Knight Ridder Case Study

The United States appeals from a decision of the District Court, holding that Knight-Ridder Newspapers ("Taxpayer" or "Knight-Ridder") is entitled to recover certain federal income tax payments with respect to its 1972, 1973, and 1974 taxable years. The payments represent various deficiencies assessed by the Internal Revenue Service and involve three separate legal issues. Taking them in order, we hold first that the Commissioner of Internal Revenue ("Commissioner") did not abuse his discretion under I.R.C. Sec. 446 when he determined that the cash method of accounting did not clearly reflect the income of two of Taxpayer's subsidiaries. The Commissioner acted well within his authority in requiring those subsidiaries to adopt the accrual method.

Second, we hold that Taxpayer did not properly elect to use the "Guideline Class Life System" for depreciating the press equipment of several of its subsidiaries. Taxpayer failed to substantially comply with the regulatory requirements because its tax returns contained nothing to alert the Commissioner that an election had been made.

Finally, we hold that the use of an advertising rebate reserve is a "method of accounting," such that the abandonment of the method triggers compensatory adjustments pursuant to I.R.C. Sec. 481.

FACTS AND PROCEDURAL HISTORY

Taxpayer runs a large newspaper chain. It was formed on November 30, 1974, as a result of the merger of Knight Newspapers, Inc. ("Knight Newspapers") and Ridder Publications, Inc. Knight Newspapers in turn was the sole owner of a number of subsidiaries whose main business involved the publication of newspapers. For the taxable years 1972 and 1973, Knight Newspapers filed consolidated tax returns, reporting the income of the following subsidiaries: Beacon Journal Publishing Company, Tallahassee Democrat, Inc., Macon Telegraph Publishing Company, Boca Raton News, Inc., Philadelphia Newspapers, Inc., Detroit Free Press, Inc. ("Detroit Free Press") and Knight Publishing Company. The Lexington Herald Leader Company was a party to the consolidated return for 1973.

In addition, Knight Newspapers acquired the R.W. Page Corporation ("Page") on October 1, 1973. Page had been actively engaged since 1927 in the business of publishing newspapers in Columbus, Ga. Page had also operated as a separate business the Bradenton Herald, Inc. ("Bradenton"), which published a newspaper in Bradenton, Florida. On November 1, 1973, Knight Newspapers organized Bradenton as a subsidiary of Page. Thus, Page and Bradenton were parties to the 1973 consolidated return of Knight Newspapers. Page was a party to the return for the period from October 1 through December 31, 1973; Bradenton was a party for the period November 1 through December 31.

Finally, Knight-Ridder filed a consolidated return in 1974, covering among other things, the operations of the same subsidiaries whose operations had been covered by the 1973 return filed by Knight Newspapers.

ACCOUNTING METHODS OF PAGE AND BRADENTON

One of the disputes in this case concerns whether Page and Bradenton should use the cash and disbursements method of accounting or the accrual method. To simplify the distinction: under the cash method, expenditures are deducted when made and payments included in income when received. Under the accrual method, by contrast, income and deductions are generally recognized when an obligation becomes fixed, rather than when cash payments are actually made. Thus, accounts payable and accounts receivable are taken into account when the debts are fixed, even though no money has changed hands. 

Throughout their history, Page and Bradenton have reported their income for tax purposes using the cash method. They have used the accrual method in preparing financial statements. During an audit of Page's tax returns for the years 1964 through 1966, Page proposed to the I.R.S. examining agent that the company change its method of accounting to the accrual method. The agent considered the proposal but did not require  a change of method for those years. The Service later audited Page's returns for 1969 and 1970 and again did not object to the use of the cash method. During that period, the cash and accrual methods reached substantially the same results in measuring the before-tax income of Page and Bradenton.

After Knight Newspapers bought Page and Bradenton in late 1973, however, a substantial discrepancy appeared between the two methods. In the tax year ending December 31, 1974, the cash method netted approximately $1,400,000 in taxable income for Page and Bradenton, while the accrual method would have yielded approximately $1,900,000, a difference of $500,000 (according to the calculations of Mr. William Pruitt, an accounting expert who testified for Taxpayer). See Plaintiff's Exhibit 13, at 4; Plaintiff's Exhibit 20, at 4; Plaintiff's Chart # 1. 

This distortion was the result of Knight-Ridder's investment of capital in the business of Page and Bradenton, building up accounts receivable and inventories of raw materials (newsprint and ink). The inventories in particular increased by about $240,000 in 1974, from $210,000 to $450,000. The cash and accrual methods did not show such gross discrepancies again during the years 1975 to 1979.

In an audit of the 1973 and 1974 tax returns of Knight-Ridder and its subsidiaries, the Commissioner determined that the cash method did not clearly reflect income for Page and Bradenton in those years. He found that a timing distortion resulted because of the accounts receivable and inventory fluctuations. Therefore, he required Page and Bradenton to switch to the accrual method for the short tax period ending December 31, 1973 (i.e., the months after the take-over by Knight-Ridder), and the full tax year ending December 31, 1974.

In line with that decision, the Commissioner required Taxpayer to include in its income for those years the adjustments prescribed by section 481 of the Internal Revenue Code, 26 U.S.C. § 481. Section 481 adjustments are designed to compensate for the duplication or omission of items of income or expense that occurs when a taxpayer changes its method of accounting. Taxpayer paid the tax resulting from these adjustments and, after satisfying the requisite administrative claim procedure, filed this suit for a refund.

The case was tried to the bench in the Southern District of Florida. The trial court held that the Commissioner had consented to Page's and Bradenton's use of the cash method and that, in any event, the method clearly reflected their income. Therefore, the Commissioner had abused his discretion in requiring Page and Bradenton to use the accrual method for 1973 and 1974.

PRESS EQUIPMENT DEPRECIATION

The Internal Revenue Code has always permitted depreciation to be taken on the "facts and circumstances" method. That method requires a taxpayer to assign a separate useful life to each capital item based on a judgment as to how long it is expected to last. In recent years the Code and regulations have permitted taxpayers to elect various "class life" systems under which whole classes of assets may be assigned the same specified, and artificially short, useful life. The "Guideline Class Life System" applies to assets put into service before 1971. Since at least 1970, Taxpayer's policy has been to take the most rapid depreciation allowed on the press equipment of its subsidiaries. It advised its tax accountant of the policy; and its subsidiaries accurately computed depreciation on their own books in accordance with the Guideline Class Life System.

A number of the subsidiaries, however, did not indicate on their tax forms for 1972 and 1973 that they were electing to use the system. Knight-Ridder's consolidated returns were prepared by a national independent accounting firm. A local office of the firm prepared the returns for the local subsidiary of Knight-Ridder. Then, the local office sent the returns to the Miami office where all of the forms were collected and attached to Knight-Ridder's consolidated return.

A number of the forms as prepared did not comply with Treasury Regulations governing the election of the Guideline Class Life System, Treas.Reg. Sec. 1.167(a)-12, 26 C.F.R. Sec. 1.167(a)-12 (1983). The Regulations require the taxpayer to "check" a box provided in Schedule G of its Corporate Tax Return and file a completed Form 5006 with the return. For their 1972 and 1973 taxable years, two of the subsidiaries--the Detroit Free Press and the Knight Publishing Company--checked the appropriate box and filed Form 5006. However, for the same years, neither Knight Newspapers nor any of its other seven subsidiaries  checked that box or filed Form 5006. Nor did the information required by the Treasury appear anywhere else in their returns. Most of them did, however, check a similar box electing to use the "Class Life ADR System," which applies only to assets put into service after 1971. 

The Commissioner concluded that Knight Newspapers and the seven subsidiaries had not elected the Guideline Class Life System for pre-1971 assets. He recomputed their depreciation according to the "facts and circumstances" test, determining that the proper useful life for the press equipment was 18 years rather than the 11 years prescribed by the Guideline Class Life System.  The Commissioner assessed deficiencies which the Taxpayer then paid.

The District Court, however, noted that Taxpayer and its subsidiaries had intended to use the Guideline Class Life System, had computed their depreciation in accordance with the system, and had properly maintained their own books and records. Therefore, the court held that Taxpayer had substantially complied with the election requirements and legislative purpose of the class life statute  and regulations.  Taxpayer was entitled to depreciate its press equipment pursuant to the system.

ADVERTISING REBATE RESERVE

Taxpayer's subsidiary, the Detroit Free Press, maintained its books and records on the accrual basis. In its advertising contracts, the Free Press provided that an advertiser would qualify for a lower per line rate if its annual volume of advertising exceeded a specified level. The advertiser would be entitled to a rebate of the excess amounts previously paid at the higher rate. Because the measuring year did not always coincide with the Free Press's tax year, rebates were often paid in a different tax year from that in which the advertising revenues were earned.

The Free Press established a reserve on its books for anticipated advertising rebates and each year added an amount based on an estimate of what the rebate liability would be for that year. Deductions were taken when the amounts were added to the reserve. Later, when rebates were paid, they were charged against, and served to reduce, the level of the reserve. As of January 1, 1972, the balance of the reserve stood at $120,000. In each of the years 1972, 1973, and 1974, the Free Press' estimated deductions, actual rebate payments, and ending reserve balance were as follows:

Ending Taxable Balances Increases Year Estimated Actual Cash In Reserve for Taxable Ended Rebates Disbursements Accounts Year -------- ----------- ------------- ----------- ----------- 12/31.71 $120,000.00 12/31/72 $369,000.00 $339,000.00 150,000.00 $ 30,000.00 12/31/73 524,671.00 464,671.00 210,000.00 60,000.00 12/31/74 737,866.00 622,866.00 325,000.00 115,000.00

Upon audit of Taxpayer's 1972 return, the Commissioner determined that the Free Press was not entitled to maintain the reserve for 1972 or thereafter. He eliminated the deductions for 1972 through 1974 and included in Taxpayer's 1972 income the opening reserve balance of $120,000. Taxpayer objected that the statute of limitations barred the Commissioner from challenging any improper deductions prior to 1972. The Commissioner, however, concluded that he was entitled to correct the $120,000 balance pursuant to I.R.C. Sec. 481. He felt that the reserve was an accounting method and, therefore, that Taxpayer had changed its accounting method when it ceased to use the reserve. Since it had changed the method, it was required to make adjustments under section 481 to prevent a double deduction. Otherwise, the change of methods would have provided a deduction when the $120,000 was first put into the reserve and a second deduction when rebates were actually paid after 1972.

Taxpayer paid the deficiencies and challenged only the $120,000 adjustment when it brought this action in the District Court. It pressed the statute of limitations argument, contending that section 481 does not apply to the rebate reserve which is not a method of accounting. The trial court agreed that the reserve is not an accounting method and held that the Commissioner is barred from recovering the $120,000 in deductions.

ISSUES

To summarize the issues on this appeal, the trial court held that

(1) the Commissioner abused his discretion in requiring Page and Bradenton to change to the accrual method;

(2) Taxpayer substantially complied with the requirements for electing the Guideline Class Life Depreciation System; and

(3) an advertising rebate reserve is not a method of accounting.  The Commissioner challenges each of these holdings on the law. We agree with the Commissioner on each issue and reverse.

ACCRUAL VERSUS CASH ACCOUNTING

A. The Cash Method, the Accrual Method, and Section 446.

The initial issue in this case concerns the authority of the Commissioner to force a taxpayer to change accounting methods, in particular to change from the cash to accrual method. These are the two most common accounting methods and could be said to emblemize the polar nature of the human spirit. The cash method--simple, plodding, elemental--stands firmly in the physical realm. It responds only through the physical senses, recognizing only the tangible flow of currency. Money is income when this raw beast actually feels the coins in its primal paw; expenditures are made only when the beast can see that it has given the coins away.

The accrual method, however, moves in a more ethereal, mystical realm. The visionary prophet, it recognizes the impact of the future on the present, and with grave foreboding or ecstatic anticipation, announces the world to be. When it becomes sure enough of its prophecies, it actually conducts life as if the new age has already come to pass. Transactions producing income or deductions spring to life in the eyes of the seer though nary a dollar has moved.

The Internal Revenue Code, the ultimate arbiter, stands to the side, shifting its eyes uneasily from the one being to the other. The Code is possessed of great wisdom and tolerance. It knows that man must generally choose his own way. Therefore, it leaves to the Taxpayer the original choice of which accounting method to use. Section 446(c) specifically authorizes both the cash and accrual methods. 26 U.S.C. § 446(c).

Yet the Code also understands that either extreme possesses inherent weaknesses and can become blinded to reality. Thus the Code and subsequent Treasury Regulations empower the Secretary of the Treasury and the Commissioner of Internal Revenue to cure the blindness. Section 446(b) of the Code provides that 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.

26 U.S.C. § 446(b). Treasury Regulations Section 1.446-1(a) (2) adds that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income." 26 C.F.R. Sec. 1.446-1(a) (2).

The courts have consistently interpreted this mandate to give the Commissioner "broad discretion to set aside the taxpayer's method if, 'in [his] opinion,' it does not reflect income clearly." Thor Power Tool v. Commissioner, 439 U.S. 522, 540, 99 S. Ct. 773, 785, 58 L. Ed. 2d 785 (1979). His decision "should not be interfered with unless clearly unlawful." Id. 99 S. Ct. at 781; Lucas v. American Code Co., 280 U.S. 445, 449, 50 S. Ct. 202, 203, 74 L. Ed. 538 (1930). A court may not "overturn his determination unless the evidence clearly shows that he has abused his discretion." Drazen v. Commissioner, 34 T.C. 1070, 1076 (1960); accord Loftin and Woodard v. United States, 577 F.2d 1206, 1229 (5th Cir. 1978).

Of course, in deciding whether the Commissioner has abused his discretion, we immediately face an age-old philosopher's dilemma: how can we mere mortals know who sees the truth most vividly? How can we know whether the primal cash method or the mystical accrual method sees income more clearly without knowing what income really is? If it is really cash on hand, then the cash method is more accurate. If it is really fixed obligations, then the accrual method is more accurate. By embracing both conceptions, the Code provides no general baseline against which to assess the accuracy of an accounting method. In effect, we risk being led in circular fashion to arbitrarily choose one method as accurately reflecting income. When another method differs from it, that other must not clearly reflect income.

Fortunately, we need not be so arbitrary in this case. The Code and regulations do provide guidance in the case of businesses that sell merchandise. Such businesses are generally required to use inventories, and where the taxpayer uses inventories, it must use the accrual method. Section 471 of the Code provides:

Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of 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.

26 U.S.C. § 471. The Regulations implementing Section 471 provide:

In order to reflect taxable 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. The inventory should include all finished or partly finished goods and, in the case of raw materials and supplies, only those which have been acquired for sale or which will physically become a part of merchandise intended for sale * * *.

26 C.F.R. Sec. 1.471-1. Once a taxpayer uses such inventories, it must adopt the accrual method unless the Commissioner consents to another:

In any case in which it is necessary to use an inventory the accrual method of accounting must be used with regard to purchases and sales unless otherwise authorized under subdivision (ii) of this subparagraph. 

26 C.F.R. Sec. 1.446-1(c) (2) (i).

The reasoning behind this regulatory scheme is straightforward. According to accounting wisdom, the income realized from the sale of merchandise is most clearly measured by matching the cost of that merchandise with the revenue derived from its sale. See Chirelstein, supra note 1, p 12.03, at 221 (quoting the American Institute of Certified Public Accountants); Bittker, supra note 1, p 105.41, at 77, 82. In order to achieve such a matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials, and manufacturing expenses. These costs are not deducted immediately when paid but are deferred until the year when the resulting merchandise is sold. 

To make the matching complete, the taxpayer must report income on the accrual method. That method helps to ensure that income from the sale (like the inventory costs) is reflected in the year of the sale. For example, if the sale is made on credit, the accrual method nevertheless treats the income as accrued and reflects it when the sale occurs. See Caldwell v. Commissioner, 202 F.2d 112, 114 (2d Cir. 1953). The prophetic skills of the accrual shaman permits it to recognize both income and deductions in the same year.

By contrast, the primal cash method is unable to achieve such a mystical joinder of inventory deductions and credit sale income. To be sure, the cash method could theoretically operate in tandem with inventories. The beast could conceivably close its eyes to deductions until the year of the sale. It could never learn, however, to prophesy future cash payments. If there were a credit sale, the beast could not grasp income and deductions simultaneously in its rugged paw. See id. The goal of matching costs and revenues would fail. 

Thus, "the 'inventory' system is generally recognized as synonymous with the accrual system of accounting." 2 Mertens, supra note 1, Sec. 16.03, at 5. If the taxpayer must use inventories, the Commissioner may also require it to adopt the accrual method. 26 C.F.R. Sec. 1.446-1(c) (2) (i). C. The Accounts of Page and Bradenton: When Must a Newspaper Keep Inventories?

Returning to our case, the initial question arises whether Page and Bradenton were required to keep inventories. Taxpayer argues that Page and Bradenton are not the type of merchandisers envisioned by the inventory regulations. These companies sell an extremely perishable commodity; a two day-old newspaper is stale. Thus, if they reported on the inventory method, they would have virtually no inventories of finished goods. In addition, most of the companies' revenues are not derived from sales to readers. Almost 80% of total revenues come from advertisers. Taxpayer contends that the newspaper business is most accurately described as a service business, providing information to its readership and running advertisements for its clients.

We hold, however, that these companies do come within the requirements of Treas.Reg. Sec. 1.471-1. The sale of merchandise is an "income-producing factor" for Page and Bradenton. Twenty percent of their revenues come directly from the purchasers of newspapers. Moreover, the sheer cost of producing the physical pages (let alone the intellectual content) is significant in comparison to total revenues. The cost of newsprint and ink alone in 1973 and 1974 was $2,456,428, or 17.6% of the total cash receipts. 

In Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352 (1st Cir. 1970), the First Circuit faced a similar "mixed service and merchandising business" and held that the sale of merchandise was an income-producing factor within section 1.471-1 when the cost of the physical merchandise averaged 15.1% of total cash receipts. The taxpayer ran a funeral home. It provided caskets as part of its funeral service, but did not charge for them separately. Instead, the cost of a casket was included in the total price for the service. The taxpayer contended that it ran a service business and that the sale of caskets was not an income-producing factor.

The court, unable to separate out the relative prices of caskets and service, compared the cost of the caskets to total receipts. The court held that the cost of the caskets (15.1% of revenues)  was high enough to make them a substantial income-producing factor, even assuming that the taxpayer sold them at cost. Id. at 355.  Similarly, in our case, where the cost of raw materials for the newspapers was 17.6% of total revenues and the actual sales price accounted for 20% of revenues, we hold that the sale of newspapers was a material income-producing factor.

We do not believe the newspaper is any less merchandise because it provides information. Books are classic examples of merchandise requiring the use of inventories, yet their primary value likewise inheres in the message they communicate. 

2. The Requirement that Inventories or Inventory Fluctuations Be Substantial

Taxpayer contends that inventories (and the accrual method) are unnecessary in the newspaper business because the overall inventory account would be insubstantial. The number of finished goods held in inventory would be virtually nil, and the value of raw materials reflected in the account would be insignificant relative to total revenues. The Tax Court has held that inventories are not necessary when they would be "so small as to be of no consequence." Ezo Products v. Commissioner, 37 T.C. 385, 393 (1961). 

We agree that in deciding whether a taxpayer must adopt inventories, the size of the account and fluctuations therein are relevant. Admittedly, section 1.471-1 does not explicitly direct us to consider whether inventories are insignificant. The regulation requires inventories in "every case in which the ... sale of merchandise is an income producing factor." 26 C.F.R. Sec. 1.471-1. Nevertheless, given that the ultimate goal of the regulation is "to reflect taxable income correctly," id., we hold that that purpose is not served where inventories and inventory fluctuations would be de minimis and have virtually no effect on the reflection of income. See Bittker, supra note 1, p 105.4.1, at 88. 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.

In the case at bar, we need not decide whether the absolute level of Taxpayer's account would have been significant enough. The fluctuation in the inventory of newsprint and ink clearly would have been substantial in 1974. Such a fluctuation must be an increase and must have a significant effect on taxable income. Taxpayer suggests that we compare the fluctuation to total revenues. See Reply Brief at 22, note *. We believe, however, that the proper standard for comparison is taxable income. The Internal Revenue Code authorizes the Commissioner to require inventories "in order clearly to determine the income of [the] taxpayer." I.R.C. Sec. 471, 26 U.S.C. § 471. This language apparently refers to taxable income because inventories have an impact only at that level; total revenues are the same whether or not the taxpayer keeps an inventory account. The implementing regulations are even more specific. They provide that inventories are necessary " [i]n order to reflect taxable income correctly." 26 C.F.R. Sec. 1.471-1.

Since the goal of the inventory provisions is to reflect taxable income clearly, we hold that the Commissioner may require inventory accounting when fluctuations in the inventory would be substantial relative to taxable income. Cf. Ezo Products v. Commissioner, supra, 37 T.C. at 387, 388, 392 (inventory method required where fluctuation in inventories substantial relative to before-tax income).  Such was the case with Page's and Bradenton's purchase of raw materials in 1974. Had the companies reported their income using inventories, the raw materials inventory would have increased by $240,000 in that year (from an opening balance of $210,000 to a closing balance of $450,000).  Put differently, in the absence of inventories, Page and Bradenton took $240,000 in deductions that they would not have had under the inventory method. Clearly, the $240,000 fluctuation was not insignificant relative to the $1,400,000 taxable income that the cash method yielded for that year.  We hold that a fluctuation of 17.1%  relative to taxable income is substantial enough to trigger section 1.471-1. 

Taxpayer argues, however, that we should overlook the distortion in 1974 because there was not a great divergence in other years: throughout most of the history of Page and Bradenton, the cash and accrual methods produced substantially the same level of taxable income. Thus, according to Taxpayer, we should not require Taxpayer to use inventories (and the concomitant accrual method) merely because of a distortion in one year.

This argument fails on several counts. First, Page and Bradenton are part of a much different organization than they were before 1973.  They are now subsidiaries of a massive corporation capable of injecting large sums of money into their businesses and inventories. Thus, much of the data concerning their reporting history before 1973 is less relevant than it would have been prior to the take-over by Knight-Ridder. Nor does the data after 1974 prove that the inventory fluctuations will not repeat. On the contrary, in 1976 inventories rose by $100,000.

More important, ours is an annual system of accounting. Wilkinson-Beane v. Commissioner, supra, 420 F.2d at 356. A distortion in one year means an absolute loss for the government. The clear reflection of income during a few interim years does not by itself prevent future losses. Id. The substantial distortion in 1974, coupled with the new ownership by Knight-Ridder, are sufficient to support the Commissioner's determination that inventories posed a threat to the clear reflection of income.

Taxpayer was required to use inventories pursuant to Treas.Reg. Sec. 1.471-1 and, consequently, to adopt the accrual method of accounting pursuant to Treas.Reg. Sec. 1.446-1(c) (2). The Commissioner did not abuse his discretion in requiring Taxpayer to switch to the accrual method for the last months of 1973 and the tax year 1974.

Of course, section 1.446-1(c) (2) provides an exception to the use of the accrual method if the Commissioner has authorized the use of a different method. Taxpayer argues that the Commissioner is bound by his consent to Page's and Bradenton's use of the cash method in earlier tax years. During an audit of the 1969 returns, an I.R.S. agent considered Page's proposal to switch to the accrual method but did not require such a change. During a subsequent audit of the 1969 and 1970 returns, the Service again failed to object to Page's use of the cash method. The trial court found that the Commissioner had consented to the use of the method for those years. The court did not find, nor does Taxpayer argue, that the Commissioner had required Page or Bradenton to use the cash method during those years. He had merely consented to its use.

We cannot agree that the Commissioner is thereby barred from changing Taxpayer's accounting method during a subsequent year in which it becomes apparent that the method does not clearly reflect income. This Circuit and others have long held that the Commissioner cannot so easily "waive for future years the discretionary power which the Congress has granted." Wood v. Commissioner, 245 F.2d 888, 892 (5th Cir. 1957); see Lincoln Electric Co. v. Commissioner, 444 F.2d 491, 493 (6th Cir. 1971). Greater experience with the actual effects of the method or a significant change in the nature of the taxpayer's business may convince the Commissioner that the consent given for earlier years is no longer appropriate. See R.C.A. Corp. v. United States, 664 F.2d 881, 889 (2d Cir. 1981), cert. denied, 457 U.S. 1133, 102 S. Ct. 2958, 73 L. Ed. 2d 1349 (1982). His decision to consent, for whatever reason, to the use of a method in one year cannot bind his hands in perpetuity. As long as he has not abused his discretion in determining that income is not clearly reflected by the taxpayer's method, the Commissioner may require a change. As we have seen, there is no abuse of discretion in this case.

The second major issue in this appeal concerns Taxpayer's use of the Guideline Class Life System in depreciating press equipment. The Commissioner determined that a number of Taxpayer's subsidiaries had failed to meet the requirements for electing the system. Taxpayer responded (and the District Court held) that the subsidiaries had "substantially complied" with the requirements. We disagree and reverse the judgment of the court below.

Section 167(m) (1) of the Internal Revenue Code authorizes the Commissioner to establish depreciation class lives which taxpayers may elect to employ. 26 U.S.C. § 167(m) (1). In addition, section 167(m) (3) gives the Commissioner authority to prescribe the time, manner, and conditions of the taxpayer's election. 26 U.S.C. § 167(m) (3). Pursuant to this statutory authorization, the Commissioner issued regulations establishing the Guideline Class Life System (pre-1971 assets) and Class Life System (post-1970 assets) as well as specific election requirements for each. See Treas.Reg. Secs. 1.167(a)-11, 12; 26 C.F.R. Secs. 1.167(a)-11, 12 (1983). Section 1.167(a)-12(e) provides that for taxable years prior to 1977, a taxpayer desiring to use the Guideline Class Life System must make an election in either of two ways. First, the taxpayer may file Form 5006 with the tax return for that year. Id. at Sec. 1.167(a)-12(e) (3) (i). Alternatively, the election is deemed to be made if the taxpayer provides information sufficient to establish the following:

(a) Each asset guideline class for which the election is intended to apply;

(b) The class life for each such asset guideline class ...;

(c) For each asset guideline class ..., (1) the total unadjusted basis of all qualified property, (2) the aggregate of the reserves for depreciation of all accounts in the asset guideline class, and (3) the aggregate of the salvage value established for all accounts in the asset guideline class;

* * *

Id. at Sec. 1.167(a)-12(e) (3) (ii).  In either event, Schedule G of the corporate tax form also provides a box which the taxpayer must check to substantiate its election to use the Guideline Class Life method.

If a taxpayer fails to make a proper election, it is required to depreciate its equipment under the "facts and circumstances" method.  Both sides agree that certain subsidiaries of Knight-Ridder failed to comply literally with the election requirements. They failed to file Form 5006, they did not otherwise provide the information alerting the Commissioner to an election, and they failed to check the box in Schedule G.

Taxpayer argues, however, that the subsidiaries "substantially complied" with those requirements of Treas.Reg. Sec. 1.167(a)-12 which go to the essence of the legislative purposes of Section 167(m). Knight-Ridder asserts that the legislative purposes are to simplify and reduce the number of depreciation systems and to reduce the number of disputes between taxpayers and the government. It then reasons that those purposes are met when it calculates its depreciation properly under the Guideline Class Life System, reports the amount accurately on its tax return, and maintains its books and records adequately to allow an audit. Any other election requirements are merely "procedural details," unnecessary to the legislative purposes.

In support of this argument, Taxpayer cites a number of Tax Court decisions in which taxpayers had failed to meet the literal requirements for an election but the courts held that they had substantially complied. American Air Filter v. Commissioner, 81 T.C. 709 (1983); Tipps v. Commissioner, 74 T.C. 458 (1980); Columbia Iron & Metal v. Commissioner, 61 T.C. 5 (1973); Hewlett-Packard v. Commissioner, 67 T.C. 736 (1977); Sperapani v. Commissioner, 42 T.C. 308 (1964); O'Dowd v. Commissioner, 35 T.C.M. (CCU) 754 (1976), aff'd, 595 F.2d 262 (5th Cir. 1979). The courts looked to see whether specific requirements related to the "essence" of the statutory and regulatory scheme. See Tipps, supra, 74 T.C. at 468; Valdes v. Commissioner, 60 T.C. 910, 913 (1973). If not, then literal compliance was not necessary for a valid election. The court in Hewlett-Packard listed a number of factors to be considered:

In ascertaining whether a particular provision of a regulation stating how an election is to be made must be literally complied with, it is necessary to examine the purpose, its relationship to other provisions, the terms of the underlying statute, and the consequences of failure to comply with the provision in question. * * *

67 T.C. at 749, quoting Valdes, supra, 60 T.C. at 913.

Applying that same analysis here, we find that the Taxpayer has overlooked certain essential purposes of I.R.C. Sec. 167(m) and Treas.Reg. Sec. 1.167(a)-12. First, the Congress plainly intended that each taxpayer's election be binding. An election to come under the class life system for a taxable year may not be changed or revoked. See S.Rep. No. 92-437, 92nd Cong., 1st Sess. 49, H.R.Rep. No. 92-533, 92nd Cong., 1st Sess. 33, U.S.Code Cong. & Ad.News 1971, p. 1825. This policy is furthered by requiring a clear manifestation to the government of taxpayer's election. Merely calculating depreciation accurately without expressly electing the system would leave room for the taxpayer to argue later that it had never intended to make an election but, rather, was applying the facts and circumstances test. The taxpayer could, therefore, argue that it was not bound to meet other conditions put on the class life system by the Commissioner, see I.R.C. Sec. 167(m) (3), or by Congress itself. 

A related regulatory goal is that the Commissioner actually know an election has been made. This ultimately serves the policy of minimizing disputes between taxpayers and the Internal Revenue Service. See Treas.Reg. Sec. 1.167(a)-12(a) (1). A clear indication of the taxpayer's election to employ the class life system removes any ground for dispute over whether the system applies and what the appropriate useful life should be. Moreover, informing the Commissioner of an election helps him to assess whether the system is being abused--for example whether the taxpayer is applying the wrong class life to a particular asset class. Alternatively, if the taxpayer has not informed the Commissioner of an election, the Commissioner can be sure that the system does not apply and can better assess the taxpayer's analysis of facts and circumstances.

In sum, the elaborate election provisions of section 1.167(a)-12 are designed to inform the Commissioner that an election has been made and which asset classes it affects. We are not saying that each and every requirement is critical, but the goal of clearly informing the Commissioner of an election is essential.

In all but one of the "substantial compliance" cases cited by Knight-Ridder, the taxpayer's return indicated that an election was being made even though the taxpayer had failed to comply with a minor procedural detail. For example, in Tipps, the taxpayer clearly indicated on its form that it was electing to employ accelerated depreciation pursuant to I.R.C. Sec. 167(k). It specified the election and the property to which it would apply, failing only to supply certain "per unit information." The court held that "Even if the per-unit information had been filed exactly as [the Commissioner] desired, [he] would not have had any additional information identifying or describing the property to which the elections applied or specifying that the elections were being made." 74 T.C. at 468. Since the taxpayer had effectively reported that it was making an election, the court held that it had substantially complied with the election requirements. Id.

Similarly, in Columbia Iron and Metal, the taxpayer indicated on its return that it was electing to take a charitable deduction; its failure to attach corporate minutes authorizing the charitable contributions did not prevent an effective election. 61 T.C. at 6-7, 9. Finally, in Hewlett-Packard, O'Dowd, and Sperapani, the taxpayer's failure to meet certain procedural requirements did not prevent substantial compliance with election requirements, where the taxpayer in each case had clearly notified the Commissioner of its intent to make an election. See Hewlett-Packard, supra, 67 T.C. at 747-49 (taxpayer filed information specified by regulations but attached it to wrong part of the return and mailed it to wrong office of Internal Revenue Service); O'Dowd, supra, 35 T.C.M. 754 (election to have business taxed as corporation was filed, but not signed by wife or principal shareholder); Sperapani, supra, 42 T.C. at 329-331 (taxpayer filed timely election to have business taxed as partnership, but failed to attach a supporting statement). 

By contrast, nothing in the returns of Knight Newspapers and the seven subsidiaries indicated that they were electing the Guideline Class Life System. Their returns were especially misleading, because two other subsidiaries of Knight-Ridder  did check the box and did file Form 5006 electing the Guideline Class Life System. Since all of the returns were filed jointly and some showed an election while others did not, the implication was that the latter group had not made the election. This implication was reinforced because four members  of the latter group had actually checked the box electing the Class Life ADR System (post-1971 assets), but had not checked the adjacent box for the Guideline Class Life System (pre-1971 assets). The forms clearly seemed to state that these subsidiaries were electing Class Life ADR but not Guideline Class Life. 

Taxpayer argues, however, that the government does not need an explicit election, because it can discover the errors on audit. That argument does not answer our concerns. The Commissioner needs to know that an election has been made in order to determine whether an audit is necessary in the first place and what its scope should be. The information required by the election provisions of section 1.167(a)-12 directly serves this policy. Therefore, we cannot agree that the requirements are mere procedural details. On the contrary, they go to the essence of the regulatory scheme. In failing to indicate in any manner that it was making an election, Taxpayer failed to comply substantially with section 1.167(a)-12. The subsidiaries that did not meet the election requirements are not entitled to employ the Guideline Class Life System for the years in question. 

The third major issue in this case concerns whether the advertising rebate reserve used by the Detroit Free Press was an "accounting method" or simply an "improper deduction." If the reserve was not an accounting method, then the Commissioner would be barred by the statute of limitations from challenging any rebate reserve deductions taken before 1972.

If, on the other hand, the reserve was an accounting method within the meaning of the Internal Revenue Code, then the Commissioner would not be barred. Ceasing to use the reserve in 1972  would constitute a change of accounting method; and I.R.C. Sec. 481 would permit the Commissioner to make certain adjustments in taxpayer's income to prevent a duplication of income or deductions resulting from the change.  26 U.S.C. § 481. In particular, if Taxpayer had deducted an item under the former method and the item would again be deducted in a future year under the new method, the Commissioner could force an adjustment to prevent the double deduction.  The effect is to permit the Commissioner to correct for deductions made in tax years beyond the normal limitations period. See Graff Chevrolet v. Campbell, 343 F.2d 568, 571-72 (5th Cir. 1965). The seeming inconsistency between section 481 and the statute of limitations has been justified on the ground that:

When a taxpayer uses an accounting method which reflects an expense before it is proper to do so or which defers an item of income that should be reported currently, he has not succeeded (and does not purport to have succeeded) in permanently avoiding the reporting of any income; he has impliedly promised to report that income at a later date, when his accounting method, improper though it may be, would require it. Section 481, therefore, does not hold that taxpayer to any income which he has any reason to believe he has avoided, and does not frustrate the policy that men should be able, after a certain time, to be confident that past wrongs are set at rest.

Id. at 572, quoting Note, Problems Arising From Changes in Tax-Accounting Methods, 73 Harv. L. Rev. 1564, 1576-77 (1960).

Section 481 applies only if there has been a change in accounting method, however. Thus, the dispute between Taxpayer and Commissioner boils down to a single basic issue--whether a rebate reserve is an accounting method. Knight-Ridder contends that the reserve was merely an improper deduction. We disagree and hold that the reserve was an accounting method; therefore, the Commissioner was entitled to make the appropriate section 481 adjustments.

The Internal Revenue Code does not specifically define an "accounting method." However, the implementing regulations provide:

A change in accounting method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of a material item used in such overall plan....

A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction.

Treas.Reg. Sec. 1.446-1(e) (2) (ii) (a); 26 C.F.R. Sec. 1.446-1(e) (2) (ii) (a) (1983) (emphasis added); see also Treas.Reg. Sec. 1.481-1(a) (1); 26 C.F.R. Sec. 1.481(a) (1) (1983).  The essential characteristic of a "material item" is that it determines the timing of income or deductions. See Bittker, supra note 1, p 105.6.2, at 124-25.  For example, there is a change in the treatment of a material item when a taxpayer shifts from deducting dividends when paid to deducting them in the year they are declared. See Commissioner v. O. Liquidating Corp., 292 F.2d 225 (3rd Cir. 1961), cert. denied, 368 U.S. 898, 82 S. Ct. 177, 7 L. Ed. 2d 94 (1961).

The change of a single item may trigger section 481 adjustments. Graff Chevrolet v. Commissioner, supra, 343 F.2d at 570-71.

In the case at bar, the Free Press's rebate reserve was an item which affected the timing of a deduction. There is no question that a deduction would be proper in the year that rebates were actually paid to advertisers. The reserve method merely accelerated the taking of that deduction to the time when the amounts were originally added to the reserve. Later, when the rebates were paid, the reserve was reduced accordingly. The reserve did not determine whether or not a rebate would be deducted, but when that deduction would occur.

Taxpayer, however, refers to Schuster's Express v. Commissioner, 66 T.C. 588 (1976), aff'd per curiam, 562 F.2d 39 (2d Cir. 1977), in which the Tax Court faced a similar reserve account and concluded that it was not an accounting method within the meaning of section 481. The taxpayer had maintained a reserve for insurance expenses and deducted amounts added to the reserve. When the taxpayer abandoned the method, the Commissioner attempted to require section 481 adjustments. The Tax Court held that section 481 did not apply because the reserve was not a material item. The court argued that the reserve did not involve the timing of deductions. 66 T.C. at 596-97.

The court's reasoning is not entirely clear.  However, the main concern seems to be that the taxpayer had made larger contributions to the reserve than were necessary. There was an excess balance that had never been--and might never be--offset by actual insurance expenditures. The court felt that this excess did not involve the mere timing of an otherwise proper deduction, because the deduction might never match up with a proper expense. The taxpayer could avoid income for all time rather than simply deferring it. Id. 

Knight-Ridder would raise the same objection in our case, for the balance of the rebate reserve account never decreased after 1971. See supra at 786. We do not agree, however, that this undermines the argument that the rebate reserve involved a question of timing. To understand this, it is helpful to realize that though we talk about the timing of deductions, the basic issue is whether income is reflected and taxed. The reserve method determines when income will be taxed. When deductions are taken early (at the time money is added to the reserve), an equal amount of income is obviously not taxed. That income is taxed, however, at the later time when deductions would have been taken under a different system (i.e., at the time rebates are paid, the absence of deductions means that an equal amount of income is taxed). Most important, at the time the company ceases to use the reserve (e.g., when the company closes out its business), any remaining balance in the reserve must be included in taxable income. See Levelland Savings and Loan Assoc. v. United States, 421 F.2d 243, 246 (5th Cir. 1970); Bird Management v. Commissioner, 48 T.C. 586, 595 (1967); Hawes Corp. v. Commissioner, 44 T.C. 705, 707 (1965).  Thus, no income is avoided altogether. Any excess deductions in earlier years are offset by an equal amount of taxable income in the final day. The question becomes one of timing, whether income is taxed when the amounts are added to the reserve or when the reserve is abandoned at the Day of Armageddon.  Thus, Taxpayer's rebate reserve method was a "material item" and a method of accounting within section 481. Compare Rev.Rul. 81-93 (insurance expense reserve a method of accounting).

We note, incidentally, that the 1954 Congress intended to treat a similar statutory "reserve for estimated expenses" as an accounting method. Section 462 of the 1954 Code authorized taxpayers to keep reserves for expenses that could be estimated with "reasonable accuracy." See S.Rep. No. 1622, supra, 1954 U.S.Code Cong. & Ad.News, at 4945. A taxpayer could establish such a reserve to cover the cost of quantity discounts, id. at 4946, and could deduct anticipated expenses in the year they were added to the reserve.

The legislative history to the accounting provisions (sections 446 and 481 ), indicates that the adoption or abandonment of a section 462 reserve would constitute a change of accounting method:

A change in the method of accounting ... includes a change from an accrual method without estimating expenses to an accrual method with estimated expenses, or vice versa....

Id. at 4940; H.R.Rep. No. 1337, supra, 1954 U.S.Code Cong. & Ad.News, at 4297.

Congress repealed section 462 in 1955 because the deduction of estimated expenses threatened a serious revenue loss during the transitional period. See B. Bittker and L. Stone, Federal Income Taxation 1057 (1980); Chirelstein, supra note 1, at 221. Nevertheless, the legislature's words in the 1954 reports give an indication of Congress's view of reserves in general and further substantiate our conclusion that the rebate reserve is a method of accounting. The Commissioner did not err in requiring Taxpayer to make adjustments when it changed that method.

CONCLUSION

In sum, we hold that

(1) the Commissioner did not abuse his discretion in requiring Page and Bradenton to adopt the accrual method of accounting;

(2) Knight Newspapers and its seven subsidiaries did not substantially comply with the requirements for electing Guideline Class Life depreciation; and

(3) the Detroit Free Press was required to make section 481 adjustments when it ceased to use its rebate reserve method.

Accordingly, this case is

REVERSED and REMANDED.

“Could anyone imagine 10 years ago saying that in 10 years, Knight Ridder would not exist?” asked Jay T. Harris, a former publisher for Knight Ridder at The San Jose Mercury News who quit in 2001 rather than make cuts that the company sought. “It was one of the strongest newspaper companies in America. How could you have a hand like that and play it in such a way that you would end up losing everything?”

The dismantling of Knight Ridder is a study of the hurdles facing publicly traded newspaper companies in a time of seismic change in the industry. The migration of readers and advertisers to the Internet, as well as rising costs and falling revenue, are threatening the financial well-being — even the very existence — of some of the industry’s most storied brand names.

A review of the dynamics behind the Knight Ridder sale and the aftermath of its breakup also offers a cautionary tale: that deep cuts in expenses to satisfy Wall Street will not necessarily save a newspaper company, and may not even bring financial gains to shareholders or buyers.

“Financial restructuring is not the answer to what ails the newspaper industry,” said Peter P. Appert, a newspaper industry analyst at Goldman Sachs, which advised Knight Ridder during the sale. “It’s not a panacea that’s going to create value from a shareholder point of view.”

LAST Thursday night, at a dinner in San Francisco, McClatchy celebrated its takeover of Knight Ridder with the bankers and lawyers who had advised the company on the transaction. But from the stock market’s perspective, McClatchy has very little to celebrate so far.

Once a Wall Street darling, McClatchy — like most other newspaper companies, including The New York Times Company — has seen its stock price plunge. McClatchy’s stock closed at $39.03 on June 27, the day it acquired Knight Ridder, well below its 52-week high of $67.23 . The stock has yet to recover; it now trades at $40.19. (Gary Pruitt, the chief executive of McClatchy, said the company’s weak stock performance was “more a reflection of industry trends than a verdict on the deal,” although Wall Street is concerned about the debt McClatchy incurred in the transaction.)

McClatchy quickly sold 12 of the 32 papers picked up in the Knight Ridder acquisition. All 12 ended up in private hands, and at least one has been subject to further cutbacks. Last Tuesday, Black Press Ltd., which bought the ailing Akron Beacon Journal from McClatchy, announced that it was laying off a quarter of the 161 employees in The Beacon Journal’s newsroom.

Mr. Sherman’s own portfolio of newspaper holdings is now worth about 16 percent less than it was just before he forced the Knight Ridder sale. He had a modest gain on his Knight Ridder shares, but that was offset by the downturn in his holdings of McClatchy.

“Our investment in newspaper stocks continues to cause concern for some clients,” Mr. Sherman wrote in a letter to clients earlier this summer. “Given the disappointing returns thus far, we understand their consternation. In some regards, it would be easier for us to abandon the investment theme than to continue to argue the point.”

While Mr. Sherman’s firm has been shedding some of its newspaper stocks, largely at the direction of dissatisfied clients, about 10 percent of his portfolio remains invested in newspapers. (As of June 30 his firm owned 13 percent of the common stock of The New York Times Company.)

Despite the industry’s woes, some in the newspaper industry have sharply criticized Mr. Ridder for not fighting harder to save his company. He had been acquiescing to Wall Street for years, they say, and his sale of the company was only the final, most striking, example.

“The real story of the fall and decline of Knight Ridder is not Bruce Sherman,” said James M. Naughton, once executive editor of The Philadelphia Inquirer, formerly a Knight Ridder paper, and a retired president of the Poynter Institute for Media Studies. “It’s the notion that you can continue whittling and paring and reducing and degrading the quality of your product and not pay any price. Tony’s legacy is that he destroyed a great company.”

Mr. Ridder, whose great-grandfather founded one of Knight Ridder’s predecessor companies in 1892, dismisses such criticism. “I’m very proud of the journalism of Knight Ridder, and I think Jim Naughton is a bitter guy who was passed over for the top editor’s job,” he said in an interview on Friday. “The issue was what’s happened to the newspaper industry over the last couple of years and the growth of revenue. To say that if we had more people in our newsrooms this could have been avoided is incredibly naïve.”

The paradox for Knight Ridder is that it was making good money when it put itself on the auction block. Its profit margin when it was sold was higher than that of many Fortune 500 companies, including ExxonMobil. But Wall Street’s pessimism about the industry’s ability to overcome its problems kept driving down newspaper shares, including Knight Ridder’s. Mr. Ridder’s decision to sell helped persuade Wall Street that the company’s management lacked confidence in the industry’s future. The sale was a sign of defeat.

When the sale was announced in March, Mr. Ridder said that Mr. Sherman had backed him into a corner. He said he was “upset” and “depressed,” and when the sale became final in June, he pronounced the day a sad one.

Nearly three dozen potential buyers were contacted when Knight Ridder went on the block, and 21 responded. All but two took a pass. (In addition to McClatchy, a consortium of private-equity firms stepped forward but never made a final offer.)

Analysts concluded that the paucity of bidders suggested there was no longer a market for big newspaper groups as a whole. But McClatchy’s ability to sell a dozen of the Knight Ridder papers after the sale indicated that individual newspapers had value. “No one would have anticipated that a year ago,” said Lauren Rich Fine, an analyst at Merrill Lynch. “A year ago there was a presumption that Gannett and Tribune were still buyers of groups of newspapers and that private equity would be very interested, too.”

But in the interim, powerful changes in the industry — particularly the accelerating shift of advertisers from print to online and the effect on big-city dailies — changed the equation.

“The business is not as sickly as all the rhetoric would suggest, but a year later the industry is in declining health, with cost pressures galore,” Ms. Fine added.

That leaves bleak options for newspaper companies that lack the financial resources to ride out the current upheaval or do not have the ingenuity to reinvent themselves to remain profitable purveyors of information, analysis and entertainment in the digital age.

Knight Ridder, formed in 1974 by the merger of Knight Newspapers and Ridder Publications, initially defied conventional wisdom that newspaper chains could not produce excellent newspapers; it racked up a large slate of journalism awards. But by the early to mid-1990’s, newsprint costs were spiraling out of control, and revenue at many papers was sagging.

Knight Ridder responded by making deep reductions in its staff and scaling back its offerings. This was years before Mr. Sherman came calling, and it left Knight Ridder walking a narrow line.

“It was trying to promise shareholders improving margins at the same time it was trying to preserve the culture of quality, and in that sense it couldn’t be true to anyone,” Ms. Fine said. “But you can’t cut the journalism and still put out a good paper.”

Still, Knight Ridder’s profit margin hovered at 20 percent until this year, when it slipped to about 16.4 percent largely because of severance packages in Philadelphia and San Jose. That was almost three points below the industry average of 19.2. Historically, the newspaper industry has produced even higher margins, which helped to raise expectations of investors looking for value investments in traditional media stocks despite the industry’s problems.

Mr. Sherman’s Private Capital Management began investing in Knight Ridder in April 2000, and by 2004 it had become the company’s largest shareholder, with a 19 percent stake. Mr. Ridder said Mr. Sherman was optimistically buying newspaper stocks after the Internet bubble burst because he was driven by the belief that “the Internet is not going to be as big a factor for the industry, so we’ll go with newspapers.”

But by mid-2004, newspaper ad revenues had taken a turn for the worse and stocks across the industry started to slide. By the spring of 2005, Mr. Sherman, who, by some accounts, was overextended in newspapers, had fully 14 percent of his portfolio invested in the sector.

Mr. Sherman first approached Mr. Ridder in April 2005 about selling the company, according to proxy statements. Because of their stock structure, Knight Ridder and Gannett, in which Mr. Sherman also held a stake, were vulnerable to unhappy shareholders. According to people who have spoken with Mr. Sherman, he thought that Gannett was probably too big for any other newspaper company to buy, but he was also frustrated with Knight Ridder.

Last November, Mr. Sherman delivered a letter to the Knight Ridder board, saying that the company’s shares were undervalued; he pressed for an “aggressive” effort to sell it. He said Knight Ridder had failed to address four major issues: the consolidation of print advertising; media fragmentation that was diverting newspaper ad dollars to other media; margins that fell below the industry standard, and the lack of a strategy to leverage its content online.

MR. SHERMAN was intent on a sale and planned to carry it out by having his own slate of directors elected to Knight Ridder’s 10-member board, according to proxy statements. Mr. Ridder said the board believed him. “We were convinced that they would get three directors elected in April so they would have three of 10, then seven of 10 in April ’07 and then the game was over,” he said.

Had Mr. Ridder tried to resist, the agitators might have taken over the board and simply thrown Mr. Ridder out. “Wall Street would have sold him down the river in a heartbeat,” said Edward Atorino, a media analyst at the Benchmark Company, a financial research firm.

Once Mr. Ridder decided to sell, he did not discuss his company’s prospects publicly. But behind the scenes, according to several people involved in the talks with prospective buyers, Knight Ridder tried to elevate potential buyers’ interest by saying that there was still room to cut costs and that the company could become more profitable.

That pitch was based in part on a report by Morgan Stanley, which had said that a new owner could save $150 million a year by reducing Knight Ridder’s work force by 5 percent, trimming benefits and streamlining corporate expenses. Knight Ridder also suggested that copy-editing functions could be consolidated, even among far-flung papers. And it said that the physical size of the newspapers could be reduced, something that many papers, including The New York Times, are doing or are planning to do in order to save on newsprint costs.

Mr. Ridder’s public silence fostered a perception that he had no heart for a fight.

“He gave up,” said Brian P. Tierney, the adman who led the group of investors that bought the Philadelphia newspapers, The Inquirer and The Daily News. “I’m sure he could have found investor bankers who, if they saw the fight in your eye, they would have said, ‘You have a chance.’ But it’s like someone getting a bad report from the doctor and not trying to beat the disease.”

At the time of the sale, Ms. Fine recommended to Knight Ridder that it consider other options. “I said, if you have the conviction that the news business and the online are a win, put up a ‘work in progress’ sign and say that margins are going to go down” while the company retrenches, she said.

She said she still thought that Knight Ridder, as well as other newspaper companies, could benefit from fresh management at the top, “an outsider with a healthy respect for journalism but who has no ties to the way business has been done.”

Some thought that Mr. Ridder could have sold off pieces of the company in order to keep it afloat. William Dean Singleton, the chief executive of the MediaNews Group, which eventually bought four of the Knight Ridder papers from McClatchy, was one.

“In retrospect, if Tony had it in him to sell Philadelphia and Akron, as Gary has done, the company he had left would have looked good,” he said, referring to Mr. Pruitt’s sale of the Knight Ridder papers in those markets. Without those papers, Mr. Singleton said, “his financial performance would have been among the best in the industry.”

MR. RIDDER said that none of these options would have worked. Selling off underperforming papers would have produced hefty capital gains taxes. And even as those papers were lagging, they were still generating enormous cash flow, which he said he did not want to give up. Selling the papers, he said, would be a “liquidation” strategy, not a strategy for growth.

But to McClatchy, absorbing such taxes on the 12 papers it sold was worth the short-term hit. “We’ll pay $585 million in taxes as a result of selling those papers,” Mr. Pruitt said. “But long term, it put us in a stronger position. We wouldn’t have done the deal if we hadn’t been able to sell those papers.”

In any case, Mr. Ridder, who said Mr. Sherman had never complained to him about how he ran the company, said he felt he had two choices: “We could have this public battle and eventually lose, or we could have some control over the process.” If the company did not like the bids it received, he said, it could have refused them, although financial analysts said that would have created an uproar on Wall Street.

“Part of me would have loved to have had this fight,” Mr. Ridder said. “But what was the point? To look macho? I would have felt better, but there would be all this turmoil.” He said the chief lesson he had learned was this: “For those who have two classes of stock, don’t ever give them up.”

Knight Ridder had a single-class stock structure that made it vulnerable to restive shareholders in a way that companies with a regular class of common stock paired with a special class of voting stock — The New York Times and The Washington Post, for example — are not. But the lack of interested buyers in Knight Ridder, and broader changes undermining the industry’s financial health, mean that even companies with two-tiered stock structures may not remain insulated from pressures that continue to rock the industry.

Very few in the industry, either on the news side or the business side, seem to believe that public ownership is worth the grief, at least in the current climate.

“There’s a big lesson in terms of the pressures of public stock ownership,” said Larry Jinks, who had been a Knight Ridder senior vice president for news and was a top executive at two of its papers. “Particularly with mature businesses, those pressures can be destructive, and I think they were in the case of Knight Ridder. There’s a tendency over time with public ownership for the editorial presence in the corridors of power to decline.”

Mr. Appert of Goldman Sachs said he expected that the Knight Ridder experience might persuade public newspaper companies to take themselves private.

“You’ll have these financial pressures forever,” he said. “To the extent you want to maintain the same level of quality, maybe you are better off not being subject to the public financial market.”

Mr. Pruitt said McClatchy’s public ownership offered him a leg up: if it were private, he would not have been able to use stock as part of his currency when buying Knight Ridder. He said that going private is not a near-term option for him because his company has too much debt it needs to repay.

For the time being, he said, the lessons from the Knight Ridder sale are these: “The media business is tougher today than it was a generation ago, with a smaller margin for error. And in the age of shareholder activism, the consequences of market underperformance are great.”

Mr. Ridder, despite his sorrow at losing the company, said earlier this year that there was nothing he would have done differently. He said he had not reduced his expenses nearly as deeply as Wall Street sometimes wanted. “I guarantee you we could have had a higher margin if we had been tighter on costs,” he said.

Mr. Ridder said that there was a link between staff size and the quality of newspapers, but that staff reductions had not been a problem at Knight Ridder. “I wouldn’t say you could reduce the staff and it has no impact on the quality,” he said. “But I feel that over all, I don’t feel that any of our newspapers are inadequately staffed.” On Friday, he said, “I’ve not heard of anybody who has bought any of those papers say, ‘We think we need to add more resources.’ ”

Whether the former Knight Ridder papers will be better off, financially and journalistically, under new management remains to be seen. Some may get infusions of energy that had dissipated under Knight Ridder. But they will also continue to grapple with the Internet as they reorient themselves to a media world in which pressmen, truck drivers, reporters and editors are all rethinking how they do their jobs.

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