A business which prepares full Annual Accounts (much larger businesses than the ones I'm concentrating on here), might value their stock in particular ways which are acceptable in the Accounts, but of which HMRC doesn't approve, and therefore have to adjust their figures for their tax return. However, I'm dealing with small businesses here who don't usually draw up a Profit & Loss and Balance Sheet and Notes explaining their accounting policies, so this post is going to be all about how to value your Stock in ways that HMRC accept are within the current tax law, and which methods aren't acceptable to HMRC.
I think it's worth noting that this is an area that is, how do I put it, slightly more fluid than HMRC would like. However, as with the rest of this series, I am sticking to the HMRC line because that's less likely to get you into trouble, unless there's a seriously viable alternative that the various accounting & tax institutes themselves are fighting for (and winning on) - if that applies I'll flag it up very clearly that it's a potential, but risky approach and not favoured by HMRC to be considered at your own risk. Just so you know, this article doesn't have any of those alternative type approaches in it.
Featured Seller: KnittedLove find her on etsy here and more about her work at the foot of the article
You have to value your 'cost of sales' or stock to work out what expense to claim each year
I'm making the sweeping assumption that all small crafting businesses have good stock control and know exactly how much stock they've got - as raw materials, work in progress or finished products ready to sell at the end of their trading period each year, ready for slotting into their workings for their tax return per TSCB 6 article on Stock.
Failing to keep track of the valuation of your stock and just declaring the expense based on what you've bought in the year, with no connection at all to what you've used in the products you've sold is absolutely not acceptable to HMRC because that's the Cash Basis, and not the Accruals Basis you're supposed to be using. It's non-negotiable.
Just a reminder, UK tax runs under the Self Assessment Regime. HMRC only checks what a taxpayer is doing if, as & when they open an enquiry. But by signing your tax return (or submitting it online) you are stating that you've prepared it based on current law. And if they find out you didn't actually stick within the law, there will be penalties, and an awful lot of hassle to sort it out.
So, the rest of this article assumes that you've accepted the need to value your 'cost of sales' or stock for your tax return. How? Well, TSCB 6 explained how HMRC recommend you deal with stock movements for your tax return, including the all important annual stocktake, but what it didn't do was talk about what value to put on the stock items during that stocktake.
How not to Value your Stock:
- Wild Guesses - why not? because you're running a business with an intent to profit and the law says you have to keep a grip on your paperwork and be able to prove whatever figures you use are based on fact and are prepared reasonably and consistently. That said, sometimes you can use estimates as a starting point (more on that below), but not an end point.
- Notional Replacement Cost - where you work out what you price you would buy the raw materials or goods for resale at to make your normal rate of profit. Why not? Same reason as before, it's not based on fact. The notional replacement cost might be a useful number to help you work out whether it's worth putting a particular design into production: but it's a no-no for tax.
- Last In First Out - where you keep track of what you sell, and allocate the most recent raw materials you purchased to those products, leaving the older raw materials until last (whether or not you did actually do this in reality or not). Why not? Because it leads to inconsistencies by artificially lowering your profits (which is what you pay tax on). Although that assumes the cost of materials has risen, and no-one would choose this basis if costs were falling as it would lead to higher profits and therefore a higher tax bill. This method also doesn't necessarily reflect what actually happened and leads you to ignore the purpose of opening & closing stock each tax year. Again, it's a no-no for tax.
But I've included them for completeness, and also in case you have been talking to people who say they use them.
Remember, just because HMRC's not actually told them they shouldn't use a particular basis, doesn't actually mean they can - we have a Self Assessment Regime which puts the burden of getting it right on the TaxPayer: not on HMRC, who are only doing random sample checks to make sure the system's more or less working.
On the other hand, you might actually be in a trade where there are agreements in place to allow these methods - and that's key really - larger businesses get HMRC approval before they use methods that HMRC aren't keen on. So if you are in a trade where these might apply, you still should get written approval from HMRC before you start using them, to make sure that you're within the law.
- Discounted Selling Price: This is usually used by Department Stores and called the 'Retail Method'. It can apply where genuinely huge numbers of genuinely rapidly changing items are held, so that it's not practicable to do anything other than take the retail price less the departmental markup (markup equals profit per item and is usually a percentage rather than an actual number). It can realistically only be used if it gives a reasonable approximation to actual cost. By definition the small crafting business is unlikely to have sufficient turnover that they can't keep track of their stock acquisition costs, so it's not a good idea to use it.
What am I aiming for?
Assuming you've accepted there are valuation methods (above) that are unacceptable for tax purposes, within that, you are free to choose any method to work out which stocks have been sold provided it gives a fair approximation to what has actually happened. Remember, your stock expense is claimable only to the extent that you've actually sold products that used the stock. The key words here are 'Fair Approximation' (see below).
So, for example if you were a painter and bought a load of tubes of paint, some of which you used to make 10 paintings, but you only sold 3 paintings in the trading period - only the value of the tubes of paint represented by the 3 sold paintings can be claimed as 'cost of sales'/stock expenses in that period. The unused tubes of paint and the 7 completed but unsold paintings form part of the value of unsold stock - part of your 'closing balance' that gets carried forward to the next trading period as your 'opening balance' for stock for that year.
And that example, quite rightly because that's why I used it, begs the question - how do I work that out? do I need know which tubes of paint were used? And therefore what value to use? Are you telling me that I have to know exactly how much of the cost of each tube was used in each painting? Seriously?
The answer is, no, I'm not. Because that would be ridiculous and kill businesses stone dead before they started. Whilst the UK tax regime is a bit strange sometimes, it's not actually been designed to make businesses fail by tying them up in crazy levels of red tape.
Year end valuation method
In an ideal world, you'd know exactly what has happened, because you'd have a stock control system that clearly shows you what the value of your stock held was at the beginning of the year, what stock you've added and what the value of your stock held is at the end of the year. And the difference between opening stock plus stock added less closing stock gives you the stock used figure to put into your tax return as a claimable expense. This should be familiar to you as it's the pattern laid out in TSCB 6.
Following on from the previous example, doing it that way means that you don't have to keep track of what happened to individual tubes of paint in terms of what paintings they were used in, and then which paintings were sold.
All you need to do is make sure you know
- how many paintings were sold (and declare it as income) and
- how much stock you started with, extra you bought in the year and what you've got left over at the end - and the difference between those three numbers magically equals not just what was used in the paintings that were sold, but gets you relief for any paint wastage as well. And it's that difference between the three numbers that you claim in your tax return as an expense. But only if you get the values right for those three numbers.
The Fair Approximation doesn't relate to the actual physical stock you have on hand, that's non-negotiable You've either got 100 yards of fabric or metres of wire or Venetian Murano beads, or half-used tubes of paint, or you haven't. That's proveable by
- keeping receipts for stock acquired AND
- counting (and keeping a record of that count) during an annual stocktake of what numbers of physical stock you've got in the cupboard.
- what it cost you to acquire (your starting point)
- what the physical state of the stock is when you do the annual stocktake - has it physically deteriorated or been destroyed (and therefore lost some of its original acquisition cost value)
- is it still fit for sale? has fashion changed? are you going to be able to sell it at a profit or a loss?
- is it going to be more valuable over time (say because it's a discontinued item that people will want)?
You never increase the cost value above the acquisition cost (say for example if you've got something you know will make a killing) because if you did that, you'd be anticipating income & profits, which wouldn't be Prudent. See TSCB 8 for why stock expenses have to be Prudent - it cuts both ways - you can't anticipate stock expenses useage, and you can't anticipate profits before the sale actually happens. It would also be stupid, because you'd be artificially reducing your expense claim, and therefore increasing your taxable profits, and paying more tax on a profit you were just hoping for but hadn't made yet.
You always have the acquisition cost as your starting point for valuing your stock at your year end, but if there are other factors that adversely affect the acquisition cost, then that cost can be reduced if that reduction is based on fact, is reasonable and consistent (ie you reduce all stock affected in the same way by the same amount - often a percentage).
Sticking with the painter example - the painter would look at those tubes of paint in hand at the end of the year, and it would be quite reasonable and be based on fact to value any unopened tubes at full acquisition cost, and any opened tubes at a lower value. It might be that the painter decides that due to various factors such as heat or humidity or chemical instabilities etc, the opened tubes might not last more than 3 months before drying up - so even if a tube is only a little bit used, say 10%, the reduction in value should be more than that, because of the likely deterioriation. It may be that the painter decides that it's reasonable, based on past experience, that every opened tube is valued at 25% of the acquistion cost when they're counted at year end, and applies this consistently to all opened paint tubes of that type every year.
This is an example of where estimates (as mentioned above in Wild Guesses) or formulas can be used to value stock. As long as they are based on fact, are reasonable and are consistently applied, and, most importantly, give a fair approximation to what actually happened.
To be honest, the Year End Valuation Method is probably the easiest and most simple option for most small crafting businesses, and that's the one that HMRC assume you're going to use in their Helpsheets (see TSCB 6), and the one that I'm assuming you're going to use in these articles.
And the reason I say that is because that method does all the tricky stuff for you - you don't need to match up individual stock items used to actual products sold, you just need to know what you started with, what you added and what you were left with at the end of the year.
The only difficult bit is when what's left of the stock at the year end isn't worth the acquisition cost attributable to that unused proportion - then you use estimates to make sure that any wastage or spoilage value is claimed in the trading period not held over until a future period. In TSCB 6 you can see that this goes further and you can (re)value for any wastage or spoilage that happens after the end of the Trading Period but before you prepare your Accounts and/or tax return.
Work in Progress
One final point on the Year End Valuation Method relates to unfinished Work In Progress and Net Realisable Value. If you've got any unfinished products at year end, then it's not just a matter of altering the acquisition cost. I explained how to deal with what you do need to do in TSCB 6, but it's worth reiterating here.
You start with the acquisition cost then you work out what other costs need to be incurred to get that unfinished piece into a saleable state, and you work out your selling price. You then compare (a) the acquisition cost of stock needed in that product (Cost in accounting speak) to (b) the selling price less extra costs that need to be incurred to get the unfinished piece into a saleable state (Net Realiseable Value in accounting speak). And you take the lowest of the two as the stock valuation.
What that comparison calculation does is makes sure that if you are likely to make a loss on that unfinished product when it's actually sold, that the element of that loss relating to raw materials used in the product is given to you as tax relief now. If you're likely to make a profit, then the comparison calculation makes sure you're not overclaiming now for the raw materials. Really all the HMRC rules are doing is making sure that everyone is on a level playing field when it comes to working out their taxable profits, regardless of the size or nature of their business.
Other Valuation bases you could use:
- Continuous Inventory
For example, I had a chat with someone last week who used to work in the automotive manufacturing industry. She was responsible for product control for individual car components. When designing a car, and costing it up and working out what raw materials were needed, they factored in certain percentages for wastage and spoilage and poor manufacturing processes. When the car was put into production, those estimates were refined based on what actually happened, for example, a whole tonne of aluminium could 'disappear' if the furnace was at the wrong heat.
Throughout the year she kept a record of what the anticipated stock costs were, what the actual stock costs were and any wastages/ spoilage as well as what was actually used in cars that were sold. The figure claimed as 'cost of sales' expense for that tiny element of the company's output was based on those records. She started with estimates, but these were firmed up with the records of reality.
It's more detailed than the Year End Valuation Method and effectively does keep track of which tubes of paint were used in which pictures, and which pictures were sold. To be honest, it's overkill for a small crafting business.
- First In, First Out (FIFO) Method
Remember above in the list of Valuation Methods that are banned there was a ban on Last In, First Out (LIFO). Strangely enough, HMRC doesn't object to a business valuing stock the other way round, that is, assuming that their stock is used up in the order in which it was acquired (FIFO).
So, with the painter, if at the year end 6 tubes of paint were totally used, HMRC would accept that those 6 tubes of paint used in the paintings sold could be assumed to represent the cost of 6 tubes of paint from the artist's earliest invoice for paint that hadn't been used up (claimed) yet. Again, it has to be factual, reasonable and consistent.
The downside of this is that you still have to keep track of which receipts (or part of receipts) you've claimed and which you haven't. And I'd imagine most products aren't made out of raw materials bought all on the same day, so it can get a bit complicated. You also have to keep track of how much of each raw material is used in each sold product so you can make a fair approximation at matching that up to the relevant receipt for materials purchased that you're claiming. Frankly, I think the Year End Valuation Method is easier to do, and easier not to make a mistake. But if you want to do it this way, you can. I would advise you to look at the HMRC Manual on Stock Valuation (link in TSCB 6) first to make sure you understand exactly how to do it right.
- Averaging Method
With this method, you take all the receipts for a particular category of stock, say paint. Not different categories, so for example as paint is used at a different rate than canvas, those are probably two separate categories. You add all the paint receipts together, and then divide (apportion) the total receipts for paint between the paintings sold and paintings not sold. So if you used the paint to make 10 paintings, and sold 3 - 3/10ths (or 30%) of the total receipts could be claimed as 'cost of sales' in your tax return.
But, as ever, the method has to give a fair approximation. So, if you only use some of the paint to make the paintings, and only sell some of the paintings made, how are you going to work out the apportionment - factually, reasonably and consistently? Quite!
To be honest, because it's difficult to apportion where only some of the raw materials are used (but not impossible) the averaging method works better for goods purchased for resale (ie a supplier or reseller) who doesn't carry huge amounts of slow moving stock, rather than a business which is in effect a manufacturer and retailer. Again, use it if you want to, but make sure you read HMRC's manual (link in TSCB 6) to be sure you know what you're doing.
Whilst I'm not endorsing some of the opinions posted in it, here's the link to that Question & Answer string, which hopefully should show you that whilst the whole area of Stock Valuation isn't covered by hard & fast, black & white rules, there are still boundaries to what you can & can't do, and that whilst some people think that doesn't matter - I can assure you it does. I personally don't agree that a small crafting business can value stock at the year end as though the business is just about to cease, TSCB 8 showed quite clearly that accounting standards expect figures to be prepared as though the business is continuing. If HMRC make enquiries and find that what a business is declaring for tax purposes is outside the law, they can, and will, inflict not just what they consider to be a more accurate tax liability, but significant penalties too (there'll be a posting on penalties later in the series as there've been some changes in the last year).
The next article will be an Example of how the Year End Valuation Method works in practice in the light of the scenario given in the earlier example on expenses in TSCB 7.
Featured Seller: Knitted Love picked knitting club at primary school without really knowing what it was. Years later a successful school business project brought knitting back into her life, and it's never really left since, and there's many more new designs in her Etsy store than the school project ever saw!
Find them at her Etsy store at www.KnittedLove.etsy.com