing service to the taxpayer's customers, see,
e.g., Rev. Rul. 75-407, 1975-2 C.B. 196 (public utility should
continue to deduct the cost of fuel actually consumed and used to
generate electricity distributed during its taxable year), and
for expensing materials consumed in operation of a taxpayer's
business, see, e.g., Rev. Rul. 90-65, 1990-2 C.B. 41 (the cost of
unrecovered platinum from prills used in refining petroleum is a
material or supply expense allowed under sec. 1.162-3, Income Tax
Regs., during period prills are in use; the expense is then
required to be capitalized as provided under sec. 263A).
     In addition, provided the taxpayer can verify the amount of
the expense, the Commissioner has allowed deductions for supplies
transferred to clients in the operation of taxpayer's service
business. See, e.g., Tomsykoski v. Commissioner, T.C. Memo.
1974-105 (drugs and supplies provided free of charge to
patients).
     Finally, this Court has held that supplies consumed in the
provision of a service are not subject to sec. 1.471-1, Income
Tax Regs. See, e.g., Smith Leasing Co. v. Commissioner, 43 T.C.
37, 40-41 (1964) (truck leasing company allowed to charge cost of
gasoline, tires and tubes, and replacement parts directly to
expense).
                                - 22 -

intention that they should be otherwise construed.12    See supra

note 8.     Inventory is, simply stated, property that is held for

sale.     Grant Oil Tool Co. v. United States, 108 Ct. Cl. 620, 381

F.2d 389, 397 (1967).

     We have found that the emulsified asphalt is not merchandise

held for sale by petitioner in the operation of petitioner's

service business, and that petitioner does not keep any raw

materials or finished goods on hand.     Previously, the Court of

Appeals for the Second Circuit considered the fact that the

taxpayer had no stock or merchandise on hand and no warehouse or

storeroom for merchandise, and that goods were delivered directly

from the manufacturer to the customer, to be conclusive in

finding that the taxpayer did not maintain inventories.     See

Simon v. Commissioner, 176 F.2d 230, 232 (2d Cir. 1949) (buyer


     12
          "Inventory" is defined in The Random House College
Dictionary (1982) as:
     1. a detailed, often descriptive, list of articles, giving
     the code number, quantity, and value of each; catalog. * * *
     3. a complete listing of merchandise or stock on hand, raw
     materials, etc., made each year by a business concern. 4.
     the objects or items represented on such a list, as a
     merchant's stock of goods. 5. their aggregate value.
     Similarly, "inventory" is defined in Webster's Second New
International Dictionary (1957) as:
     1. an account, catalog, or schedule, made by an executor or
     administrator, of all the goods and chattels, and sometimes
     of the real estate, of a deceased person; a list of the
     property of a person or estate; hence an itemized list of
     goods or valuables, with their estimated worth; specif., the
     annual account of stock taken in any business; * * * 2.
     Inventoriable goods, hence stock of such; * * * .
                               - 23 -

and seller of paper box-board maintained no inventory, was not

engaged in business of "merchandising" requiring use of accrual

method in computing income for Federal income tax purposes).13

If petitioner made "a complete listing of merchandise or stock on

hand, raw materials, etc.", either at the beginning or end of any

day, there could be nothing to list; thus, the amount and value

of petitioner's opening and closing inventory would always be

zero.14   Therefore, we hold that petitioner does not maintain

inventories.

C.   Accrual Method of Accounting

     Petitioner used the cash receipts and disbursements method

of accounting (cash method) to report its income for the taxable


     13
          Interpreting the requirements of Reg. 111, sec.
29.22(c)-1. For the taxable year before the court, Reg. 111,
sec. 29.22(c)-1 provided:

     Need of Inventories.--In order to reflect the net income
     correctly, inventories at the beginning and end of each
     taxable year are necessary in every case in which the
     production, purchase, or sale of merchandise is an income-
     producing factor. * * * Merchandise should be included in
     the inventory only if title thereto is vested in the
     taxpayer. Accordingly, the seller should include in his
     inventory goods under contract for sale but not yet
     segregated and applied to the contract and goods out upon
     consignment, but should exclude from inventory goods sold
     (including containers), title to which has passed to the
     purchaser. A purchaser should include in inventory
     merchandise purchased (including containers), title to which
     has passed to him, although such merchandise is in transit
     or for other reasons not been reduced to physical
     possession, but should not include goods ordered for future
     delivery, transfer of title to which has not yet been
     effected.
     14
          Although cognizant of this fact, respondent proposes to
require petitioner to use an inventory method of accounting "as
if" petitioner had merchandise or stock on hand.
                               - 24 -

years at issue.    Respondent determined that petitioner had

inventories and therefore was required to use the accrual method

of accounting.    We have found that petitioner has no merchandise

inventories; however, our finding does not preclude the

possibility that petitioner may be required to use the method of

accounting selected by respondent in order to clearly reflect

income.

     The issue we must decide is whether respondent's

determination that petitioner must report its income on the

accrual method of accounting constitutes an abuse of discretion.

The Commissioner is granted broad discretion in determining

whether a taxpayer's use of an accounting method clearly reflects

income.   Sec. 446(b); United States v. Catto, 384 U.S. 102, 114 &

n.22 (1966), rehearing denied 384 U.S. 981 (1966); Commissioner

v. Hansen, 360 U.S. 446, 468 & n.12 (1959); Lucas v. American

Code Co., 280 U.S. 445, 449 (1930).     No method of accounting is

acceptable unless, in the opinion of the Commissioner, it clearly

reflects income.    Sec. 1.446-1(a)(2), Income Tax Regs.   Thus, a

prerequisite to the Commissioner's requirement that a taxpayer

change its present method of accounting is a determination that

the method used by the taxpayer does not clearly reflect income.

Sec. 446(b); Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31

(1988).

     Whether an abuse of discretion has occurred depends on

whether the Commissioner's determination is without sound basis

in fact or law.    Ansley-Sheppard-Burgess Co. v. Commissioner, 104
                              - 25 -

T.C. at 371; Ford Motor Co. v. Commissioner, 102 T.C. 87, 91-92

(1994), affd. 71 F.3d 209 (6th Cir. 1995); see Cole v.

Commissioner, 586 F.2d 747, 749 (9th Cir. 1981), affg. 64 T.C.

1091 (1975).   The reviewing court's task is not to determine

whether, in its own opinion, the taxpayer's method of accounting

clearly reflects income but to determine whether there is an

adequate basis in law for the Commissioner's conclusion that it

does not.   Ansley-Sheppard-Burgess Co. v. Commissioner, supra at

371; Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-105.

Consequently, section 446 imposes a heavy burden on the taxpayer

disputing the Commissioner's determination on accounting matters.

Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533

(1979).   To prevail, a taxpayer must establish that the

Commissioner's determination is "clearly unlawful" or "plainly

arbitrary".    Id.   However, if the taxpayer's method of

accounting is specifically authorized by the Code or the

regulations thereunder and has been applied on a consistent

basis, the Commissioner is ordinarily not permitted to reject the

taxpayer's method, as not providing a clear reflection of income,

and require the use of another method.     Hallmark Cards, Inc. v.

Commissioner, supra at 31; Peninsula Steel Prods. & Equip. Co. v.

Commissioner, 78 T.C. 1029, 1050 (1982).    Furthermore, this Court

has held that the Commissioner cannot require a taxpayer to

change from an accounting method which clearly reflects income to

an alternate method of accounting merely because the Commissioner

considers the alternate method to more clearly reflect the
                              - 26 -

taxpayer's income.   Molsen v. Commissioner, 85 T.C. 485, 498

(1985); Peninsula Steel Prods. & Equip. Co. v. Commissioner,

supra at 1045; Bay State Gas Co. v. Commissioner, 75 T.C. 410,

422 (1980), affd. 689 F.2d 1 (1st Cir. 1982).

     Section 446 specifically authorizes a taxpayer to use the

cash receipts and disbursements method of accounting (cash

method) to compute taxable income, provided it is the method of

accounting the taxpayer regularly uses to compute his income in

keeping his books, and it clearly reflects income.   Sec. 446(a),

(b) and (c)(1).

     Generally, under the cash method of accounting, an item of

income or expense is reported when received or paid without

regard to the economic events giving rise to the item.    On the

other hand, under the accrual method of accounting, an item of

income or expense generally is reported for the accounting period

during which all the events have occurred which fix the

taxpayer's right to receive the item of income or which establish

the fact of liability giving rise to the deduction, and the

amount thereof can be determined with reasonable accuracy.

Hallmark Cards, Inc. v. Commissioner, supra at 32; secs. 1.446-

1(c)(1)(ii), 1.451-1(a), Income Tax Regs.   Thus, each method

properly applied to the same facts may yield different results.

     This Court is aware that "By definition, the cash method may

result in mismatching between expenses and income where expenses

are paid in a year prior to the receipt of the related income."

RLC Indus. Co. v. Commissioner, 98 T.C. 457, 493 n.29 (1992),
                               - 27 -

affd. 58 F.3d 413 (9th Cir. 1995).      However, mismatches between

expenses and income will over time tend to cancel out provided no

attempt is made to unreasonably prepay expenses or purchase

supplies in advance.   Van Raden v. Commissioner, 71 T.C. 1083,

1104 (1979), affd. 650 F.2d 1046 (9th Cir. 1981).     Respondent did

not contend that petitioner attempted to unreasonably prepay

expenses or purchase supplies in advance.     In fact, petitioner

paid its suppliers only after receiving payment from its

clients.15   Therefore, in this case, income and expenses were not

mismatched.16

     Furthermore, respondent's determination that petitioner's

use of the accrual method of accounting would increase its income

tax liability for taxable years 1989 and 1990 by $111,613 and

$775, respectively, is not, per se, indicative that petitioner's

use of the cash method failed to clearly reflect income.      RLC



     15
          Petitioner is billed by the asphalt supplier, and that
invoice is due within 30 days. When a job is complete,
petitioner bills its client and creates an account receivable.
Petitioner pays the invoice when the client pays petitioner.
Thus, we can conclude that if petitioner pays its supplier's
invoices on time, then petitioner receives payment from its
customers within 30 days of completing the paving job.

     16
          The accrual method requires a taxpayer to recognize
income in the taxable year when all the events have occurred that
fix the right to receive the income and the amount can be
determined with reasonable accuracy (the "all-events test"),
secs. 1.446-1(c)(1)(ii)(A), 1.451-1(a), Income Tax Regs., rather
than when the taxpayer actually receives payment. Accordingly,
under the accrual method petitioner would be required to
recognize income when petitioner completes each paving job; i.e.,
approximately 30 days earlier than when it recognizes income
under the cash method.
                                  - 28 -

Indus. Co. v. Commissioner, supra at 503.       The best method is not

necessarily the one that produces the most tax in a particular

year.     Id.

     Respondent's final argument is that if petitioner is to

establish that respondent has abused her discretion, petitioner

must demonstrate substantially identical results between

petitioner's method and the method selected by respondent.        We

disagree.       We have found that petitioner does not have any

inventories.      Respondent's contention that we must apply the

substantial-identity-of-results test17 in cases where the

taxpayer is not required to maintain an inventory is without

support in the case law.       Ansley-Sheppard-Burgess Co. v.



     17
           The substantial-identity-of-results test is a judicial
creation; the test was first articulated in Wilkinson-Beane, Inc.
v. Commissioner, 420 F.2d 352 (1st Cir. 1970). In that case, a
cash-method taxpayer who was required to maintain an inventory
and thus report income on the accrual basis argued that the
difference in income determined by the method it used and the
method selected by the Commissioner was negligible. The court
found that where the Commissioner has determined that the
accounting method used by a taxpayer does not clearly reflect
income, in order to prevail, "the taxpayer must demonstrate
substantial identity of results between his method and the method
selected by the Commissioner." Id. at 356.
     In Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C.
367, 377 (1995), we held that a taxpayer that is required to use
the inventory method of accounting must meet the substantial-
identity-of-results test in order to show that the Commissioner's
determination requiring it to change from the cash method to the
accrual method of accounting was an abuse of discretion.
However, respondent's contention that we must apply the
substantial-identity-of-results test in cases where the taxpayer
is not required to use an inventory is without support in case
law. Id.
                              - 29 -

Commissioner, 104 T.C. at 377; Austin v. Commissioner, T.C. Memo.

1997-157.   Thus, petitioner is not required to show a substantial

identity of results for this Court to find that respondent abused

her discretion in changing petitioner's method of accounting.

     Respondent required petitioner to change from an accounting

method which clearly reflects income to an alternate method of

accounting merely because respondent considers the alternate

method to more clearly reflect its income.    We previously have

held that to do so exceeds the bounds of her discretion.

     On the basis of the facts of the instant case--including the

fact that petitioner has consistently used the cash method of

accounting without any evidence that it attempted to prepay

expenses unreasonably or purchase supplies in advance, does not

have inventories and is not required to use an inventory method

of accounting, and is not otherwise required by the Code or

regulations to use the accrual method of accounting--we hold that

respondent's determination that petitioner's use of the cash

method of accounting did not produce a clear reflection of income

was an abuse of discretion.

     To reflect the foregoing,

                                      Decision will be entered

                                 for petitioner.
