INVENTORY AND COST OF GOODS SOLD

A sole proprietor who sells goods must track inventory, because the cost of goods sold is usually the largest deduction the business has. Getting the year-end inventory figure right matters twice: it fixes this year's cost of goods sold and becomes next year's opening inventory. This page covers how inventory is recorded during the year, how it is counted and valued at year end, what is included in its cost, and how damaged, obsolete or personally used stock is handled. The T2125 lines where the figures are reported are set out on the Form T2125 Line by Line page.

RECORDING INVENTORY DURING THE YEAR

• Periodic system: purchases of goods for resale are recorded in a purchases account during the year, and cost of goods sold is worked out only at year end from a physical count. Simple, and common for small retailers.

• Perpetual system: each purchase is added to the inventory account and each sale moves its cost to cost of goods sold immediately, usually through point-of-sale or bookkeeping software. It shows stock levels at any time and makes shrinkage visible.

• Count still required: even with a perpetual system, a physical count at year end is needed to confirm the records.

WHAT IS INCLUDED IN COST

• Included: the purchase price, freight-in, customs duties and other costs of bringing the goods to their present location and condition, less trade discounts and rebates received.

• Manufacturing: for goods the business makes, direct materials, direct labour and a reasonable share of production overhead.

• Sales tax: GST/HST recovered through input tax credits is not part of the cost. Provincial sales tax and any GST/HST that cannot be recovered are.

• Not included: selling costs, such as advertising and delivery to customers, and general office costs.

COST FLOW METHODS

• Specific identification: each item's actual cost is tracked. Suits unique, high-value items such as cars, jewellery or artwork.

• First in, first out (FIFO): the oldest costs go to cost of goods sold first, so closing inventory reflects the most recent purchase prices.

• Weighted average cost: each unit is costed at the average cost of all identical units available.

• Last in, first out (LIFO): not accepted for income tax purposes in Canada.

• Consistency: the method chosen must be used from year to year. A change generally requires a good business reason.

VALUING CLOSING INVENTORY

• Two options for tax: each item can be valued at the lower of its cost and its fair market value, or the whole inventory can be valued at fair market value.

• Fair market value: for goods bought for resale, generally the replacement cost; for goods the business makes, usually the expected selling price less the costs of selling them.

• Same method every year: the closing value of one year must be the opening value of the next, and the valuation method should not change from year to year.

• Artists: an individual who produces works of art can elect to value that inventory at nil, deducting the costs of producing it as they are incurred.

THE YEAR-END COUNT

• Timing: count as close as possible to the last day of the fiscal year. If the count is done a few days later, adjust for sales and purchases in between.

• Cut-off: goods received before year end and recorded as purchases must be counted; goods shipped to customers and recorded as sales must not be.

• Goods not on the premises: include stock held by others on consignment or in transit if the business owns it at year end.

• Keep the count sheets: the item, quantity, unit cost and extension, signed and dated, form part of the records the CRA may ask to see.

WORKED EXAMPLE

A retailer using the periodic system has the following for the year.

• Opening inventory: $10,000, last year's closing count.

• Purchases and freight-in: $50,000 of goods plus $2,000 of freight-in, for $52,000.

• Closing inventory: the count totals $13,000 at cost. One line of 50 units that cost $30 each now sells for only $20 to replace, so it is written down by $500, giving a closing value of $12,500.

• Cost of goods sold: $10,000 + $52,000 − $12,500 = $49,500.

WRITE-DOWNS, LOSSES AND PERSONAL USE

• Damaged or obsolete stock: valuing it below cost at year end, under the lower of cost and fair market value rule, deducts the loss through cost of goods sold. Keep evidence, such as photos or disposal records.

• Theft and shrinkage: under a periodic system, missing stock reduces closing inventory automatically and so increases cost of goods sold.

• Goods taken for personal use: their cost is removed from purchases or cost of goods sold and recorded as drawings.

• Samples and donations: goods given away for promotion are a business cost; goods donated to a registered charity can be treated as a sale at fair market value with a matching donation receipt.

KEY POINTS

• Count every year end: closing inventory drives cost of goods sold and next year's opening figure.

• No LIFO: use specific identification, FIFO or weighted average, consistently.

• Lower of cost and market: write stock down to fair market value where it has lost value.

• Cost includes freight-in: but not recoverable GST/HST or selling costs.

SOURCES

• Income Tax Act: sections 10 and 10(6); Income Tax Regulations, section 1801.

• Canada Revenue Agency: Guide T4002, Part 3D, Cost of goods sold and inventory valuation.

• Canada Revenue Agency: Interpretation Bulletin IT-473R, Inventory Valuation.