T2125 Cost of Goods Sold: Opening and Closing Inventory

Do I fill in cost of goods sold on my T2125, and which part is it?

Yes, if your business buys goods to resell or makes goods to sell. Cost of goods sold is Part 3D of the T2125. The CRA's guide says you claim the cost of goods in the fiscal period (your business year) in which you sell them, not the period in which you buy or make them. So stock you have bought but not yet sold is not a deduction this year: closing inventory on line 8500 takes it out, and it becomes next year's opening figure. A business with no stock and no goods cost usually leaves Part 3D blank.

This page covers the federal T2125, which is the same in every province. Quebec residents also file with Revenu Québec, which this page does not cover.

A case stops being simple when:

• This is your first T2125 with stock, or the first year you count it.
• Last year's closing inventory is missing, was a guess, or does not match your records.
• Your books recorded purchases but never tracked what was left on the shelf.
• You make the goods yourself, so closing stock also carries labour and overhead.
• You have partners, or a partnership holds the stock.
• You bought stock in US dollars.
• Some stock is now worth less than it cost.

Gather before you start: a year-end count sheet, the year's supplier invoices, last year's closing figure from last year's return, and sales by month.

What is the cost of goods sold formula on the T2125?

Cost of goods sold is opening inventory, plus purchases, direct wages, subcontracts and other costs, minus closing inventory. Part 3D of the form sets it out line by line, and says to enter only the business part of the costs.

Part 4 of the form starts from line 8519 when you fill in Part 3D, so a mistake in Part 3D flows straight into net income.

Why must opening inventory equal last year's closing inventory?

Because the Income Tax Act ties the two together: inventory at the start of a year is valued at the same amount as it was valued at the end of the preceding year (section 10(2)). The CRA's guide says the same for line 8300. In your first year of business there is no opening inventory to enter.

Each year-end figure is one year's closing and the next year's opening, so an error in it moves profit between those two years by the same amount. If last year's closing figure is missing or wrong, changing only this year's opening breaks the link the Act requires; the first-year section below covers what to do.

What goes into purchases on line 8320?

Line 8320 holds your net purchases for the year: what you bought, minus returns, allowances and discounts, including delivery, freight and express charges, minus the cost of any goods you took for personal use (CRA guide).

Enter everything you bought in the year, including stock still unsold. Closing inventory takes the unsold stock back out.

What labour counts: direct wages, subcontracts and my own pay?

Direct wages and subcontracts count; your own pay never does. Line 8340 is for pay to employees who work directly in making your goods. Line 8360 is for the cost of hiring outside help for tasks related to the goods you sell (CRA guide).

Line 8340 excludes indirect wages, a salary paid to yourself or a partner, and withdrawals you took from the business. A sole proprietor's own take is a drawing, not a wage; see sole proprietor drawings. Pay for people who do not work directly on making the goods is indirect; the expense lines guide shows where it goes. Claim a wage once, on line 8340 or in Part 4, never both.

A business that only resells goods usually has no direct wages.

How do I count and value closing inventory?

Count your stock at the end of the fiscal period, then value it by one of two methods. The CRA's guide says to do an actual stock count at the end of each fiscal period unless you use a perpetual inventory system, under which you do periodic counts and keep a written record of each count. Closing inventory on line 8500 includes raw materials, goods in process and finished goods, and unused packaging material and supplies (CRA).

A count sheet lists each item or group with a description, the quantity on hand, the unit cost and the total. Count the stock you own on the last day of the period, wherever it is kept.

For the lower-of-cost method, the fair market value of packaging material, parts and supplies in stock is their replacement cost, except for items that are obsolete, damaged or defective (Act, s. 10(4) and 10(5)).

If an item is worth more than it cost, the whole-inventory method counts it at the higher value, which lowers cost of goods sold and raises profit for the year. The item-by-item method never counts an item above its cost, and needs a cost for each item or group.

For goods you buy, cost means laid-down cost: the invoice price plus duties, transportation and other costs of getting the item to you. For goods you make, the CRA's archived inventory bulletin (1998) adds the direct labour applied to the product and does not accept leaving overhead out. Which overhead to include, and which cost applies when you paid different prices for the same item, are judgment calls; ask before you set them up.

Do I have to use the same inventory valuation method every year?

Yes, unless the CRA agrees to a change. Section 10(2.1) of the Income Tax Act requires the method used at one year end to be used at the next, unless you adopt another permitted method with the Minister's concurrence and on any terms the Minister specifies. The CRA's guide says to keep the method you chose, and lets you pick either method in your first year of reporting business income.

Your first return therefore sets the method for the years that follow. To change it you need the CRA's agreement, so ask before you file the return for the year of change. If you changed methods without asking, get advice before you file.

How should I track inventory cost in my books during the year?

Choose a periodic or a perpetual record, and make your books produce the same figures Part 3D asks for.

Whichever you use:

• Record each purchase's price, freight and duty so the cost traces back to an invoice, and record returns and discounts as reductions.
• Keep GST/HST you claim back out of the inventory cost.
• Take goods you use personally out of cost of goods sold and record them as a drawing.
• Keep each count sheet with your other records; see how long to keep business records.
• At year end, check that the books' cost of goods sold matches line 8518, and that next year's opening balance equals this year's closing.

For the accounts themselves, see setting up the books. For stock bought in US dollars, see USD inventory cost in CAD books.

How do GST/HST and PST affect the purchases and sales I enter?

For GST/HST, leave it out of cost of goods sold if you remitted it or claimed an input tax credit (the GST/HST you get back on business purchases); under the Quick Method, include it. The T2125 says so for Parts 3D, 4 and 5. A registrant who claims an input tax credit reduces the cost by the credit (CRA guide, chapter 3).

A business with no GST/HST registration has no credit to claim. The form says to leave the tax out only when it was remitted or claimed, and the CRA's guide says deductible expenses include the GST/HST you incur less any credit claimed, so tax you pay and cannot claim back stays in your purchases. If you register part-way through the year, the split depends on the dates; get bookkeeping help. Quick Method books are covered in Quick Method in the books.

On sales, the T2125 starts gross sales with GST/HST collected or collectible, then removes GST/HST, provincial sales tax, returns, allowances and discounts at amount 3B. Whether tax you collect is income is answered in is GST/HST collected income.

PST on purchases depends on your province. In British Columbia, for example, goods obtained solely for resale are exempt when you give the supplier your PST number or a certificate, but not for small sellers (PST 208). See provincial sales tax and check your own province's rules.

What if this is my first year with inventory, or I never counted it before?

Your case decides what goes on line 8300. Count your stock on the last day of the fiscal period, value it, and enter it on line 8500.

If earlier returns deducted every purchase and never showed closing stock, you cannot simply set this year's opening figure to a new number (section 10(2)), and only the CRA can act under section 10(3): it may direct that an opening figure not valued as required be treated as valued as required, which its audit manual describes as a way to correct an unacceptable year-end valuation without also adjusting the opening value. A filed return is changed by a request to the CRA (how to change a return). The CRA can normally reassess an individual's return within three years of the original notice of assessment, and a refund cannot be issued for an adjustment request made more than 10 calendar years after the end of the tax year; see how far back the CRA can reassess. Which years to change, what each year's closing stock should be and how profit moves between them depend on the facts, so get help before you file. If the books are also months behind, see catching up on overdue books.

Example

These examples are illustrative. All figures are in Canadian dollars and exclude GST/HST.

Alberta candle maker, full year

Sales are C$60,000. Opening inventory is C$3,000, last year's closing figure. Purchases, net of returns and including freight, are C$22,000. There are no direct wages, subcontracts or other costs. The December 31 count, at cost, is C$4,000.

Cost of goods sold is 3,000 + 22,000 − 4,000 = C$21,000. Gross profit is 60,000 − 21,000 = C$39,000. Next year's line 8300 starts at C$4,000.

Reseller that starts in July

The reseller has no opening stock, so line 8300 is blank. It buys C$15,000 of goods by year end, and the December 31 count of unsold stock, at cost, is C$6,000. Cost of goods sold is 15,000 − 6,000 = C$9,000. Next year's opening inventory is C$6,000.

Jackets worth less than they cost

A shop holds 40 jackets that cost C$3,000 and are now worth C$2,000. Valued item by item at the lower of cost and fair market value, they go into closing inventory at C$2,000, so this year's cost of goods sold is C$1,000 higher than if they were kept at cost. Next year's opening figure for them is C$2,000, not C$3,000.

Different for you?

• This is your first T2125 with stock, last year's closing figure is missing or wrong, or your books never tracked stock: the opening and closing numbers, the valuation method and the correction of earlier years need professional judgment. Get bookkeeping help to settle them, and bring your count sheet, invoices and last return.
• Your books are months behind: see catching up on overdue books and ask for bookkeeping help.
• You make the goods yourself: closing stock then carries labour and overhead as well as materials. Ask bookkeeping help to set up the costing.
• You buy stock in US dollars: follow USD inventory cost in CAD books.
• Some stock purchases have no invoice: see business expenses without receipts.
• You need the T2125 line for each expense: use self-employed expense lines.
• You collect GST/HST or use the Quick Method: see is GST/HST collected income and Quick Method in the books.
• You are a partner: a partnership computes its income as if it were a separate person (Income Tax Act, s. 96(1)(a)), so it works out its own cost of goods sold; general partnership first-year return shows how each partner reports it. Ask about bookkeeping help for the partnership's books.
• Your activity may be an adventure or concern in the nature of trade: inventory must then be valued at cost, not at fair market value or lower of cost and market (section 10(1.01)). Whether an activity is one is a question of fact; ask about individual tax help.
• You make original artwork to sell: if the business is your own artistic endeavour (works you create, such as paintings, prints or sculptures, not reproductions), you can elect, in your return for the year, to value inventory at nil (Act, s. 10(6) to 10(8)). The CRA's guide says to enter zero at line 8500, and the election carries into later years unless the CRA agrees to a change. Settle whether you qualify before you file; ask about individual tax help.
• You are a corporation, or about to become one: a corporation reports cost of goods sold on its T2 return; see chart of accounts for GIFI. For moving a sole proprietorship's books and opening balances into a company, see books after incorporating.
• You want to know what the profit costs you in tax: see how self-employed income is taxed.