GAAP / IFRS determines the accounting treatment, with tax largely following suit.

Valuing your trading stock, also known as inventory, is a critical aspect of financial accounting and business management—not to mention tax compliance.

Accurate valuation of inventory ensures that a company’s financial statements present a true and fair view of its financial position, directly impacting profitability, tax obligations, and decision-making.

This article explains the key concepts, methods, and considerations involved in valuing stock in trade.

What is trading stock?

The term ‘trading stock’ or inventory refers to the goods and materials that a business holds for the purpose of resale or production.

Trading stock includes raw materials, work-in-progress (WIP), and finished goods that a business holds with the intent to sell. It forms a part of current assets on the balance sheet.

The value of this stock plays a significant role in calculating the cost of goods sold and ultimately affects the net income of a business. With the tax treatment largely following the accounting treatment, the stock valuation also impacts one’s taxable income, and, ultimately, the amount of tax payable.

Principles of valuing trading stock

According to generally accepted accounting practice (GAAP), inventory should be valued at the lower of cost or net realisable value (NRV). This conservative approach prevents overstatement of assets and profits.

‘Cost’ would typically include the purchase price, import duties, transport, handling, and other costs to bring the goods to their present location and condition. NRV, on the other hand, is the estimated selling price in the ordinary course of business, less the estimated costs of completion and selling expenses.

Methods of valuation

There are several accepted methods for valuing trading stock. The choice of valuation method depends on the nature of the business, consistency in accounting, and applicable standards.

1. First-In, First-Out (FIFO)

This method assumes that the oldest inventory (first-in) is sold first. The remaining stock is valued at the most recent purchase price. It reflects the actual flow of goods in many businesses, and is particularly common when it comes to perishable goods.

In times of inflation, this method provides an inventory value that is realistic and has the advantage of matching older costs against current revenues, resulting in higher profits. However, in cases where the cost of inventory is rising rapidly, this method can result in an inflated profit figure.

2. Last-In, First-Out (LIFO)

This method assumes that the most recently purchased items are sold first. Accordingly, the closing inventory is valued at older prices. While this method can reduce the tax liability in periods of high inflation, it will also result in understated inventory values on the balance sheet.

In countries that use International Financial Reporting Standards (IRFS), which includes South Africa, this valuation method is not permitted.

3. Weighted Average Cost

This method averages out the cost of all items available during a period and applies this average cost to ending inventory. It is particularly useful in cases where individual units are indistinguishable or where it is difficult to track the costs thereof.

It also provides a simplified method of valuation when inventory costs fluctuate but remain within a stable range, or when dealing with large volumes of identical or similar items, typically in a large retail or manufacturing environment.

The downside is that this method may not reflect the actual flow of goods.

4. Specific Identification

This method is used when each inventory item is unique, can be tracked individually, and is typically of a higher value. For example, motor vehicle dealerships would normally use this method to value the cars that they hold as their stock in trade.

Tax considerations

The tax treatment for the valuation of stock-in-trade generally follows the accounting treatment, provided that the method used does not result in such stock being undervalued.

The general principle of valuing stock at the lower of cost (however determined, i.e. FIFO, weighted average, or specific identification) or net realisable value will therefore normally be accepted by SARS, provided that the method used in determining net realisable value can be justified.

Reductions in the value of trading stock due to obsolescence, changes in market value, damaged goods, or items that have been stolen are all methods that would be considered justifiable, provided that supporting evidence can be provided should SARS require this.

However, given that the reduction of the value of trading stock results in lower taxable profits, SARS tends to be alert to what Practice Note 36 (dated 13 January 1995) described as “a variety of questionable methods … used by taxpayers to write-off slow moving and obsolete stock, without reference to its actual net realisable value”.

The practice of arbitrarily writing off a portion of one’s stock value by a random amount or a fixed percentage basis ‘across the board’, without reasonable justification, will be disallowed as a deduction against the cost price of such stock held and not disposed of at the end of the year of assessment.

This is in terms of Section 22 (1) of the Income Tax Act 1962 (as amended) (‘the Act’).

Practice Note 36 goes on to refer to Income Tax Case No. 1489 (53 SATC 99), in which it was held, inter alia:

1. That if a method of reducing the cost of stock by a percentage is adopted, the percentage reduction should not only be supported by trading history and, where appropriate, post-balance sheet experience, but the Receiver of Revenue (as SARS was then known) should be told how that percentage is arrived at; and
2. That the Commissioner for Inland Revenue (as the SARS Commissioner was known at the time) has to exercise a discretion with regard to the amount by which the value of trading stock had been diminished, and cannot exercise that discretion if [they are] not told on what basis the accounts submitted … have been prepared; hence the Act, by implication, requires such a disclosure.

When drawing up one’s annual financial statements (especially where IFRS is used as the accounting framework), taxpayers are required to disclose the basis on which trading stock is valued when submitting their annual tax return.

In cases where trading stock is valued at an amount lower than cost, this fact, and the basis thereof, must be disclosed to SARS. Such disclosure must include reasons for the lower value, as well as the basis on which such lower value is determined.

Practice Note 56 also notes that “if stock has been written off on a fixed, variable, or any other basis, not representing the actual value by which it has been diminished, the write-off will not be accepted without reasonable justification for such basis.”

As is the case with any omission or understatement in one’s tax return, SARS may impose penalties in cases where trading stock has been undervalued and this fact has not been disclosed to SARS.

Interest may also be charged on the amount by which the tax has been understated, and (in serious breaches) criminal charges may be brought against the taxpayer.

 

WRITTEN BY STEVEN JONES

Steven Jones is a retired tax practitioner and member of the South African Institute of Professional Accountants.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.