Income Tax Audit Manual

Compliance Programs Branch (CPB)

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Chapter 20.0 Valuation of inventory

Table of Contents

• 20.1.0 Overview
  • 20.1.1 Adventure in the nature of trade
  • 20.1.2 Valuation of manufactured inventory
  • 20.1.3 Incorrectly valued inventory
  • 20.1.4 Retail inventory method to value inventory
  • 20.1.5 Valuation of nursery stock
  • 20.1.6 For future use
  • 20.1.7 Farm inventory valuation
• 20.2.0 Reference

20.1.0 Overview

The term "inventory" is defined in subsection 248(1) of the Income Tax Act (ITA) as a description of property, the cost or value of which is relevant in computing a taxpayer's income from a business for a tax year. Section 10 of the ITA and Part XVIII of the Income Tax Regulations (the “Regulations”) set out the rules to value inventory for this purpose.

In most cases, a business may use either of the following 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
• IT504R2-CONSOLID, Visual Artists and Writers

20.1.1 Adventure in the nature of trade

As discussed in Income Tax Interpretation Bulletin IT473R, Inventory Valuation, 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. For more information, go to Income Tax Interpretation Bulletin IT459, Adventure or Concern in the Nature of Trade.

20.1.2 Valuation of manufactured inventory

The term "cost" is explained in Income Tax Interpretation Bulletin IT-473R, Inventory Valuation.

The cost of work in progress and finished goods inventories acquired for a manufacturing process 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. “Laid-down cost” includes invoice cost, customs and excise duties, transportation and other acquisition costs, and, where they are significant, storage costs. Either direct costing, which allocates variable overhead to inventory, or absorption costing, which allocates both variable and fixed overhead 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. Standard costing is an acceptable basis for inventory valuation, provided that there is no significant variation between the aggregate standard costs and the aggregate actual costs properly applicable to the inventory. 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

In the absence of a direction under subsection 10(3) of the ITA, at the time of assessment, generally accepted accounting principles [(GAAP); refer to the CPA Canada Handbook – Accounting] require that the opening and closing inventories be determined on the same basis to arrive at the taxpayer's profit for the year.

Subsection 10(3) provides that if a taxpayer's inventory at the start 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 valued, as required by that subsection. Subsection 10(3) provides a mechanism whereby the Canada Revenue Agency (CRA) can change the method used to value inventory at year end from an unacceptable to an acceptable method without also adjusting the value of the inventory at the start of the 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-11.1.19, Adjustment to Ending Inventory – Valuation Letter, for a template letter to make a direction under subsection 10(3).

20.1.4 Retail inventory method to value inventory

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 (refer to the CPA Canada Handbook – Accounting).
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 slightly 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, accurate, clear, and timely information.

If the retail inventory valuation used by the taxpayer for tax purposes is in accordance with GAAP (refer to the CPA Canada Handbook – Accounting) 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, if 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 in accordance with GAAP (refer to the CPA Canada Handbook – Accounting) and is acceptable.

Note however, that to determine market under methods other than the retail inventory method, the CRA will accept net realizable value, that is, 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                                                                           1.                             2.                            3.
                                                                                                                             Include                   Include                 Exclude
                                                                                                                             markups                markups               markups
                                                                                Purchases at                      Exclude                  Include                  Exclude
                                                                                cost                                      markdowns          markdowns          markdowns
Opening inventory                                              $ 20,000                                $ 30,000                $ 30,000                $ 30,000
Purchases less returns                                          80,000                                  120,000                 120,000                 120,000
Markups - net (1)                                                                                                     8,000                      8,000
Markdowns - net (2)                                                                                                                              (6,000)
TOTAL                                                                    $100,000                              $158,000                $152,000                $150,000
Cost ratio (cost to retail)                                                                                      63.29%                   65.79%                   66.67%
Closing inventory - retail (6)                                                                            $  32,000                $  32,000                 $ 32,000
Closing inventory value                                                                               (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 does not 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 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 in which 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 factors or 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 does not 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

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).

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 in accordance with section 10 or section 1801, as applicable.

20.1.6 For future use

20.1.7 Farm inventory valuation

Farmers and fishers are subject to the inventory valuation rules found in section 10 and Part XVIII of the Regulations. However, they may elect to use the cash method of accounting, as opposed to the accrual method, in accordance with subsection 28(1) of the ITA, which would have a direct impact on the valuation of inventory. Using the cash method will generally mean that inventory amounts will not appear on the balance sheet, as they will have been expensed in the year they were purchased. A small percentage of farmers may still maintain a “basic herd” as defined in subsection 29(3) of the ITA, which is treated similar to capital assets.

For those that opt for the cash method, paragraph 28(1)(c) of the ITA imposes a mandatory inventory adjustment in a loss year equal to the lesser of:

• the loss from that year; and
• the value of purchased inventory on hand.

Subsection 28(1.2) of the ITA requires that inventory be valued at the lesser of the total amount paid for the inventory, and its fair market value. However, there is an exception therein 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, to income for the year.

As a result, in order to determine the lesser of cost or fair market value for the purposes of subsection 28(1)(c), the farm business must track the amount paid for inventory that has been purchased (the “cash cost”), as opposed to inventory that has been propagated, bred, or developed. Farm inventory may be:

• livestock
• other animals, birds, fowl, fish, etc.
• silage feeds
• nursery plants or seedlings

For more information about inventory adjustments relating to farmers, go to Income Tax Interpretation Bulletin IT-526, Farming – Cash Method Inventory Adjustments.

20.2.0 Reference

For more information, go to Income Tax Interpretation Bulletin IT473R, Inventory valuation.