The year-end inventory count: what CRA expects to see

For a business with stock, closing inventory is among the largest figures on the corporate return: it sets cost of goods sold, and so profit. It is also easy to get wrong and easy to test, because the goods were on the shelf at year-end or they were not.

The count itself

The CRA’s long-standing position is that a physical count should normally be done at year-end. The only exception is a reliable perpetual inventory system that has been periodically verified against actual quantities on hand.

A count that will stand up later has a few features:

• It is dated. The count sheets show the date and, if the count happened a day or two either side of the year end, the roll-forward or roll-back for movements in between.
• It is by two people. One counts, one records, or a sample is recounted independently.
• It records quantity and description, not value. Pricing happens afterwards, from purchase records.
• Cut-off is documented. Note the last receiving slip number and the last shipping document number used before the count so goods are not counted and expensed twice.
• Damaged, obsolete and slow-moving items are flagged during the count, not identified from a spreadsheet in March.

Keep the original count sheets. They are the primary evidence, and the record retention rules apply to them like any other book of account.

What goes in the count

Inventory usually includes all materials to which the business has title, wherever they physically sit. The practical test for the awkward cases is ownership, not location:

• Goods in transit — include them if title has passed to you at the year-end date; the shipping terms on the purchase order decide this.
• Goods you hold on consignment for someone else — exclude; you do not own them.
• Your goods held at a customer’s site on consignment — include; you still own them.
• Goods at a third-party warehouse or fulfilment centre — include, and get a stock report from the operator as of the year-end date. This one catches out a lot of online sellers.

Putting a value on it

Section 10 of the Income Tax Act and section 1801 of the Regulations give two general methods: value each item at the lower of the cost at which it was acquired and its fair market value at the end of the year, or value the entire inventory at fair market value. Almost every small business uses the first.

The comparison is made item by item, or by usual class of items where individual items are not readily distinguishable, and the lower figure for each is carried into the total. You cannot net a write-down on one product line against unrealized appreciation on another.

What “cost” means

Cost means laid-down cost: original cost plus everything reasonably incurred to bring the item to its year-end condition and location. For resale goods or raw materials: invoice cost, customs and excise duties, transportation and other acquisition costs, and significant storage. For work in process and finished goods: materials, direct labour and a share of production overhead. Direct and absorption costing are acceptable; prime costing, with no overhead, is not.

Which cost-flow method

Where specific items can be identified, use their actual laid-down cost; otherwise use specific item, average cost or first in, first out. LIFO and the base stock method are not accepted for income tax purposes. Normally use the same method as the financial statements, consistently; a change is accepted only where the new method gives a truer picture of income.

Write-downs: what is allowed and what is not

A write-down is the lower-of rule at work: year-end fair market value has fallen below cost. Fair market value here matches “market” in lower of cost or market, and generally means replacement cost or net realizable value.

Two refinements. Goods too deteriorated to sell normally may use net realizable value — estimated selling price less predictable preparation and marketing costs — even if the rest uses replacement cost. For advertising or packaging material, parts and supplies, fair market value means replacement cost unless obsolete, damaged or defective.

So an obsolete part that nobody has ordered in two years can be written down. A seasonal line you expect to discount next spring, in a market that has not yet moved, cannot.

Tie it back to the books

Reconcile the priced count to the ledger and investigate differences instead of posting a plug. Unexplained shrinkage draws questions; the usual cause is a cut-off error, unrecorded returns, or goods issued to a job but never relieved from stock. See inventory accounting for BC businesses, and add the count to your year-end checklist.

Get the count right and the rest of the year-end file is straightforward. Get it wrong and every downstream number — gross margin, taxable income, instalments — is wrong with it.

This article is general information, not tax advice for your specific situation. Tax rules and CRA administrative positions change — confirm anything that affects a decision with the CRA or with us first.