What it is:
An inventory reserve is anentry that reflects a reduction in the of a company's .
How it works/Example:
For example, let's say that Company XYZ bought 1,000,000 widgets for $4 each. Company XYZ sells them for about $10 each to retailers. The retailers typically mark them up to $20.
Let's say a study finds that widgets cause cancer in people over 65 when two or more widgets are held together. As a result, the demand for widgets plummets, leaving retailers unable to charge $20 for widgets; today they're only selling for $6. As a result, retailers (Company XYZ's customers) are willing to pay only $3 per widget from Company XYZ.
The trouble is, Company XYZ's widgets cost it $4 each, and now it can only sell them for $3. Company XYZ is going to record a $1,000,000 increase in its inventory reserve ($4 - $3 = $1 x 1,000,000).
To record this, Company XYZ decreases the value of its account (on the balance sheet) by $1,000,000 and increases its cost of goods (on the income statement) sold by $1,000,000. This has the effect of reducing the value of the company's total assets and its net income for the period by $1,000,000. The decrease in the account actually occurs in a sub-account called " reserve."
Once the company is reasonably aware that the problem exists, the company has an to reflect that in the financial statements, regardless of whether the loss has actually occurred. For this reason, companies record increases in their reserves prior to actually selling the for less than they paid for it.
Why it matters:
Inventory reserves happen when companies have to write down their inventories for theft, spoilage, obsolescence, or other situations. Many times, companies maintain an inventory reserve as a matter of course; they set the reserve as a percentage of all
reserves reflect conservative because they show that a company is reflecting losses before they have occurred. These reserves also cushion the in case a larger-than-expected loss occurs. In this regard, managers may be tempted to artificially increase the reserve when things are good and then reduce that reserve to plump up profits artificially when things are bad.