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

For any business that holds stock, the closing inventory number is one of the largest single figures on the corporate tax return. It sets cost of goods sold, and therefore profit. It is also one of the easiest numbers to get wrong — and one an auditor can test directly, because the goods either existed on the shelf at the year-end date or they did not.

The count itself

The CRA’s long-standing position is that in the usual case a physical stocktaking should be carried out at the end of the year. The exception is narrow: only where a reliable perpetual inventory system is used, and only where that system has been periodically verified against actual quantities on hand, is a year-end count not required.

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 unrealised appreciation on another.

What “cost” means

Cost is laid-down cost: the original cost of the item plus everything that can reasonably be considered to have been incurred to bring that item to its condition and location at the year end. For goods bought for resale or raw materials, that means invoice cost, customs and excise duties, transportation and other acquisition costs, and storage costs where they are significant. For work in process and finished goods it means the laid-down cost of materials, plus direct labour, plus the applicable share of production overhead. Direct costing and absorption costing are both acceptable; prime costing, which allocates no overhead at all, is not.

Which cost-flow method

Where specific items can be identified, use their actual laid-down cost. Otherwise the commonly accepted methods are specific item, average cost, and first in, first out. LIFO and the base stock method are not accepted for income tax purposes. Whichever method you use should normally be the same one used for the financial statements, and it has to be followed consistently — a change is only accepted where the new method is more realistic and gives a truer picture of income.

Write-downs: what is allowed and what is not

A write-down is simply the lower-of rule doing its job: fair market value at the year end has fallen below cost. For inventory purposes, fair market value is the same idea as “market” in the accounting phrase lower of cost or market, and generally means either replacement cost or net realizable value.

Two refinements matter in practice. Where goods have deteriorated so badly by year end that they cannot be sold through the normal channel, net realizable value — estimated selling price less reasonably predictable preparation and marketing costs — is accepted for those items even if replacement cost is used for the rest of the inventory. And for advertising or packaging material, parts and supplies, fair market value means replacement cost, except where the property is 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

Once the count is priced, reconcile it to the general ledger and investigate the difference rather than posting a plug. Large unexplained shrinkage is exactly the kind of thing that draws questions, and the explanation is usually mundane — a cut-off error, unrecorded returns, or goods issued to a job and never relieved from stock. Our guide to inventory accounting for BC businesses covers the bookkeeping side, and the count belongs on your year-end checklist alongside the bank and receivable reconciliations.

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.