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20.0 Valuation of inventory
(Revised April 2015)
20.1.0 Overview
(Revised November 2013)
To calculate a taxpayer’s income from a business for a tax year, determine the value of property
described in the business’ year-end inventory. Section 10 of the Income Tax Act (ITA) and
section 1801 of the Income Tax Regulations set out the rules to value inventory for this purpose.
In most cases, use either of these two methods to value inventory:
1. Value each item in inventory at the lower of original acquisition cost or its fair market
value at the end of the year.
2. Value the entire inventory at fair market value at the end of the year.
Other methods to value inventory may be available or required depending on the type of
business. For more information, go to Income Tax Interpretation Bulletin IT473R, Inventory
Valuation, at www.cra-arc.gc.ca/E/pub/tp/it473r/README.html.
20.1.1 Adventure in the nature of trade
(Revised May 2013)
As discussed in IT473R, if the business is an adventure or concern in the nature of trade,
subsection 10(1.01) of the ITA requires that the property described in the inventory of the
business be valued at the cost at which the taxpayer acquired the property.
Subsection 10(1.01) was added in response to the decision in Friesen v. The Queen (SCC) 1995.
In the case, the Supreme Court allowed the taxpayer to value a parcel of raw land (held as an
adventure in the nature of trade) in accordance with former subsection 10(1), resulting in a
business loss realized on the property before its sale. By virtue of subsection 10(1.01), such
inventory cannot be written down and any loss is only realized once the property is sold.
20.1.2 Valuation of manufactured inventory
(Revised May 2013)
The cost of work in progress and finished goods inventories includes the laid-down cost of
materials plus the cost of direct labour applied to the product and the applicable share of
overhead expense properly chargeable to production. Either direct costing, which allocates
variable overheads to inventory, or absorption costing, which allocates both variable and fixed
overheads to inventory, is acceptable as a method of costing inventory, but the method used
should be the one that gives the truer picture of the taxpayer's income. Prime costing, a method
in which no overhead is allocated to inventory, is not accepted for income tax purposes as a
method to cost inventory.
20.1.3 Incorrectly valued inventory
(Revised November 2013)
In the absence of a direction under subsection 10(3) of the ITA at the time of assessment,
generally accepted accounting principles (GAAP) require that the opening and closing
inventories be determined on the same basis to arrive at the taxpayer's profit for the year.
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Subsection 10(3) provides that if a taxpayer's inventory at the beginning of a tax year has not
been valued as required by subsection 10(1), the minister may direct that it be deemed to have
been so valued for the purpose of computing the taxpayer's income for the year. Subsection 10(3)
provides a mechanism whereby the method used to value inventory at the year-end can be
changed by the Canada Revenue Agency (CRA) from an unacceptable to an acceptable method
without also adjusting the value of the inventory at the beginning of the year. The authority to
make a direction under subsection 10(3) is a delegated power by virtue of subsection 220(2.01).
For a list of delegations from the minister of national revenue (many acts) and the commissioner
of revenue (Corporations Tax Act (Ontario) and part of the Excise Tax Act), go to Delegation of
powers, duties, and functions, at www.cra-arc.gc.ca/tx/tchncl/dlgtnfpwrs/menu-eng.html. For a
list of ITA delegations, by ITA section, go to Authorization to Exercise Powers or Perform
Duties of the Minister of National Revenue, at www.cra-arc.gc.ca/tx/tchncl/dlgtnfpwrs/mnstr/itaitr-11-eng.html.
If a taxpayer's opening inventory has been incorrectly valued, it is necessary to issue a
ministerial direction regarding that opening inventory before reassessing to adjust an incorrect
closing inventory value for the same tax year. If the inventory value is being corrected for more
than one tax year, the direction is made for the earliest tax year adjusted. Go to Appendix
A-20.1.1, Sample letter, for a template letter to make a direction under subsection 10(3).
20.1.4 Retail inventory method to value inventory
(Revised April 2015)
Since the general effect of the retail inventory method is to value the inventory at the lower of
cost or market, the method is generally acceptable to CRA if it meets these three conditions:
1. The business has many different commodities for resale (for example, a grocery store
or a department store).
2. The values are established in accordance with GAAP.
3. The established values are used for both tax and financial statement purposes.
To use the retail inventory method, determine a cost ratio by recording purchases both at cost
and at retail (selling price). The total amount of the opening inventory at cost plus purchases
during the year (or other relevant period) at cost is compared to the total amount of the opening
inventory at retail plus purchases during the same period at retail.
To determine the estimated inventory value, apply the resulting cost ratio to the book inventory
at retail (the price being asked at that time) or, if a physical inventory count is taken, to the retail
value of that physical inventory count.
Before making a proposal to the taxpayer for apparently undervalued year-end inventory based
on the use of a variation of the retail inventory method, consider if the taxpayer's approach is
reasonable from an overall perspective. If the taxpayer's method does not materially distort the
year-end inventory amount, accept that overall amount, even if it differs somewhat from the
calculated amount described in this section. However, if there are concerns that the method the
taxpayer used could result in a material distortion in the future, bring it to the taxpayer's
attention. Notify the taxpayer in writing of deficiencies in the method used and of changes
required for future years. The Taxpayer Bill of Rights affirms the taxpayer’s right to complete,
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accurate, clear, and timely information. For more information, go to www.craarc.gc.ca/E/pub/tg/rc4417/README.html.
If the retail inventory valuation used by the taxpayer for tax purposes is according to GAAP and
the information is also used by third parties, such as banks, shareholders, and creditors, the CRA
will not challenge the valuation unless the taxpayer or the person filing the information has made
or participated in making a false statement or omission as described in subsection 163(2) of the
ITA.
Determine and apply a cost ratio
The following example sets out three methods to determine the cost ratio, the effect of markups
and markdowns on the determination, and the estimated inventory value by applying the
respective cost ratio to the closing inventory at retail. The three methods acceptable to the CRA,
provided the same cost ratio method is used consistently from year to year, are:
1. Include markups, exclude markdowns.
2. Include markups, include markdowns.
3. Exclude markups, exclude markdowns.
Businesses normally use the first method. Exclude markdowns to determine the cost ratio to
apply to the retail price of goods in inventory. The valuation will be equivalent to lower of cost
or market, where market means net realizable value less a normal profit margin. This
valuation, established under the retail inventory method, is according to GAAP and is acceptable.
Note however, that to determine market under methods other than the retail inventory method,
the CRA will accept net realizable value - the established selling price in the ordinary course of
business less reasonable predictable preparation and marketing costs. However, a further
reduction to preserve a normal profit margin, if any, for subsequent years will not be accepted.
Example
Purchases at retail
Opening
inventory
Purchases less
returns
Purchases at
cost
1.
Include
markups
Exclude
markdowns
2.
Include
markups
Include
markdowns
3.
Exclude
markups
Exclude
markdowns
$ 20,000
$ 30,000
$ 30,000
$ 30,000
80,000
120,000
120,000
120,000
8,000
8,000
Markups - net (1)
Markdowns - net (2)
TOTAL
Cost ratio (cost to
(6,000)
$100,000
$158,000
$152,000
$150,000
63.29%
65.79%
66.67%
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retail)
Closing inventory - retail (6)
Closing inventory value
$ 32,000
$ 32,000
$ 32,000
(3) $ 20,253
(4) $ 21,053
(5) $ 21,334
(1) Markups less markup cancellations
(2) Markdowns less markdown cancellations
(3) Equivalent to lower of cost or market
(4) Equivalent to cost
(5) Equivalent to an amount that allows for a normal profit
(6) Closing inventory will be the same in each case after taking into account markups,
markdowns, and sales less returns (assume $120,000)
Reductions of inventory value determined under the retail inventory method
The retail inventory method is based on averages and assumes that all required markdowns have
been made to prices to which the cost ratio has been applied. This method may overvalue the
inventory to some extent, as discussed above. A further reserve is appropriate in such
circumstances.
Turnover distortion
The cost ratio reflects an average rate of markup. Because the proportion of low markup goods
and high markup goods in the closing inventory is not the same as in the goods offered for sale,
applying this average rate to the closing inventory at retail often results in its overvaluation.
Usually, goods with a low markup turn over more rapidly than goods with a high markup.
Consequently, at year-end, proportionately less of the low markup goods would normally be in
inventory. When this is the case, applying an average rate of markup will overvalue inventory.
The extent of this overvaluation depends on the degree of inventory departments or categories. If
there is a wide variation in markups, use a separate cost ratio for each department or category of
goods and the degree of error will be less than if an overall cost ratio is used for the whole
business. Also, if the markup rate is not uniform throughout the year, periodically compute the
cost ratio to reduce the overvaluation.
If there are high and low markups, the taxpayer may develop separate cost ratios from records
kept for each department, each section within the department, or appropriate classifications of
goods with similar markups and these may be used to support a reduced value. Use cost ratios
based on records maintained for special circumstances or conditions, such as sales events.
If a taxpayer fails to provide adequate information to support the reduction claimed to
compensate for turnover distortion, it may be appropriate to disallow the partial or total
reduction, depending on materiality.
Future markdowns
The timing of markdowns has an important bearing on the valuation of inventory. The asking
prices of goods included in inventory may not in some cases reflect the prices that will
eventually be realized. Although it may be known that asking prices of certain goods will be
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eventually reduced as the result of events that occurred before the inventory date, the timing as to
when each particular price markdown should be taken is a matter of judgement. Consider factors
such as market conditions, type, and selling cycle of the goods. In some cases, losses in use due
to obsolete, slow-moving, or shop-worn goods may not have been recognized by markdowns
before the inventory date and heavy markdowns are made immediately after the business
year-end. This may be occasioned by an effort to clear out such goods.
The CRA will accept a reduction in the valuation arrived at under the retail inventory method for
future markdowns only if they relate to events that occurred before the inventory date, that is, the
reduction in value must have taken place before that time. Normally, the reduction by a certain
percentage will depend on the taxpayer's policy of taking markdowns and on past experience as
disclosed by the taxpayer’s records. However, consider conditions existing at the particular
year-end. The reduction is sometimes determined by relating the markdowns taken in the
turnover period immediately following the previous year-end with the inventory at that year-end
(preferably by department or classification of goods), and applying that ratio to the current
inventory. To determine this ratio, do not assume that all markdowns in this turnover period
result from events, conditions, or circumstances that occurred before the inventory date. Certain
categories of markdowns are a cost of the period in which they occur and therefore, should be
excluded. To account for markdowns:
•
used as a promotional device (to stimulate sales or meet price competition), record the
cost in the period of the promotion;
•
due to poor buying or selling policies or other operational factors, account for in the
period in which the policies were in effect or the operational factors occur;
•
arising from economic factors or any other conditions that affect the saleability of goods
(such as changes in style or customer buying habits), charge to the period in which the
conditions arose; and
•
taken according to general pricing policy or normal business practice, record the cost in
the period of the markdown.
Markdowns immediately after year-end may provide audit evidence about existing conditions at
the inventory date. Take care to segregate irrelevant markdowns, as discussed above.
If a taxpayer fails to provide adequate information to support the reduction claimed for future
markdowns, consider disallowing the partial or total reduction.
How the cost ratio is determined
Consider the extent of any overvaluation that may be present because of the circumstances
described above and review the taxpayer’s selling techniques. Some retailers may use the
promotional device of displaying some goods at an inflated markup and immediately mark the
goods down for subsequent sale. Using a cost ratio without taking such promotional markdowns
into account, results in undervalued inventory. When this happens, consider adjusting the extent
of the undervaluation.
20.1.5 Valuation of nursery stock
(Revised May 2013)
Nursery inventory includes all growing plants whether growing in the field or not (for example,
in beds, flats, or pots, and includes the containers and soil for potted plants).
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Growing and maintaining plants, trees, and flowers for resale is full of obstacles. The uncertainty
of the final saleability of the nursery stock makes it very difficult, if not impossible, to accurately
value the stock for inventory purposes.
The industry practice is to value this inventory at a nominal value of $1.00. This practice is also
acceptable to the CRA for income tax purposes.
An inventory of plants, trees, and flowers purchased solely for immediate resale, however, does
not qualify for this treatment, and must be valued according to a method normally acceptable to
the CRA.
20.1.6 Section removed
(Revised May 2013)
The information from this section is now included in Appendix A-20.1.1.
20.1.7 Farm inventory valuation
(Revised April 2015)
Farmers and fishers are allowed to choose the cash method of accounting, as opposed to the
accrual method, see ITA section 28. Using the cash method will generally mean that inventory
amounts will not appear on the balance sheet as they have been expensed. A small percentage of
farmers may still maintain a “basic herd” as defined in ITA subsection 29(3), which is treated
similar to capital assets.
For those that opt for the cash method, paragraph 28(1)(c) requires that they track, at a minimum,
inventory that has been purchased (as opposed to propagated, bred, or developed). This is
normally referred to as the “mandatory inventory adjustment.” In a loss year, paragraph 28(1)(c)
requires an add back of the lesser of:
•
the loss from that year; and
•
the value of purchased inventory on hand.
ITA subsection 28(1.2) says that the “value” of the inventory is the lesser of the total amount
paid for acquisition and fair market value. There is an exception for the valuation of horses and,
if the taxpayer elects, for bovines registered under the Animal Pedigree Act.
Paragraph 28(1)(b) allows an optional inventory adjustment. If the fair market value of the entire
inventory (purchased or otherwise) exceeds the mandatory inventory adjustment, the taxpayer
may add that amount or any part thereof.
At a minimum, the farm business must track “cash cost” of purchased inventory in order to
determine lesser of cost or fair market value. Farm inventory may be:
•
livestock;
•
other animals, birds, fowl, fish, etc.;
•
silage feeds;
•
nursery plants or seedlings.
More topics relating to the valuation of inventory will be added to this chapter to reflect new or
changes to existing policies and procedures.
20.2.0 Reference
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(Revised November 2013)
For more information, go to Income Tax Interpretation Bulletin IT473R, Inventory valuation, at
www.cra-arc.gc.ca/E/pub/tp/it473r/README.html.
Appendix 20.1.0 Letters
(Revised May 2013)
A-20.1.1 Sample letter
(Revised May 2013)
Date
Name of Taxpayer
Address
City/Town, Province, Postal Code
Attention: (insert name of contact and title)
Dear (insert name of contact):
Re:
Your corporate income tax return for the taxation year ended (insert date)
BN: (insert number)
As a result of our audit of your income tax returns, the (month, day, year; for example, June 30,
1998) inventory of your business was determined to be an amount of $_______ rather than the
amount of $_______ as reported by you.
In accordance with subsection 10(3) of the Income Tax Act (the “Act”) and the authority
delegated to me by subsection 220(2.01) of the Act, you are advised that the property described
in the inventory of your business at the commencement of the ______tax year in the amount of
$_______ has been deemed to have been valued as required by subsection 10(1) of the Act and
the Income Tax Regulations made thereunder.
Yours sincerely,
(one of the delegated authorities)
______________Tax Services Office
Published May 2015