Generally accepted accounting principles (GAAP) require that all inventory reserves be stated and valued using either the cost or the market value method—whichever is lower. However, accountants who apply the GAAP to inventory reserves often use a significant amount of personal judgment.
It is important to recognize that GAAP is not a stagnant set of principles. Rather, it changes to reflect changes in regulations and 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.
Breaking Down 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. They may be in the form of 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.
Applying GAAP to Inventory Reserves
If the cost of inventory exceeds the market value, an adjustment must be made to the inventory value entry on the balance sheet. 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 a decline in market value of crude oil $5.00
Credit: Inventory $5.00
In the case of crude oil, the 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 is stated at replacement cost if there is a difference between the market value and the replacement value, but upper and lower boundaries apply. This is known as the lower of cost and market value method of inventory valuation.
The upper boundary, called the ceiling, is in place to remove the opportunity for a company to overstate the value of its inventoried assets. 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 lower boundary, called the floor, is in place to remove the opportunity for a company to unrealistically overstate profit by understating the value of its inventoried assets. 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.