Wednesday, 5 January 2011

TSCB 6: Expenses - Stock, Work in Progress & Appropriations

As a crafting business you often are both manufacturer and retailer. Stock control is important so you know what you’ve got on hand to sell, but it also matters for working out your expenses for tax. You need to know what you started with, what you used, what you’ve sold and what you’ve got left.

To be absolutely clear, you can only claim the underlying expenses relating to the products you have actually sold (or have left your ownership) in the Trading Period – all the other expenses for raw materials/ supplies etc that you’ve bought aren’t eligible for tax relief until those materials or supplies have been sold. They just sit in your stockpile until they are ‘used up’.

So, if you have been claiming expenses for raw materials or supplies purchased during the Trading Period that you haven’t actually used to make something that has actually been sold or otherwise taken out of your ownership during the Trading Period– technically you’ve been doing it wrong because that’s the ‘cash basis’ and you should be using the Accruals Basis (see the last post about Cash & Accruals Basis). To regularise your position you will have to make an adjustment to add back the expenses you have overclaimed in earlier years, based on what stock you have on hand on the first day of your new Trading Period. You really also ought to tell HMRC, which could lead to a revised and higher tax liability for earlier years (or reduced losses), penalties and penalty interest.

Featured Seller: Poppy Sparkles (Viv Smith) See her Etsy shop here
and about her work at the foot of this article

What is Stock and what can I claim?

At any given point in time you probably possess
  • raw materials or consumables (that you bought or someone gave you for free), and
  • products that you are half-way through making or work in progress, and
  • products that you’ve finished making that are ready to sell or finished goods, and
  • goods for resale (for example destashing), and
  • if you do custom orders, money on account from buyers.
All of these possessions count as Stock, and under the Accruals Basis, you have to include movements in your stock levels during your Trading Period as an expense to work out your taxable profits. That’s not everything you spent on stock in the year: the movement is what you spent on stock less what you’ve got left at the end of the year.

To get to the stock level at your year end on the strict basis, you need to do the following calculation:
  • Stock you’ve added during the year that you paid for (less any adjustment if you’ve overclaimed expenses in earlier years as above. The adjustment reduces the stock added figure).
  • PLUS opening stock at the beginning (zero for new businesses, or last year’s closing Stock figure for continuing businesses)
  • LESS what’s left in Stock at the end of the year (this year’s closing Stock figure)
  • EQUALS what Stock you’ve used during the year. This is the figure that HMRC are interested in for your tax return. If after your adjustment for overclaiming expenses in earlier years (as above), this figure is a minus, you really need to discuss it with HMRC before you file your return as it should be a positive figure.
If you don’t need to do formal Accounts, you don’t have to do the full calculation so long as you actually keep a proper count of the value of Stock used in the year – how you do that is up to you – it should be enough that you keep a list of materials used for every product sold with how much they cost, then you’ll know your income and expenses. You can do this on a per product basis (if they’re repeatable) or a per item sold basis, but you will need to keep tabs on any price increases you’ve incurred in the underlying raw materials, and how many products were made at the old materials price, and how many at the new, as well as how many of each made at the two different cost prices were sold.

If you don’t have large volumes of raw materials or finished products building up, and you make sure you don’t have any unfinished products at your year end, it’s not difficult to keep track of the value of what raw materials have been turned into finished products and been sold or the value of what finished goods offered for resale have been sold – which is effectively what HMRC are interested in for your tax return. But if you have slow stock turnover or high stock levels, it really is a good idea to follow the strict basis calculation so you don’t miss anything out or doublecount it. Also, sometimes you have to include values for stock that don’t actually represent real cash (see below).

Let’s pretend you are doing the full calculation because then you’ll know what actually goes into the figure the HMRC are interested in for what they call ‘cost of goods bought for resale or goods used’ for the Full Self-Employment pages, but which also forms part of that single Total Expenses figure you need for the Short Self-Employment pages of your tax return.


Stock added this period – Raw Materials - purchased, gifted or bartered?


Most of the stock you’ve added to your business will have cost you money – if it was at normal market value (not a special price just for you) you use the price you actually paid.

But some stock might have been given to you for free or at a significant discount or as a swap. If you received stock for free, your price for that stock is ZERO (forever).

If it was at a very significant discount, then if HMRC asked questions they might recalculate your figures and substitute the discounted price with the price that anybody else would have to have paid (normal market value), but otherwise, you use the price you paid for it.

If you obtained the stock through a swap or barter transaction, then you have to use a value that relates to the monetary value you and the person you bartered with have put on the transaction – pretty much what it would have cost if you’d done the transaction with money instead of swapping.

So, if you bought, and bartered some stock during the year, your stock calculation contains some numbers that are real cash (reflected in your bank account or pockets) and some numbers that aren’t real cash, but which still need to be counted to work out your taxable profits – which I’ll call ‘ghost’ numbers for want of a better word. It’s important you understand this, because if your eventual stock figure on your tax return doesn’t reconcile back to your cash position, it’s because of these ‘ghost’ numbers.

Stock added this period – Work in Progress – Unfinished items

This only applies to products that you’ve started working on but haven’t actually finished on the day your year ends. It’s part of the Accruals Basis (see the last post).

For unfinished items - you have to work out two sums and then you take the lower value as the value of the unfinished stock:
  1. What is the cost of the unfinished item(s) to date? You do NOT include the cost of your time to get as far as you have in this, just the materials; because you’re a sole trader, but if you have a helper or employee, you do include the cost of their time.
  2. What is the price you would sell it for if it was finished, LESS an estimate of the further costs required to get the unfinished item to the finished state. Again, you’re a sole trader, you don’t include your time, but you do include a helper or employee’s time.
NB Strictly, if you have taken money on account for a custom order, the value of that money in your hands, but not yet spent on making the item needs to be included here. It reduces the value of the Stock Added Total. Alternatively you could make sure you include the money on account for custom orders on the income side instead – where it increases the Income Received Total. The net profits will end up the same, but the individual expense and income totals will be different depending on whether you go for the strict & correct basis of taking the money through stock, or the practical (and a not correct) one of calling it income instead. Whatever you do, be consistent year on year and make sure you’re not double counting income or expenses.

In an ideal world, you make sure you don’t actually have any unfinished custom orders or unfinished product items hanging around at your year end, then you don’t have to do this calculation at all!


End of year stocktaking


Following the strict calculation, you work out what stock you have left each year by doing an annual Valuation or Stocktake. Basically this means looking at your list of opening stock, and stock added, and comparing that to what you’ve still got at year end. You are checking whether its value has stayed the same or reduced (maybe because of damage or deterioration or its passed its sellby date or it was stolen). If the value has reduced, then you reflect that change when you add up the value of all the stock you have left. If the stock came in at zero (say as a gift) it stays at zero in the annual stocktake.

The figure for your annual stocktake is your closing stock figure for the current Trading Period, and also your opening stock figure for the next Trading Period. If you need to make any adjustments, say because you’ve decided that you want to do it properly on the strict basis going forwards, then you put in the correcting figure as though you incurred the cost on the first day of the new Trading Period. You never add the adjustment to the closing figure to get a new opening figure.

Result: Stock used during the year

If you take your opening stock, add new stock and take away the end of year stocktaking value, you end up with a figure which equals stock used during the year.

What that final figure represents is:
  • The cost of materials (stock) used in items you sold in the year
  • The value by which materials (stock) went down because of damage or deterioration
  • The value you can claim as an allowable expense in your tax return.
If you have stock on consignment in someone’s shop or gallery

If you still own the stock until it’s sold, then it needs to be included in your annual stocktake as still being part of your Stock (probably reduced in price due to sticky fingers & careless handling).

However, if your agreement with the shop or gallery says that they own the stock in their shop, then it counts as stock used, as though it was sold. You record the price that shop owes you as income according to the date the contract or your invoice says the income was due, even if the stock leaves your ownership before the end of the tax year, and the income’s due date is afterwards – you end up with a timing difference and a bit of a mismatch between expense & income.

If you aren’t following the strict basis you need to make sure you remember to include everything that left your ownership during the year, at the right price to get the right resulting figure to claim as an expense.

New businesses and Pre-Trading Expenses

As some of you will be aware, you are allowed to claim eligible expenses that you incurred in the seven years before your Commencement Date of your new business (there’ll be a post specifically on this later in the Series).

If you bought raw materials or items for reselling before your commencement date (ie in the 7 years before your business started) you include them as Stock Added as though you bought them on the very first day of trading ie your Commencement Date. You don’t include them as your Opening Stock, your Opening Stock is zero. If they were gifted or bartered, you follow the same rules outlined above for their value.

This means that these pre-trading purchases of stock are treated exactly the same way as any other purchases of stock, eligible for tax relief only when they’ve been made into something and sold or otherwise disposed out of your business.


Appropriations - taking stock for your own use


Appropriations happen when the business owner takes any of his stock for his own (or his family’s) personal use (which includes because you're giving it away to someone else as a present). There is a special box for them called ‘Goods and services for your own use’ in the ‘Calculating Your Taxable Profit & Loss’ in both the Full and the Short Self-Employment pages of your tax return.

I’m including them here because although they go in a different place on the Return to expenses, they affect your stock levels.

If you’re following the strict basis for stock, once you take raw materials or a finished product out of your stock, it doesn’t feature in the annual stocktake, and therefore the appropriation is automatically reflected in the final answer of what’s been used. If you aren’t following the strict basis for stock, you need to remember to add the cost value of appropriated stock to the value of goods used figure you declare to HMRC (either in the Full pages as a specific number, or as part of the Total Expense figure for the Short pages). That deals with the expense side of the Appropriation.

But, you also need to deal with the fact that you’ve just taken the item(s) out of stock on the income side as well. And HMRC rules say that you have to treat an Appropriation as being of market value ie the price anyone else would have paid you if they took the item(s) from your stock. No cash changes hands, because you are the business owner & sole trader, the Appropriation is another example of a ‘ghost’ number that you need to use for the Accruals basis, but which doesn’t represent real cash. You put the value of the Appropriated items in the special ‘Goods & Services for your own use’ box.

The effect of taking the Appropriation materials cost out of the Stock side and adding the Appropriated finished item’s sale ‘ghost’ price into the special box as 'ghost' income, is that the difference between the two, which would have been your profit if it had been a real sale, is treated as ‘ghost’ profit subject to tax, even though you never actually had the cash in your hands.

Using stock for marketing

If you sometimes use small finished products or supplies and put them in with a sold item as a marketing freebie for a buyer or similar, then it is not an appropriation for the owner's private use. 

If you are following the strict basis for Stock, then the fact that these items are no longer in your stock means that your using them for freebies/ marketing has automatically been accounted for.  If you aren't following the strict basis then you need to remember to include the cost Stock value of these items in the 'cost of goods used' expense claim in your tax return.

Personally, I feel that following the strict basis for Stock, once it's set up, makes it much easier for a small craft business to get the Stock expense figure correct each year; than to try and remember all the ad hoc transactions that didn't involve cash during the Trading Period and to make sure you're claiming the right amounts at the right time.

Further Reading:
  • Full Self-Assessment Pages and Notes here
  • Short Self-Assessment Pages and Notes here
  • Helpsheet 222 here
  • HMRC Manual: about Stock & Work In Progress here, about Appropriations here
The next category for the HMRC Full Self-Employment pages is Construction Industry payments to subcontractors. By definition this is irrelevant to small craft businesses, so we’re passing straight on to how to deal with the costs of helpers or employees and also travel costs in the next article.




Featured Seller: PoppySparkles (Viv Smith) is a self-taught jewellery artist and owner of Poppy Spakles, based on the Fylde Coast, near Blackpool, UK. She creates jewellery for young and old(er) girls using Freshwater pearls, Swarovski Crystal, gemstones and sterling silver. Her work predominantly focuses on birthstone jewellery, providing the perfect keepsake gift for babies, baptism, birthdays and for New Mums. Bespoke requests are welcome. Find her work at www.PoppySparkles.etsy.com

8 comments:

Poppy Sparkles said...

Wow! So much information, but all valuable. Really, really good stuff and invaluable reading for small crafting businesses.
Thank you for including my jewellery images too
Viv :)

Goblinf said...

I agree re the 'so much information' - trouble is, I'm trying to get through it all in time for people filing their tax return at the end of the month - I so should have started this series before Christmas!

But apologies if it makes your brain hurt! I suggest people just read the articles through to get the gist of them, then concentrate on the bits that are important to them!

Cecca said...

Hi Lois, thank you so much for these blog posts, they are really helping my understanding of all of the terminology. After watching HMRC's videos and browsing through a number of there worksheets I was still left wondering exactly how to calculate that first stock figure. I've been keeping and recording all my receipts for everything and I am now a bit clearer on the next step - working out how much stock I've used.. It still seems a massive amount of work to record it all for the tiny amount of turnover I've had... As a mixed media painter & printmaker I use a huge number of different materials, all of which are pretty low cost individually but add up. And I've painted and printed hundreds of differently costed works. I saw on an american blog that artists shouldn't be doing a full 'cost of goods' calculation, - is there an easier way to calculate everything when turnover is extremely low and material expenses are complex?
Many thanks, Cecca :-)

Goblinf said...

Sorry for the delay in putting up your comment Cecca, client personal tax returns in the run up to 31 January 2013 deadline took over!

I think the first thing to recognise is that this blog deals only with UK tax. So what the Americans do is irrelevant - they have a totally different set of tax rules to the UK.

Assuming your are trading in the UK: is there an easier way?

The UK tax system dealing with businesses is set up for big big business. That means that little businesses are often caught up with what feels like a lot of unnecessary admin - but just imagine how many individual bits go into a single car, and how many cars a big manufacturer may make - they in fact have the exact same headaches you do on stock.

One of the ways they deal with that is to be totally and utterly in control of their stock levels, so that they really only have both the bare minimum of raw materials and finished or part finished unsold stock sitting in their hands at their accounting year end. So yes, make it easier on yourself by not carrying too much stock.

Goblinf said...

The other way they deal with it is to have very very tight design costings - so for example, sticking with car manufacturers, they work out exactly what goes into each of their designs down to the last mili-litre of oil and tiny screw or screw-head cover, then as they go along they use the design costings every time they buy in & use the stock to make finished goods. In the same way, the more control you have over exactly what goes into any particular finished product, and you refine the original design costings for new prices for raw materials, the easier your stock control will be.

They (car manufacturers) also have policies. Say, they have a tank of paint, they know it should cover x number of cars, with a certain amount of potential wastage. So, they are able to calculate the likely number of cars covered (with proportion of wastage allocated to each car). In the same way, I'm just making up some more valentines cards. I reckon a single tube of paint could make 100 cards. So that makes it easy for me to work out (a) how much paint costs per card (for costing and for accounting) and (b) how much paint I need to keep in stock. Also, because I know how many cards I've made, from that paint, cos I keep a record, I can work out how much (very roughly) paint I still have left at the end of the year. It's then up to me to work out a policy for paint, that I then apply consistently. Do I count a paint tube as wholly used for stock as soon as I use it once to make my end of year stock count easier, or do I work out how much paint I started with, and how much I've got now (including in finished unsold cards) and only count what's left my business as my stock. That depends on what would be considered reasonable by HMRC, so the value of that particular stock item matters. I'd do the first one for a tube of paint costing a few pounds, but if I worked in silver, and several hundred pounds was at stake, I'd use the second one. There's no hard & fast rule - you have to remember that tax follows the accounting, and there's a certain degree of flexibility in the accounting because businesses are so very diverse.

Finally, there is a glimmer of hope on the horizon. The government recognise that the admin burden on small businesses is disproportionately high, and they set up a body to have a look at simplifying the tax system. That body came up with recommendations, there was a consultation process, and come the Budget next month and the Finance Act (which will start from April 2013 but not be enacted until July 2013 so there's a time lag) there will be a simplified form of accounting for small businesses - including for stock.

I'm in the process of looking at the draft legislation and because although it's a step forwards, it's not without pitfalls - I will be writing a series of e-books (probably in pdf form) that I will sell through my Etsy shop giving explanations of what each business needs to consider to choose between the current Accruals or the new Simplified accounting on an annual basis.

Hope that helps!

Lois
TootHillMedley

Anonymous said...

Hello,
This is a great post which has really helped me. I'm currently filling out my self employed tax return online (I'm a small designer/maker business and 2012-13 was my first trading year). I have the following question:
When I've worked out my closing stock figure which I put in the allowable expenses section, is there anywhere on the tax return to record the opening stock figure for next year?
Obviously I will record the opening figure in my own paperwork ready for next year's allowable expenses on next year's tax return. It just seems awkward to have expenses that are allowable next year from the previous year's actual hard copy reciepts/invoices (i.e. dated 2012 but being put into a 13-14 tax return).

Thanks for help!

Goblinf said...

Hello Anonymous (sorry it's taken so long to publish your comment and reply).

Your Question: Does the Closing Stock figure show on the tax return anywhere?
Answer: No. It doesn't. Because it's a number that you use to work out a different number that goes on the tax return.
What happens is that in Helpsheet 222 on page 2
http://www.hmrc.gov.uk/helpsheets/hs222.pdf
- if you do the calculation, the Closing Stock figure for the year at Box D for this year, is the figure that goes into Box B next year.

Or at least it does if you're staying on the Accruals Basis. What it'll look like if you're moving onto the new Cash Accounting for Small Biz next year will look like hasn't been published yet. So remember to think carefully about which of the two choices you are going to pick for next year.

Lois/ Goblinf/ TootHillMedley

Goblinf said...

hmm that was coherent. not. what I meant to say was - who knows what goes in which box next year when HMRC have to implement the new Cash Accounting Basis. Just be aware.