Abby Jenkins | Product Marketing Manager | August 14, 2023
Even for healthy, growing companies, it’s inevitable that not all of their inventory will get sold 100% of the time. Some percentage of inventory will go bad or become obsolete. A business’s inventory reserve is its estimate of that percentage; it plays an important role in correctly valuing the company’s inventory and, therefore, in presenting a full picture of the business’s financial worth, health and flexibility.
What Is an Inventory Reserve in Accounting?
To create an accurate picture of the business’s inventory position, businesses estimate how much inventory won’t be sold and will eventually be written off — the inventory reserve. Companies own raw materials, partially completed products and finished goods. These items are all included in a company’s gross inventory. Business managers know that not all of their raw materials will be used and not all of their finished goods will be sold. That reserve is deducted from the value of gross inventories to arrive at the company’s net inventory position. Net inventory is typically what appears on a company’s balance sheet.
In accounting terms, the inventory reserve is a “contra” asset balance sheet account that reduces gross inventory value to arrive at a company’s net inventory. Inventory accounts have a natural debit balance, meaning they are increased with debits. Contra asset accounts, like an inventory reserve, have natural credit balances and serve to reduce the value of their associated assets. But if you’ve never seen an inventory reserve account appear on a financial statement balance sheet, don’t fret; companies typically publish only the rolled up or netted high-level accounts. In this case, that would be net inventory.
When an inventory reserve is created on the balance sheet, an expense of the same amount is included in cost of goods sold (COGS) on the income statement. By doing this, the company is recognizing a cost today that won’t occur until some point in the future.
Inventory Write-Off vs Inventory Reserve: Timing is the main difference between an inventory write-off and an inventory reserve. An inventory reserve is the amount of inventory a
business anticipates will not be sold in the future. An inventory write-off recognizes inventory that has lost value today.
There’s also a second difference. The inventory reserve is based on management’s estimate of what percentage of total inventory will not be sold in the future. It is looking at inventory as a whole and not forecasting that any specific item in inventory will not be sellable. In a write-off, management has identified specific inventory items that cannot be sold or are overvalued and must be written off. Reserves are fluid and should be constantly reevaluated; write-offs are specific and permanent.
· An inventory reserve is a balance sheet item reflecting the value of inventory that management believes will never be sold.
· Business managers use data from previous years, and their judgment, to decide the size of the reserve.
· When an inventory reserve is created, an expense is also created and included in cost of goods sold on the income statement.
· Software can easily and precisely track what inventory doesn’t get sold each year, which helps managers more accurately determine the inventory reserve in future years.
Inventory Reserve Explained
Despite a company’s best efforts, not everything in inventory may ultimately get sold. Sometimes inventories don’t sell because they’ve become obsolete. This often happens with technology software and equipment. When a new, faster computer hits the market, no one wants to buy the older, slower computer. It may have to be sold at a discount — or it’s obsolete and may not ever sell.
Sometimes external changes make inventory outdated. The new connector and plug used on smartphone accessories might sell like hotcakes, but if manufacturers switch to a faster port, the accessories remaining in inventory may never get sold. Some inventory is perishable. Food and beauty products, for example, go bad after a certain date and legally can’t be sold. And there’s often a certain percentage of inventory that gets damaged, broken or stolen during the regular course of business.
For all these reasons, business managers must create an inventory reserve that reflects the value of inventory that might never be sold in the future.
How Does an Inventory Reserve Work?
To calculate an inventory reserve, managers track the percentage of inventories that were never sold or spoiled in past fiscal periods. The percentage can be adjusted based on a manager’s evaluation of the current market environment or customer demand and preferences.
The percentage is then applied to the company’s current gross inventory to calculate an inventory reserve, which is then deducted from gross inventory to arrive at the company’s net inventory. It is typically the company’s net inventory that appears on the balance sheet.
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Why Do Inventory Reserves Matter?
Reserves exists as an inventory management practice because they can influence a company’s bottom line, its ability to obtain debt or the terms of such debt. If a business consistently sees too much inventory going unused, it could signify a breakdown further up the supply chain between demand and supply.
At the same time an inventory reserve is created on the balance sheet, an expense is created and included in COGS on the income statement. COGS is subtracted from revenue, so — assuming revenue is constant — when COGS increases, net income decreases. Conversely, when COGS decreases, net income increases. Therefore, the inventory reserve has a direct impact on a company’s bottom line and supply chain resilience.
Companies can also use their inventory as collateral for loans. Banks may rely on companies’ valuation of their inventory when deciding how much money to lend and what interest rate to charge.
Function of Inventory Reserve
A company’s inventory reserve helps it present an accurate inventory position. Since inventory is an asset that can be sold to generate revenue or be used as collateral for debt, awareness of a company’s inventory and its inventory reserve helps investors understand a company’s worth and its future revenue opportunity.
Accounting for Inventory Reserves
Business managers must tally the current value of the company’s inventory in every fiscal period to provide the most accurate and up-to-date picture of the organization’s assets as business conditions change. Determining that value requires accounting for inventory reserves, which involves multiple steps. First, the total, or gross, inventories are valued at the lesser of their market value or their cost under Generally Accepted Accounting Principles (GAAP).
Next, managers calculate the inventory reserve by looking at historical financial reports to learn how much inventory wasn’t sold, as a percentage of revenue, in past years. That percentage is
then applied to the company’s gross inventory to estimate how much of today’s inventory may not be sold in the future.
Management has some flexibility to use judgment when calculating the inventory reserve. After reviewing actual data, they may determine that the current selling environment is better — or worse — than it was in the past and change the inventory reserve accordingly. For example, new competitors may have arrived in the market that make it more likely the company won’t sell all of its inventory, in which case the reserve might need to increase. Conversely, there could be an industrywide problem sourcing materials that hikes demand for the products a company has in inventory and increases the likelihood that all of its inventory will sell out. In this case, the reserve might need to be lowered.
Then, gross inventory is netted against the inventory reserve to arrive at net inventory. Net inventory is the figure that appears on a company’s balance sheet.
In a related accounting step, when an inventory reserve is created on the balance sheet an expense is also created and added to cost of goods sold on the income statement. By doing this, a company’s income statements reflect today an expense that will be recognized in the future.
Later, when managers acknowledge that a specific piece or pieces of inventory will not sell, an inventory write-off is created to take the pertinent items of inventory off the company’s books. On the balance sheet, the amount of the write-off is deducted from gross inventory (using a credit) and the inventory reserve is reduced by the same amount (using a debit). The net inventory amount remains unchanged because it already reflects loss that had been previously anticipated.
Once it’s recognized that inventory won’t be sold, management must write down the inventory immediately. Recognition of the loss cannot be spread over the course of a year, for example. However, companies can opt to retain inventory that has been written off in hopes that it will sell at some point in the future, or can be repurposed or sold for parts and materials. However, management will have to weigh the potential benefit of future revenue from that written-off inventory against the cost of warehousing the inventory and the risk the inventory’s value will decline even further.
There may also be times when a product’s value drops below its cost but the business still believes it can be sold at a discount. In that scenario a write-down occurs. An accountant would recognize the lower value of the item and adjust the gross inventory and the inventory reserve accounts accordingly.
Inventory Reserves & GAAP
GAAP standards and principles are meant to make it easier for investors and analysts to compare different companies; accountants in public companies are obliged to follow GAAP in assembling financial statements. A number of GAAP standards apply to inventory reserves. For example, the method used to determine the size of an inventory reserve must be consistent from one year to the next, and accountants must disclose any changes to that reserve method.
The GAAP principle of prudence — i.e., accountants are expected to use facts whenever possible and minimize speculation — also applies to inventory reserves. So, when accountants set inventory reserves, they mainly use historical write-off data to determine what percentage should be used when calculating the current year’s inventory reserve.
In addition, inventory write-offs should be recognized as soon as they occur. This fulfills GAAP’s principle of periodicity, whereby companies are expected to report events in the correct time period.
Inventory is valued at either its cost or its market value, whichever is lower. To prevent companies from inflating or underestimating their inventories’ value, a ceiling and floor exist.
The ceiling states that the market value of the inventory must not be more than its net realizable value, which is an estimate of the inventory’s future selling price minus its cost of sale, transportation or disposal. The floor states that the market value of the inventory must not be less than the net realizable value of the inventory minus the estimated profit realized from the inventory’s sale.
Inventory Reserve Example
Let’s look at an illustration of how inventory reserves work. Jane’s Pet Emporium has $100,000 of total, or gross, inventory. After looking at 10 years of financial reports, Jane determines that 1% of gross inventory never gets sold because pet food expires and a small amount gets stolen or damaged. Jane’s accountant creates a $1,000 inventory reserve as a contra asset account on the company’s balance sheet.
Gross inventory is netted against the inventory reserve, resulting in net inventory of $99,000. Net inventory is the figure that appears on Jane’s Pet Emporium’s balance sheet. At the same time, a $1,000 expense is created and included in the company’s COGS.
Six months later, Jane takes stock of inventory and finds that $100 of pet toys have been broken and can’t be sold. Her accountants recognize that loss by reducing the amount of gross inventory to $99,900. They also reduce the inventory reserve to $900. By doing so, the loss is recognized but Pet Emporium’s net inventory remains unchanged at $99,000.
Net inventory is unchanged because Jane’s already anticipated the loss with its inventory reserve. Likewise, the company’s expenses don’t increase at the time of the write-off because the expense was recognized when the inventory reserve account was established.
Fraudulent Uses of Inventory Reserves
Companies can commit fraud by incorrectly reporting the value of their inventory reserve.
A company might improperly increase the inventory reserve when business is booming even though the outlook on its ability to sell the inventory hasn’t changed. Boosting the inventory reserve will result in an expense on the income statement that artificially reduces income and taxes. The inventory reserve rolls over from one period to the next. So, in a year or two, when times are tougher, the company might fraudulently decrease its inventory reserve and enter a “negative” expense in COGS, which boosts net income. In this case, the company is improperly using its inventory reserve as a piggy bank, inflating it when times are good and withdrawing from it when times are bad to fraudulently manipulate earnings.
Another fraudulent use can occur when management wants to sell the company. It could reduce its inventory reserve because doing so would boost the value of net inventory and total assets. A company with more assets should theoretically fetch a higher purchase price.
Auditors are expected to ask a company to provide an explanation anytime the assumptions used to create an inventory reserve change. Companies must disclose the change, explain why the change occurred, show the adjustment due to the change and restate prior financial statements using the new accounting method. Not disclosing a change is fraudulent.
Manage Inventory Reserves With Accounting Software
Inventory software helps companies track their inventory position, reduce obsolete inventory and keep inventory reserves and write-offs to a minimum. It also tracks how much inventory is written off each year, giving managers the data needed to accurately estimate their inventory reserve going forward. An accurate history of inventory write-offs prevents a company from under-reserving for inventory and being caught with unexpected expenses in the future. It also prevents companies from over-reserving for their inventories, which would result in an unnecessary expense today. Accounting software also ensures that assumptions used in a company’s books are applied consistently from year to year.
In addition to all this, NetSuite Inventory Management provides business managers with a real-time view of inventory across all locations and sales channels. It gives managers visibility into what inventory hasn’t sold in the past, so they can more accurately forecast inventory reserves in the future.
Properly valuing a company’s inventory is essential to understanding its net worth and future revenue opportunities. Creating an accurate inventory reserve presents business managers and investors with a conservative look at a company’s net inventory position, because it recognizes future losses and expenses today.
Inventory Reserve FAQs
How do you calculate inventory reserve?
To calculate an inventory reserve, review historical data to learn what percentage of inventory is left unsold. Deduct a percentage from gross inventory to determine net inventory, which appears on the company’s balance sheet. Use discretion to change the percentage of the reserve to reflect changing business conditions.
How does an inventory reserve account work?
An inventory reserve account is a “contra” asset balance sheet account that reduces gross inventory value to arrive at a company’s net inventory. Contra asset accounts, like an inventory reserve, have natural credit balances and serve to reduce the value of their associated assets.
Can you reverse an inventory reserve?
If more inventory is sold than was expected, then yes, the inventory reserve can be reversed. At the same time, COGS must also be reduced by an equal amount, since the inventory reserve is reflected as a COGS expense on the income statement.
What is inventory obsolescence reserve?
An obsolescence reserve is created when a company determines that specific items, or a category of items, in its inventory are worth less than their book value. When that occurs, a company creates an inventory obsolescence reserve on its balance sheet and enters the difference between the items’ book value and their current market value. At the same time, an expense on the income statement would be recorded for the same amount.
Let’s consider the example of Jane’s Pet Emporium. It has 10 fancy dog beds in inventory that cost $50 each. The competition is offering a comparable dog bed for $30. Jane decides to recognize that her dog beds won’t sell for $50. She creates a $200 obsolescence reserve by first calculating the difference between the cost of her dog bed and the new expected market value of the dog bed ($50 – $30 = $20). She then applies the difference in value to each of the 10 beds in inventory (10 x $20 = $200). At the same time, she creates an obsolete inventory expense for $200.