Inventory Reserve

What it is:

An inventory reserve is an accounting entry that reflects a reduction in the market value of a company's inventory.

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 inventory 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 inventory account actually occurs in a sub-account called "inventory reserve."

Once the company is reasonably aware that the problem exists, the company has an obligation to reflect that in the financial statements, regardless of whether the loss has actually occurred. For this reason, companies record increases in their inventory reserves prior to actually selling the inventory 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 inventory. They do this because they know from experience that a percentage of their inventory is bound to be defective, stolen, spoiled, etc. Then they add to or reduce the inventory reserve as they see fit.

Inventory reserves reflect conservative accounting because they show that a company is reflecting inventory losses before they have occurred. These reserves also cushion the financial statements in case a larger-than-expected loss occurs. In this regard, managers may be tempted to artificially increase the inventory reserve when things are good and then reduce that inventory reserve to plump up profits artificially when things are bad.