I was asked the question - well I hope this was the question - why is stock treated differently from other expenses and what makes an expense a 'stock' expense?
Featured Seller: KatieDidOnline: See her Etsy shop here and about her work at the foot of the article
Basic Accounting Concepts
To answer that, you have to know that there are a couple of basic concepts that accounting (and therefore tax because tax treatment follows the accounting treatment) rest on:
- the business is a going concern and assumed to continue for the forseeable future
- income and expenses are declared on a 'true & fair' basis which means they are dealt with in the period they actually relate to (the Accruals Basis)
- income or revenue is not anticipated, but included only when realised - which is where the 'stock expense' differs from other expenses, because the 'stock expense' (of raw materials or goods purchased for resale) directly relates to the income generated. (Prudence in accounting speak).This means you do the accounting based on what products you sold not what products you made for 'stock' expense purposes.
- consistency in treatment within a trading period and in successive years (and the adoption of reasonable policies in dealing with income and expenses).
Applying the Basic Accounting Concepts to expenses
So, to try and make it clearer, ALL expenses are within the Accruals Basis: whether or not we're talking about utility bills, stationery or raw materials The concepts of accruals and prepayments (where you bring more than just the cash transactions into the trading period) applies to all income and expenses.
Once you've done your accruals and prepayments and got your expenses together that matter for your trading period, you then have to work out which of those expenses relates to 'stock', because those are treated slightly differently because you have to be Prudent.
The issue of Prudence, that is - only recognising income AND profits when they are realised - applies to 'stock' expenses in particular, because in a manufacturing or retail business, income arises from the sale of stock (either as bought-in finished goods or raw materials to be made into goods).
Effect of Recognising Income & Profits only on Realisation (Prudence)
Two elements make up your selling price - the profits on which you're taxed, and the cost of that product to you (stock), on which you get tax relief.
- This is why when stock is acquired, you value it at 'cost' and not the value you 'hope' to sell it for - otherwise you'd be paying tax on profits you've not actually made yet, and might never make!
- And in the same way (but opposite direction) you therefore don't include the 'stock' expense you've incurred until the finished product is sold, otherwise you're counting, and getting tax relief on, the difference between the sale price and the profit that you've not actually made yet (ie the cost of what you're selling), and might never make either.
Cost of Sales - just raw materials?
Another term for the cost of what you're selling, or 'stock', is 'cost of sales' - it is up to each individual business to work out which of their expenses are 'cost of sales' and which are overheads or administration expenses.
For example, it's easy to see that the cloth or silver wire you buy to make your products are raw materials, therefore stock, therefore fall into 'cost of sales'. However, you might make a product that requires particular packaging to reach the point at which is it 'saleable' - do you include that packaging cost as 'cost of sales' or as an overhead? You might have a stock of paper for invoices and envelopes and stamps for sending orders out, these are generally accepted to be part of Overheads/ Admin Expenses not Cost of Sales. However if you actually used paper to make your product, that particular stock of paper would be a 'stock' expense.
Which brings us to the answer to the question we started with - expenses which are NOT 'cost of sales' (being goods used or goods bought for resale ie 'stock' expenses), such as administrative expenses & overheads aren't subject to the additional 'hoop' you have to jump through for 'stock' expenses as explained in TSCB 6 for how you deal with it for tax and in this article in terms of Prudence.
And yes, there's a grey area in the middle where an expense might be 'stock' or might not be, depending on how you run your business and what products you make - the key is to be factual, reasonable and consistent in how you treat this sort of expense.
Bear in mind that unless you have very fast moving stock levels, taking a 'grey area' expense into 'stock' rather than overheads, such as packaging, can delay tax relief. The HMRC rules assume that businesses run as a going concern with intent to make a profit only buy in such supplies as they need to cover what they reasonably expect to sell. If I'm brutally honest, I'm not that disciplined, are you? And as a result, the rules can be painful to people like me who buy because something 'might' be useful for a product, not because I have proper plans to make it into product that I hope will be sold by the end of my trading period. There'll be more about stock control in the next article.
Now I understand what Stock/Cost of Sales expenses are - what next?
Once you've worked out which of your expenses relate to 'cost of sales' and which don't (TSCB 4, 5 & 7 deal with non-'cost of sales' expenses ie admin expenses & overheads) - you have in your hands the actual acquisition cost of your 'cost of sales' or stock expenses.
However, unlike the other expenses where if they belong in that period, you claim them at acquisition cost, with 'stock' expenses, you need to look at the 'stock' expenses to see (a) when you can claim them and (b) at what value.
TSCB 6 explained how the 'stock' expense is claimed and the timing - the when - so I'm not going to repeat it here.
But TSCB 6 didn't explain much about how to value the stock expenses, and how not to value them.
The next article is going to be about the different bases of Stock Valuation - which ones can be used and which can't. Then we'll be back on track with a Stock Valuation Expense example, followed by the employee expenses and travel costs promised last week.
HMRC expect all businesses to follow standard accounting practice for stock valuation, and in TSCB 6 there was the link to the HMRC manual on stock valuation, which includes references to the Accounting Standard SSAP 9, so if you want to go and look at the detail, that's where you'll find the links.
Featured Seller: KatieDidOnline is where her passion for food, fabrics, and sustainability come together. She makes upcycled aprons, coasters, bibs and other fabric crafts related to eating and entertaining. All fabric used in her creations is repurposed from charity shop finds - meaning her products help UK charities while being eco-friendly and fashionable! Find her work to buy at http://www.katiedidonline.etsy.com/,
on her website at http://www.katiedidonline.com/ for her blog and also to buy and finally
on facebook at http://www.facebook.com/pages/Katiedidonline/124680884254107.
I've just realised KatieDidOnline has three different ranges, the pics above are the Erica range from her Etsy shop, she also has a Mayumi range at her Folksy shop and a vintage/retro themed range at her Dawand shop - links to all of them here http://www.katiedidonline.com/blog/?page_id=236 They're all very different - check them out!