Thursday, 10 February 2011

TSCB 10: Those rules apply to me? How? Part 2: Cost of Sales & Stock Expenses

This article follows on from the example of Alice the fudgemaker in TSCB 7 here. I was originally intending this article to be published before the 31 January 2011 deadline for tax returns, but real life got in the way. So, for the purposes of this article, we’re still pretending it’s before the deadline (even though it isn’t)!

As a result of TSCB 6 on Stock Work in Progress & Appropriations here which caused a bit of consternation: I wrote TSCB 8 & 9 to clarify the issues. TSCB 8 was about how to distinguish between stock expenses (raw materials or products bought in for resale otherwise called Cost of Sales) and other expenses (called Overheads) here and TSCB 9 was an explanation of a variety of different methods of stock valuation (essentially what you can & can’t do) here. You might find it useful to read these earlier articles before moving onto this one (I did!) but you should also be able to make reasonable sense of it even if you don’t go back –use the new Tax articles Index tab here to find them.

When we last encountered Alice she’d got most of her paperwork sorted, and had separated out her stock expenses receipts, but she hadn’t done anything with them. And she’d decided to follow the HMRC method of working out what stock expense she could claim tax relief on (see Helpsheet 222 on HMRC website here).

Featured Seller: ElliesTreasures find her on Folksy here and more about her work at the foot of the article

Alice has her pile of stock expense receipts for the period before she started trading (pre-trading expenses) and another pile of stock expense receipts for raw materials she bought once she’d started trading up until her 31 March 2010 year end. She has her Accounts book that tells her what stock she sold in the year. She also has a note about the products she took for her own use for her husband’s Valentine gift (an Appropriation) and also about the additional stock she bought right at the end of the trading period, some of which was ruined after the year end but before she did her Accounts/Tax Return.

The basic calculation HMRC recommends is:
  • Opening Stock Value
  • Plus Stock added
  • Equals Total Stock
  • Less Annual Stocktake Valuation and adjustments equals Closing Stock
  • Equals Stock/ Cost of Sales Expense to claim on the tax return.
TSCB 6 explained the theory behind this calculation and how it’s not just cash items that count. TSCB 8 explained what the differences are between a stock or cost of sales expense and an overhead expense (so you can identify them correctly). TSCB 9 explained what methods you are allowed to use (and not allowed to use) in your Annual Stocktake Valuation. I’m not going to go over those again now, but you will probably find them helpful when trying to apply the principles to your own business.

Let’s apply this to Alice and her fudgemaking business:

Alice's Opening Stock

Alices’ Opening Stock on her first day of trading (1 June 2009) is Zero. She’s a new business, and the only number that ever shows up as Opening Stock is last year’s Closing Stock brought forwards into the next year. There’s never any adjustments or changes made in between Closing & Opening Stock, if you need to adjust, you do it in Stock Added or the Stock Valuation (see below).

Alice's Stock Added – Pre-Trading expenses

The expenses that Alice incurred before her first day of trading (Pre-Trading Expenses) such as sugar, butter, flavourings etc to make her first batch of fudge which was her first product offered on her first day of trading are (in strict accounting speak) treated as Stock Added on that first day of trading 1 June 2009 – but that doesn’t matter too much for small businesses, you just need to know that those Pre-Trading Expenses that relate to Cost of Sales form part of the Stock Added bit of the Calculation.

Alice's Stock Added – normal position

The expenses that she incurred during her trading period of 1 June 2009 to 31 March 2010 are also treated as Stock Added. Just to be clear, using the HMRC method means you use the actual cash expense figures in this calculation.

Alice's Closing Stock – Annual Stocktake

Alice’s closing annual stocktake is quite simple. She’s got a new business using perishable ingredients, and she hasn’t stockpiled a lot of raw materials. She buys what she needs as she goes along, so all that’s left at her year end is the large purchase of raw materials she made very close to the year end because it was a good deal.

She just values what’s in the cupboard on 31 March 2010 – and because she’s read TSCB 9 she’s decided that unopened packets will have a value of 100% of cost and opened packets will have a value of 50% due to decreased shelf life. She has a Stock List of what raw materials she’s bought, and what she’s used of those throughout the year (on a first in, first out basis because the goods are perishable so that’s the order she uses them in anyway), so all she needs to do is get her List, and compare it to the cupboard contents and apply the appropriate 100% or 50% to the cost price on the List to come up with her annual stocktake total. Alice, being sensible, has written the Annual Stocktake valuation on her Stock List for each item (or set of items) so she has a permanent record of exactly what was left at the year end.

In TSCB 6 I mentioned that the Annual Stock Valuation should take account of the state of the stock at year end (in the first paragraph after the End of Year Stocktaking heading) – stock can be valued at lower than the actual cost where it is damaged or deteriorated or perhaps unsaleable due to a change in fashions (so it’s unlikely to sell) or in product lines (ie has been discontinued). The whole point of the stock valuation is it gives a snapshot of the actual value of those raw materials on the 31 March 2010 (or whatever your year end is).

The Stock Added is always the actual cost you paid for the raw materials. The Stock Valuation is always what the current value of that stock is (which forms the basis of the Closing & Opening Stock figure).

It’s the difference between the two that gives you your tax deductible expense – and doing it this way means that your tax deductible expense includes not just raw materials contained in products sold, but also a ‘writeoff’ for any deterioration or destruction of those raw materials so that you get tax relief on a timely basis for those costs.

To be clear, if I only buy raw materials and I turn them into products but don’t sell anything and I keep my raw materials & products in a good saleable state – then I will not have a tax deductible cost of sales expense to put on my tax return (well I will, but it will be Zero).

However, is entirely possible that you buy a load of raw materials (in good faith), and the cost forms part of stock added, but in the end you find the products you make with those raw materials don’t sell and you stop making them, so their Stock Valuation is close to, say, zero. And without actually selling anything, you can actually end up with a tax deductible expense – to the extent of the cost of those materials that can no longer be used.

The rationale behind this is that whilst HMRC limit tax relief on cost of sales expenses to what’s been used up – generally through actual sales - they also recognise that sometimes stock is destroyed or inadequate etc or the general business climate changes, and that businesses legitimately respond to those changes by changing their product lines or writing off useless raw materials – and this is a fair way of ensuring that tax relief is obtained in those circumstances.

At its root – tax relief is obtained on raw materials when (a) the product containing them is sold or (b) the raw materials whether already made into a product or not, have deteriorated or are no longer saleable such that a loss will be made.

Obviously you can’t just designate all your unused raw materials as being of zero value, that would be foolish and HMRC would be deeply unimpressed – as ever any judgement calls you make of that nature should be reasonable, factual and consistent so that if HMRC asks you any difficult questions, you can answer them honestly and openly from a position of strength.

However, it’s not just a change in the value of your stock as at the year end (31 March 2010 for Alice) that you can take into account. In certain circumstances you can change the Valuation for events that happen after your year end – and accelerate the tax relief accordingly into the earlier tax year.
Alice's Closing Stock - Post Year End Events & Adjustments

You might remember from TSCB 6 that shortly after the year end, Alice’s washing machine flooded her raw materials cupboard. And some of those raw materials were ruined and were totally unuseable – effectively reducing their value to Zero. They can never be made into fudge to be sold – so how does Alice get tax relief on this disaster? And when?

Alice is entitled to amend her Annual Stocktake figure in the light of this disaster after her year end of 31 March 2010, so long as it happened before she has completed her Formal Accounts (if any) or Tax Return. If the disaster had happened after she completed a Formal Set of Accounts or a Tax Return, then no adjustment could be made to the Tax Year 2010 figures, it would all come out in the wash in her Tax Year 2011 figures.

The reason she would want to make an adjustment is to accelerate the tax relief for the cost of those ruined supplies to Tax Year 2010 (and her tax payment date of 31 January 2011) rather than waiting until Tax Year 2011 (and her tax payment date of 31 January 2012).

This issue here is not that the disaster happened so does she get tax relief.  Yes she does.  This issue is about WHEN Alice gets the tax relief – it’s all about timing - expense recognition timing (in accounting speak).

What Adjustment does Alice need to make for the ruined stock? and How?

Alice already knows exactly what her stock was at 31 March 2010, because she has it written on her Stock List (see above) when she did her Annual Stock Valuation. She knows what was ruined because she made a separate list of that at the time (when she made a note in her Accounts Book, and worked out the actual cost of what was ruined).

She therefore deducts the cost of the ruined raw materials from her Annual Stocktake to give the Closing Stock figure for her Stock calculation.

Just so you’re clear on this – the Closing Stock figure is made up of two elements, the Annual Stocktake and (or rather, less) the Ruined Stock Cost which are combined to make the Closing Stock figure.

Then this Closing Stock figure is what she uses as her Opening Stock figure for 1 April 2010.

And to avoid any confusion – if Alice had already done her Tax Return by the time the disaster happened, so she couldn’t make the adjustment in her Tax Return 2010 – then, the Annual Stock Valuation wouldn’t be reduced and the cost of the ruined raw materials would still be sitting in the Closing Stock figure. She wouldn’t need to make any adjustments at all, it would all ‘come out in the wash’ because by 31 March 2011 those ruined raw materials had been thrown away, so they wouldn’t show up in the Annual Stock Valuation for 31 March 2011, so she would automatically get tax relief for the ruined stock in her Tax Return 2011.

However, for the purposes of my Alice example, she hadn’t finished her tax return before the disaster, so she makes the adjustment to the Stock Valuation as though it was 31 March 2010 and gets relief in Tax Year 2010.

Alices’s Stock Calculation for her Tax Return 2010:

So, Alice’s calculation will look like this:
  • Opening Stock = Zero
  • Stock Added = all cost of sales expenses for trading period 1 June 2009 to 31 March 2010 PLUS pre-trading expenses relating to cost of sales.
  • Equals Total Stock In = Opening Stock plus Stock Added
  • Less Closing Stock = Annual Stocktake Valuation less deduction for ruined stock since the year end
  • Equals Tax Deductible Expense for the tax year for her Tax Return.
To put that in context, let’s imagine the following numbers: Alice has zero opening stock, she has £150 pre trading expenses relating to stock and she has £2,000 added stock. Her Annual Stocktake Valuation was £1,000 but the washing machine disaster ruined half her raw materials so that's £500 of costs she's never going to be able to recoup by sales - she has to recoup via an adjustment for loss.

Alice’s calculation in numbers looks like this:
  • Opening stock Zero
  • Added Stock is £2,000 plus £150 = £2,150
  • Less Closing Stock of £1,000 less £500 = £500
  • Equals Tax Deductible Expense of £1,650 to put onto the Tax Return.
How NOT to make the adjustment for ruined stock (cos it won't work properly)

Remember above I said the Closing Stock figure can’t change? I wasn’t saying it can’t change in itself, I was saying that the Closing & Opening Stock figure must be the same figure, you can’t just say this is my Closing Stock, but I had a disaster so I reduce my Opening Stock figure for the next year – Nope. You adjust earlier to get the lower Closing Stock to carry forward as Opening Stock, or you adjust afterwards as part of Added Stock. Closing and Opening stock always equal each other.

So, if Alice had those numbers above but did the adjustment in the wrong place (say in Opening Stock instead of at the Stock Valuation stage), she’d have
  • Opening as Zero,
  • Added as £2,150 and
  • Closing as £1,000, but Opening as £500 (closing £1,000 less disaster of £500).
  • And a tax deductible expense of £1,150.
Yes she’d end up with the right Opening Stock of £500, but the wrong Closing Stock at £1,000 with an unexplained difference of £500 that would lead to awkward questions and a lot of wasted time if HMRC ever came looking at her business records.

Rather more concerning: doing it that way would lead to a tax deductible expense of only £1,150.

Alice would not only have messed up her books, but also would have deferred £500 of tax relief (relating to the ruined ingredients) into the Tax Year 2011 for no good reason, instead of claiming it in Tax Year 2010. Bad idea!

How does Alice know she’s got it right?

I can quite imagine that just having HMRC and me saying, ‘Do it this way, it works!’ isn’t very comforting, especially if you find faffing around with numbers like this a bit bewildering.

You may remember from TSCB 6 that Alice kept a record as she went along of how much of each batch of fudge cost to make, and how much of each batch was sold (or thrown away). She wanted that information to help her run her business on a daily or weekly basis (what is often called Management Accounting). Keeping track of such numbers means she builds up a pretty good idea of how much fudge she made and when her busy and slow times were for sales, so that she can reduce wastage and/or increase production and end up with higher profits in future years.

However, those numbers are also useful to triangulate or prove her tax numbers - she can use those numbers collated through the year to give her a rough idea of how much of her sales income is represented by the actual raw materials costs.

Now obviously she’d have to take that rough raw materials costs figure and adjust it for the ruined stock and also the fact that she has some opened packets at the year end that she valued at 50% not 100% of cost to get a reasonable approximation of the same answer – but it does enable her to see that the HMRC calculation works, and does truly reflect a tax relief claim for only the cost of sales expenses that were ‘used up’ in actual sales or actual wastage.

If Alice had chosen not to use the HMRC calculation, she would have had to keep a record of the extent to which she’d used the raw materials in products she’d sold plus of any raw materials used in products she’d bartered or traded with others, and used in, say, the Valentine’s gift to her husband.

It may be that for some craftspeople, keeping track of raw materials in terms of what’s been sold is actually easier than the HMRC calculation.

Which brings me to the next article, where I’m going to explain ways people can deal with a situation where they start their business with huge stock levels acquired over many years – for example this might apply to someone who, say, collected a lot of vintage items with no thought of selling them, but now wants to use those items as the basis to start their business. I imagine people who don’t have adequate records of what’s happened so far and would like to move onto the correct basis for claiming ‘cost of sales’ expenses would have similar concerns as to how to handle the sheer volume of stock to get them where they are supposed to be.

Then after that we’ll eventually end up working our way through the rest of different categories of expenses HMRC use on the Tax Return, unless of course it turns out there’s more that needs covering on Stock/ Cost of Sales first...

Featured Seller: ElliesTreasures: She enjoys creating something new from left over pieces of material that would otherwise go to waste.  All her items are hand sewn, and she says that 'There is something very lovely about an item made by hand. May be it’s the notion that it’s unique and carefully finished, perhaps a little uneven in places, and always the knowledge that no two items will be exactly the same.'

Find her products on Folksy at  
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acanthusjd said...

Fantastic information for the tax return challenged!!

Christina said...

Thank you so much for writing this series. I'm just starting setting up and have been having real difficulties working out what's what with tax. Your posts have been a HUGE help.
Will you be doing anything on VAT?
I have posted on my (rather empty so far!) blog about your series here.
Thanks again! :-)

Goblinf said...

I am thrilled you find them helpful Christina - I write them and I can see the hits from the stats, but it really helps to know I've got a happy audience!

In answer to your question:

Well. Sort of. Eventually.

My tax ‘specialisation’ covers quite a lot of ground – in my day job I advise UK & internationals individuals, sole traders, partnerships & trusts in the areas of income tax, capital gains tax and inheritance tax – I occasionally deal with employee issues (so PAYE & NIC) but never ever with corporate tax & VAT on anything other than a very very general basis.

However, once we’ve staggered our way through the expenses & income issues for tax returns articles, I’m planning a more general series (which will hopefully be a bit less solid to chew through) on areas like NIC, consequences of having a day job and a crafting business, customs, international trading issues, pensions, and also VAT – but I’m hoping that a fair number of those general series articles will be by guest bloggers. I do have my beady eye on a VAT practitioner for guest bloggage, but haven’t approached them yet: now you’ve signalled interest, it’s pushed it up my to do list.

Christina said...

Wonderful! Thanks. Look forward to reading them all.