How a 1979 Supreme Court hammered book publishing

1) Most significantly, we're looking only at the tax view and for only one year. Companies typically keep two sets of related financials: "book" and "tax." The "book" financials are on an accrual basis (for most companies), which means that expenses are matched with income according to the period in which they occur. The tax books are kept on a cash basis, meaning that they look at what cash came in and out in a given period.

What is happening here is that the book and tax results are temporarily diverging (quite common) because they treat this item differently, with the payments to the IRS creating a deferred tax asset that will ultimately reverse.

Specifically, for "book" or financial reporting purposes, the inventory is carried at $0.50, reflecting its current value. For tax purposes, however, that is disallowed. As a result, the company pays more in cash to the IRS this year (as the post describes).

What it misses, though, is that this situation will reverse in the next period, when the company will owe less tax. (For financial reporting purposes, it would record the tax payment as a deferred tax asset on its balance sheet.)

Now move forward a year. When the inventory is sold off at $0.50, it produces no profit on the financial books: we held it at $0.50, and we sold it at $0.50. On the tax side, however, we held it at $1.00 and sold it at $0.50, generating a loss that will reduce our cash tax bill. As a result, the deferred tax asset (the money we paid to the IRS as a result of the higher cash profits in the prior period from not writing down the inventory) will reverse, and we'll pay less taxes.

This is a bit complicated, but the basic idea is that the post is misleading: because it only looks at one period, we see the publisher paying more in taxes in the first period, but we don't see the reversal where the publisher pays less tax in the second period.

2) Publishing is actually better off than most industries here, because a) books are cheap to manufacture relative to other, more complex manufactured items; b) Nobody sells books for $2 that cost $1 to print. In the real world, the slight change in inventory holding costs has a lesser impact on the cash taxes paid by the publisher when books that cost $1 to print are sold for $10 or $20, even if some are pulped at $0.50. In other words, this is a bigger deal for industries other than publishing, as publishers can sell their products for quite a bit more than they cost to manufacture (as is true of many IP products).

3) From an economic profit view (ignoring accounting), nobody wins when items are manufactured and written off as unsold inventory. The incremental tax expense in the first period from temporarily paying higher taxes on a higher inventory value is swamped by the overall profitability improvement of not printing books that never sell. No matter what industry you're in, unsold inventory represents a loss.

4) Printing fewer items means less cash is tied up in inventory. This is a huge benefit to the company's overall economic profit and return on assets, as having cash tied up in unsold inventory carries financing costs and results in lower return on equity.

5) This long trip into accounting-land has nothing to do with the fact that ebooks are a damn sight better for many reasons, even if they upend the publishing industry in its current form.

* «We have 100 widgets in inventory», you have one file copy,

* «a publisher prints 60,000 copies (instead of 80,000)», you still have only one file copy,

* «this book is out of print», files do not go "out of print",

* «dispose of inventory -- i.e., pulp it --», physical books have another counterpart: they are paper that can be sold, this has no parallel for electronic books,

* «competition for rack space», there is no rack space to compete for (there is competition for attention, that that is the same for every sellable thing).

The author neglects one factor which is especially salient given the above - if a publisher finds a book is selling they will go for a second print run to milk it!

The government should not attempt to even the playing field by clamping down on technology and the internet. Instead it should eliminate taxes on unsold physical inventory and eliminate retail sales taxes and retail property taxes.

Trade paperbacks are going print-on-demand, and e-books have overtaken print books in some categories already.

When is the last time you heard anyone boast "I'm in my fifth printing?"

So, while this puts some inefficiency and perverse incentives into part of the publishing industry, the effects of this have been washed out, in most cases, by technological change and changes in the supply chain.