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 (GAAP) and International Financial ... 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. How is work in progress (WIP) typically measured in accounting?

    Understand what work in progress is and why a company would have this on its financials. Learn how work in progress is typically ... Read Answer >>
  4. How should a change in accounting principle be recorded and reported?

    Learn about changes in accounting principle and why businesses make them, as well as the reporting and recording requirements ... Read Answer >>
  5. What is the difference between work in progress (WIP) and raw materials in accounting?

    Learn about the difference in inventory financial accounting between works in progress and raw materials, as reported in ... Read Answer >>
  6. Does US GAAP prefer FIFO or LIFO accounting?

    Investigate the use of LIFO and FIFO inventory accounting methods under U.S. GAAP, and learn why there is pressure from some ... 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

    How to Calculate Average Inventory

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

    Understanding Periodic vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
  4. 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.
  5. Investing

    Measuring Company Efficiency To Maximize Profits

    Efficiency ratios can provide indications of profitability, shows how efficiently a company is being managed, utilizes its assets and handles liabilities.
  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

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  8. Investing

    API Reports 4.08 Million Barrel Inventory Draw, WTI Oil Price Dips On Gasoline Disappointment

    The latest American Petroleum Institute inventory data for the week ending September 29 recorded a headline draw of 4.08 million barrels after an unexpected draw of 0.76 million barrels the previous ...
  9. Investing

    When & Why Should a Company Use LIFO

    By using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
RELATED TERMS
  1. Beginning Inventory

    Beginning inventory is the book value of inventory at the start ...
  2. Average Inventory

    Average inventory is a calculation that estimates the value or ...
  3. Average Age Of Inventory

    The average age of inventory is the average number of days it ...
  4. Days Sales Of Inventory - DSI

    The days sales of inventory value (DSI) gives investors an idea ...
  5. Inventory

    Inventory is the term for merchandise or raw materials on hand.
  6. Obsolete Inventory

    Obsolete inventory is a term that refers to inventory that is ...
Trading Center