A:

As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying GAAP to inventory reserves often use a significant amount of personal judgment. Unfortunately, the judgments made are usually only as accurate as the accountants are honest. With that in mind, let's explain inventory reserves.

An inventory reserve is money that is taken out of earnings for the purpose of paying cash or non-cash anticipated future costs associated with inventory. Matters pertaining to inventory reserves are a very small part of a wide body of rules associated with inventory accounting. Costs of keeping inventory can come in many forms, and most of them are seen by the market as having the potential to negatively affect a corporation's profitability. Such costs may be holding costs, storage costs, shrinkage costs, or any type of cost arising from a decrease in the value of the inventoried assets. Inventory reserves or allowances are contra accounts as they may partially, fully or more than fully offset the balance of the inventory account.

GAAP requires that all inventory reserves be stated and valued using either the cost or the market value method - whichever is lower. If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value entry on the balance sheet. Since it is unlikely that a company would produce and inventory a product at a cost to the company that exceeds market value, such a situation would usually occur because of a negative change in the market value of the inventoried asset. For example, let's say a company produces crude oil at a cost of $25.00 per barrel. If the market price of crude oil drops to just $20.00 per barrel, then an accounting entry must be made to adjust for the change in the market value of the inventory. The entry would look something like this, assuming the company only produced one barrel of oil at $25.00 per barrel:

Debit Loss from decline in market value of crude oil $5.00
Credit Inventory $5.00

In the case of crude oil, market price is very easy to determine, as it's a commodity that is traded internationally and the price has a very low bid-ask spread. In most cases, the market price of inventory is much less easily determined. In the United States GAAP requires that inventory be stated at replacement cost, if there is a difference between the market value and the replacement value, but upper and lower boundaries are applied to the replacement cost of the inventory. This is known as the lower of cost and market value method of inventory valuation.

The upper boundary is called the ceiling. The ceiling applied to the market value of inventory is such that the market value must be below the net realizable value (NRV), which is a reasonable estimation of the eventual selling price of the asset in inventory minus the costs of the sale or disposal of the asset. The ceiling is in place to remove the opportunity for a company to overstate the value of its inventoried assets.

The lower boundary is called the floor. The floor applied to the market value of inventory is such that the stated market value must not be lower than the NRV minus an approximation of profit realized from the asset's sale. The floor is in place to remove the opportunity for a company to unrealistically overstate profit by understating the value of its inventoried assets.

It is important to recognize that GAAP is not a stagnant set of principles: rather, it changes to reflect changes in regulation and changes in standards employed by businesses operating in different industries throughout the economy as a whole. Changes are made regularly to what is, and what is not, a generally accepted principle of accounting.

(For further reading, see Inventory Valuation For Investors: FIFO Vs LIFO and Measuring Company Efficiency.)

RELATED FAQS
  1. How do you analyze inventory on the balance sheet?

    Learn how to analyze inventory using financial statements and footnotes by doing ratio analysis and performing qualitative ... Read Answer >>
  2. Why should investors care about the Days Sales of Inventory (DSI)?

    Learn about days sales of inventory and what it measures; understand why an investor would want to know a company's days ... Read Answer >>
  3. Why is it sometimes better to use an average inventory figure when calculating the ...

    For a couple of key reasons, average inventory can be a better and more accurate measure when calculating the inventory turnover ... Read Answer >>
  4. How does inventory accounting differ between GAAP and IFRS?

    Learn about inventory costing differences between generally accepted accounting principles, or GAAP, and International Financial ... Read Answer >>
  5. How do you find a company's days sales of inventory (DSI)?

    Discover the formula to calculate days sales of inventory and how it is helpful to market analysts and investors, but it ... Read Answer >>
  6. What is the formula for calculating inventory turnover?

    Learn about the inventory turnover ratio, how it is calculated and what this efficiency metric tells businesses about their ... Read Answer >>
Related Articles
  1. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  2. Investing

    Days Sales of Inventory

    Days Sales of Inventory, also called Days Inventory Outstanding, is a key financial measurement of a company's performance pertaining to inventory management. In simple terms, it tells how many ...
  3. Investing

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  4. Investing

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  5. Investing

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  6. Investing

    What is Involved in Inventory Management?

    Inventory management refers to the theories, functions and management skills involved in controlling an inventory.
  7. Investing

    Understanding Periodic Vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  8. Investing

    Reading The Inventory Turnover

    Inventory turnover is a ratio that shows how quickly a company uses up its supply of goods over a given time frame. Inventory turnover may be calculated as the market value of sales divided by ...
  9. Small Business

    How Does a Perpetual Inventory System Work?

    Perpetual inventory is a system that continually tracks inventory items for quantity and availability.
  10. Investing

    Measuring Company Efficiency

    Three useful indicators for measuring a retail company's efficiency are its inventory turnaround times, its receivables and its collection period.
RELATED TERMS
  1. Lower of Cost and Market Method

    A requirement of GAAP in the United States that inventory be ...
  2. Inventory Reserve

    An accounting entry that represents a deduction from earnings ...
  3. Ending Inventory

    The value of goods available for sale at the end of the accounting ...
  4. Average Inventory

    A calculation comparing the value or number of a particular good ...
  5. Perpetual Inventory

    A method of accounting for inventory that records the sale or ...
  6. Carrying Cost Of Inventory

    This is the cost a business incurs over a certain period of time, ...
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center