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 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 >>
  2. 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 >>
  3. 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 >>
  4. Does working capital include inventory?

    Learn about inventory that is part of current assets and working capital, which is the difference between current assets ... Read Answer >>
  5. How do I calculate the inventory turnover ratio?

    The inventory turnover ratio is a key measure for evaluating how efficient management is at managing company inventory and ... Read Answer >>
  6. How can a company control its holding costs?

    Learn about the specific costs that go into a company's overall inventory holding costs, and understand how a company can ... 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

    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.
  3. 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 ...
  4. 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.
  5. Investing

    US EIA Oil Inventory Preview

    U.S. Department of Energy crude oil inventory data released later today should provide an indication of what is next for oil prices.
  6. Investing

    Uncovering Oil And Gas Futures

    Find out how to stay on top of data reports that could cause volatility in oil and gas markets.
  7. Investing

    Calculating Net Realizable Value

    An asset’s net realizable value is the amount a company should expect to receive once it sells or disposes of that asset, minus costs from its disposal.
  8. Investing

    Is Sales Growth Weaker Than Inventory Growth?

    Find out why Goldman Sachs Equity Research is concerned about inventory growth, which appears to be outpacing sales growth for many U.S. sectors.
  9. Investing

    Spotting Creative Accounting On The Balance Sheet

    Companies have ways of manipulating their balance sheets that investors should be aware of.
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. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that eventually eliminated tariffs to encourage economic activity between the United ...
  2. Agency Theory

    A supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving ...
  3. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  4. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  5. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  6. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
Trading Center