Peter MacIntosh
It seems like inventory should be a pretty straight forward issue for accounting and tax purposes. As a basic concept, inventory should be valued as an accumulation of the costs that were required to manufacture a product and an applicable share of overhead related to the production process. However, the issue of when and how to value inventory, in the context of farming and wineries, is not really well defined in the Income Tax Act. Furthermore, the calculation of inventory directly impacts the profitability of your business as reported in your financial statements.
When are you required to account for inventory?
Farming operations are allowed to account for income and expenses on a cash basis for tax purposes. When you spend cash you get to take a deduction for tax. Similarly, when you receive cash from product sales you include it in income. Additionally, there are other adjustments that allow bona fide farmers to smooth their income from year to year and manage their tax liability.
Subsection 248(1) of the Income Tax Act states farming “includes tillage of the soil, livestock raising or exhibiting, maintaining of horses for racing, raising of poultry, fur farming, dairy farming, fruit growing and the keeping of bees”. Growing grapes would meet the definition of farming. However, what happens when you convert grapes to wine? Are you still in the business of farming and allowed to use the cash basis of accounting and tax reporting? Or are you no longer operating a farming business and you must adopt accrual accounting?
Canada Revenue Agency has held a long standing administrative policy that the business of making wine is separate and distinct from farming operations such as growing grapes. A recent tax court case challenged this position and the taxpayer was successful in arguing that its operation of an estate winery was in fact a farming business. However, the court’s decision was very clear in stating that the facts of any situation will determine whether a business, such as a winery, is a farming business or a combination of a farming business and a non-farming business. As a winery expands or acquires more property then these facts could impact the farming/ non-farming analysis. The important point to note is that the specific facts of each business situation must be examined on a regular basis. More often than not, making assumptions about your farming status will lead you to wrong choices for your tax reporting.
How to account for inventory?
If you have determined that you cannot use the cash method of accounting then you will need to record your inventory value as part of your accounting system. Setting up inventory values on your balance sheet for month end or fiscal year end reporting is referred to as accrual accounting. Accrual accounting is less flexible, as compared to cash basis accounting, in terms of allowing business owners to smooth their income for tax purposes over several periods.
We see two main mistakes that business owners make when trying to value inventory. The first is they value their inventory at retail prices i.e. what they sell it for to their customers. Secondly, we see inventory being valued at some kind of “industry standard” for bulk and bottled wine. Inventory must be based on an accumulation of actual costs incurred by a business and it is not correct to record inventory at its retail value. Using a “standard cost” is fine as long as the standard cost is based on the specific business’ unique cost structure and not some general rule of thumb number.
The wine industry is unique in that the cost structure for each vintage can be quite different due to changes in crop yield. A crop year with a larger yield that resulted in higher cases of bottled wine will have a lower per bottle cost than a crop year that was lower producing. If a winery buys grapes from an outside grower one year, when it does not normally make grape purchases, will have its cost structure, and related inventory value, impacted for that year. There are other variables that can impact inventory valuation as well and this is where the “art” of valuation of wine inventory comes into effect.
How does this affect my business?
Normally the cash basis of accounting involves early recognition of expenses. If a winery owner makes the wrong choice of cash versus accrual accounting then the potential adjustments to its income for tax purposes can be significant. If Canada Revenue Agency was successful in denying a winery the utilization of cash basis accounting then the result could be a big tax bill.
Inventory valuation is important because it directly impacts the net income of a business. In addition, inventory is the asset that must be well managed in a winery business in order to avoid cash flow issues. If it is not being valued correctly then financial information could be misrepresented and wrong business decisions made.
Frequently reviewing your system of accounting for inventory with your internal accounting staff or external accountant is always an excellent idea.
Peter MacIntosh, CPA, CA is a partner with White Kennedy LLP. White Kennedy has offices in West Kelowna, Penticton and Osoyoos. Peter can be reached at 250-492-9984 or pmacintosh@whitekennedy.com.