Leftover stock at the end of the financial year directly impacts the amount of tax you pay.
This article explains how unsold inventory affects your taxes and how keeping track of your inventory costs can help you achieve the right profit margins to reduce your tax bill.
- Read more: The Complete Guide to Inventory Accounting
Taxable income and cost of goods sold
As a business, you’re required to pay taxes on your taxable income. Taxable income is your profits at the end of the year. Any unsold inventory you have left over will directly affect your reportable earnings. This is because inventory plays a significant role in determining your costs of goods sold (COGS).
Cost of goods sold can be calculated using the formula:
Beginning Inventory + Net Purchases – Ending Inventory = COGS
COGS is an inventory expense which, if not properly calculated, means you could be either overstating or understating your taxable income. Overstating your ending inventory has an adverse effect on your tax obligation because you’ll have understated COGS. This will result in a higher taxable income and higher taxes owed.
Understating your ending inventory means you’ll have overstated your COGS. This results in a lower taxable income and less taxes to pay.
However, incorrect inventory valuation and non-compliance to taxation standards can result in negative consequences if you’re ever audited by the tax office. These include legal penalties, financial losses, and reputational damage. You may also be subject to additional, more-invasive legal investigation and a loss of government benefits.
How does unsold inventory affect taxes?
Exactly how unsold inventory affects your taxes is specific to the country where you file your tax return. Different countries have different rules. In the United States, your inventory tax is based on the state where inventory is stored and not where your business is registered.
In general, unsold inventory affects taxes positively or negatively depending on where your business operates.
Let’s look at three examples:
- When inventory's starting and ending position is used to determine your taxable profit by calculating the cost of goods sold (COGS), unsold inventory is an asset on your balance sheet. In this instance, unsold inventory affects taxes by reducing your gross earnings to lower your taxable income.
- Where taxes are paid on the inventory levels at the end of the accounting period, high levels of unsold inventory translate to bigger tax obligations. Here you need to consider your business’s unsold inventory when calculating the tax to be paid at the end of the financial year.
- Where your inventory taxes are accounted for like property tax, this tax will be imposed on your company’s unsold stock at the end of the financial year. Your inventory is taxed within the same range as any furniture, tools, or equipment that belongs to your business. This inventory tax must be paid regardless of whether any profit is made.
Read more: Inventory Reduction: 15 Strategies for Reducing Stock
Methods for valuing your inventory for tax purposes
How unsold inventory affects taxes depends on how you produce, manufacture, or acquire your inventory. There are a variety of methods to value your inventory for tax purposes and the one you choose for greater tax gains is the one that produces the lowest value of inventory stock.
While different valuation methods can be applied to different classes of inventory the simple approach is to adopt a consistent method across all stock. The three ways in which to value your inventory for tax purposes are:
- Cost-based. Cost-based is the simplest approach. Inventory is valued at its purchase price plus any transportation and handling costs incurred. Total values are easy to determine on basic items that don’t have hidden costs. With cost-based inventory, any unsaleable stock isn’t counted as part of your inventory assets. Any losses incurred on unsold inventory items are shown as higher COGS on your business financial statement and tax return.
- Retail valuation. Retail valuation is measured by profit margin. This method of valuing inventory is done by multiplying your average markup, usually as a percentage of your on-hand inventory stock. This is where inventory is valued at the sales price, and any markups are deducted. The cost of the items is determined after retail values have been added. However, the retail method of valuing your inventory for tax purposes only works when your markup percentage remains consistent.
- Lower cost or market valuation. The lower-cost approach compares the cost of your inventory to its market value at a set date. The inventory is recorded at the value for that specific date. Using the lower cost or market rule valuation of inventory means that you may be required to reduce the inventory valuation to the market value.
Sales taxes, VAT, and GST added to the price of goods are paid by the buyer purchasing these items. This sales tax does not factor into your business profits. The inventory tax your business is obligated to pay is calculated on the value of inventory that remains unsold at the end of the financial year.
Inventory write-offs
In many countries, businesses are entitled to claim a tax deduction for any inventory that was damaged or has become obsolete. For example, when you have goods that were intended for sale, but they have lost all value and can’t be sold you can record this as an inventory write-off. This is because the closing value of your inventory, after allowable deductions, forms part of your assessable income.
In the lead-up to the end of the financial year in the country where your business is registered for tax purposes, you should review your stock to identify slow-moving or obsolete stock. Then you can determine if it should be written off completely for that tax year. Different valuation methods may result in larger reductions in your business’s taxable income.
Here’s the inventory write-off process in three steps:
- Review your inventory reports to determine any slow-moving or obsolete inventory.
- Ensure any write-off is determined before the end of the financial year/period, so the tax deduction can be claimed for the current financial year.
- Any damaged or broken inventory that is unsaleable during the financial year should be written off immediately. This ensures the accuracy of your current inventory valuation and will provide a tax deduction for the current financial year.
Unsold inventory is not a tax-deductible asset. Tax deductions can only be applied to inventory you’ve sold, not your inventory purchases unless it has a lower market value than when originally purchased. This means you can only claim a tax deduction on inventory stock that has a lower valuation or is obsolete, subject to theft, or as tax write-offs.
Unsold inventory stock affects your profit, and can reduce your taxable income, but unsold inventory also means you have capital tied up in stock that you are not receiving any return on for your investment.
