What Is an Inventory Reserve?
An inventory reserve is a contra asset account on a company's balance sheet made in anticipation of inventory that will not be able to be sold. Every year, a company has an inventory that will not be able to be sold for various reasons. It may spoil, fall out of fashion, or become technologically obsolete.
In anticipation of this, the company will create an entry on the balance sheet called inventory reserve. Inventory reserve accounts for the predicted amount of inventory that will not be able to be sold that year. Inventory is counted as an asset, and inventory reserve is counted as a contra asset, in that it reduces the net amount of inventory assets at the company.
Inventory reserve is an estimation of future inventory spoilage based on the company's past experiences. Once inventory that is unable to be sold is actually identified it is written down in official recognition of the loss.
Understanding Inventory Reserve
An inventory reserve is an important part of inventory accounting in GAAP. Tracking a company's inventory reserve allows that company to make a more accurate representation of its assets on the balance sheet. An asset is any good that has future value to the firm.
Since a portion of a company's inventory goes unsold each year, it makes sense that the company would not include the entire amount of its inventory as an asset on their balance sheet. The inventory reserve contra asset account subtracts value from the inventory asset entry on the balance sheet to create a more accurate representation of the portion of inventory that will actually be sold to create future value for the company. Without the inventory reserve entry, the value of the company's assets would be overstated.
A company estimates how much of its inventory will "go bad" based on its past experience, its assessment of current industry conditions, and its knowledge of customer tastes.
By accounting industry standards, inventory reserve is a conservative methodology. It attempts to predict inventory losses even before a loss has been confirmed to have happened. As such, inventories are made up of goods that have future economic value, which qualifies them as assets. The principles of conservative accounting prescribe reporting assets as close to their current value as possible. Doing this with inventories requires a method to make estimations.
- Companies create inventory reserve accounts for the inventory they predict will not be able to be sold that year.
- Inventory is counted as an asset, and inventory reserve is counted as a contra asset, in that it reduces the number of inventory assets.
At some point, a company will have to concede that they have inventory that can't be sold. Such would be the case with a pallet of rotten tomatoes in a grocer's warehouse, for example, or a stock of outdated computer components. When this happens, the company "writes off" those items, meaning it takes them off the books, and the company absorbs the costs.