Annual Stock Valuation - Small Businesses
Figures in brackets refer to the section in the Income Tax Act.
A "small business" for tax purposes is one (combined with its associated persons) which has a turnover of less than $3 million per year.
Associated person rules apply. This means, for example, a person having an interest in two companies must add the turnovers to see whether the total is still less than $3million. A company is associated when this person owns 50% or more of the shares.
What is "Trading stock"?
In general it is anything bought for resale. It includes work in progress and the, as yet, unprocessed raw materials. For example, to a cardboard box maker, the partly completed boxes are stock and subject to these rules. Stock purchased, but not yet delivered, forms part of your end of year stock and must be included in your stocktake. However, the value of such stock, not paid for by year end, should be included in the amount owing in your accounts payable (Sundry Creditors) schedule.
These rules do not apply to:
Livestock, except when used in dealing operations
Nursery plants( special rules apply and there are new ones for the 2002 year)
Consumable aids such as lubrication oil
Spare parts unless they are your trading stock
Land ( including crops in the ground)
The following expenses are either not stock or do not form part of trading stock
Ways to value stock
Discounted selling price
Cost - Retailer
Selling Price - above cost
- below cost
You must basically value stock in accordance with the Financial Reporting Standard No 4. These standards are developed by the Institute of Chartered Accountants
If by using FRS4 it is materially different to cost then you must use cost
You are no longer permitted to value stock on one basis for the bank and another for tax purposes. The bases you choose for tax must be the same as for your business's annual accounts.
You may, however, value different stock lines using different bases. Some stock can be valued at selling price and other at cost.
You must keep a record of your valuation methods and how you have applied them, as well as records of your stocktake. Records have to be retained for seven years.
You may only reduce the price of obsolete and slow moving stock in accordance with these rules.
There are consistency requirements in respect of the cost valuation method. The basis ie FIFO or WAC, is the method of calculating discounted selling price, and the use of market selling price versus cost, unless there are sound commercial reasons
1. Discounted selling price (EE 8)
You may use this method if you use this method in your financial statements or you do not compile financial statements( Financial statements means general financial statements not specific ones).
You start by valuing your trading stock at retail.
You are expected to divide your stock into departments, grouping stock of similar profit margins together.
Determine the gross profit margin for each department and discount the selling price of the stock to bring it back to cost.
Retailers (only), with annual sales of $1million or less, do not have to separate the stock into departments but may apply the discount across the entire stock. (EE 9)
You must recalculate the normal gross profit margin each year.
When calculating the gross profit margin, take into account all the costs listed below under the headings Cost Reseller and Cost Manufacturer.
2. Cost - Retailer (EE 7(3))
Freight on goods into shop
Insurance cost relating to getting the stock onto the shelf
Import duty and any other direct costs.
Whether you use FIFO or weighted average cost, you must continue to use it from year to year.
3. Cost - Manufacturer
Costs to a manufacturer include
Direct material and labour costs
Indirect materials and labour costs
Utilities, such as power and water, but not telephone.
Repairs to factory plant.
Factory plant depreciation or rental.
Costs of production included in your financial statements, which are additional to the above list, must also be included in stock valuation.
You are permitted to value stock at cost even though selling price may be lower.
If you bought the trading stock rather than manufactured it you must include the costs above for a retailer
Paradoxically, a major repair to factory plant has the effect of increasing the value of your stock and consequently your profit!
The cost for reporting purposes will have to be reconciled to tax purposes for items such as Tax depreciation, holiday pay accruals and other normal tax adjustments
4. Market Selling Price - above cost (EE 16(3)(e))
If you choose this option you must use it for that line of stock every year, unless you have a good commercial reason to change other than tax advantages. (EE16(4)) . Keep records of your reasons (EE16(5)).
There could be some tax planning advantages in choosing this option. It would probably be best applied to stock you are not expecting to continue with in future years.
Once sales exceed $3 million you will go into the big league and selling price above cost is not an allowable option.
5. Market Selling price - below cost (EE 12)
You must have reasonable evidence of market selling price. If you cannot get reasonable evidence use cost (EE 12(3))
In arriving at selling price you may deduct:
Discounts to buyers
If you choose this option you must also use it in your financial statements
You may choose either the last price you paid (EE 11(4)), or the amount you would have to pay to replace the stock item at balance date. (EE 11(2))
Very small stock
At the time of writing these notes, there is a bill before parliament which proposes businesses having less than $1.3million sales, being able to dispense with valuing their stock, "if the taxpayer reasonably estimates that the stock's value is less than $5,000". This change will not apply until the start of the 2003 financial year.
All information in these notes is, to the best of the author's knowledge, true and accurate. However notes such as these are, of necessity, only a summary of the law rewritten in lay terms and they do not purport to be the complete rules for valuing stock. No liability is assumed by the author or ourselves for any losses suffered by any person relying directly or indirectly upon these notes. They should be used for guidance only and we advise you to consult us so we can consider your circumstances before deciding on and advising you of the correct valuation rules to be used for your business.