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 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 >>
  2. 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 >>
  3. 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 >>
  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 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. What does days sales of inventory (DSI) represent as a ratio?

    Discover what the days sales of inventory (DSI) ratio represents for traders or market analysts and how this ratio is used ... 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

    Explaining Carrying Cost of Inventory

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

    How to Calculate Average Inventory

    Average inventory is the median value of an inventory at a specific time period.
  4. 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.
  5. Investing

    Understanding Periodic Vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  6. 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 ...
  7. 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.
  8. Investing

    Why It Is Important to Follow Crude Oil Inventories

    Discover what oil inventories are, how they are communicated and what important insights they provide into the state of the oil market.
  9. Investing

    AR & Inventory Turnover Is Key For These Sectors

    Accounts receivable and inventory turnover are two important ratios in the current asset category. We will also discuss the key industries that benefit from a thorough understanding of these ...
  10. 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.
RELATED TERMS
  1. Inventory Reserve

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

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

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

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

    This is the cost a business incurs over a certain period of time, ...
  6. Days Sales Of Inventory - DSI

    A financial measure of a company's performance that gives investors ...
Hot Definitions
  1. Smart Home

    A convenient home setup where appliances and devices can be automatically controlled remotely from anywhere in the world ...
  2. Efficient Frontier

    A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a ...
  3. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  4. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the ...
  5. Border Adjustment Tax

    A tax levied on goods based on where they are sold – exported goods are exempt from tax; those imported and sold in the ...
  6. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
Trading Center