If you operate a business as a sole proprietor or in an unincorporated partnership, you need to report your business income annually using Form T2125 Statement of Business or Professional Activities. The form is exhaustive and requires many calculations, including one that is often misunderstood: inventory. Here is what you need to know to make sure you comply with the Income Tax Act.
Basic Rule for Deducting Expenses
One of the most basic rules regarding reporting business income in Canada is that you are entitled to deduct all the expenses that you incur earning that income. Fundamentally, inventory refers to the goods that you have purchased for resale as part of your business. Because your inventory earns income for your business, you can deduct its cost.
Inventory and the Cost of Goods Sold
From an accounting perspective, inventory can be described as both an asset and an expense. It is an asset because you own the actual physical goods, which have value. It is also an expense because you spent money to acquire them. Annually, you are entitled to deduct the portion of the money that you spent to acquire goods that you actually sold. This is called the “cost of goods sold,” and you must calculate it and report it on your T2125 form. To calculate your cost of goods sold, you need to know three essential elements: the value of your inventory at the start of your fiscal period, the value of your inventory at the end of your fiscal period, and the cost of your purchases during the fiscal period. To get that information, do an actual stock count at the end of each fiscal period, or use a perpetual inventory system. In all cases, keep detailed records of your inventory. If this is your first year of reporting business income, you need to choose a method for valuing your inventory. In subsequent years, you must continue to use the same method, so choose carefully.
Filling out Form T2125
The inventory portion of Form T2125. is in Part 4, or lines 8300 to 8500. Enter your opening inventory amount at line 8300 and your closing inventory amount at line 8500. On line 8320, enter the amount of purchases you made during the year. Your purchases should include the cost of the goods themselves as well as incidental costs such as delivery, freight, and express charges. Conversely, subtract any discounts you may have received. On line 8340, indicate the direct wage costs (remuneration) you paid to employees who work directly in the manufacture of your goods. Do not include indirect wages such as administrative salaries or a salary paid to yourself or a partner. On line 8360, enter the costs of outside contractors (as opposed to employees) whom you hired to perform tasks related to the goods you sold. Finally, on line 8450, enter any other direct costs that you incurred as part of producing or acquiring your inventory.
Add lines 8320, 8340, 8360, and 8450 to your opening inventory amount (line 8300). The sum is your total cost of inventory. From that amount, subtract the value of your closing inventory (line 8500). The remainder is your annual cost of goods sold for the year. This is the amount you can deduct from your gross business income to arrive at your gross profit. The secret to making inventory calculations simple is keeping detailed and timely records. When you use those, filling out Form T2125 is not nearly as daunting as it first appears.